Investing Strategies v.2010

Options

Options Concepts – The Basics

The concepts covered here:

• basic option terminology
• premium, intrinsic value, time value and time decay
• basic terms of equity and index calls and puts, the rights of long option contracts and the obligations of short contracts
• when options actually expire and when they last trade
• how and when to exercise long option contracts
• assignment notification and how to avoid it
• basic information about the options marketplace

For more information on these subjects you might turn to one of the many classes located here in the Learning Center. You may also download and install on your computer a free copy of The Options Toolbox, a comprehensive and interactive educational software program that covers much of these concepts in greater depth.

How can you use equity options?
Consider some of the benefits of equity options:

• protection of stock holdings from a decline in market price
• increased income against current stock holding
• prepare to buy a stock at a lower price
• benefit from a stock price rise…buying the stock outright

If you anticipate a certain directional movement in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity. The decision as to what type of option to buy depends on whether your outlook for the underlying security is bullish or bearish. If your outlook is bullish, buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value. Conversely, if you anticipate downward movement, buying a put option will enable you to either participate financially in a downward underlying stock move or to protect underlying shares against downside risk without limiting profit potential. Purchasing equity calls or puts allows you to position yourself according to your market expectations so that you may potentially profit and/or protect yourself with limited risk.

How can you use index options?
Consider some of the benefits of index options:

• benefit from an up or down move in the broad market or a specific industry sector
• protection of a portfolio of stocks from a decline in value
• diversification for investment capital

Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace.

Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the costs and complexities of doing so.

Options Concepts – Terminology

Option Type
The two types of option contracts are calls and puts.

Option Class
All calls and puts on a given underlying security or index represent an “option class.” In other words, all calls and puts on XYZ stock are one class of options, while all calls and puts on ZYX index are another class.

Option Series
All options of a given type (calls or puts) with the same strike price and expiration date are classified as an “option series.” For example, all XYZ June 110 calls would be an individual series, while all XYZ June 110 puts would be another series.

American vs. European Options?
An American-style option contract is one that may be exercised at any time prior to its expiration date. Currently, all equity options traded on U.S. option exchanges, including LEAPS, are American-style, as are certain index options. A European-style option can be exercised only during a specified period of time just prior to its expiration. Many index options are European-style.

What is an at-the-money option? An in-the-money option? An out-of-the money option?
When the price of the underlying security or index is equal to the strike price, a call or put option is at-the-money.

• A call option is in-the-money if the strike price is less than the current price of the underlying security or index, and out-of-the-money if the strike price is greater than the price of the underlying security or index.
• A put option is in-the-money if the strike price is greater than the current price of the underlying security or index, and out-of-the money if the strike price is less than the price of the underlying security or index.

Opening Purchase Transaction
An opening purchase transaction is one that creates or increases a long position in a given option series.

Opening Sale Transaction
An opening sale transaction is one that creates or increases a short position in a given option series. Such a sale is also referred to as “writing” an option contract.

Closing Purchase Transaction
A closing purchase transaction is one that eliminates or reduces a short position in a given option series. Such a purchase is commonly referred to as “covering” a short option position.

Closing Sale Transaction
A closing sale transaction is one that eliminates or decreases a long position in a given option series.

Exercise Settlement Value
Exercise settlement value is the level of an underlying equity index used to calculate the cash settlement amount for a cash-settled index call or put.

Cash Settlement Amount
Cash settlement amount is the difference between the exercise price of a cash-settled index call or put and the exercise settlement value of the index on the day an exercise notice is tendered, multiplied by the index multiplier.

Physical Delivery Options
A physical delivery option gives its owner the right to receive physical delivery (if it is a call), or to make physical delivery (if it is a put), of underlying shares when the option is exercised. Currently, all equity options are physical delivery contracts.

Cash-Settled Options
The process by which the terms of an option contract are fulfilled through the payment or receipt in dollars of the amount by which the option is in-the-money, as opposed to delivering or receiving the underlying instrument. Index options are generally cash-settled.

