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Chapter 2

Chapter 2. Basic Principles of Stock Options. 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. What Options Are and Where They Come From.

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Chapter 2

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  1. Chapter 2 Basic Principles of Stock Options

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

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

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

  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. 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. 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. 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. 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. Trading Mechanics • Bid PriceandAsk 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. Trading Mechanics (cont’d) • Types of orders • Amarket 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. 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. 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. The Option Premium • Intrinsic value and time value • Option price quotations

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

  31. Strike Expiration Call Put Volume Last Open Interest Volume Last Open Interest 20 SEP 03 0 8.60 462 0 0 51 20 OCT 0 8.62 3079 0 0 13013 22.50 SEP 0 6.04 781 0 0 5920 22.50 OCT 0 6.06 7050 2 0.05 35024 Option Price Quotations (cont’d) Intraday Prices from September 15, 2003 Microsoft Stock Price = $28.51

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

  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. 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. 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. 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. 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. Buying a Call Option (cont’d) Breakeven = $28.70 0 5 10 15 25 30 Maximum loss = $3.70

  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. Writing a Call Option (cont’d) Breakeven = $28.70 Maximum Profit = $3.70 0 5 10 15 25 30

  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. Buying a Put Option (cont’d) $23.90 Breakeven = $23.90 0 10 15 20 25 30 $1.10

  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. Writing a Put Option (cont’d) Breakeven = $23.90 $1.10 0 10 15 20 25 30 $23.90

  45. A Note on Margin Requirements • A margin requirement is analogous to posting collateral and can be satisfied by a deposit of cash or other securities into your brokerage account • The margin system is to reduce the likelihood that option writers will be unable to fulfill their obligations

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