gray area, where there is some dispute over what was saidand never repeated.
ELECTRONIC TRADINGToday, many traders use electronic platforms to place their (option)trades. The same items must be specified as when placing your orderover the phone, although the computer software handling your trade
EXERCISE AND ASSIGNMENT
15
may be smart enough to tell whether you are opening or closing theposition—and it won’t ask if you’re “firm” or “customer” because itwill already know that. An electronic order entry screen will normallyshow you your order before you send it to the floor. This is yourchance to check for errors (similar to asking the phone clerk or broker to repeat the order back to you, if you are using humans in yourorder entry process). Do not get in the habit of automatically clickingon “OK” without rereading the particulars of your order. Any errorsthat occur are necessarily yours because there are no other peopleinvolved in the order entry process.Later on in the process, it may turn out that a computer malfunction at either your electronic brokerage firm or on the tradingfloor kept you from getting the execution you thought you were entitled to. This is not an “order entry error” and may be correctable, butyou would have to talk to some humans at your electronic brokeragefirm in order to sort out what, if any, compensation you deserve.
EXERCISE AND ASSIGNMENTAn option is said to have intrinsic value when the stock price isabove the strike price of a call or below the strike price of a put.Another term that describes the situation where an option has intrinsic value is to say that the option is in-the-money. If the option hasno intrinsic value, it is said to be out-of-the-money. For calls, thiswould mean that the underlying’s price is currently below the strikingprice of the call; and for puts, it would mean that the underlying’sprice is above the strike price of the put.Another related definition that is important is that of parity. Anyderivative security that is trading with no time value premium is saidto be trading at parity. Sometimes parity is used as a sort of measuring stick. One may say that an option is trading at a half-point or aquarter-point above parity.Example: XYZ is 53.July 40 call: 123⁄4July 45 call: 8July 50 call: 31⁄4
1
⁄4 point below parityAt parity1⁄4 point above parity
16
OPTION HISTORY, DEFINITIONS, AND TERMS
Ultimately, one of two things happens to an option as it reachesexpiration: (1) it is exercised or (2) it expires worthless. The owner(also called the holder) of an out-of-the-money option will let itexpire worthless. This is any call where the stock, index, or futuresprice is below the strike price at expiration. In the same manner, hewill let a put expire worthless if the underlying price is higher thanthe strike price at expiration. For example, if one owned the IBMJuly 50 call and IBM was trading at 45 at expiration, why would youwant to exercise your call to buy 100 shares of IBM at 50 when youcan just go to the stock market and buy 100 shares of IBM for 45?You wouldn’t, of course. Believe it or not, though, in the early daysof option trading, things like that did happen occasionally.In the movie Brewster’s Millions, starring Richard Pryor, a minor leaguebaseball player stands to inherit a large amount of money—something like$300 million—providing that he fulfill the terms of a rather crazy will: hemust spend (or lose) something like $30 million in a short period of time. Ofcourse, he goes through all kinds of crazy maneuvers to barely accomplishhis appointed task by the given date. It’s an intriguing movie, as it gets youthinking about how much money you could spend quickly. I’ve oftenthought that he could have simplified his life considerably by just buyingsome options that were about to expire, whose strike price was way abovethe current market price, and exercising them. He could have squanderedthe $30 million in an instant!
