underlying security.2. Moneyness.
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3. Time to expiration.4. Dividend.5. Change in interest rates.6. Volatility.
UNDERSTANDING OPTION EXPIRATION
Although expiration is a relatively straightforward concept, it is one thatis  so  important  to  the  options  trader  that  it  requires  a  thorough  under-standing. Each option contract has a speciﬁc expiration date. After that,the contract ceases to exist. In other words, the option holder no longerhas  any  rights,  the  seller  has  no  obligations,  and  the  contract  has  novalue. Therefore, to the options trader, it is an extremely important dateto understand and remember.
Have you ever heard someone say that 90 percent of all options expireworthless? While the percentage is open to debate (the Chicago Board Op-tions Exchange says the ﬁgure is closer to 30 percent), the fact is that op-tions  do  expire.  They  have  a  ﬁxed  life,  which  eventually  runs  out.  Tounderstand why, recall what an options contract is: an agreement betweena buyer and a seller. Among other things, the two parties agree on a dura-tion for the contract. The duration of the options contract is based on theexpiration  date.  Once  the  expiration  date  has  passed,  the  contract  nolonger exists. It is worthless. The concept is similar to a prospective buyerplacing a deposit on a home. In that case, the deposit gives the individualthe right to purchase the home. The seller, however, will not want to grantthat right forever. For that reason, the deposit gives the owner the right tobuy the home, but only for a predetermined period of time. After that timehas elapsed, the agreement is void; the seller keeps the deposit, and canthen attempt to sell the house to another prospective buyer.
While an options contract is an agreement, the two parties involveddo not negotiate the expiration dates between themselves. Instead, optioncontracts are standardized contracts and each option is assigned an expi-ration cycle. Every option contract, other than long-term equity anticipa-tion securities (LEAPS), is assigned to one of three quarterly cycles: theJanuary  cycle,  the  February  cycle,  or  the  March  cycle.  For  example,  anoption on the January cycle can have options with expiration months ofJanuary, April, July, and October. The February cycle includes February,May, August, and November. The March cycle includes March, June, Sep-tember, and December.
In general, at any point in time, a stock option will have contractswith  four  expiration  dates,  which  include  the  two  near-term  months
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and  two  further-term  months.  Therefore,  in  early  January  2005  a  con-tract on XYZ will have options available on the months January, Febru-ary, April, July and October. Index options often have the ﬁrst three orfour  near-term  months  and  then  three  further-term  months.  The  sim-plest  way  to  view  which  months  are  available  is  through  an  optionchain (see pp. 58–59).
The actual expiration date for a stock option is close of business priorto the Saturday following the third Friday of the expiration month. For in-stance, expiration for the month of September 2005 is September 17, 2005.That is the last day that the terms of the option contract can be exercised.Therefore,  all  option  holders  must  express  their  desire  to  exercise  thecontract by that date or they will lose their rights. (Although options thatare in-the-money by one-quarter of a point or more will be subject to auto-matic  exercise  and  the  terms  of  the  contract  will  automatically  be  ful-ﬁlled.) While the last day to exercise an option is the Saturday followingthe third Friday of the expiration month, the last day to trade the contractis the third Friday. Therefore, an option that has value can be sold on thethird Friday of the expiration month. If an option is not sold on that day, itwill either be exercised or expire worthless.
While the last day to trade stock options is the third Friday of theexpiration  month,  the  last  trading  day  for  some  index  options  is  on  aThursday.  For  example,  the  last  full  day  of  trading  for  Standard  &Poor’s 500 ($SPX) options is the Thursday before the third Friday of themonth.  Why?  Because  the  ﬁnal  settlement  value  of  the  option  is  com-puted  when  the  500  stocks  that  make  up  the  index  open  on  Fridaymorning. Therefore, when trading indexes, the strategist should not as-sume that the third Friday of the month is the last trading day. It couldbe on the Thursday before.
According to the Chicago Board Options Exchange, more than 60 per-cent of all options are closed in the marketplace. That is, buyers sell theiroptions in the market and sellers buy their positions back. Therefore, mostoption strategists do not hold an options contract for its entire duration. In-stead, many either take proﬁts or cut their losses prior to expiration. Never-theless, expiration dates and cycles are important to understand. They setthe terms of the contract and spell the duration of the option holder’s rightsand of the option seller’s obligations.
SEVEN CHARACTERISTICS OF OPTIONS
Options  are  available  on  most  futures,  but  not  all  stocks,  indexes,  orexchange-traded funds. In order to determine if a stock, index, or exchange-
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traded fund has options available, ask your broker, visit an options symboldirectory, or see if an option chain is available.
