© 2002 South-Western Publishing 1 Chapter 2 Basic Principles of Stock Options

2 Outline What options are and where they come from Why options are a good idea Where and how options trade Components of the option premium Where profits and losses come from with options

3 Options - modern day history the Chicago Board of Trade organized a new exchange exclusively for options - the Chicago Board Options Exchange (CBOE) – calls – puts Many commodity exchanges now trade options The OTC market began to develop through the 80’s - high level of institutional activity Active market today for both exchange traded and OTC options

4 Options - the basics Exchange traded options OTC options or customized options Options on various financial instruments - interest rate or foreign exchange, stocks and commodities

5 Options - the basics Call Options – A call option gives its owner the right to buy; it is not a promise to buy For example, a store holding an item for you for a fee is a call option Put Options – A put option gives its owner the right to sell; it is not a promise to sell For example, a lifetime money back guarantee policy on items sold by a company is an embedded put option

6 Options - the basics American style option - gives the holder the right to exercise the option anytime prior to the expiration date European style option - may only be exercised at expiration the American style obviously provides the holder with more flexibility

7 Options - the basics The option premium is the amount you pay for the option Exchange-traded options are fungible – For a given company or underlying asset, all options of the same type with the same expiration and striking price are identical The striking price/strike price/exercise price of an option is its predetermined transaction price - if the option is exercised it is done at the strike price.

8 Exchange Traded Options Options are traded in North America on: – Chicago Board Options Exchange - CBOE – American Stock Exchange - AMEX – Philadelphia Stock Exchange – Pacific Stock Exchange – International Securities Exchange – Canada - Montreal Exchange

9 Opening and Closing Transactions The first trade someone makes in a particular option is an opening transaction for that person When the individual subsequently closes that position out with a second trade, this latter trade is a closing transaction

10 Opening and Closing Transactions (cont’d) When someone buys an option as an opening transaction, the owner of an option will ultimately do one of three things with it: – Sell it to someone else – Let it expire – Exercise it For example, buying a ticket to an athletic event

11 Opening and Closing Transactions (cont’d) When someone sells an option as an opening transaction, this is called writing the option – No matter what the owner of an option does, the writer of the option keeps the option premium that he or she received when it was sold

12 The Role of the Options Clearing Corporation (OCC) The Options Clearing Corporation (OCC) contributes substantially to the smooth operation of the options market – It positions itself between every buyer and seller and acts as a guarantor of all option trades – It sets minimum capital requirements and provides for the efficient transfer of funds among members as gains or losses occur

13 How Options Are Used Speculation – options provide significant financial leverage to speculators Portfolio risk management - hedging – altering the risk profile of the portfolio by transferring risk Income generation

14 Where and How Options Trade Exchanges Over-the-counter options Standardized option characteristics Other listed options Trading mechanics

15 Exchanges Major options exchanges in the N.A. – Chicago Board Options Exchange (CBOE) – American Stock Exchange (AMEX) – Philadelphia Stock Exchange (Philly) – Pacific Stock Exchange (PSE) – Montreal Exchange

16 OTC Options - Characteristics tailored or customized – Institutions enter into “private” option arrangements with brokerage firms or other dealers – The strike price, life of the option, and premium are negotiated between the parties involved private market - transactions are not known to the public - no price transparency - no ‘price signals’ are sent

17 OTC Options - Characteristics The OTC market is unregulated - government approval not needed, leads to the development of creative options that meet the needs of two parties Over-the-counter options are subject to counterparty risk and are generally not fungible

18 Standardized Option Characteristics Expiration dates – The Saturday following the third Friday of certain designated months for most options Striking price – The predetermined transaction price, in multiples of $2.50 or $5, depending on current stock price Underlying Security – The security the option gives you the right to buy or sell – Both puts and calls are based on 100 shares of the underlying security

19 Other Listed Options Long-Term Equity Anticipation Security (LEAP) – Options similar to ordinary listed options, except they are longer term May have a life up to 39 months – All LEAPs expire in January – Presently available on only the most active underlying securities