Of course, if the option is in-the-money—that is, the price of theunderlying is higher than the strike price of a call—then the owner ofthe call will exercise it because it has value. In an example similar tothe previous one, if you own the IBM July 50 call and IBM is sellingat 55, then you would exercise the call because you can buy IBM at50 via your call exercise, whereas you would have to pay 55 to buyIBM in the open market. Conversely, a put holder would exercise hisput if it is in-the-money—that is, if the underlying’s current pricewere below the strike price—because the put gives him the right tosell at the higher price, the strike.At the end of an option’s life, there is a good chance that it endsup in the hands of a market maker, or other “firm” trader, if it hasintrinsic value. This is because most “customers” sell their options in
EXERCISE AND ASSIGNMENT
17
the open market rather than exercise them. They do this for two reasons: (1) they are required to come up with substantially more cash tobuy the stock than it takes to buy the option, and (2) the commissionon one option trade is smaller than two stock trades (if you exercisea call and buy stock, for example, you’re going to have to sell thestock someday and pay another commission). Firm traders don’t paycommissions (so that’s why those seats cost so much!), and as expiration nears, they buy options from customers who are selling themin closing transactions. There is nothing particularly good or badabout this phenomenon, it’s just the most efficient way for everybodyto act as expiration approaches. The firm traders then exercise theoptions at expiration; they are not as concerned about capitalrequirements as most customers would be. In all probability, the firmtraders have already “squared up” their positions by the time theyexercise, so they don’t end up being long or short much stock orfutures at all.Many people have heard and even repeated the statement that“90 percent of all options expire worthless.” It’s unclear where thatgot started—some say from a study done back in the 1940s regarding the illiquid over-the-counter market at that time. This statement ispatent nonsense with respect to listed options, and one only has tothink about it to realize the fact. Consider this scenario: whenoptions are initially listed, they have striking prices that surround thecurrent price of the underlying (if IBM is trading at 50, then there willbe strikes of 40, 45, 50, 55, and 60, etc.). Now, puts and calls aretraded at all strikes—not necessarily in equal quantities, but there willbe some open interest in all series. As the stock fluctuates during thelife of the options, various strikes will become more liquid as IBM’sstock price nears that particular strike. As a result, open interest willbuild up at various strikes.By expiration, if IBM has risen in price, nearly all the calls will bein-the-money and therefore will not be worthless; if IBM falls in price,nearly all the puts will be in-the-money at expiration. Since optionsare listed at least nine months in advance of expiration, there is a significant chance that the stock or futures contract will have a seriousprice change by the time expiration rolls around. In either case, I canassure you that far less than 90 percent of the options are expiringworthless.
18
OPTION HISTORY, DEFINITIONS, AND TERMS
Statistics have been kept by the CBOE since options first startedtrading in 1973, and they show that only 30 percent of equityoptions expire worthless. The CBOE says that this figure is ratherconsistent, expiration after expiration, year after year. Not that theCBOE’s data would need verification, but we have kept similar statistics at our own firm, McMillan Analysis Corp., since 1998, and ourfigures match up quite well with the CBOE’s. What we have done isto look at the closing bid and offer of all equity options on the lastday of trading. If the option has a bid of 60 cents or more, wedeclare it to “have value.” Since 1998, on average, approximately58 percent of all options “have value” at expiration, based on openinterest. The CBOE further claims that about 10 percent of alloptions are closed out prior to expiration in transactions where bothparties (the buyer and the seller) are executing closing transactions.Adding this 10 percent figure to our observed statistics of 58 percentgives us the fact that 68 percent of all options have some worth atexpiration (and this doesn’t even count the ones that are worth morethan zero but less than 60 cents). Of course, this doesn’t mean thatonly 30 percent of option buyers lose money—they may have paidmore for the option than its worth at the end. Nor does it say anything about what percentage of out-of-the-money options expireworthless, but it does prove that the old wives’ tale of 80 percent or90 percent of options expiring worthless is a falsehood. This isimportant for novices to realize: many are led to naked option selling—sometimes with disastrous results—because they feel that theycan sell any option since they are operating under the false assumption that there will be a 90 percent chance of it expiring worthless.I personally began trading options in 1973 when my broker, Ron Dilks, firstpointed out a Business Week article to me that talked about listed optionson Kresge. Since then, through my various endeavors as individual trader,risk arbitrageur, and money manager, I have had several hundred thousand contracts that were held until expiration. I have no exact way of knowing how many were exercised or assigned and how many expired worthless,but my general feeling is that the count is about 50-50. That is, about halfwere in-the-money at expiration, and half were not. I do know, with a certainty born of 20 years of experience, that nowhere near 90 percentexpired worthless.
