Options Explained

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© Copyright FMRAnalysts, 2007. All rights reserved.

Options – Explained

An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price. This can occur on, or before, a predetermined date. To have this right, the taker (buyer) pays a premium to the writer (seller) of the contract.

Index

How options can benefit you ......................................................................................................................... 2 Terminology.................................................................................................................................................. 4 Call Options .................................................................................................................................................. 5 Put Options ................................................................................................................................................... 6 Advantages of Option Trading....................................................................................................................... 7 Pricing Options ............................................................................................................................................. 8 Key factors which affect the time value of an option are:............................................................................. 10 Who are the Takers and Writers?................................................................................................................. 11 Index Options.............................................................................................................................................. 13 Payoff Diagrams ......................................................................................................................................... 14 Resources.................................................................................................................................................... 16 Disclaimer................................................................................................................................................... 17

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How options can benefit you

There are a number of reasons an investor/trader may get involved in options:

• Leverage • Earning Extra Income • Protecting the value of your shares • Capitalizing on share price movements without having to purchase shares • Time to decide what to do • Index options let you trade all the stocks of an index • Multiple strategies to limit risk

Leverage First and foremost, a trader will choose to trade options over shares because of leverage.

In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns.

Options generally cost a fraction of a share price, but increase (and decrease) and a higher percentage to the stock price movement. There are many other factors involved with leverage in options, which are explained throughout this document.

Earning Extra Income Writing options against shares you already own or plan to purchase can be one of the simplest and most rewarding strategies.

• Writing options against shares you already own • Writing options at the same time as buying shares • Writing options to sell your shares above the current market price

Protecting the value of your shares This strategy can be useful if you are a shareholder in a particular company and are concerned about a short term fall in the value of the shares. Without using options you can either watch the value of your shares fall, or you could sell them. Using options could give you some protection from this decline. Writing call options to give you downside protection Take (purchase) put options

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Capitalizing on share price movements without having to purchase shares You can profit from a movement, either up or down, in the underlying shares without having to trade the underlying shares themselves. Take (buy) calls when expecting the market to rise Take (buy) puts when expecting the market to fall

Using options gives you time to decide Taking a call option can give you time to decide if you want to buy the shares. You pay the premium, which is only a faction of the price of the underlying shares. The option then locks in a buying price for the shares if you decide to exercise. You then have until the Expiry Date of the option to decide if you want to buy the underlying shares. Put options can work in a similar fashion. By taking a put option you can lock in a selling price for shares you already own and then wait until the Expiry Date to see if it is worthwhile exercising the option and selling your shares. Otherwise, you can let the option lapse and continue to hold your shares. In both cases, the most you can lose is the premium you have paid to purchase the option in the first place.

Index options let you trade all the stocks in an index with just 1 trade By using call and put options over an index, you can trade a view on the general direction of the market, or hedge a portfolio with just 1 trade. If you are bullish on the market but don’t know what stock to buy or which sector of the market will rise, you can buy a call option over the whole index. This means you don’t have to choose a particular stock to invest in, you can just take a view on the direction of the broad stockmarket. If the level of the index rises the value of the call options will rise, just as for call options over individual shares.

Other strategies Options can allow you to construct strategies that allow you to take advantage of many market situations. These can be quite complex and involve varying levels of risk. What this allows the trader/investor to do is benefit from market conditions where there is a lack of direction, or when markets are falling.

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Terminology

• Options: Are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security.

• Taker (buyer): The person who purchases the option from the Writer (Seller)

• Writer (seller): The person who sells the option to the Taker (Buyer)

• Type of Option: There are 2 types of options. 1) Call options, and 2) Put options

• Underlying Asset: An option is a “derivative”. That is, it derives from another product. In majority of cases, this will be a stock, but it can also be an index

• Exercise/Strike Price: This is the price at which the option taker may buy or sell the underlying if the option is exercised. The strike price is defined as either At/Near The Money (ATM or NTM), Out of The Money (OTM) or In The Money (ITM).

• Exercise Types: There are 2 types of exercise styles. 1) American style options can be exercised at any time up to and including the expiry date, or 2) European style options can only be exercised at expiry.

• Expiry Date: This is the date when all unexercised option contracts for that series are cancelled.

• Premium: This is the price of the option. Stock options are quoted in dollars and cents. Index options are quoted in terms of index points.

• Contract Size: US option contracts are 100 shares per contract. Australian option contracts are 1000 shares per contract. For both countries, index options apply an index multiplier per index point.

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Call Options

Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined exercise date.

Call option structure

When defining an option, you must be specific with the details. An error can cause you to place the wrong order. A Call option is structured in the following manner

Stock Code – Expiry Date – Strike price – Call – Option value

Example: XYZ December 20.00 Call option @ $2.00

A call option increases in value when a share price rises. The buyer (taker) of a call option will make a profit if the underlying share price rises, but will lose value in their option if the share price falls.

