Chapter 10: Option Fundamentals

The current market value of a stock is below the strike price of a call option. This situation is referred to as:

Call options are in-the-money when the current market value of the underlying stock is above the option's strike price. However, if the stock's market price is below the strike price of a call, the option is out-of-the-money. Out-of-the-money and at-the-money options have no intrinsic value.

The price for ABC common stock is currently $75. Which of the following options is in-the-money?

Call options are in-the-money when the market price of the underlying stock is up above the call's strike price (i.e., call up). In this question, with a stock's price is $75, the call with a strike price of $70 is in-the-money by $5. If an investor exercises the $70 call, he will buy the stock at $70 and then is able to sell the shares at $75, thereby making $5 on the exercise of the option and sale of stock. Puts are in-the-money when the underlying stock's market price is down below the strike price (i.e., put down).

All of the following are offered by an issuing corporation, EXCEPT:

Call options are not issued by a corporation; instead, many options are issued by the Options Clearing Corporation (OCC) and entered into by two investors (i.e., the buyer and seller). When securities are created this way, they're referred to as derivatives. Rights, warrants, stocks, and bonds are all initially created by a corporation.

2 Types of Options

Call, Buy - gives buyer the right to buy the stock at strike price - buyer hopes the stock goes up in value - buyer has the right to buy the stock at the strike price Call, Sell - obligation to sell the stock at the strike price - seller wants to see the stock go down in value Put, Buy - right to sell the stock price - hoping the stock goes down Put, Sell - obligation to buy the stock at the strike price - they want stock to increase

Options Disclosure Document

Either at or before the time that an option account is opened for a customer, a member firm is required to provide the customer with the options disclosure document (ODD)—also referred to as the Characteristics and Risks of Standardized Options. This brochure offers investors with a description of the options market and discusses the relevant terminology, tax implications, transaction costs, margin requirements, and trading risks. The disclosure document is created by the OCC.

Exercise (cont.)

For equity options, since exercise involves the purchase and sale of the underlying stock, settlement of an exercised option occurs in two business days (T + 2). A picture of the steps involved in the exercise of an option is shown below:

Speculation versus Hedging

Investors purchase and sell options to either speculate on the potential movement of an underlying instrument or hedge an existing position. Speculation refers to generating a profit based on an anticipated price change in the value of a security on which the investor has no existing position. Buying a call in anticipation of an increase in the price/value of an underlying instrument and buying a put in anticipation of a decrease in the price/value of an underlying instrument are examples of speculation. Conversely, writers of either calls or puts are simply speculating that their options will expire worthless. Hedging refers to purchasing options to protect against the risk of adverse movement in the value of the underlying instrument. For example, an investor who owns stock can buy a put option to hedge the risk of the stock declining in value. The put purchase locks in sales price (the strike price) if the underlying stock falls in value. Hedging will be covered in greater detail

Options

Let's start with answering the question, what's an option? An option is a derivative security and, in the simplest terms, is a contract whose value is derived from the movement of an underlying stock, index, currency, or other asset. These derivatives trade in markets that are very similar to those in which stocks and bonds trade. The foundation for understanding options is to examine the terms that are essential to any option discussion.

Liquidate, Trade, or Close-out

Liquidating (trading) an option position is essentially an alternative to exercising the option. To liquidate an option, an investor (either the buyer or seller) executes an opposite transaction on the same option contract. Since there's an active and liquid secondary market for listed option contracts, an investor who is long an XYZ May 30 call may close out the position by selling it. On the other hand, an investor who is short an XYZ May 30 call may close out that position by buying it. 1. The buyer of an option creates the position with an opening purchase and could subsequently liquidate the position through a closing sale. 2. The seller of an option creates the position with an opening sale and could subsequently liquidate the position through a closing purchase. The difference between what an investor pays and what he receives is the profit or loss. For example, an investor bought (made an opening purchase) an XYZ May 30 call at 3. Later, XYZ stock has increased to $40 and

Summary of Profit and Loss Potential for Various Positions

Long Call - unlimited profit; limited loss Long put - limited profit; limited loss Short call (uncovered) - limited profit, unlimited loss Short put (uncovered) - limited profit; limited loss Covered Call - limited profit; limited loss

Hedging with Options

Many people view options as risky, speculative investments; however, options can actually provide a significant hedge (protection) for an investor with an existing stock position. For example, when a person wants to insure or protect his life, home, or car, he purchases an insurance policy. Similarly, if a person has either a long or short stock position and wants to hedge or protect against potential risk, he may purchase an option. The following chart summarizes the two basic hedging strategies: - long stock, expect the value to rise - short stock, expect value to decline

When do options trades settle?