EXERCISE AND ASSIGNMENT
19
Mechanics of Exercise and AssignmentThe control of exercise is at the behest of the owner of the option.He is the one that determines when to exercise. To exercise a stockor index option, he must notify his broker by 4 P.M. Eastern time (or5 P.M. on expiration Friday) that he wants to exercise his option. Hisbroker then notifies the OCC, which is the central clearing house forall listed stock options. The OCC only deals with member firms (yourbrokerage firm, for example), so it does not “know” individual customers or individual accounts. The OCC then gathers all exercisenotices that it received that night and randomly assigns them tomember firms who are short the option series that have been exercised. The next morning, the member firm who was assigned thenrandomly picks out customer accounts that are short that particularoption series and notifies those option writers that they have beenassigned. This assignment notice should be received by the optionwriter well in advance of the opening of trading so he can plan anynecessary trading action that the assignment notice might necessitate. The trades are deemed to have taken place on the day of theexercise; thus the person who is assigned doesn’t find out until a dayafter the trade has actually taken place.Futures option exercises work in a similar manner, althoughtimes may vary slightly; and the exchange is the clearing center, notthe OCC.Figure 1.1 summarizes what transaction takes place in the underlying security when a put or call option is exercised or assigned. Forexample, if you exercise a put, you sell the underlying; and the sellerof the put, who is then assigned, buys the underlying. This illustrationis not correct for cash-based options (see Figure 1.2).Most novice investors understand that you may first buy a security and then later sell it to take a profit or a loss. There are only tworules you need to know about making money in any market.1. Buy low and sell high, not necessarily in that order.2. He who sells what isn’t his’n, must buy it back or go toprison.That is, you may sometimes be better able to profit by selling asecurity first and buying back later. This is apropos to stocks,
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OPTION HISTORY, DEFINITIONS, AND TERMSFigure 1.1EXERCISE AND ASSIGNMENT OF STOCK ORFUTURES OPTIONSCall Option
Put Option
Exercise
Buy Underlying
Sell Underlying
Assigned
Sell Underlying
Buy Underlying
options, futures, bonds, or just about anything. The second rule,though, indicates that if this is a physical security—stocks or bonds—then you can’t sell it without first borrowing it from an existingholder, or you could have a problem on your hands. However,futures and options may be sold short without any searching forexisting physical securities since they are contracts.This is a good place to define what the term cover means. In thecontext of stock trading, when you first buy stock and then later sellit, you are said to liquidate your position. However, if you had firstsold it short, then when you later buy it to close out your position,you are said to cover your position. Thus, it is common nomenclature to describe the closing out of a short position as covering. Theterm also applies to options. If you initially sell an option as the firsttransaction, that is called an opening sell transaction. This leavesyou short the option, and you may someday be assigned on thatoption, if you do not first buy it back (cover it).An extremely important point should be noted here: if you arean option seller, you can’t always tell if you’re going to beassigned at expiration merely by observing the closing price of theunderlying stock; you really need to wait until Monday morning tocheck your assignment notices. There are two reasons for this. Oneis that if a stock holder has a large position that he can’t sell in theopen market, he might decide to exercise puts (if he owns them) to“blow out” his position. This may be easier than holding onto thestock and trying to rehedge it, or trying to sell it in the open market.
EXERCISE AND ASSIGNMENT
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When I managed the arbitrage department for a major brokerage firm, wewere long a lot of Dayton Hudson stock on Friday, October 16, 1987, thetrading day before the crash. The stock had closed at about 50 on October15. We also owned the Oct 45 puts as a hedge. Friday, October 16, wasexpiration day for the October options. As the day progressed, the marketdropped over 100 points (the first time in history that that had happened)and Dayton Hudson was being smashed. It closed at 451⁄ 2, but with very little stock being bid for. It appeared that there was no way we could sell ourstock in the open market on Monday since the market was weak and thereweren’t many bids for the stock (of course, we didn’t realize that on Monday there was going to be a crash). In addition, the longer-term options inDayton Hudson were quite expensive and also rather illiquid. So, we exercised our Oct 45 puts and sold our entire position at 45—below the lastsale price. Thus, whoever was short those Dayton Hudson puts wasassigned, even though they were out-of-the-money, and he found out onMonday morning that he had bought stock at 45. I believe the stockopened around 42 and traded down from there.