Call option values rise and fall congruent to the stock price, but not at the same rate. That is, a $1 rise in the share price will find the call option rising in value too, but the call option will not necessarily rise $1 in value. There are numerous factors that affect the proportion of change the option will have, which are explained further in the Pricing Option section.

Because the share price has risen, the value of the call option rises. Let’s work through an example:

Original Price Price rises to $ gain % gain XYZ stock $20.00 $25.00 $5.00 25%

XYZ Dec 20.00 Call

$2.00 $4.00 $2.00 100%

We can see from the above table that a rise in the stock price also produces a rise in the call option price. Leverage has produced a 100% gain on the option for a 25% increase in the stock price.

Remember, leverage also affects losses in the option price. If the share price were to fall, it will not take a very large percentage fall in stock value to find the call option trading at zero (or worthless).

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Put Options

Put options give the taker the right, but not the obligation, to sell the underlying shares at a predetermined price, on or before a predetermined exercise date.

Put option structure

When defining an option, you must be specific with the details. An error can cause you to place the wrong order. A Put option is structured in the following manner

Stock Code – Expiry Date – Strike price – Call – Option value

Example: XYZ December 20.00 Put option @ $2.00

A Put option increases in value when a share price falls. The buyer (taker) of a put option will make a profit if the underlying share price falls, but will lose value in their option if the share price rises.

Put option values rise and fall congruent to the stock price, but not at the same rate. That is, a $1 fall in the share price will find the put option rising in value, but the put option will not necessarily rise $1 in value. There are numerous factors that affect the proportion of change the option will have, which are explained further in the Pricing Option section.

Because the share price has fallen, the value of the put option rises. Let’s work through an example:

Original Price Price rises to $ gain/loss % gain/loss XYZ stock $20.00 $15.00 $5.00 (loss) 25% loss

XYZ Dec 20.00 Put $2.00 $4.00 $2.00 100% gain

We can see from the above table that a fall in the stock price has produced a rise in the put option price. Leverage has produced a 100% gain on the option for a 25% loss in the stock price.

Remember, leverage also affects losses in the option price. If the share price were to rise, it will not take a very large percentage gain in stock value to find the put option trading at zero (or worthless).

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Advantages of Option Trading

Risk Management Put options allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out “insurance” against a fall in the share price.

Time to Decide By taking a call option, the purchase price for the shares is locked in. This gives the call option holder until the Expiry Date to decide whether or not to exercise the option and buy the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares.

Speculation The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way, the holder can sell the option prior to expiry to take a profit or limit a loss.

Leverage Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risk than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share

Diversification An investor can build a diversified portfolio for the same, or even lower, initial outlay. Rather than purchasing shares directly.

Income Generation Shareholders can earn extra income over and above dividends by writing call options against their shares. By writing an option they receive the option premium upfront. While they get to keep the option premium, there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price.

Strategies Between stocks and options, investors have a large number of different strategies to suit different market conditions. Investors can create a wide range of potential profit and risk management scenarios.

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Pricing Options

When considering an option, it is important to understand how the premium is calculated. Option premiums change according to a range of factors, including the price of the underlying security and the time left until expiry. An option premium can be separated into 2 parts: 1) Intrinsic Value, and 2) Time Value. Different factors influence intrinsic value and time value.

Intrinsic Value Intrinsic value is the difference between the exercise price of the option and the market price of the underlying shares at any given time.

Intrinsic value can never be less than zero. For call options, they have intrinsic value if the share price of the underlying is above the strike price of the option. For put options, they have intrinsic value if the share price of the underlying is below the strike price of the option.

Example Call Option:

Stock Price 20.00 Call Option Price

Intrinsic Value

$21.20 $2.60 $1.20

The difference between the stock price ($21.20) and the call option strike price ($20.00) is $1.20. Therefore, the difference between stock price and the strike price = $1.20 intrinsic value.

Example Put Option:

Stock Price 20.00 Put Option Price

Intrinsic Value

$18.70 $2.60 $1.30

The difference between the stock price ($18.70) and the put option strike price ($20.00) is $1.30. Therefore, the difference between stock price and option strike price = $1.30 intrinsic value.

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Time Value Time value represents the amount an investor is prepared to pay for the possibility that the market might move in their favor during the life of the option. It represents an extra payment to the writer of the option to offset the risk that the underlying share will move, and result in a loss to the writer. Time value will vary with ITM, ATM and OTM options and is greatest for the ATM options.

Example Call Option:

Stock Price 20.00 Call Option Price

Intrinsic Value Time Value

$21.20 $2.60 $1.20 $1.40

Time value is the difference between the option premium ($2.60) and intrinsic value ($1.20). For the above example, this means the time value = $1.40.

