Share Example: Let us use an example such as BP. Assume it is November, and you are interested in betting on the March option. The current mid-cash-price of the share on the stock market is 638.5p.
The March PUT option strike price of 550p is quoted as 7p (bid), at 9.5p.(offered).
The March CALL option strike price of 700p is quoted as 11.5p (bid), at 14p (offered).
This means that if you think that the price of BP ordinary shares will collapse between now and the option expiry date in March, and you want to 'open' a financial spread bet by 'buying' a put at a strike price of 550p, you would execute the following transaction.
Buy to open BP March PUT option at strike price of 550p @ 9.5p at, say, £100 per 1p (or whatever is the appropriate unit quoted).
If the BP Ordinary share price fell at any time between now and the option expiry date next March to, say, 600p, the price of the option would change to, say, 11.5p at 14.5p.
If you decided to take a profit at that time, you would 'close' the bet by 'selling to close' at the prevailing bid price of 11.5p.
Sell to close BP March PUT option at strike price of 550p @ 11.5p at £100 per 1p.
In this example you would have shown the following result.
Bought BP March PUT option to open at strike price of 550p 9.5.
Sold BP March PUT option to close at strike price of 550p 11.5.
2.0p x £100 per 1p = £200.
You can see that if the underlying share price falls, the bid and offer prices of a PUT option at a strike price that is lower than the cash price will rise.
Thus, as you would expect, if the underlying share price falls, the bid and offer prices of a CALL option at a higher strike price will fall.
Using the same example, assuming that you had thought that the underlying share price of BP was going to rise, you might have bought a March CALL option at a strike price of 700p. which was quoted as 11.5p (bid), 14p (offered).
You would have executed the following transaction.
Buy to open BP March CALL option at strike price of 700p @ 14p at £100 per 1p.
However, the BP share price fell to 600p. You decide to close the bet and cut your loss before it falls any further. To do this, you have to 'sell the CALL to close'. The costs of a 700p CALL option have now fallen to 9.5p (bid) at 12p (offered).
Sell to close BP March CALL option at strike price of 700p @ 9.5p at £100 per 1p.
The result would have been as follows.
Bought BP March CALL option at strike price of 700p 14.
Sold BP CALL option at strike price of 700p 9.5.
4.5p x £100 per 1p = £450.
There is another choice open to you. If the underlying share price continues to move in your favour, you can hold the bet open until the option terminates, and provided that the cash price in the market of the underlying share is below the PUT option strike price (assuming you bought a PUT option to open), or above your CALL strike price (assuming you bought a CALL option to open), then you may make a profit. However you have to take your costs of opening the bet (option costs) into consideration to calculate your profit or loss.
In the examples shown above, the following calculations would apply to arrive at the cash share price required before you break even.
At a strike price of 550p, with a PUT option cost of 9.5p already paid, the cash price would have to fall to 540.5p. Any further fall would put you into profit by the amount of the difference.
At a strike price of 700p, with a CALL option cost of 14p already paid, the cash price would have to rise to 714p. Any further rise would put you into profit by the amount of the difference.
Stop loss limits can be imposed when the financial spread bet is opened, and it is recommended that they should always by used to control your exposure to potential high risk.
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