Options Cliff Trent September 17, 2010

Options An option is a contract or “Right” between a buyer and seller for a stock at a predetermined price by a certain date. Options are Securities. Options carry risk (sometime significant risk) and should not be used without the proper knowledge. The following is a brief overview on Options and should not be taken as advice to use options or as a replacement for formal training on options. Options in some opinions can be compared to gambling. You have no idea what your odds of success are and the chances for LARGE losses can be high.

Basic Definitions Buyer = Long or owner Seller = Short or writer Put = Gives buyer right to sell Call = Gives buyer the right to buy Strike price = Price written in the option Exercise = The execution of an option at the strike price Covered = You own the stock for which you are writing the option Uncovered = You don’t own the stock you are writing the option for; HIGH RISK! Premium = Cost of option paid by buyer.

Reasons to use Options They can be used as a hedge against a portion of your portfolio. They can also provide extra income.

The 4 kinds of Options Buying a Call = Bullish on the market Right to buy shares at a set price Also known as Long a Call Selling a Put = Bullish on the market Obligated to buy if the option is exercised. Also known as Short a Put

The 4 kinds of Options Selling a Call = Bearish on the market Obligated to sell if the option is exercised Also known as Short a Call Buying a Put = Bearish on the market Right to sell shares at a set price. Also known as Long a Put

Simple memory aid Selling a Put Bullish Expect price of stk to rise Buying a Call Buy a stock ---------------------------------------------------------------------------- Buy a Put Bearish Expect price of stk to fall Selling a Call Sell a stock

The 4 kinds of Options Buying a Call = Right to buy shares Leverage profit – maximize return Ex: Buy 1 GE 50 @ 5 Call Investor only had to put out $500 instead of $5000 and waits on price to rise. (Break even = $55/share) Delayed buying of shares – wait and see how a company performs Short protection – Locks in a purchase price and takes away unlimited risk. Selling a Put = Obligated to buy Premium Income – Make a profit without selling a security Purchase the stock at a set price

The 4 kinds of Options Selling a Call = Obligated to sell Greater Return – To gain premiums by the sale and hopefully unexercised writings of calls Choose a sale price – You get to chose the sale price for the stock. Could be above or below the current mkt value. Partial downside protection – Writing a “Covered” call by using the premium received to offset the loss on the stock. Buying a Put = Right to sell to the writer. Gain on market decline = Looking for stock to decline in price and sell either stock or option Protecting a Long Position = Locks in a sale position should prices decline.

Rules to remember Buy Calls Maximum Gain = Unlimited Maximum Loss = Premium paid Sell Calls Maximum Gain = Premium paid Maximum Loss = Unlimited* *note – if you own the stock then it is different between price paid per share and mkt value at time of exercise of option. Buy Puts Maximum Gain = Strike price - premium Sell Puts Maximum Loss = Strike price – premium -------------------------------------------------------------------------------------------- Calls Break Even on option = Premium + strike price Puts Break Even on option = Premium - strike price

How an option appears in the paper Call Put Option/Strike Exp. Vol Last Vol Last Merck 70 Apr 108 5.40 900 1.25 7420 75 Apr 218 2.00 733 3.20 7420 80 May 789 1.20 300 6.70 MerrLyn 13 Jul 235 4.50 500 2.19 1350 13 May 798 7.90 287 5.70 Call buyer would pay a premium of 5.40 per share for: Buy 1 Merck Apr 70 Call

Last date of when option can be exercised Example of an option Name of stock Strike price Type Type Sell 1 XYZ Dec 80 Call 12 Premium Number Of Shares Last date of when option can be exercised Note: Number of Shares and Cost of Option are always multiples of 100 ie. 1 = 100 and 12 = 1200

Expiration of Options Sell 1 XYZ Dec 80 Call 12 This option expires on the 3rd Friday of the month of December. Options are generally set up to expire on the 3rd Friday of the month listed.

How to read an option Sell 1 XYZ Dec 80 Call 5 Math: Maximum gain = premium received of $500 or 5 Maximum loss = unlimited due to the price per share can rise to infinity. Break Even = price per share of $80 + (premium of $500/100 shares = $5 per share) = $85 Maximum Gain: $500 Maximum Loss: Unlimited Share price Break Even point: 85 per share If you own 100 shares of XYZ. Maximum Gain: $500 Maximum Loss: Difference between option price and mkt value when option is exercised Share price Break Even point: 85 per share

How to read an option Buy 1 XYZ Dec 80 Call 5 Math: Maximum loss = premium received of $500 or 5 Maximum gain = unlimited due to the price per share can rise to infinity. Break Even = price per share of $80 + (premium of $500/100 shares = $5 per share) = $85 Maximum Gain: Unlimited Maximum Loss: $500 Share price Break Even point: 85 per share If you own 100 shares of XYZ. Maximum Gain: $500 Maximum Loss: Difference between option price and mkt value when option is exercised Share price Break Even point: 85 per share

Taxes Options contracts are only good for a year or less. So all returns on Options are considered to be short term gains. You should consult with your Tax Professional before buying or selling options to discuss your tax ramifications.