Options trades typically settle within one business day (T + 1). However, if equity options are exercised, the settlement of the stock transactions occurs on the second business day (T + 2).

Which of the following option positions obligates the investor to sell shares if exercised against?

A short call position obligates the investor to sell shares if exercised against. Remember, buyers of options have the right to exercise, while sellers of options assume obligations if exercised against.

Components of an Option

An equity option is a contract to buy or sell a specific number of shares of a particular stock at a fixed price over a certain period. An option contract is described by the name of the underlying security, the expiration month of the contract, the exercise (strike) price, and the type of option. For example, let's assume that an investor purchased one call option on XYZ stock, with a May expiration, an exercise price of $30, and a premium of 3. The contract will appear as follows:

Index Options

As mentioned in the introduction of this chapter, options are also available on indexes (e.g., the S&P 500). Although there are many similarities in the analysis of equity options and index options, one significant difference involves exercise settlement. Cash Settlement With equity options, the exercise settlement involves the receipt or delivery of the underlying stock; however, with index options, the exercise settlement involves the receipt or delivery of cash. The seller of an index option must deliver to the buyer cash which represents the amount by which the option is in-the-money (i.e., the difference between the contract's strike price and the index value).

Equity Options - Terminology

Buyers and Sellers An option is a contract that's entered into by two parties. On one side of the contract is the buyer, owner, or holder of the option, who is also considered long the option. The buyer pays the option's premium (i.e., the contract's market price) and receives the right to exercise the contract. Depending on the type of contract that's purchased, the holder has the right to either buy or sell the underlying security. On the other side of the contract is the writer or seller of the option, who is also considered short the option. The seller receives the option's premium and assumes an obligation if the contract is exercised in the future. Depending on the type of contract that's sold, the writer may be obligated to either buy or sell the underlying security. Remember, a buyer pays the premium and receives the right to exercise. However, if the option expires worthless, the premium paid represents the buyer's maximum loss. A seller receives the premium and assumes an obligation if exercised against. However, if the option expires worthless, the premium received represents the seller's maximum gain.

Option Events

Since an option is a security with a fixed life, the contract will eventually be subject to one of three possibilities. The contract may be liquidated, it may be exercised, or it may expire.

Determining Time Value

Since only in-the-money options have intrinsic value, any premium associated with at- or out-of-the-money options will consist only of time value. However, for in-the-money options, the time value may be determined by simply subtracting the intrinsic value from the premium. Using the earlier example, let's assume the XYZ May 30 call has a premium of 3 at a time when XYZ stock is trading at $32 per share. The premium of 3 consists of the 2 points of intrinsic value (from 30 to 32), with the remainder being 1 point of time value. If the XYZ May 30 call has a premium of 3, but the stock is trading at $30 per share, how is the premium determined? With the stock at $30, a 30 call option is at-the-money. This would mean that the option has zero intrinsic value, and therefore, the entire 3-point premium is time value. Generally, the longer the time until an option expires, the greater its time value. If it's currently January, an XYZ August 30 call will trade at a higher premium than an XYZ May 30 call since the August option has more life remaining than the May option. However, an option's time value will diminish with the passage of time and, at expiration, it will have no remaining time value.

If an investor buys two ABC Feb 40 calls at $5, what's the breakeven point?

To calculate the breakeven on a call, the premium is added to the strike price (i.e., call up). In this question, the breakeven is $45 ($40 strike price + $5 premium). The fact that the customer bought more than one option doesn't impact the breakeven point.

An investor has written an uncovered call. The underlying stock's market price is rising and the investor is concerned about his uncovered position. What action may be taken by the investor to reduce exposure to this contract position?

To close out the position, the investor must purchase an offsetting contract with the same terms. Since a call was written to open the position, a call must be purchased to close out the position and limit his upside risk on the uncovered call. If an investor's opening transaction is the sale of an option, the closing transaction requires the purchase of the same option. (23450)

Covered and Uncovered Option Positions (cont.)

Uncovered Call If an investor sells an XYZ call and doesn't own XYZ stock, it's an uncovered call. An uncovered call writer has an unlimited maximum potential loss since there's no limit as to how high the price of the security may rise. The investor is effectively short the stock since she doesn't own the deliverable if the contract is assigned. This risky position may only be created in a margin account. Covered Put The seller of a put is obligated to buy the underlying stock if the buyer of the put exercised the contract. Therefore, for the put to be covered, the seller must either be short the underlying stock or deposit cash equal to the strike price. If an investor sells an XYZ put and doesn't deposit sufficient cash, the position is considered an uncovered put.

