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

2. 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. 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. 4 Call and Put Options 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

5. 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. 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. 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. 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. 9 Identifying An Option Microsoft OCT 80 Call Expiration (3 rd Friday in October)Type of option Underlying asset (Microsoft common stock) Strike price ($80 per share)

10. 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. 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. 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. 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. 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. 15 Why Options Are a Good Idea Increased risk Instantaneous information Portfolio risk management Risk transfer Financial leverage Income generation

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

17. 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. 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. 19 Some Exotic Options As-You-Like-It 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. 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. 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. 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. 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. 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. 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. 26 The Option Premium Intrinsic value and time value Option price quotations

27. 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. 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. 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. 30 Option Price Quotations Every service that reports option prices will show, at a minimum, the – Striking price – Expiration – Premium

31. 31 Option Price Quotations (cont’d) Intraday Prices from September 15, 2003 Microsoft Stock Price = $28.51 StrikeExpiration CallPut VolumeLastOpen InterestVolumeLastOpen Interest 20SEP 03 0 8.604620051 20OCT08.6230790013013 22.50SEP06.04781005920 22.50OCT06.06705020.0535024

32. 32 Profits and Losses With Options Understanding the exercise of an option Exercise procedures Profit and loss diagrams

33. 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. 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. 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. 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. 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. 38 Buying a Call Option (cont’d) Breakeven = $28.70 020406080 100 Maximum loss = $3.70

39. 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. 40 Writing a Call Option (cont’d) Breakeven = $28.70 Maximum Profit = $3.70 020406080 100

41. 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. 42 Buying a Put Option (cont’d) $23.90 Breakeven = $23.90 020406080 100 $1.10

43. 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. 44 Writing a Put Option (cont’d) Breakeven = $23.90 $1.10 020406080 100 $23.90