The other reason that an option seller can’t be sure about assignments until Monday morning after expiration is that corporate newsmay be released after the 4 P.M. Friday close. Since options may beexercised up until 5 P.M. on expiration Friday, it is possible for newsto come out after the market closes that would make holders of theoptions want to exercise. This, by the way, is the reason your brokerage firm considers you to have written a naked option if you sellanother option on expiration Friday without bothering to cover adeeply out-of-the-money option for a sixteenth.Major news has come out between 4 P.M. and 5 P.M. on expiration Fridaymany times. Some of these have involved takeovers and some earningsnews, or other corporate news. A rather famous one occurred in 1994.Gerber Products was the subject of takeover rumors for quite a while. OnFriday, May 20 (expiration day), the stock closed at 345⁄8. After the close, atakeover bid was announced, and the stock opened at 51 on Monday, May23. Many sellers of the May 35 calls received assignment notices on thatMonday morning and were rather upset; some had gone home Friday nightassuming that their short May 35 calls were expiring worthless. There wereeven lawsuits filed, claiming that exercise notices were not delivered to theOCC on time. That is a very difficult allegation to prove, however.
22
OPTION HISTORY, DEFINITIONS, AND TERMS
Exercises Prior to Expiration. Futures options are rarely exercised prior to expiration, except when they are deeply in-the-money.In that case, an option holder may exercise in order to reduce his carrying costs for holding an expensive option. Stock options, however,are exercised prior to expiration fairly often. The most common timeis on the day before the stock goes ex-dividend. An equity call holderis not entitled to the dividend, so an in-the-money call that has notime value premium will drop in price by the ex-dividend amount.Example: XYZ is trading at 55 and is going to go ex-dividend by 50 centstomorrow. The July 50 call, which has only a short time remaining untilexpiration, is trading at 5. Tomorrow, the stock will open at 541⁄2 (aftergoing ex-dividend the 50 cents). Thus, the call will be trading for 41⁄2 thenext morning. The call holder will exercise (or sell his call to a marketmaker, who will exercise) rather than squander a half point.
Hence, if an in-the-money call has no time value premium on theday before the stock goes ex-dividend, the call holder will generallyexercise in order to preserve his value. The call seller, who isassigned, doesn’t find out until the next day (the morning that thestock is going ex-dividend). Thus, the seller finds out that he actuallysold the stock on the previous day, and thus he does not get thestock dividend. For this reason, it is often the case that when a stockdeclares a large cash dividend, the terms of the option are adjusted.Such an adjustment protects the call holder.Cash Option Exercise. We mentioned earlier that index optionsconvert into cash, rather than stock. This is a convenient arrangement that avoids having to deliver hundreds of stocks for one optionexercise. For example, there are options on the S&P 500 index.Suppose that the index is trading at a price of 453.47. Then, if anS&P call option is exercised, rather than receive a few shares of eachof 500 stocks—which would be a back-office nightmare—the personwho exercises receives cash in the amount of $45,347 (100“shares” at 453.47) less the value of the strike price. If a Dec 400call was being exercised, the call holder would thus receive a net of$5,347 ($45,347 – $40,000), less commission. The person who is
EXERCISE AND ASSIGNMENT
23
Figure 1.2EXERCISE AND ASSIGNMENT OF CASH-BASEDINDEX OPTIONSCall Option
Put Option
Exercise
Receive Cash
Receive Cash
Assigned
Pay Cash
Pay Cash
assigned is debited a like amount of cash, plus commission. Figure1.2 illustrates the exercise and assignment for cash-based options.American-style options can be exercised at any time during theirlife. All stock options, ETF options, and futures options are of thistype, as are OEX Index options. European-style options can only beexercised at the end of their life. Most index options are Europeanexercise. In Chapter 5, accompanying the discussion of intermarketspread strategies, you will find an in-depth description of how European options behave.Sellers of American-style options can be “surprised” by anassignment notice, because it can come at any time during the life ofthe option (there is usually one huge clue as to when such an assignment may happen, and it is that the option no longer has any timevalue premium). Writers of European-style options, however, knowthat they can only be assigned at expiration, so they can’t get calledout of their position early. This is an important difference whereindex options are concerned because all index options are cashbased, and American-style index options can create rather nasty scenarios when assigned.Example: Suppose that you own a spread in OEX options (which arecash-based and American-style): you are long the December 410 call andshort the Dec 420 call, with the index trading at 440. Your spread isprobably trading near its maximum value of 10 points (the differences ofthe strike prices). Then, you come to work one morning and find that
24
OPTION HISTORY, DEFINITIONS, AND TERMS
your Dec 420 calls have been assigned. Your account is debited 20 pointscash (440 – 420) and you are now left with the Dec 410 calls long, all bythemselves. You have gone from a hedged position with very little marketexposure to complete market exposure from the long side. If the stockmarket, as measured by OEX, were to open down substantially on themorning that you receive your assignment notice, you could lose a lot ofmoney very quickly.
