© 2002 South-Western Publishing 1

Chapter 2

Basic Principles of Stock Options

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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

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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

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

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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

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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

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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

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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

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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

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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

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Why Options Are a Good Idea

Increased risk Instantaneous information Portfolio risk management Risk transfer Financial leverage Income generation

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Where and How Options Trade

Exchanges Over-the-counter options Standardized option characteristics Other listed options Trading mechanics

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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)

Foreign options exchanges also exist

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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

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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

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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

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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

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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

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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

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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)”

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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

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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

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Components of the Option Premium

Intrinsic value and time value Option price quotations

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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

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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

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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

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Option Price Quotations

Every service that reports option prices will show, at a minimum, the– Striking price– Expiration– Premium

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Option Price Quotations (cont’d)

Closing prices from July 10, 2000

Microsoft stock closing price = 79 7/16

 

Strike Expiration

Call Put

Volume Last Open Interest Volume Last Open Interest

60 Aug 1 21 880 10  1/4 1116

60 Oct 21 21 1/2 7732 1115  5/8 245504

65 Aug 6 16 1/4 204 ... ... 52392

65 Oct 11 17 1/8 13872 1109 1 3/16 83896

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Where Profits and Losses With Options

Understanding the exercise of an option Exercise procedures Profit and loss diagrams A note on margin requirements

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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

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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

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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

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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

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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

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Buying a Call Option (cont’d)

Breakeven = $87

0 20 40 60 80 100

Maximum

loss = $7

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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

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Writing a Call Option (cont’d)

Breakeven = $87

Maximum

Profit = $70 20 40 60 80

100

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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

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Buying a Put Option (cont’d)

$74 1/8Breakeven

= $74 1/8

0 20 40 60 80 100

$5 7/8

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Writing a Put Option (“Short Option”)

The put option writer has the obligation to buy if the put is exercised by the holder

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Writing a Put Option (cont’d)

Breakeven = $74 1/8

$5 7/8

0 20 40 60 80 100

$74 1/8