What strategy is the portfolio manager of a mutual fund employing when call options are being sold on stock that's held in the portfolio?

When a call option is written (sold) against a position in a portfolio, it's referred to as a covered call. The strategy is neither bullish nor bearish; instead, it's a conservative and neutral strategy that's designed to generate income from the receipt of the premium. The writer of the option doesn't believe the value of the underlying stock will rise or fall significantly.

Covered and Uncovered Option Positions

The concept of covered or uncovered relates to the seller of an option position. It's the responsibility of a firm's margin department to verify that a client who writes an option is in a position to deliver securities (if short a call) or cash (if short a put) if exercised against. Covered Call The seller of a call is obligated to sell (deliver) the underlying stock if the buyer of the call exercises the contract. Therefore, for the call to be covered, the seller must own the underlying stock. If an investor is long XYZ stock and has written (is short) an XYZ call option, he has created a covered call and is interested in generating income on his portfolio. A covered call writer anticipates that the market price of the underlying security will not rise above the strike price prior to expiration and hopes that the option will expire worthless. If the contract expires, the investor will generate income from the premium received plus any potential cash dividend that's paid on the

Intrinsic Value and Time Value

The premium of an option is potentially made up of two components—intrinsic value and time value. Intrinsic value is the amount by which an option is in-the-money, while time value is the portion of an option's premium that exceeds its intrinsic value. For calculation purposes, remember than an option will only have INtrinsic value if it's IN-the-money. Option Premium = Intrinsic Value + Time Value

In-, At-, and Out-of-the-Money

The relationship between the strike price of an option and the current market price of the underlying security determines whether an option is in-, at-, or out-of-the-money. For call options, the relationships may be summarized as follows: Calls are in-the-money if the stock's market price is above the strike price of the option. Calls are at-the-money if the stock's market price is the same as the strike price of the option. Calls are out-of-the-money if the stock's market price is below the strike price of the option. For put options, the relationships are the opposite: Puts are in-the-money if the stock's market price is below the strike price of the option. Puts are at-the-money if the stock's market price is the same as the strike price of the option. Puts are out-of-the-money if the stock's market price is above the strike price of the option.

Exercise

The second event that would close an option position is an exercise. The investor who is long an option has the exclusive right to exercise that option. The two styles of exercise are: American Style Exercise: Options using American style may be exercised at any time up to the day on which they expire. All listed equity options use American style exercise. European Style Exercise: Options using European style may only be exercised at a specified point in time, usually on the day of expiration. European style exercise is prevalent with index and currency options. If an investor is long an XYZ May 30 call and the underlying stock is trading at $38 per share, the call holder could exercise the option and buy the stock at the strike price of $30 per share. Thereafter, the investor could sell the stock in the market for $38 per share, which results in a gain of $8 per share (actual gain is less the premium paid). Similarly, an investor who is long an XYZ May 30 put may choose to exercise that contract if the stock is trading at $22. Assuming the investor did not currently own the stock, he could buy it in the secondary market for $22 per share, and then immediately sell the stock at the strike price of 30. The purchase at $22 and subsequent sale at $30 would result in a gain of $8 per share (actual gain is less the premium paid).

Conclusion

This concludes the chapter on options. Remember, the four basic option strategies are directional bets in which an investor is either bullish or bearish on an underlying stock. The buyers risk their money (premium) in return for significant potential profits. On the other hand, the writers receive their money (premium) up front and will retain these funds if the option expires worthless. Lastly, remember that hedgers buy options as insurance for their core stock position.

Exercise (cont.)

If a buyer exercises an option, the seller is required to fulfill his obligation. For this reason, the seller is considered to have been assigned an exercise notice. If the seller of a May 30 call is exercised against, he must deliver 100 shares of XYZ at a price of $30 per share, regardless of the market value of the stock at that time. The seller of a put has an opposite obligation. If the seller of an XYZ May 30 put is exercised against, he must buy 100 shares of XYZ stock for $30 per share, even if the stock is worth much less. Buyer's Exercise / Writer's Assignment Step 1 - The process begins when an investor decides to exercise her contract and notifies her broker-dealer. Step 2 - The broker-dealer will then notify the Options Clearing Corporation (OCC). Step 3 - Once the OCC (discussed later) receives exercise instructions from the purchaser's broker-dealer, it will randomly issue the exercise notice to a broker-dealer whose account shows a short option position that's identical to the long option position being exercised. Step 4 - The broker-dealer that receives the exercise notice, must select a client to whom the notice will be assigned. There are three methods by which this assignment may be accomplished—(1) using random selection, (2) using first-in, first-out (FIFO), or (3) using any other method that's deemed to be fair and equitable. Every member firm must notify its clients as to which method is used and how it will be implemented.