For the reason described in the example, most index optionswere designed to be European-style so that these problems wouldn’toccur. However, OEX options remain American-style, a sort of outlaw venue, where macho traders don’t fear to tread. Since OEXoptions are the most heavily traded—and therefore the most liquid—index options, these situations arise quite often, especially shortlybefore expiration. In fact, it has become rather commonplace forarbitrageurs with large stock and OEX positions to attempt to influence the market so that they can favorably exit their positions viaearly exercise. These machinations are discussed in Chapter 3.
FUTURES AND FUTURES OPTIONSSince futures and especially futures options are less well-known tomost investors, some time will be taken to describe them. First, let’sdiscuss futures contracts; then we’ll get to the options. As notedearlier, futures contracts are standardized, calling for the delivery ofa specific amount of a commodity at some set time in the future.That “commodity” may be a physical commodity, such as corn ororange juice, or it may be cash, typically the case for index futures.Notice that there is no mention of anything like a “striking price”such as we have with options. Thus, futures contracts can rise infinitely and fall all the way to zero—owning one does not have limitedrisk like owning an option does. The margin required for a positionin futures is generally much smaller than the actual value of thephysical commodity underlying the futures contract—perhaps only5 percent or 10 percent of the value. This makes the leverage infutures trading quite large, and consequently makes them a ratherrisky trading vehicle.
FUTURES AND FUTURES OPTIONS
25
One of the things that makes futures so confusing to many is thatthere is no real standardization between the various commodities.What one might think of as the “expiration date” of a futures contractis typically referred to as the last trading day. The last trading day canvary widely within the expiration month, depending on which futurescontract you are talking about. For example, March grain futures(corn, wheat, soybean) don’t necessarily expire on the same day ofthe month as March pork belly futures or March S&P 500 futures.
First Notice DayA more important date for a futures trader is actually the first noticeday. For futures with a physical delivery, the first notice day is usuallyseveral weeks before the last trading day. After the first notice day,the holder of a futures contract may be called upon to take delivery of the underlying physical commodity. Thus, if a futures contract on gold calls for delivery of 100 ounces of a certain grade ofgold, and you are long gold futures past the first notice day, you mayhave to accept delivery of 100 ounces of gold at the current marketprice. If the current price of gold were $400 an ounce, that wouldrequire an investment of $40,000. It was mentioned earlier thatfutures can be traded for only a small amount of margin, thereby creating huge leverage. However, after first notice day, many brokeragefirms will require a much larger margin deposit because you are atrisk of having to take delivery.Normally, individual traders in the futures market are speculatorswho are not interested in taking or making delivery of physical commodities. They close out their positions in advance of first notice day.However, there is always the possibility that you could forget aboutthe date and wind up being called upon to take delivery of some commodity. There are any number of false horror stories about someonehaving to take delivery of 5,000 bushels of soybeans and havingthem dumped in their front yard. These are patently false, but theymake for good story telling, of course. In reality, your brokerage firmwill make arrangements for a physical storage facility to take deliveryin your name. You will then be charged fees for use of the storagefacility, and any other related charges.
26
OPTION HISTORY, DEFINITIONS, AND TERMS
One trader that I knew had a position in gold futures that he rolled frommonth to month as each contract expired (that is, he sold the near-termmonth future that he owned and replaced it by buying the gold futures contract that expired in the next month). He figured it was cheaper to own goldin this manner than to actually buy gold and store it in a safe deposit box. Hewas very careful about rolling the futures out before the first notice day of thecontract that he owned, but once he forgot and received a delivery notice.His brokerage firm told him that they were taking delivery of the requisite amount of gold, in his name, in a depository in Philadelphia. He wasassessed a fee of $190 per contract for this service. Of course, since hedidn’t really want to take delivery of the gold, his broker had to sell out thephysical gold and then replace it with futures in his account. This type oftransaction is rather common and is called exchanging physical forfutures. Selling the gold cost another commission, of course, but the netresult was rather painless for him. He never actually had to take possessionof the gold; he merely had to pay the handling fees for delivery and sale ofthe physical gold.