Also, keep in mind that futures and futures options fall under a sepa-rate  regulatory  authority  from  stocks,  stock  options,  and  index  options.Therefore,  trading  futures  and  options  on  futures  requires  separate  bro-kerage accounts when compared to trading stocks and stock options. As aresult, a trader might have one brokerage account with a ﬁrm that special-izes  in  futures  trading  and  another  account  with  a  brokerage  ﬁrm  thattrades  stocks  and  stock  options.  If  you  are  new  to  trading,  determine  ifyou want to specialize in stocks or futures. Then ﬁnd the best broker tomeet your needs.
Whether  trading  futures  or  stock  options,  all  contracts  share  the
following seven characteristics:
1. Options give you the right to buy or sell an instrument.2. If you buy an option, you are not obligated to buy or sell the underly-
ing instrument; you simply have the right to exercise the option.
3. If you sell an option, you are obligated to deliver—or to purchase—the underlying asset at the predetermined price if the buyer exerciseshis or her right to take delivery—or to sell.
4. Options are valid for a speciﬁed period of time, after which they ex-pire and you lose your right to buy or sell the underlying instrument atthe speciﬁed price. Options expire on the Saturday following the thirdFriday of the expiration month.
5. Options are bought at a debit to the buyer. So the money is deducted
from the trading account.
6. Sellers receive credits for selling options. The credit is an amount ofmoney equal to the option premium and it is credited or added to thetrading account.
7. Options are available at several strike prices that reﬂect the price of theunderlying security. For example, if XYZ is trading for $50 a share, theoptions might have strikes of 40, 45, 50, 55, and 60. The number of strikeprices will increase as the stock moves dramatically higher or lower.
The premium is the total price you have to pay to buy an option or thetotal  credit  you  receive  from  selling  an  option.  The  premium  is,  in  turn,computed  as  the  current  option  price  times  a  multiplier.  For  example,stock options have a multiplier of 100. If a stock option is quoted for $3 acontract, it will cost $300 to purchase the contract.
One more note before we begin looking at speciﬁc examples of putsand calls: An option does not have to be exercised in order for the owner
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to make a proﬁt. Instead, an option position can, and often is, closed at aproﬁt  (or  loss)  prior  to  expiration.  Offsetting  transactions are  used  toclose  option  positions.  Basically,  to  offset  an  open  position,  the  tradermust  sell  an  equal  number  of  contracts  in  the  exact  same  options  con-tract. For example, if I buy 10 XYZ June 50 calls, I close the position byselling 10 XYZ June 50 calls. In the ﬁrst case, I am buying to open. In thesecond, I am selling to close.
MECHANICS OF PUTS AND CALLS
As  we  have  duly  noted,  there  are  two  types  of  options:  calls  and  puts.These two types of options can make up the basis for an inﬁnite numberof trading scenarios. Successful options traders effectively use both kindsof options in the same trade to hedge their investment, creating a limited-risk  trading  strategy.  But,  before  getting  into  a  discussion  of  more  com-plex strategies that use both puts and calls, let’s examine each separatelyto see how they behave in the real world.
Call Options
Call options give the buyer the right, but not the obligation, to purchasethe underlying asset. A call option increases in value when the underlyingasset  rises  in  price,  and  loses  value  when  the  underlying  falls  in  price.Thus, the purchase of a call option is a bullish strategy; that is, it makes aproﬁt as the stock moves higher.
In order to familiarize you with the basics of call options, let’s explorean example from outside the stock market. A local newspaper advertisesa sale on DVD players for only $49.95. Knowing a terriﬁc deal when yousee  one,  you  cut  out  the  ad  and  head  on  down  to  the  store  to  purchaseone. Unfortunately, when you arrive you ﬁnd out all of the advertised DVDplayers have already been sold. The manager apologizes and says that sheexpects to receive another shipment within the week. She gives you a raincheck  entitling  you  to  buy  a  DVD  player  for  the  advertised  discountedprice of $49.95 for up to one month from the present day. You have just re-ceived a call option. You have been given the right, not the obligation, topurchase the DVD player at the guaranteed strike price of $49.95 until theexpiration date one month away.