Example Put Option:

Stock Price 20.00 Put Option Price

Intrinsic Value Time Value

$18.70 $2.60 $1.30 $1.30

Time value is the difference between the option premium ($2.60) and intrinsic value ($1.30). For the above example, this means the time value is also = $1.30.

Time Decay

As time draws closer to expiry and the opportunities for the option to become profitable decline, the time value declines. This erosion of option value is called Time Decay. Time value does not decay at a constant rate, but becomes more rapid towards expiry.

Time Value

Time Expiry Date

Generally, options (both calls and puts) will lose about 1/3 of their time value during the first half of its life, and 2/3 during the second

half

The final 3 weeks before expiration is when time decay really affects an options value

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Key factors which affect the time value of an option are:

Time to Expiry The longer the time to expiry, the greater the time value of the option

Market volatility In general, the more volatile the market, the higher the premium will be. This is due to the fact that the writer is exposed to a greater probability of incurring a loss. Writers are compensated for this added risk by receiving higher premium income

Interest Rates A rise in interest rates will push call option premiums up and put option premiums down

Dividend Payments The payment of dividends tends to lower call option premiums and raise put option premiums because shares fall in price once they are no longer eligible for a dividend. Holders of option contracts who do not own the underlying securities are not eligible for dividends payable on those shares.

Market Expectations Ultimately supply and demand determine the market value of all options. During times of strong demand, premiums will be higher.

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Who are the Takers and Writers?

Option Taker • An option taker is an investor or trader anticipating a significant move in a particular share price

• Taking an option offers the opportunity to earn a leveraged profit with a known and limited risk.

• Taking a call option gives an investor the right to buy the shares covered by the option at the exercise price at any time until expiry. In general, call option premiums rise as the underlying share prices rises. For this reason, the taker of a call option expects the underlying share price will rise.

• Taking a put option gives the right, but not the obligation, to sell the underlying shares. Put option premiums usually rise as the underlying share price falls. For this reason, the taker of a put option expects the underlying share price to fall.

• In taking this right to buy or sell, the taker pays the Writer a premium. This premium represents the maximum possible loss on the option for the taker.

• It is important to remember that it is not necessary for the taker of a put option to own the underlying shares at the time of taking the put option. Certainly, if the taker chooses to exercise the put option, they will be required to deliver the underlying shares, at the exercise price, to a randomly selected writer of put options in that series. However, the taker also has the choice of closing out the position prior to expiry.

• If the taker chooses to close out the option, a loss will be incurred if the premium that the investor receives on writing a contract to close out is lower than the premium paid by the investor for the original taken contract. A profit will occur if the reverse is true. Any time value in the premium for the option will be lost if the option is exercised.

• On average, less than 15% of all taken options are exercised. The remaining 85% or so either expire unexercised or are closed out. This figure represents the average over recent times and varies depending on current volatility and other factors.

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Option Writer • The writing of an option offers investors the opportunity to earn premium income. However, if their

market view proves incorrect, they will lose money.

• The put option writer’s market view would be for prices to remain steady or to rise, whereas the call option writer expects the underlying share to remain steady or to fall.

• The writer of a put option has a loss potential if the underlying share price falls. The writer may be forced to buy the shares from the taker at a price which is well above the current market price. This loss is unknown but limited as the shares can only fall to zero.

• The writer of a call option who does not own the underlying shares has an unlimited loss potential as the stock price could keep rising and the writer would be forced to buy the shares at the current market price in order to deliver them at the exercise price.

When deciding whether to trade options, there are a number of factors to be aware of:

• You will need to understand the costs of trading options • You need to know how to track the value of your option position • If you have written an option and have not lodged collateral, you will required to pay margins and you

may be eligible to receive refunds of margin

The decision to exercise the option rests entirely with the option taker. In most instances, an option writer may be exercised against at any time prior to expiry. However, this is most likely to occur when the toption is ITM and close to expiry, or when the underlying share is about to pay a dividend. Call option takers may exercise in order to receive the dividend.

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Index Options

Index options give investors exposure to a share market index. They offer investors similar benefits and flexibility to that of options traded over individual stocks, with the added advantage of offering exposure to a broad range of securities comprising an index, rather than being limited to one particular company.

Investors can use index options to trade a view on the market as a whole, or on the sector of the market that is covered by the particular index.

There are some important differences between index options and options over individual securities: Index options are usually cash settled, rather than deliverable. This is because it is not practical to deliver all the securities which make up the index. An investor will receive a cash payment on exercising an ITM index option Index options are usually European in exercise style The strike price and premium of an index option are usually expressed in points. A multiplier is then applied to give a dollar figure.

Index options offer the following advantages:

Exposure to the broader market Investing in index options approximates trading a share portfolio that tracks a particular index. It provides exposure to the broader market which the index represents, with no specific company risk. Often index options are over benchmark indices traded by professional investor. Investors are less dependent on having to “pick individual winners”.

Greater leverage Like options over a single company, index options provide leveraged profit opportunities. When the market rises (or falls), percentage gains (or losses) are far greater for the option than rises (or falls) in the underlying index.

Protection for a share portfolio By purchasing index put options, an investor can lock in the value of a share portfolio, without having to sell all the stocks in the index. An investor may fear a market downturn, but have food reasons for not wanting to sell stocks. By purchasing index put options, the investor can make profits if the index falls when the bearish market view proves correct. Profits on put options compensate the investor for the loss of value in the stocks in the portfolio. This outcome effectively insures the portfolio at the level of the put options less the cost of the put.

Reduce the cost of share trading As is the case with options over individual securities, no stamp duty is payable on index options. More importantly, the amount of capital outlaid in a share transaction is usually much higher than that associated with an option trade providing similar market exposure, meaning that transaction costs are generally lower in option trades. An investor can therefore gain exposure to broader share market moves with low transaction costs.

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Payoff Diagrams

A payoff or breakeven diagram shows the potential profit or loss on the strategy at different stock prices at expiry. These diagrams help show when a particular option position will make a profit and when it will make a loss upon exercise at expiry. Payoff diagrams can be drawn for any option or combination of options in the one class.

Example Long Call

Total Profit/Loss

3

2

1

0

1

2

3

4

47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00 56.00 57.00

Stock Price at Expiry

Profit/Loss

The thick dark blue line depicts the payoff diagram for this example. When the thick dark blue line is below the horizontal 0 line, the call option trader will be in a loss. We can see above that the thick dark blue line crosses 0 at $53.33 – this is our breakeven point

The breakeven point for the call option taker is the Exercise price of the option plus the premium paid. In this example; it is $51.00 + $2.33 = $53.33

The diagram shows that while the stock is below $53.33, the call option taker has an unrealized loss. The most the call option taker can lose is the premium paid ($2.33). As the share price rises above $53.33, the call option taker begins to profit. The maximum profit is unlimited as the higher the share price goes, the larger the taker’s profit.

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Example Long Put

Total Profit/Loss

3

2

1

0

1

2

3

4

5

45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00

Stock Price at Expiry

Profit/Loss

The thick dark blue line depicts the payoff diagram for this example. When the thick dark blue line is below the horizontal 0 line, the put option trader will be in a loss. We can see above that the thick dark blue line crosses 0 at $49.25 – this is our breakeven point

The breakeven point for the put option taker is the Exercise price of the option minus the premium paid. In this example; it is $51.00 $1.75 = $49.25

The most the put option taker can lose is the premium paid. The further the share price falls below the breakeven point of $49.25, the larger the investors potential profit. The breakeven point for put option takers is the exercise price less the premium paid. The maximum profit is unlimited although the share can only fall to zero.

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Resources

The information contained in this article portrays all the basic information you require to understand options. However, your understanding may not yet be completely clear.

Most of the information you will need to completely understand options is available for free on the internet. FMR Analysts has researched the best resources for you to complete your learning of options.

Chicago Board Options Exchange – Learning Centre Go straight to the exchange to learn about options. At the CBOE online Options Institute, you can:

• View selfguided online tutorials • Conduct selfpaced interactive online courses • Watch live interactive educational webcasts, or • Book to attend a live seminar.

http://www.cboe.com/LearnCenter/default.aspx

Books There are many books written on options, and how to understand them. The following are selections FMR Analysts recommends for the beginner:

Options for Equity Investors Author: Wendy Newton

The Secrets of Writing of Options Author: Louise Bedford

Options: A complete guide for Australian investors and traders Author: Guy Bower

FMR Bookstore: http://fmranalysts.blogspot.com/2006/09/bookstore.html

http://www.cboe.com/LearnCenter/default.aspx

http://fmranalysts.blogspot.com/2006/09/bookstore.html

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Disclaimer

Trading involves risk of loss and may not be suitable for you. Past performance is no guarantee or reliable indication of future results. This advertisement is of the nature of general information only and must not in any way be construed or relied upon as legal, financial or professional advice. No consideration has been given or will be given to the individual investment objectives, financial situation or needs of any particular person. The decision to invest or trade and the method selected is a personal decision and involves an inherent level of risk, and you must undertake your own investigations and obtain your own advice regarding the suitability of this product for your circumstances. Please ensure you obtain and read the current offer documentation prior to acquiring the products advertised herein, so you are fully informed regarding the key risks and costs associated with these products.

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Options Explained