A.M. Settlement
A settlement style for certain index options in which the index’s exercise settlement value is based on the reported level of the index derived from the opening prices of the component securities on the day of exercise.

P.M. Settlement
A settlement style for certain index options in which the index’s exercise settlement value is based on the reported level of the index derived from the last reported prices of the component securities of the index at the close of market hours on the day of exercise.

What is a strike price?
The strike (or exercise) price of an equity option is the specified price per share at which underlying stock will change hands after a call or put is exercised by its owner. For a cash-settled index option, the strike price is the base for the determination of the amount of cash, if any, that the option holder is entitled to receive upon exercise (see Cash Settlement Amount and Exercise Settlement Amount).

What is the contract size of an equity option?
The contract size of an option refers to the amount of the underlying asset covered by the options contract. For each unadjusted equity call or put option, 100 shares of stock will change hands when one contract is exercised by its owner. These 100 shares of underlying stock are also referred to as the contract’s “unit of trade.”

What is the contract size of an index option?
The contract size of a cash-settled index option is determined by its multiplier. The multiplier determines the aggregate value of each point of the difference between the exercise price of the option and the exercise settlement value of the underlying interest. For example, a multiplier of 100 means that for each point by which a cash-settled option is in the money upon exercise, there is a $100 increase in the cash settlement amount.

Options Concepts – Premium

What is option “premium”?
The premium is the price at which an option trades, and is paid by the buyer to the writer (seller) of the contract. The premium paid by the buyer is non-refundable payment for the rights inherent in the long contract. The writer (seller) of an option contract keeps the premium received, whether assigned or not, and is in turn obligated to fulfill the short contract’s obligations if assignment is received. The two components of an option?s total premium are intrinsic value and time value.

Intrinsic Value
Intrinsic value represents the amount, if any, by which an option contract is in-the-money. By definition, at- and out-of-the-money options do not have intrinsic value.

Time Value
Time value represents the portion of an option’s total premium that exceeds its intrinsic value, if it has any. By definition, the premium of at- and out-of-the-money options is entirely time value.

What is “time decay”?
Time decay (or time “erosion”) is the inevitable phenomenon of decay, or decrease, of an option premium’s time value due to the passage of time. The rate of this decay increases as expiration approaches. At expiration a call or put is worth only its intrinsic value, if it has any.

You entered an order to buy a call option for $3.25 but your brokerage firm rejected the price?
As an industry standard, most option contracts traded at prices greater than $3.00 must trade in $0.10 (10¢) increments. Therefore, the purchase price for this buy order must be either $3.20 or $3.30. For prices under $3.00 the increments may be $0.05 (5¢)

Options Concepts – Equity Calls & Puts

What are equity call options?
The buyer of an equity call option has purchased the right, but not the obligation, to buy 100 shares of the underlying stock at the stated exercise price at any time before the option expires. Once the option is purchased the buyer is then “long” the call contract, and to purchase 100 underlying shares he notifies his brokerage firm of his intent to exercise the call contract. For example, the buyer of one XYZ June 60 call option has the right to purchase 100 shares of XYZ stock at $60 per share up until June expiration.

Potential Profit: Unlimited as the underlying stock price increases
Potential Loss: Limited to premium paid for call

An investor who sells an option contract that he does not already own is known as the option “writer,” and is then “short” the contract. The writer of an equity call option, commonly referred to as the “seller,” has the obligation to sell 100 shares of the underlying stock at the stated exercise price if assigned an exercise notice at any time before the option expires. For example, the writer of an XYZ June 75 call option has the obligation to sell 100 shares of XYZ stock at $75 per share if assigned at any time until June expiration.

Potential Profit: Limited to premium received from call’s initial sale
Potential Loss: Unlimited as the underlying stock price increases

What are equity put options?
The buyer of an equity put option has purchased the right, but not the obligation, to sell 100 shares of the underlying stock at the stated exercise price at any time before the option expires. Once the option is purchased the buyer is then “long” the put contract, and to sell 100 underlying shares he notifies his brokerage firm of his intent to exercise the put contract. For example, the buyer of one XYZ June 70 put option has the right to sell 100 shares of XYZ stock at $70 per share up until June expiration.