Long and Short Hedge

If an investor is long stock and fears that the stock will decline, buying a put on the stock creates a long hedge. This is an effective protection strategy since the put will gain value as the stock declines; therefore, any loss on the stock is offset by the gain on the put. To breakeven on the position, the stock must rise by an amount equal to the stock's purchase price plus the premium paid. If an investor is short stock and fears that the stock will rise, buying a call on the stock creates a short hedge. This is an effective protection strategy since the call will gain value as the stock rises; therefore, any loss on the stock is offset by the gain on the call. To breakeven on the position, the stock must decline by an amount equal to the short sale proceeds minus the premium paid. Remember, to hedge or protect a position, an investor must buy the option.

Options Clearing Corporation (OCC)

In an effort to eliminate the possibility of option sellers being unable to fulfill their obligation and to protect options investors from counterparty risk, the OCC guarantees all listed options. Essentially, the OCC acts as a seller for every buyer and a buyer for every seller.

In-, At-, and Out-of-the-Money (cont.)

The following illustrations summarize when options are in-, at-, and out-of-the-money:

Components of an Option (cont.)

The individual components of the option contract shown above represent the following: Underlying Security — XYZ Each equity option typically represents the right to buy or sell 100 shares (one round lot) of the underlying stock. Expiration Month — May All listed options (those that trade on an exchange) have fixed expiration dates. If an option has not been exercised or liquidated prior to its expiration, it expires (ceases to exist). In this example, the buyer of the call has the right to purchase 100 shares of XYZ stock from the writer until the option expires in May. Exercise (Strike) Price — 30 The exercise price, also referred to as the strike price, is the price at which the call owner may buy stock from the writer. For put options, it's the price at which the put owner may sell stock to the writer. Type of Option — Call Remember, a call option gives the owner of the contract the right to buy the stock, while the seller accepts the obligation to sell the stock if ex

Expiration

The last event that could close an option position is the expiration of the contract. If an option is at- or out-of-the-money on the expiration date, the holder of the contract has no incentive to exercise the contract. Also, since there would be no time remaining on the contract, the contract expires worthless. This expiration triggers the maximum profit for the seller of a call or put (i.e., the premium initially received). Conversely, the expiration of an option triggers the maximum loss that the buyer of the call or put could experience (i.e., the premium paid). Deadlines for Expiration In the life of an option, the third Friday of the expiration month is an important day. Although most options expire at 11:59 p.m. ET on the third Friday of the expiration month, a buyer must notify her brokerage firm of her intent to exercise the option by 5:30 p.m. ET on that Friday. Additionally, at 4:00 p.m. ET on that third Friday, options stop trading.

What's the maximum profit for the buyer of a call option?

The maximum gain for the buyer of a call option is unlimited. A buyer of a call option will realize a profit if the underlying stock rises above the breakeven point. Since a stock's increase is unlimited, so too is the potential profit for the buyer of a call. On the other hand, if the stock doesn't rise and instead falls below the strike price (i.e., the option is out-of-the-money), the buyer's maximum loss is the premium paid.

Breakeven

The premium of an option is a vital component in calculating an investor's breakeven point. The breakeven point represents the price at which a stock must be trading so that an investor will neither make nor lose money. To find the breakeven point, remember the phrase "Call UP and Put DOWN." For calls, it's the strike price plus (or UP) by the premium, but for puts, it's the strike price minus (or down) by the premium. For buyers of options, breakeven represents the amount they need the underlying stock to move in their favor to recapture the premium paid. Breakeven for the buyer of a call: Strike price + premium - Investor buys an XYZ May 50 call at 5. The breakeven point is if the stock rises to $55. Breakeven for the buyer of a put: Strike price - premium - Investor buys an XYZ May 45 put at 4. The breakeven point is if the stock falls to $41. For sellers of options, breakeven represents the amount they can afford the underlying stock to move against them because they received the premium. Breakeven for the seller of a call: Strike price + premium - Investor sells an XYZ May 50 call at 5. The breakeven point is if the stock rises to $55. Breakeven for the seller of a put: Strike price - premium - Investor sells an XYZ May 45 put at 4. The breakeven point is if the stock falls to $41.