1. Basic Principles of Stock Options
Chapter 2
Basic Principles of Stock Options
© 2004 South-Western Publishing

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. What Options Are and Where They Come From
Call and put options
Categories of options
Standardized option characteristics
Where options come from
Opening and closing transactions
The role of the options clearing corporation

4. Call and Put Options Call Options Put 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

5. Categories of Options
An American option gives its owner the right to exercise the option anytime prior to option expiration
A European option may only be exercised at expiration

6. Categories of Options (cont’d)
Options giving the right to buy or sell shares of stock (stock options) are the best-known options
An option contract is for 100 shares of stock
The underlying asset of an index option is some market measure like the S&P 500 index
Cash-settled

7. 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

8. Standardized Option Characteristics (cont’d)
The option premium is the amount you pay for the option
Exchange-traded options are fungible
For a given company, all options of the same type with the same expiration and striking price are identical

9. (Microsoft common stock)
Identifying An Option
Expiration (3rd Friday in October)
Type of option
Microsoft OCT 80 Call
Underlying asset
(Microsoft common stock)
Strike price
($80 per share)

10. Where Options Come From
Unlike more familiar securities, there is no set number of put or call options
The number in existence changes every day

11. 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

12. 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

13. 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

14. 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

15. Why Options Are a Good Idea
Increased risk
Instantaneous information
Portfolio risk management
Risk transfer
Financial leverage
Income generation

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

17. Exchanges Major options exchanges in the U.S.:
Chicago Board Options Exchange (CBOE)
American Stock Exchange (AMEX)
Philadelphia Stock Exchange (Philly)
Pacific Stock Exchange (PSE)
International Securities Exchange (ISE)
Foreign options exchanges also exist

18. Over-the-Counter Options
With an over-the-counter option:
Institutions enter into “private” option arrangements with brokerage firms or other dealers
The striking price, life of the option, and premium are negotiated between the parties involved
Over-the-counter options are subject to counterparty risk and are generally not fungible

19. Some Exotic Options As-You-Like-It Option Barrier Option
The owner can decide whether it is a put or a call by a certain date
Barrier Option
Created or cancelled if a prespecified price level is touched
Forward Start Option
Paid for now, with the option becoming effective at a future date

20. 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

21. 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

22. 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 if willing to sell a particular option

23. 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)”

24. Trading Mechanics (cont’d)
Trading Floor Systems
Under the specialist system, there is a single individual through whom all orders to buy or sell a particular security must pass
Used at the AMEX and the Philly
The specialist keeps an order book with limit order from all over the country
The specialist’s job is to maintain a fair and orderly market

25. Trading Mechanics (cont’d)
Trading Floor Systems (cont’d)
Under the marketmaker system, the specialist’s activities are divided among three groups of people:
Marketmakers
Floor brokers
Order Book Official

26. The Option Premium Intrinsic value and time value
Option price quotations

27. 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

28. 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 striking 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

29. Intrinsic Value and Time Value (cont’d)
Time value is equal to the premium minus the intrinsic value
As an option moves closer to expiration, its time value decreases (time value decay)
An option is a wasting asset

30. Option Price Quotations
Every service that reports option prices will show, at a minimum, the
Striking price
Expiration
Premium

31. Option Price Quotations (cont’d)
Intraday Prices from September 15, 2003
Microsoft Stock Price = $28.51
Strike
Expiration
Call
Put
Volume
Last
Open Interest 20
SEP 03
8.60
462 51
OCT
8.62
3079
13013
22.50
SEP
6.04
781
5920
6.06
7050 2
0.05
35024

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

33. 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

34. 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

35. 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
In general, you should not buy an option with the intent of exercising it

36. 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

37. Buying a Call Option (“Going Long”)
Example: buy a Microsoft October 25 call for $3.70
Maximum loss is $3.70
Profit potential is unlimited
Breakeven is $28.70

38. Buying a Call Option (cont’d)
Breakeven = $28.70
Maximum
loss = $3.70

39. 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

40. Writing a Call Option (cont’d)
Breakeven = $28.70
Maximum
Profit = $3.70

41. Buying a Put Option (“Going Long”)
Example: buy a Microsoft April 25 put for $1.10
Maximum loss is $1.10
Maximum profit is $23.90
Breakeven is $23.90

42. Buying a Put Option (cont’d)
$23.90
Breakeven = $23.90
$1.10

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

44. Writing a Put Option (cont’d)
Breakeven = $23.90
$1.10
$23.90

45. A Note on Margin Requirements
A margin requirement is analogous to posting collateral and can be satisfied by a deposit of cash or other securities into your brokerage account
The margin system is to reduce the likelihood that option writers will be unable to fulfill their obligations