Potential Profit: Substantial and increases as the underlying stock price decreases to zero
Potential Loss: Limited to premium paid for put

An investor who sells an option contract that he does not already own is known as the option “writer,” and is then “short” the contract. The writer of an equity put option, commonly referred to as the “seller,” has the obligation to purchase 100 shares of the underlying stock at the stated exercise price if assigned an exercise notice at any time before the option expires. For example, the writer of an XYZ June 80 put option has the obligation to purchase 100 shares of XYZ stock at $80 per share if assigned at any time until June expiration.

Potential Profit: Limited to premium received from put’s initial sale
Potential Loss: Substantial and increases as the underlying stock price decreases to zero

Options Concepts – Index Calls & Puts

What are index call options?
The buyer of an index call option has purchased the right, but not the obligation, to buy the value of the underlying index at the stated exercise price before the option expires. Once the option is purchased the buyer owns, and is then “long,” the call contract. When the owner exercises an in-the-money call contract he will receive the cash settlement amount (the difference between call’s strike price and the exercise settlement value of the underlying index) in cash.

Potential Profit: Unlimited as the level of the underlying index increases
Potential Loss: Limited to premium paid for call

An investor who sells an option contract that he does not already own is known as the option “writer,” and is then “short” the contract. The writer of an index call option, commonly referred to as the “seller,” has the obligation to sell the value of the underlying index at the stated exercise price if assigned an exercise notice before the option expires. If assigned on an in-the-money contract, the call writer will pay the cash settlement amount (the difference between call’s strike price and the exercise settlement value of the underlying index) in cash to an owner who has exercised a like contract.

Potential Profit: Limited to premium received from call’s initial sale
Potential Loss: Unlimited as the level of the underlying index increases

What are index put options?
The buyer of an index put option has purchased the right, but not the obligation, to sell the value of the underlying index at the stated exercise price before the option expires. Once the option is purchased the buyer owns, and is then “long,” the put contract. When the owner exercises an in-the-money put contract he will receive the cash settlement amount (the difference between put’s strike price and the exercise settlement value of the underlying index) in cash.

Potential Profit: Substantial and increases as the level of the underlying index decreases to zero
Potential Loss: Limited to premium paid for put

An investor who sells an option contract that he does not already own is known as the option “writer,” and is then “short” the contract. The writer of an index put option, commonly referred to as the “seller,” has the obligation to purchase the value of the underlying index at the stated exercise price if assigned an exercise notice before the option expires. If assigned on an in-the-money contract, the put writer will pay the cash settlement amount (the difference between put’s strike price and the exercise settlement value of the underlying index) in cash to an owner who has exercised a like contract.

Potential Profit: Limited to premium received from put’s initial sale
Potential Loss: Substantial and increases as the level of the underlying index decreases to zero

Options Concepts – Expiration

When do options expire?
Expiration day for equity and index options is the Saturday immediately following the third Friday of the expiration month.

When is the last day to trade or exercise an equity option?
Although equity options literally expire on the third Saturday of the expiration month, a day reserved for brokerage firms and The Options Clearing Corporation to confirm customers’ positions, the day expiring equity options last trade is the Friday before expiration, or the third Friday of the month. This is also generally the last day an investor may notify his brokerage firm of his intent to exercise an expiring equity call or put. If this third Friday happens to be an exchange holiday, then the last day of trading for expiring equity options is the day before, or the third Thursday of the month. Check with your brokerage firm about its procedures and deadlines for instruction to exercise equity options.
When is the last day to trade an index option?
This depends on whether the option is American- or European-style:

For American-style index option contracts the last trading day is generally the third Friday of the expiration month, unless that day is an exchange holiday in which case the last trading day will be the previous day, or Thursday.

For European-style index option contracts the last trading day will be the business day (generally a Thursday) preceding the day on which the exercise settlement value is calculated (generally the third Friday of the month unless that day is a holiday).

