1. © 2002 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 What options are Basic option characteristics Where options come from Opening and closing transactions The role of the options clearing corporation

4. 4 What Options Are 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 Basic Option Characteristics 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 The striking price of an option is its predetermined transaction price

6. 6 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

7. 7 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

8. 8 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

9. 9 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

10. 10 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

11. 11 Why Options Are a Good Idea Increased risk Instantaneous information Portfolio risk management Risk transfer Financial leverage Income generation

12. 12 Where and How Options Trade Exchanges: http://www.cboe.comhttp://www.cboe.com http://www.amex.com/http://www.amex.com/; http://www.phlx.com/http://www.phlx.com/ www.pacificex.comwww.pacificex.com; www.iseoptions.com Over-the-counter options Standardized option characteristics Exotic Options – specific corporate or investment need and risk reduction.

13. 13 Where and How Options Trade Other listed options LEAPS-Long-term Equity AnticiPation Securities have expirations of up to three years FLEX allow investors to customize key contract terms: including expiration date, exercise style, exercise price, and expanded position limits. Trading mechanics – Bid/Ask – Market/limit order; position limit.

14. 14 Exchanges Major options exchanges in the U.S.: – Chicago Board Options Exchange (CBOE) – American Stock Exchange (AMEX) http://www.amex.com/ – Philadelphia Stock Exchange (Philly) http://www.phlx.com/ – Pacific Stock Exchange (PSE) http://www.pacificex.com/ Foreign options exchanges also exist

15. 15 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

16. 16 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

17. 17 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

18. 18 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

19. 19 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

20. 20 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

21. 21 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)”

22. 22 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

23. 23 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

24. 24 Components of the Option Premium Intrinsic value and time value Option price quotations

25. 25 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

26. 26 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

27. 27 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

28. 28 Option Price Quotations Every service that reports option prices will show, at a minimum, the – Striking price – Expiration – Premium www.wsj.com

29. 29 Option Price Quotations (cont’d) Closing prices from July 10, 2000 Microsoft stock closing price = 79 7/16 StrikeExpiration CallPut VolumeLastOpen InterestVolumeLastOpen Interest 60Aug12188010 1/41116 60Oct2121 1/277321115 5/8245504 65Aug616 1/4204... 52392 65Oct1117 1/81387211091 3/1683896

30. 30 Where Profits and Losses With Options Understanding the exercise of an option Exercise procedures Profit and loss diagrams A note on margin requirements

31. 31 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

32. 32 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

33. 33 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

34. 34 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

35. 35 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

36. 36 Buying a Call Option (cont’d) Breakeven = $87 020406080 100 Maximum loss = $7

37. 37 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

38. 38 Writing a Call Option (cont’d) Breakeven = $87 Maximum Profit = $7 020406080 100

39. 39 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

40. 40 Buying a Put Option (cont’d) $74 1/8 Breakeven = $74 1/8 020406080 100 $5 7/8

41. 41 Writing a Put Option (“Short Option”) The put option writer has the obligation to buy if the put is exercised by the holder

42. 42 Writing a Put Option (cont’d) Breakeven = $74 1/8 $5 7/8 020406080 100 $74 1/8