Chapter 2
Basic Principles of
Stock Options
1
© 2004 South-Western Publishing
Outline
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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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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
Call and Put Options
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Call Options
–
A call option gives its owner the right to buy; it is not a
promise to buy
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Put Options
–
A put option gives its owner the right to sell; it is not a
promise to sell
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For example, a store holding an item for you for a fee is a
call option
For example, a lifetime money back guarantee policy on
items sold by a company is an embedded put option
Categories of Options
5
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An American option gives its owner the
right to exercise the option anytime prior to
option expiration
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A European option may only be exercised
at expiration
Categories of Options (cont’d)
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Options giving the right to buy or sell
shares of stock (stock options) are the
best-known options
–
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The underlying asset of an index option is
some market measure like the S&P 500
index
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An option contract is for 100 shares of stock
Cash-settled
Standardized Option
Characteristics
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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
Standardized Option
Characteristics (cont’d)
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The option premium is the amount you pay
for the option
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Exchange-traded options are fungible
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For a given company, all options of the same
type with the same expiration and striking price
are identical
Identifying An Option
Expiration (3rd Friday in October)
Type of option
Microsoft OCT 80 Call
Underlying asset
(Microsoft common stock)
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Strike price
($80 per share)
Where Options Come From
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Unlike more familiar securities, there is no
set number of put or call options
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10
The number in existence changes every day
Opening and Closing
Transactions
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The first trade someone makes in a
particular option is an opening transaction
for that person
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When the individual subsequently closes
that position out with a second trade, this
latter trade is a closing transaction
Opening and Closing
Transactions (cont’d)
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When someone buys an option as an
opening transaction, the owner of an option
will ultimately do one of three things with it:
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Sell it to someone else
Let it expire
Exercise it
For example, buying a ticket to an athletic
event
Opening and Closing
Transactions (cont’d)
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When someone sells an option as an
opening transaction, this is called writing
the option
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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
The Role of the Options
Clearing Corporation (OCC)
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The Options Clearing Corporation (OCC)
contributes substantially to the smooth
operation of the options market
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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
Why Options Are a Good Idea
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Increased risk
Instantaneous information
Portfolio risk management
Risk transfer
Financial leverage
Income generation
Where and How Options Trade
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Exchanges
Over-the-counter options
Standardized option characteristics
Other listed options
Trading mechanics
Exchanges
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Major options exchanges in the U.S.:
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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
Over-the-Counter Options
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With an over-the-counter option:
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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
Some Exotic Options
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As-You-Like-It Option
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Barrier Option
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Created or cancelled if a prespecified price level
is touched
Forward Start Option
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The owner can decide whether it is a put or a
call by a certain date
Paid for now, with the option becoming effective
at a future date
Other Listed Options
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Long-Term Equity Anticipation Security
(LEAP)
–
Options similar to ordinary listed options,
except they are longer term
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May have a life up to 39 months
All LEAPs expire in January
Presently available on only the most active
underlying securities
Other Listed Options (cont’d)
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FLEX option
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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
Trading Mechanics
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Bid Price and Ask Price
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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
Trading Mechanics (cont’d)
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Types of orders
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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
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Typically require a time limit, such as “for the day” or
“good ‘til canceled (GTC)”
Trading Mechanics (cont’d)
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Trading Floor Systems
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Under the specialist system, there is a single
individual through whom all orders to buy or
sell a particular security must pass
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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
Trading Mechanics (cont’d)
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Trading Floor Systems (cont’d)
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Under the marketmaker system, the specialist’s
activities are divided among three groups of
people:
 Marketmakers
 Floor brokers
 Order Book Official
The Option Premium
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Intrinsic value and time value
Option price quotations
Intrinsic Value and Time Value
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Intrinsic value is the amount that an option
is immediately worth given the relation
between the option striking price and the
current stock price
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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
Intrinsic Value and Time Value
(cont’d)
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Intrinsic value (cont’d)
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An option with no intrinsic value is out-of-themoney
An option whose striking price is exactly equal
to the price of the underlying security is at-themoney
Options that are “almost” at-the-money are
near-the-money
Intrinsic Value and Time Value
(cont’d)
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Time value is equal to the premium minus
the intrinsic value
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As an option moves closer to expiration, its time
value decreases (time value decay)
 An option is a wasting asset
Option Price Quotations
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Every service that reports option prices
will show, at a minimum, the
– Striking price
– Expiration
– Premium
Option Price Quotations
(cont’d)
Intraday Prices from September 15, 2003
Microsoft Stock Price = $28.51
Call
31
Strike
Expiration
20
SEP 03
20
OCT
22.50
22.50
Volume
Last
Put
Open Interest
Volume
Last
Open Interest
8.60
462
0
0
51
0
8.62
3079
0
0
13013
SEP
0
6.04
781
0
0
5920
OCT
0
6.06
7050
2
0.05
35024
0
Profits and Losses With
Options
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Understanding the exercise of an option
Exercise procedures
Profit and loss diagrams
A note on margin requirements
Understanding the Exercise of
an Option
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An American option can be exercised
anytime prior to the expiration of the option
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Exercising an American option early amounts
to abandoning any time value remaining in the
option
A European option can only be exercised
at maturity
Exercise Procedures
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Notify your broker
Broker notifies the Options Clearing
Corporation
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Selects a contra party to receive the exercise
notice
Neither the option exerciser nor the option writer
knows the identity of the opposite party
Exercise Procedures (cont’d)
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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
Profit and Loss Diagrams
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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
Buying a Call Option (“Going
Long”)
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Example: buy a Microsoft October 25 call
for $3.70
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Maximum loss is $3.70
Profit potential is unlimited
Breakeven is $28.70
Buying a Call Option (cont’d)
Breakeven = $28.70
0
Maximum
loss = $3.70
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20
40
60
80
100
Writing a Call Option (“Short
Option”)
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Ignoring commissions, the options market
is a zero sum game
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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
Writing a Call Option (cont’d)
Breakeven = $28.70
Maximum
Profit = $3.70
0
40
20
40
60
80
100
Buying a Put Option (“Going
Long”)
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Example: buy a Microsoft April 25 put for
$1.10
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Maximum loss is $1.10
Maximum profit is $23.90
Breakeven is $23.90
Buying a Put Option (cont’d)
$23.90
Breakeven = $23.90
0
$1.10
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20
40
60
80
100
Writing a Put Option (“Short
Option”)
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The put option writer has the obligation to
buy if the put is exercised by the holder
Writing a Put Option (cont’d)
Breakeven = $23.90
$1.10
0
$23.90
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20
40
60
80
100
A Note on Margin Requirements
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A margin requirement is analogous to
posting collateral and can be satisfied by a
deposit of cash or other securities into your
brokerage account
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The margin system is to reduce the
likelihood that option writers will be unable
to fulfill their obligations