When is the last day to exercise an index option?
An American-style index option may be exercised at any time prior to its expiration, or at any time up to and including the Third Friday of the expiration month. A European-style index option may be exercise only during a specific period of time just prior to its expiration – generally on the last Friday prior to its expiration date.

Options Concepts – Exercise

What is “automatic exercise” of an option?
The Options Clearing Corporation has provisions for the automatic exercise of certain in-the-money options at expiration, a procedure also referred to as “exercise by exception.” Generally, OCC will automatically exercise any expiring equity call or put in a customer account that is $0.25 or more in-the-money, and an index option that is $.01 or more in-the-money. However, a specific brokerage firm’s threshold for such automatic exercise may or may not be the same as OCC’s.

When and how is an equity option exercised?
An investor with a long equity call or put position may exercise that contract at any time before the contract expires, up to and including the Friday before its expiration. To do so, the investor must notify his brokerage firm of intent to exercise in a manner, and by the deadline specified by that particular firm.

Must you exercise an expiring in-the-money equity option?
An investor with an expiring long equity call or put position that is subject to automatic exercise does not have to exercise the contract. Instructions may be given through a brokerage firm to OCC not to exercise a call or put that is in-the-money by any amount.

What happens to my long option if I never sell or exercise it?
After its expiration date a call or put will cease to exist. If you own an option and it expires unexercised, you no longer have any of the rights inherent in that contract and you lose the premium you paid for it, plus any commissions and fees you incurred at its purchase. You are free to close out a long call or put before expiration by selling it if it has market value.

Options Concepts – Assignment

How do you nullify the obligations of a short call or put?
Any investor with an open short position in a call or put option may nullify the obligations inherent in that short (or written) contract by making an offsetting closing purchase transaction of a similar option (same series) in the marketplace. This transaction must be made before assignment is received, regardless of whether you have been notified by your brokerage firm to this effect or not.

When can you be assigned on a short equity option position?
As an equity call or put option holder may exercise the contract at any time before it expires, an equity option writer may be assigned an exercise notice at anytime before expiration.

When will notice of assignment on a short contract be received?
Generally, brokerage firms will deliver notice of assignment on short option positions on the business day following an option owner’s exercise of a similar option. Check with your brokerage firm about its procedures and timing for such notification.

Will you be assigned on an equity option contract that expires exactly at-the-money?
Some professional traders will exercise an expiring call or put that is exactly at-the-money, therefore assignment on such a short contract is possible.

What happens to my short option if I am never assigned?
After its expiration date a call or put will cease to exist. If you have written an option and are not assigned an exercise notice before it expires, you no longer have any of the obligations inherent in that contract and you keep the premium you received for it, less any commissions and fees you incurred at its initial sale. You are free to close out a short call or put before expiration by purchasing a like contract in the marketplace.

Options Concepts – Marketplace

How do you nullify the obligations of a short call or put?
Any investor with an open short position in a call or put option may nullify the obligations inherent in that short (or written) contract by making an offsetting closing purchase transaction of a similar option (same series) in the marketplace. This transaction must be made before assignment is received, regardless of whether you have been notified by your brokerage firm to this effect or not.

When can you be assigned on a short equity option position?
As an equity call or put option holder may exercise the contract at any time before it expires, an equity option writer may be assigned an exercise notice at anytime before expiration.

When will notice of assignment on a short contract be received?
Generally, brokerage firms will deliver notice of assignment on short option positions on the business day following an option owner’s exercise of a similar option. Check with your brokerage firm about its procedures and timing for such notification.

Will you be assigned on an equity option contract that expires exactly at-the-money?
Some professional traders will exercise an expiring call or put that is exactly at-the-money, therefore assignment on such a short contract is possible.

What happens to my short option if I am never assigned?
After its expiration date a call or put will cease to exist. If you have written an option and are not assigned an exercise notice before it expires, you no longer have any of the obligations inherent in that contract and you keep the premium you received for it, less any commissions and fees you incurred at its initial sale. You are free to close out a short call or put before expiration by purchasing a like contract in the marketplace.

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