Later  that  week,  the  store  receives  another  shipment  and  offers  theDVD players for $59.95. You return to the store and exercise your call op-tion to buy one for $49.95, saving $10. Your call option was in-the-money.But what if you returned to ﬁnd the DVD players on sale for $39.95? The
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call option gives you the right to purchase one for $49.95—but you are un-der no obligation to buy it at that price. You can simply tear up the raincheck coupon and buy the DVD player at the lower market price of $39.95.In this case, your call option was out-of-the-money and expired worthless.Let’s take a look at another scenario. A coworker says her DVD playerjust  broke  and  she  wants  to  buy  another  one.  You  mention  your  raincheck.  She  asks  if  you  will  sell  it  to  her  so  she  can  purchase  the  DVDplayer at the reduced price. You agree to this, but how do you go aboutcalculating the fair value of your rain check? After all, the store might sellthe  new  shipment  of  DVD  players  for  less  than  your  guaranteed  price.Then the rain check would be worthless. You decide to do a little investi-gation  on  the  store’s  pricing  policies.  You  subsequently  determine  thathalf  the  time,  discounted  prices  are  initially  low  and  then  slowly  climbover the next two months until the store starts over again with a new saleitem.  The  other  half  of  the  time,  discounted  prices  are  just  a  one-timething. You average all this out and decide to sell your rain check for $5.This  price  is  the  theoretical  value  of  the  rain  check  based  on  previouspricing patterns. It is as close as you can come to determining the calloption’s fair price.
This simpliﬁcation demonstrates the basic nature of a call option. Allcall options give you the right to buy something at a speciﬁc price for a ﬁxedamount of time. The price of the call option is based on previous price pat-terns that only approximate the fair value of the option (See Table 3.1).
If you buy call options, you are “going long the market.” That meansthat you intend to proﬁt from a rise in the market price of the underlyinginstrument. If bullish (you believe the market will rise), then you want tobuy calls. If bearish (you believe the market will drop), then you can “goshort the market” by selling calls. If you buy a call option, your risk is themoney paid for the option (the premium) and brokerage commissions. Ifyou sell a call option, your risk is unlimited because, theoretically, there isno ceiling to how high the stock price can climb. If the stock rises sharply,and  you  are  assigned  on  your  short  call,  you  will  be  forced  to  buy  thestock in the market at a very high price and sell it to the call owner at the
TABLE 3.1 Call Option Moneyness
In-the-money (ITM)
The market price of the underlying asset is more than your strike price.
At-the-money (ATM)
The market price of the underlying asset is the same asyour strike price.
Out-of-the-money (OTM)
The market price of the underlying asset is less than your strike price.
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much  lower  strike  price.  We  will  discuss  the  risks  and  rewards  of  thisstrategy in more detail later.
For now, it is simply important to understand that a call option is in-the-money  (ITM)  when  the  price  of  the  underlying  instrument  is  higherthan  the  option’s  strike  price.  For  example,  a  call  option  that  gives  thebuyer the right to purchase 100 shares of IBM for $80 each is ITM whenthe current price of IBM is greater than $80. At that point, exercising thecall option allows the trader to buy shares of IBM for less than the currentmarket price. A call option is at-the-money (ATM) when the price of theunderlying security is equal to its strike price. For example, an IBM calloption with a strike price of $80 is ATM when IBM can be purchased for$80.  A  call  option  is  out-of-the-money  (OTM)  when  the  underlying  secu-rity’s market price is less than the strike price. For example, an IBM calloption with an $80 strike price is OTM when the current price of IBM inthe market is less than $80. No one would want to exercise an option tobuy IBM at $80 if it can be directly purchased in the market for less. That’swhy call options that are out-of-the-money by their expiration date expireworthless.
Strike Price
Call Option
Option Premium
Price of IBM = 80
1009590858075706560
OTMOTMOTMOTMATMITMITMITMITM
.501.002.254.756.5010.0013.7517.5020.75
Purchasing a call option is probably the simplest form of options trad-ing. A trader who purchases a call is bullish, expecting the underlying as-set  to  increase  in  price.  The  trader  will  most  likely  make  a  proﬁt  if  theprice  of  the  underlying  asset  increases  fast  enough  to  overcome  the  op-tion’s time decay. Proﬁts can be realized in one of two ways if the underly-ing  asset  increases  in  price  before  the  option  expires.  The  holder  caneither purchase the underlying shares for the lower strike price or, sincethe value of the option has increased, sell (to close) the option at a proﬁt.Hence, purchasing a call option has a limited risk because the most youstand to lose is the premium paid for the option plus commissions paid tothe broker.
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Let’s review the basic fundamental structure of buying a standard callon shares using IBM. If you buy a call option for 100 shares of IBM, youget the right, but not the obligation, to buy 100 shares at a certain price.The certain price is called the strike price. Your right is good for a certainamount of time. You lose your right to buy the shares at the strike price onthe expiration date of the call option.
Generally,  calls  are  available  at  several  strike  prices,  which  usuallycome in increments of ﬁve. In addition, there normally is a choice of sev-eral different expiration dates for each strike price. Just pick up the ﬁnan-cial pages of a good newspaper and ﬁnd the options for IBM. Looking atthis  example,  you  will  see  the  strike  prices,  expiration  months,  and  theclosing call option prices of the underlying shares, IBM.
Strike Price
January
Price of IBM = 80
758085
6.402.00.40
April
7.503.901.60
July
8.304.802.80
The  numbers  in  the  ﬁrst  column  are  the  strike  prices  of  the  IBMcalls. The months across the top are the expiration months. The num-bers  inside  the  table  are  the  option  premiums.  For  example,  the  pre-mium of an IBM January 75 call is 6.40. Each $1 in premium is equal to$100 per contract (i.e., the multiplier is equal to 100) because each op-tion  contract  controls  100  shares.  Looking  at  the  IBM  January  75  calloption,  a  premium  of  6.40  indicates  that  one  contract  trades  for  $640:(6.40 × $100 = $640).
The table also shows that the January 80 calls are priced at a pre-mium  of  $2.  Since  a  call  option  controls  100  shares,  you  would  have to pay $200 plus brokerage commissions to buy one IBM January 80 call:(2 × $100 = $200). A July 75 call trading at 8.30 would cost $830: (8.30 × $100)plus commissions:
• Cost of January IBM 80 call = 2 × $100 = $200 + commissions.• Cost of July IBM 75 call = 8.30 × $100 = $830 + commissions.
All the options of one type (put or call) that have the same underlyingsecurity  are  called  a  class of  options.  For  example,  all  the  calls  on  IBMconstitute an option class. All the options that are in one class and havethe same strike price and expiration are called a series of options. For ex-ample, all of the IBM 80 calls with the same expiration date constitute anoption series.
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Put Options
THE OPTIONS COURSE
Put options give the buyer the right, but not the obligation, to sell the un-derlying stock, index, or futures contract. A put option increases in valuewhen the underlying asset falls in price and loses value when the underly-ing  asset  rises  in  price.  Thus,  the  purchase  of  a  put  option  is  a  bearishstrategy. That is, the put option increases in value when the price of anunderlying asset falls. Let’s review the following analogy to become morefamiliar with the basics of put options.
You’ve decided to set up a small cottage industry manufacturing skijackets. Your ﬁrst product is a long-sleeved jacket complete with embroi-dered logos of the respective ski resorts placing the orders. The managerof the pro shop at a local ski resort agrees to purchase 1,000 jackets for$40  each,  if  you  can  deliver  them  by  November.  In  effect,  you’ve  beengiven a put option. The cost of producing each jacket is $25, which givesyou a $15 proﬁt on each item. You have therefore locked in a guaranteedproﬁt of $15,000 for your initial period of operation.
This guaranteed order from the resort is an in-the-money put option.You  have  the  right  to  sell  a  speciﬁc  number  of  jackets  at  a  ﬁxed  price(strike price) by a certain time (expiration date). Just as November rollsaround,  you  ﬁnd  out  that  a  large  manufacturer  is  creating  very  similarproducts for ski resorts for $30 each. If you didn’t have a put option agree-ment, you would have to drop your price to meet the competition’s price,and thereby lose a signiﬁcant amount of proﬁt. Luckily, you exercise yourright to sell your jackets for $40 each and enjoy a prosperous Christmasseason. Your competitor made it advantageous for you to sell your jacketsfor $40 using the put option because it was in-the-money.
In a different scenario, you get a call from another ski resort that hasjust been featured in a major magazine. The resort needs 1,000 jackets bythe beginning of November to fulﬁll obligations to its marketing team andis willing to pay you $50 per jacket. Even though it goes against your grainto disappoint your ﬁrst customer, the new market price of your product is$10 higher than your put option price. Since the put option does not obli-gate you to sell the jackets for $40, you elect to sell them for the highermarket price to garner an even bigger proﬁt.
These examples demonstrate the basic nature of a put option. Put op-tions give you the right, but not the obligation, to sell something at a spe-ciﬁc price for a ﬁxed amount of time. Put options give the buyer of putsthe right to “go short the market” (sell shares). If bearish (you believe themarket will drop), then you could go short the market by buying puts. Ifyou buy a put option, your maximum risk is the money paid for the option(the premium) and brokerage commissions.
Theoretically,  if  bullish  (you  believe  the  market  will  rise),  then  you
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TABLE 3.2 Put Option Moneyness
In-the-money (ITM)
The market price of the underlying asset is less than your strike price.
At-the-money (ATM)
The market price of the underlying asset is the same asyour strike price.
Out-of-the-money (OTM)
The market price of the underlying asset is more than your strike price.
could  “go  long  the  market”  by  selling  puts—but  make  no  mistake,  thiscomes with high risk! If you sell a put option, your risk is unlimited untilthe underlying asset reaches zero because, if the stock falls precipitouslyand the short option is assigned, you will be forced to buy the stock at thepreviously higher strike price. You can then either hold it or sell it backinto the market at a signiﬁcantly lower price.
A put option is in-the-money (ITM) when the price of the underlyinginstrument is lower than the option’s strike price (see Table 3.2). For ex-ample,  a  put  option  that  gives  the  buyer  of  the  put  the  right  to  sell  100shares of IBM for $80 each is in-the-money when the current price of IBMis  less  than  $80,  because  the  option  can  be  used  to  sell  the  shares  formore than the current market price. A put option is at-the-money (ATM)when the price of the underlying shares is equal to its strike price. For ex-ample, an IBM put option with a strike price of $80 is at-the-money whenIBM can be purchased for $80. A put option is out-of-the-money (OTM)when  the  underlying  security’s  market  value  is  greater  than  the  strikeprice. For example, an IBM put option with an $80 strike price is out-of-the-money when the current price of IBM is more than $80. No one wouldwant to exercise an option to sell IBM at $80 if it can be sold directly formore. That’s why put options that are out-of-the-money by their expira-tion date expire worthless.
Strike Price
Put Option
Option Premium
Price of IBM = 80
1009590858075706560
ITMITMITMITMATMOTMOTMOTMOTM
20.8017.5013.8010.006.504.752.301.00.50
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Purchasing put options is generally a bearish move. A holder who haspurchased a put option beneﬁts when there is a decrease in the price ofthe underlying asset. This enables the holder to buy the underlying assetat a lower price on the open market and sell it back at a higher price to thewriter  of  the  put  option.  A  decrease  in  the  underlying  asset’s  price  alsopromotes an increase in the value of the put option so that it can be soldfor a higher price than was originally paid for it. The purchase of a put op-tion provides unlimited proﬁt potential (to the point where the underlyingasset reaches zero). The maximum risk of the put option is limited to theput premium plus commissions to the broker placing the trade.
LEAPS
The  acronym  LEAPS  stands  for  long-term  equity  anticipation  securities.While  the  name  seems  somewhat  arcane,  LEAPS  are  nothing  more  thanlong-term  options.  Some  investors  incorrectly  view  these  long-term  op-tions  as  a  separate  asset  class.  But  in  fact,  the  only  real  difference  be-tween  LEAPS  and  conventional  stock  options  is  the  time  left  untilexpiration. That is, while short-term options expire within a maximum ofeight  months,  LEAPS  can  have  terms  lasting  more  than  two  and  a  halfyears. At the same time, however, while the only real distinction betweenconventional options and LEAPS is the time left until expiration, there areimportant  differences  to  consider  when  implementing  trading  strategieswith long-term equity anticipation securities. One of the most importantfactors is the impact of time decay.
The  Chicago  Board  Options  Exchange  (CBOE)  ﬁrst  listed  LEAPS  in1990. The goal was to provide those investors who have longer-term timehorizons with opportunities to trade options. Prior to that, only short-termoptions with a maximum expiration of eight months were available. Theexchange labeled the new securities as long-term equity anticipation secu-rities in order to differentiate between the new contracts and already ex-isting short-term contracts. According to the exchange, “the name is notimportant. It is the ﬂexibility that long-term options can add to a portfoliothat is important.”
In order to add ﬂexibility to your portfolio using LEAPS, there are anumber  of  important  factors  to  consider.  First,  like  conventional  op-tions,  these  options  represent  the  right  to  buy  (for  calls)  or  sell  (forputs) an underlying asset for a speciﬁc price (the strike price) until expi-ration.  Each  option  contract  represents  the  right  to  buy  or  sell  100shares of stock. All LEAPS have January expirations, and new years areadded as time passes. For example, the year 2007 LEAPS were created
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after the expiration of the May 2004 contract. Approximately one-thirdof the stocks that already had LEAPS were issued the 2007 LEAPS afterthe  May  expiration.  The  remaining  two-thirds  will  be  listed  when  Juneand July option contracts expire.
Not  all  stocks,  however,  will  be  assigned  long-term  options.  In  or-der to have long-term options, the stock must already have listed short-term options. In addition, according to the CBOE, long-term options arelisted only on large, well-capitalized companies with signiﬁcant tradingvolume in both their stock and their short-term options. In order to ﬁndout if a given stock has LEAPS, simply pull up an option chain on theOptionetics.com web site’s