Chapter 2
Basic Principles of
Stock Options
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© 2002 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
Options - modern day history
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1973 - the Chicago Board of Trade organized a
new exchange exclusively for options - the
Chicago Board Options Exchange (CBOE)
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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
Options - the basics
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Exchange traded options
OTC options or customized options
Options on various financial instruments interest rate or foreign exchange, stocks and
commodities
Options - the basics
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Call Options
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A call option gives its owner the right to buy; it is not a
promise to buy
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Put Options
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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
Options - the basics
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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 flexibility
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Options - the basics
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The option premium is the amount you pay
for the option
Exchange-traded options are fungible
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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.
Exchange Traded Options
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Options are traded in North America on:
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Chicago Board Options Exchange - CBOE
American Stock Exchange - AMEX
Philadelphia Stock Exchange
Pacific Stock Exchange
International Securities Exchange
Canada - Montreal Exchange
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
How Options Are Used
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Speculation
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Portfolio risk management - hedging
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options provide significant financial leverage to
speculators
altering the risk profile of the portfolio by
transferring risk
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 N.A.
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Chicago Board Options Exchange (CBOE)
American Stock Exchange (AMEX)
Philadelphia Stock Exchange (Philly)
Pacific Stock Exchange (PSE)
Montreal Exchange
OTC Options - Characteristics
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tailored or customized
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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
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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
Other Listed Options
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Long-Term Equity Anticipation Security
(LEAP)
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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 is
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)”
Option Premiums - Two
Components
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Intrinsic value
Time value
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 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
Intrinsic Value and Time Value
(cont’d)
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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)
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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
– Strike price
– Expiration
– Premium
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
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
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 80 call
for $7
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Maximum loss is $7
Profit potential is unlimited
Breakeven is $87
Buying a Call Option (cont’d)
Breakeven = $87
0
Maximum
loss = $7
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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 = $87
Maximum
Profit = $7
0
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20
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60
80
100
Buying a Put Option (“Going
Long”)
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Example: buy a Microsoft October 80 put
for $5.88
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Maximum loss is $5.88
Maximum profit is $74.12
Breakeven is $74.12
Buying a Put Option (cont’d)
$74.12
Breakeven = $74.12
0
$5.88
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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 = $74.12
$5.88
0
$74.12
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