Options
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Basics
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What is an Option?
 An option is a contract that gives Party A to buy or
sell something to Party B at a predetermined price.
 Stock Options are contracts that allow Party A to buy
or sell 100 shares of a certain stock at a specified
price per share, or strike price.
 Call Option is the right to Buy the stock
 Put Option is the right to Sell the stock
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Ancient History
 350 B.C. Thales bought options on olive presses
 Romans bought/sold options on cargoes
 European Options Exchange opened in Amsterdam
in April of 1978
 Prior to 1963 all options were sold over the counter
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Modern History
 In late 1960 Joseph W. Sullivan, Vice President of
Planning for the CBOT proposed:


standardizing the strike price, expiration, size, and other
relevant contract terms
create a mediator to issue contracts and guarantee settlement
and performance (Options Clearing Corporation )
 April 26, 1973 CBOE began trading on standardized, listed
options.
 the first day of trading:


only call option
911 contracts traded on 16 underlying stocks.
 By the end of 1974, average daily volume exceeded 200,000
contracts
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Features of Stock Options
 Strike Price (X): the price at which a the underlying
stock can be bought or sold
 Stock Price (S): the price of a share of the underlying
stock
 Expiration Date: day option expires; generally the
third Friday of the month; options in or at the money
will be automatically exercised
 Value of Call/Put (C/P): the cost to buy or price to
sell an option
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Terminology
 Long: Buy
 Short: Sell
 In the Money (ITM): an option with intrinsic value
and extrinsic value
 At the Money (ATM): an option at the strike price
 Out of the Money (OTM): an option with only
extrinsic value
Terminology
 Exercise: going through with an option
 If you bought a Put option and want to sell your shares at that
strike price, you can exercise your option and someone will
have to buy your shares for that price.
 Assigned: having to make good on an option contract
 If you sold a contract and someone on the other end wants to
exercise her right you are obligated to sell that person your
shares at the strike price.
Intrinsic and Extrinsic Value
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Definitions
 Intrinsic Value: the value of the difference between
the strike price and stock price that you would
receive if you exercised the option today ( zero if at or
out of the money)
 Extrinsic Value: the difference between the value of
the option and the intrinsic value
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Examples
Example 1: A call option is selling for $4. It has a strike
price of $50 and the stock is trading at $53.
$53-$50 = $3 of Intrinsic Value
$4-$3= $1 of Extrinsic Value
Example 2: A call option is selling for $2. It has a
strike price of $50 and the stock is trading at $49.
$50 > $49 = $0 of Intrinsic Value
$2-$0= $2 of Extrinsic Value
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Why does Extrinsic Value Exist?
 Time is money.
 Extrinsic value is a measure of how likely the stock
price is to meet or exceed the strike price before the
expiration date.
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Extrinsic Value Decay Chart
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Option Strategies
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Long Call or Long Put
 Level of Risk: cost of the option
 Long Call: buy a call option
 Long Put: buy a put option
Naked Call or Naked Put
 Level of Risk: theoretically infinite
 Naked Call: selling a call
 Naked Put: selling a put
 Naked Calls are more risky than Naked Puts because
whereas a stock price can theoretically increase to
infinity, a stock price can only sink down to $0
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Covered Call
 Covered Call: sell a call option on the shares you own
 For example, if you owned 100 shares of AAPL you could sell a
call option against those shares, so if the option was assigned
you would have to sell those shares and not have to buy shares
at market price
 Strategy: good way to make extra money on your
holdings that are mostly flat or going through
gradual appreciation, would have to be okay with
selling the stock at the set target price
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Covered Call Profits
 Bought the Stock at $30, Strike Price of $35, Sold Call for $3
Stock Decreases
Ending Price
$29
Call Option
$3
$30-$30
$0
Profit
$3
Stock Stays the Same
Ending Price
$30
Call Option
$3
$30-$30
$0
Profit
$3
Stock Increases
Ending Price
$35
Call Option
$3
$35-$30
$5
Profit
$8
 In short, selling a covered call will make you: price of the
option * 100 * number of contracts sold- commission
 If the option is assigned, you will make: price of the option *
100 * number of contracts sold – commission & assignment
fees + difference between purchasing price of stock and strike
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Covered Put
 Sell a put option, but hold enough money to buy all
the stock in reserve

For example, if you sold a put option on AAPL with a strike
price of $450, if the option was assigned, you would have the
$450*100, or $45,000 set aside to buy all 100 shares
 Strategy: could use to buy a stock you think is
overvalued at the price you would like to while
making cash premiums while you wait for it to hit
your price, works well for fundamentally strong
stocks when you have a large amount of cash sitting
in your portfolio
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Spreads
 Buy and Sell a Call or a Put option
 Can differ in strike price (vertical), expiration date
(horizontal), or both (diagonal)
 Profits and losses are capped
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Straddles
 Buy or Sell a Call and a Put
 Can differ in strike prices
 Long Straddles-losses capped, profit infinite
 Short Straddles – profits capped, losses infinite
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Other Strategies
 All other strategies are some combination of
Spreads, Straddles, and the underlying stock
 The Options Guide has a pretty extensive list of other
strategies:
http://www.theoptionsguide.com/neutral-tradingstrategies.aspx
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Other Areas of Interest
 Black-Scholes Option Pricing:
http://www.quickmba.com/finance/black-scholes/
http://www.hoadley.net/options/options.htm
 Option Greeks:
http://www.optionsplaybook.com/optionsintroduction/option-greeks/
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