20 Other Listed Options (cont’d) FLEX option – Fundamentally different from an ordinary listed option in that the terms of the option are flexible – Advantage of user flexibility while eliminating counterparty risk – In general, a FLEX option trade must be for at least 250 contracts

21 Trading Mechanics Bid Price and Ask Price – There are two option prices at any given time: Bid price: the highest price anyone is willing to pay for a particular option Ask price: the lowest price at which anyone is willing to sell a particular option

22 Trading Mechanics (cont’d) Types of orders – A market order expresses a wish to buy or sell immediately, at the current price – A limit order specifies a particular price (or better) beyond which no trade is desired Typically require a time limit, such as “for the day” or “good ‘til canceled (GTC)”

23 Option Premiums - Two Components Intrinsic value Time value

24 Intrinsic Value and Time Value Intrinsic value is the amount that an option is immediately worth given the relation between the option striking price and the current stock price – For a call option, intrinsic value = stock price – striking price – For a put option, intrinsic value = striking price – stock price – Intrinsic value cannot be < zero

25 Intrinsic Value and Time Value (cont’d) Intrinsic value (cont’d) – An option with no intrinsic value is out-of-the- money – An option whose strike price is exactly equal to the price of the underlying security is at-the- money – Options that are “almost” at-the-money are near-the-money – In the money options have intrinsic value

26 Intrinsic Value and Time Value (cont’d) Time value is equal to the premium minus the intrinsic value (note: other texts will indicate it is the option price less the intrinsic value) – As an option moves closer to expiration, its time value decreases (time value decay) An option is a wasting asset

27 Option Price Quotations Every service that reports option prices will show, at a minimum, the – Strike price – Expiration – Premium

28 Profits and Losses With Options Understanding the exercise of an option Exercise procedures Profit and loss diagrams A note on margin requirements

29 Understanding the Exercise of an Option An American option can be exercised anytime prior to the expiration of the option – Exercising an American option early amounts to abandoning any time value remaining in the option A European option can only be exercised at maturity

30 Exercise Procedures Notify your broker Broker notifies the Options Clearing Corporation – Selects a contra party to receive the exercise notice – Neither the option exerciser nor the option writer knows the identity of the opposite party

31 Exercise Procedures (cont’d) The option premium is not a down payment on the purchase of the stock The option holder, not the option writer, decides when and if to exercise As a writer; – call option - be prepared to sell 100 shares – put option - be prepared to buy 100 shares Options are generally closed out as opposed to being exercised( cost of shares/ brokerage costs) Simply selling the option will capture its value

32 Profit and Loss Diagrams Vertical axis reflects profits or losses on the expiration day resulting from a particular strategy Horizontal axis reflects the stock price on the expiration day Any bend in the diagram occurs at the striking price By convention, diagrams ignore the effect of commissions that must be paid

33 Buying a Call Option (“Going Long”) Example: buy a Microsoft October 80 call for $7 – Maximum loss is $7 – Profit potential is unlimited – Breakeven is $87

34 Buying a Call Option (cont’d) Breakeven = $ Maximum loss = $7

35 Writing a Call Option (“Short Option”) Ignoring commissions, the options market is a zero sum game – Aggregate gains and losses will always net to zero – The most an option writer can make is the option premium Writing a call without owning the underlying shares is called writing a naked (uncovered) call

36 Writing a Call Option (cont’d) Breakeven = $87 Maximum Profit = $

37 Buying a Put Option (“Going Long”) Example: buy a Microsoft October 80 put for $5 7/8 – Maximum loss is $5 7/8 – Maximum profit is $74 1/8 – Breakeven is $74 1/8

38 Buying a Put Option (cont’d) $74 1/8 Breakeven = $74 1/ $5 7/8

39 Writing a Put Option (“Short Option”) The put option writer has the obligation to buy if the put is exercised by the holder

40 Writing a Put Option (cont’d) Breakeven = $74 1/8 $5 7/ $74 1/8