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Before giving you the answer, let me be very clear…
With options, you should take the time to know what you’re doing and better understand the product. Beginners shouldn’t be slinging around thousands of dollars in the Options Market without a deeper understanding of the product. Why?
You’ll lose your money. Maybe not in the next trade or the next 10 trades. But over the long-run, ignorance in the options market leads to losses. I might even argue it’s a mathematical certainty.
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The Options Challenge - Answer
There are several answers that could be right depending on a few assumptions you might have made. The point of the exercise was to make you think, and to force you to judge whether time or distance from the stock was more important. The best thing to do with this type of example is to start with what you are sure of and build from there.
We can be sure of this order:
Since they all have the same $95 strike Puts, the option with the most time, the December $95 Puts, has the highest value.
The logic goes for these three options as well:
Leaving us these two:
We can then place the AUG $100C after the AUG $95P. If we assume that the AUG $100C approximately equals the AUG $100P (Not given to us), then the AUG $100P would be greater than AUG $95P.
If AUG $100C = AUG $100P and > AUG $95P
Then AUG $100C > AUG $95P
We can make this assumption because stocks conceptually have a 50% probability of going higher and a 50% probability of going lower, making the ATM Put and ATM Call approximately equal. This isn’t always the case and we’ll discuss in further studies, but right now that is a safe assumption. Using the same logic, we can also place the DEC $100 Calls after the DEC $95 Puts.
We’ll also need to make an assumption between the AUG $100C, the SEP $95P, and the DEC $95P. You must weigh one month (and 4 month) extra time vs. 5% difference in strike. The answer is “it depends.”
Usually, the AUG $100 C will be more valuable than the SEP $95P, but less than the DEC $95P (More in Step 2 of Understand Options in 8 Steps). Forgetting about where you placed the post-it, your attempt to try to answer this part of the question should cement the fact that there is a give and take between Strike Price and Time.
Leaving us these three:
Next, we can look at the SEP $105C, which are $5 higher than the Stock Price. We also have the SEP $95P, which are $5 lower than the Stock Price. With the assumption we made above (regarding the probability of the Stock Price going up or down to be approximately equal), then an extension of that assumption would likely make these two options approximately equal.
In reality, they generally are not. The question this brings up is “Why?” Think about what might make one, or the other, more expensive and we’ll discuss the possible answers in Step 2. For now, you get credit for placing the SEP $105C and SEP $95P next to each other.
Leaving us these two:
Frankly, the answer for these last two post-its will be “it depends.”
When we focus on the FEB $100C there are two issues:
- It has less Time than the other options, specifically the nearest option – the JUN $95P.
- It has a closer Strike Price ($100) than the JUN option ($95)
When we focus on the DEC $75P there are two issues:
- It has a lower Strike than the DEC $95P; but,
- It has more time than most of the other options.
For both options, we must again try to weigh how much time means to the value of the option vs. the differences in strikes.
Under most assumptions, these two options belong at the beginning of the sequence. My answer would be as follows: