Understanding Options: A Powerful Tool for Speculation and Portfolio Hedging

1. What is it? • An option is a contract that is bought and sold. • It gives the buyer and holder a right (but not a requirement) to force the seller of the contract to complete a certain transaction. • The transaction is generally for a certain amount of goods (such as shares of an underlying stock) at a specified price at a certain point in time when the contract is set to expire. • For some contracts, anytime in the specified period of time before the contract expires • Options are a form of derivative instrument. • Their value is a derivative of the price of the underlying stock (or other property) that they are associated with.

2. What is it? • A call option is a contract that gives the holder the right to purchase a specified number of shares of common stock at a fixed price for a stated period of time • The purchaser expects the price of the stock to go up. • A put option is a contract that gives the holder the right to sell a specified number of shares of common stock at a set price for a given period of time • The purchaser expects the price of the stock to decline. • Puts and calls are property and may be bought or sold independently of the underlying stock. • Investors may buy or sell either (or both) of these contracts depending upon their own investment strategies.

3. When is the use of this tool indicated? • When investors wish to speculate on a movement in the stock market without actually buying or selling stocks themselves • This potential movement includes either up, down, to stay within a certain range, or to move outside a certain range. • When an investor wishes to create a leveraged situation in his investment portfolio. • The leverage comes about due to the fixed price at which either a put or a call contract is exercised. • This price (also known as the exercise price or strike price) does not change during the life of the contract regardless of the movements in the price of the underlying stock.

4. Example • Assume a stock is currently selling for $60 per share. A call option is available on that same stock and has an exercise price of $55 per share. • The option alone will sell for at least the $5 per share difference between the stock price and the exercise price (and possibly for more). • If the price of the underlying stock were to double to $120 per share, the investor who merely purchased the stock would have a gain of 100% (($120-$60)/$60=100%). • If the stock did increase to $120 per share, the value of the option would increase to at least $65 per share ($120-$55=$65). • The original purchase price of the option was only $5. This is an increase of 1300% ($65/$5=1300%), a return that is 1200% higher than that earned with the purchase of the stock.

5. When is the use of this tool indicated? • When an investor has limited funds but still wishes to speculate with some of his investments. • Puts and calls are generally traded at small fractions of the price of their underlying stocks. • When an investor wishes to generate additional income from a stock portfolio without initially selling any of the positions. • By selling call options on shares in his portfolio to speculators, the writer of these options can receive a fee or “premium” for taking part in the contract. • If the stock price does rise such that the call option is exercised, the call writer will be required to provide stock to the option buyer at the specified strike price. • When an investor desires to “hedge” a stock or his entire portfolio against unexpected or unfavorable changes in the price of the stock.

6. Advantages • The fixed exercise price of option contracts creates a leverage factor that may be advantageous to the investor. • Option trading requires a relatively small investment on the part of the investor. • Income earned from the sale of either put or call contracts is paid to the investor immediately no matter what the term of the contract may be. • An investor can substantially hedge the risk of most or all of her potential portfolio losses without actually selling the underlying stock positions until desired.

7. Disadvantages • Leverage operates in both directions. • A decline (rise) in the price of a stock will typically result in a much larger percentage loss for the buyer of a call (put) option. • Both puts and calls have a relatively short life span. • Typically not more than 9 months • Sometimes referred to as “wasting assets” • They will be of no value after the expiration date unless the stock price does in fact move (or not move) as desired. • Long-Term Equity Anticipation Securities (LEAPS) are new, alternative options with long terms, extending as far as 2 years and 9 months • Call options have neither voting rights nor are they entitled to receive any dividends declared and paid during the term of the option. • This lack of income can be an important (and/or costly) disadvantage.

8. Tax Implications • Options generally are classified as capital assets for tax purposes. • They are subject to some special rules because of their unique nature. • Investors who buy call options will have a capital gain or loss if the option is sold in a “closing” transaction. • Gain or loss is calculated by subtracting the sale price of the option from the purchase price (including any brokerage fees). • Because exchange-traded call options are issued for a term of only 9 months, any capital gain or loss will be short-term. • No gain or loss is realized upon the exercise of a call option. • Capital gain or loss is realized only when the stock acquired is sold. • The cost of the call is added to the purchase price of the stock in computing the gain or loss for tax purposes. • The holding period is measured from the day after the call option is exercised.

9. Tax Implications • Investors who write calls or purchase puts and then close out their positions by repurchasing them will recognize any capital gain upon the closing. • Dispositions involving options are subject to the wash sale rule • Loss on the sale of a call option within 30 days before or after the date or purchase of substantially identical stocks or securities may not be recognized • The loss will generally increase the basis of the replacement securities • If the option expires unexercised, the investor realizes a short-term capital gain. • An investor who writes a call option that is exercised will realize a capital gain or loss upon exercise. • The capital gain or loss is actually realized on the underlying stock that is sold/delivered to the call option buyer • The premium for writing the call is added to the selling price of the stock in calculating the amount of capital gain/loss.

10. Tax Implications • Exercising a put option constitutes a sale of the stock and is a taxable event. • The cost of the put is subtracted from the selling price of the stock in computing capital gain or loss for tax purposes. • The date of exercise of the put option is treated as the sale date of the stock. • Investors who write puts and repurchase their put obligations will realize a short-term capital gain or loss on the closing. • If the option expires unexercised, the investor will realize a short-term capital gain. • Exchange-traded call options are issued for a term of only nine months.

11. Tax Implications • When a put option is exercised, the writer is required to purchase the stock put to him. • This is not treated as a taxable event for the writer of the put. • The put writer deducts the premium received for writing the put from the purchase price of the stock. • The holding period for the stock is measured from the date of exercise of the put. • The tax consequences of many options structures become more complicated when multiple options are held at once, and/or including positions in the underlying stock.

12. Alternatives • Stock purchase warrants • Have many of the same features as call options • The original term of a warrant is generally much longer than a put or call option, frequently lasting for several years. • They are offered by corporations and are frequently issued in connection with the sale of other securities such as bonds or preferred stock. • Stock rights • Enable existing shareholders to purchase new stock being issued by a corporation. • Generally, one right is issued for each share of stock an investor owns. • The rights entitle the stockholder to purchase additional shares at a stated price. • They have an extremely short life span.

13. Where and How do I get it? • Put and call options trade on several organized exchanges. • Chicago Board Options Exchange (CBOE) • The first exchange organized specifically for the trading of options • Options Clearing Corporation (OCC) • Operates as a market-maker at various exchanges to help maintain liquidity and fair pricing for all traded options. • The various exchanges include the American Stock Exchange and the NYSE. • The formal organization of options contracts has brought tremendous popularity to the options markets by increasing evaluation and liquidity. • All exchange-traded options contracts are standardized. • Option trades must be made through a “margin account” that allows a customer to buy securities with money borrowed from a broker.

14. Where and How do I get it? • Once a trade has been made, the position of the buyer or seller remains “open” until one of three events occurs: • The option may expire without being exercised. • Expiration of an option series will “close out” all positions open at that time. • This result is frequently desired by sellers of call options who hope to keep the premium they received and to keep their shares of stock as well. • The option may be exercised and the underlying shares of stock will have to be transferred. • The buyer or seller of the option may close out his original position. • This is done by entering an order opposite to the first order

15. What fees or other costs are involved? • Commissions on the purchase or sale of option contracts are similar to those paid on other security transactions. • Brokerage firms typically charge a percentage of the value of the transaction with a minimum commission of $25 or $30.

16. How do I select the best of its type? • Make an estimate of whether the stock market as a whole, or any one stock, is likely to advance or decline • If the market is moving upward, investors are more likely to want to buy calls or sell put options. • If the market or a stock is weak, then a strategy of buying puts or selling calls may be in order. • The volatility of the underlying stock has a lot to do with the movement of both put and call options. • The more active a particular issue, the more likely the option will have a wide swing in price.

17. How do I select the best of its type? • The period of time to expiration of the option should be considered before any purchase or sale is made. • The longer the term of the option, the more likely the price of the stock to change significantly, and the greater the volatility of the option. • The dividends paid on the underlying stock have a significant impact on the value of an option. • Option holders do not receive any dividends, which are paid only to holders of actual stock. • Options on high dividend-paying stocks will tend to be less valuable than those on issues with low dividends, or none at all.

18. Where can I find out more about it? • Option exchange publications • Characteristics and Risks of Standardized Options published by the Options Clearing Corporation • www.cboe.com • Large brokerage firms with options specialists frequently publish their own reports and recommendations • Investment advisory services (often collect data but do not make recommendations) • Standard & Poor’s • Value Line • Chicago Board Options Exchange • www.cboe.com