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Chapter 2
Basic Principles of
Stock Options
© 2002 South-Western Publishing

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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

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Options - modern day history
 1973 - the Chicago Board of Trade organized a new exchange exclusively for options - the
Chicago Board Options Exchange (CBOE)
–
– calls - 1973 puts - 1977
 Many commodity exchanges now trade options
 The OTC market began to develop through the
80’s - high level of institutional activity
 Active market today for both exchange traded and OTC options

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Options - the basics
 Exchange traded options
 OTC options or customized options
 Options on various financial instruments interest rate or foreign exchange, stocks and commodities

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Options - the basics


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

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Options - the basics
 American style option - gives the holder the right to exercise the option anytime prior to the expiration date
 European style option - may only be exercised at expiration
.......the american style obviously provides the holder with more flexiblity

Options - the basics
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 The option premium is the amount you pay for the option
 Exchange-traded options are fungible
– For a given company or underlying asset, all options of the same type with the same expiration and striking price are identical
 The striking price/strike price/exercise price of an option is its predetermined transaction price - if the option is exercised it is done at the strike price.

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Exchange Traded Options
 Options are traded in North America on:
– Chicago Board Options Exchange - CBOE
–
–
American Stock Exchange - AMEX
Philadelphia Stock Exchange
– Pacific Stock Exchange
– International Securities Exchange
– Canada - Montreal Exchange

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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

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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

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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

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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

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How Options Are Used
 Speculation
– options provide significant financial leverage to speculators
 Portfolio risk management - hedging
– altering the risk profile of the portfolio by transfering risk
 Income generation

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

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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)
 Foreign options exchanges also exist

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OTC Options - Characteristics
 tailored or customized
–
Institutions enter into “private” option arrangements with brokerage firms or other dealers
– The strike price, life of the option, and premium are negotiated between the parties involved
 private market - transactions are not known to the public - no price transparency no ‘price signals’ are sent

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OTC Options - Characteristics
 The OTC market is unregulated government approval not needed, leads to the development of creative options that meet the needs of two parties
 Over-the-counter options are subject to counterparty risk and are generally not fungible

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

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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

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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

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Trading Mechanics
 Bid Price and Ask 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 is willing to sell a particular option

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Trading Mechanics (cont’d)
 Types of orders
– 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

Typically require a time limit, such as “for the day” or
“good ‘til canceled (GTC)”

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Option Premiums - Two
Components
 Intrinsic value
 Time value

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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

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Intrinsic Value and Time Value
(cont’d)
 Intrinsic value (cont’d)
– An option with no intrinsic value is out-of-themoney
–
–
An option whose strike 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
– In the money options have intrinsic value

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Intrinsic Value and Time Value
(cont’d)
 Time value is equal to the premium minus the intrinsic value (note: other texts will indicate it is the option price less the intrinsic value)
– As an option moves closer to expiration, its time value decreases (time value decay)
 An option is a wasting asset

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Option Price Quotations
 Every service that reports option prices will show, at a minimum, the
– Strike price
– Expiration
– Premium

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

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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

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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

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
As a writer;
– call option - be prepared to sell 100 shares
– put option - be prepared to buy 100 shares
Options are generally closed out as opposed to being exercised( cost of shares/ brokerage costs)
Simply selling the option will capture its value

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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

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Buying a Call Option (“Going
Long”)
 Example: buy a Microsoft October 80 call for $7
– Maximum loss is $7
– Profit potential is unlimited
– Breakeven is $87

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Buying a Call Option (cont’d)
Breakeven = $87
Maximum loss = $7
0 20 40 60 80 100

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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

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Writing a Call Option (cont’d)
Breakeven = $87
Maximum
Profit = $7
0 20 40 60 80 100

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Buying a Put Option (“Going
Long”)
 Example: buy a Microsoft October 80 put for $5 7/8
– Maximum loss is $5 7/8
– Maximum profit is $74 1/8
– Breakeven is $74 1/8

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Buying a Put Option (cont’d)
$74 1/8
Breakeven = $74 1/8
$5 7/8
0 20 40 60 80 100

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Writing a Put Option (“Short
Option”)
 The put option writer has the obligation to buy if the put is exercised by the holder

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Writing a Put Option (cont’d)
Breakeven = $74 1/8
$5 7/8
0 20 40 60 80 100
$74 1/8