“First notice day” does not apply to cash-based futures, such asS&P 500 Index futures. In the case of that type of futures contract,there is no delivery; a cash settlement takes place on the last day oftrading of the contract. Therefore, since there is no physical deliverytaking place, there is no need for a first notice day.
Single Stock FuturesIn 2003, single stock futures were listed. These are futures that haveas their underlying 100 shares of listed stock, such as IBM, Microsoft, or Amgen. These futures have all the qualities of a futures contract; that is, they require very low margin (20 percent), they can besold on downticks, and they don’t need to be borrowed in order tosell short. Moreover, the regulatory agencies have worked out thedetails so that a stock owner/trader/investor does not have to havea separate futures accounts in order to trade these (whereas hewould need a separate futures account if he wanted to trade indexfutures). That works both ways, too, so a futures trader does nothave to have a separate stock account in order to trade these singlestock futures.
FUTURES AND FUTURES OPTIONS
27
There are not single stock futures listed for every stock. In fact, in2004, there were only a hundred or so. But if the product gains popularity in the future, there will be more. The actual stocks can easilybe found via an Internet search, most likely on the sites of the twofutures exchanges established specifically for the purpose of tradingsingle stock futures: NQLX and OneChicago.Single stock futures expire in various months: March, June, September, December, and the two other nearest months. They expireon the third Friday of the month, as options and index futures do;and they require physical delivery of the underlying stock if held tomaturity. As opposed to most other futures contracts, there are nodaily trading limits on single stock futures.Although there was much fanfare in the introduction of this product, it has not yet proved to be very popular with traders. Theextremely low margin—and, thus, high leverage—is apparently notconducive to what most stock traders are looking for. One of the supposed uses of this product was as a hedge. But if a person ownsstock and then sells a single stock futures against that stock, he is notonly hedged, he has effectively sold his stock position, for he can nolonger profit or lose, no matter what the stock does. In reality, ahedge is best established with options (Chapter 3 discusses usingoptions as insurance) so that a trader can limit his loss but still haveroom to make money from his stock holdings. Futures are notoptions; futures are much more like stock.Perhaps this product will become more popular in the future, butto date it has yet to find an audience.
Volatility Indices and FuturesA new product was listed by the CBOE in March 2004—futures onthe volatility indices. These volatility indices are explained in muchdetail in Chapters 3 and 4; but for definition purposes, one needs tounderstand that the CBOE, mainly, as well as the AMEX publishindices that attempt to measure the implied volatility of indexoptions. When the volatility index is high, then options are expensive; and when it is low, they are cheap, statistically. The first volatility index, VIX, was created in 1993 (although its price history wasbackdated to 1986).
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OPTION HISTORY, DEFINITIONS, AND TERMS
For more than 10 years, one could observe VIX but could nottrade it directly. It was, and still is, useful as a trading indicator (seeChapter 4), but it could not be bought or sold. Then, in 2004, theCBOE formed a futures exchange as part of its business and begantrading futures on VIX.While, at the time of this writing, it’s too early to tell whether thiswill be a successful product, it certainly seems to have a large numberof uses—from speculation to hedging for even the most conservativeaccount—and, thus, this author feels it will be a success.
Futures Options TermsExpiration Dates. Futures options expire in advance of the firstnotice day, so that all option contracts are out of the way beforephysical delivery of the underlying commodity begins taking place.This is the reason that some futures options—those on physical commodities, such as soybeans, corn, orange juice, coffee—actuallyexpire the month before the expiration month of the futures contract. Thus, March soybean futures options actually expire in February. Ask your broker, check Futures Magazine monthly, or checkthe web site of the appropriate futures exchange for the specificexpiration dates of the various futures option contracts. Also, manyfutures chart books carry the expiration dates of the options. Forthose who prefer to see the nitty gritty details themselves, AppendixB has a list of when the futures options on most of the major contracts expire. For example, coffee options expire on the first Fridayof the month preceding the expiration month of the futures contract.Thus, May coffee options would expire on the first Friday of April.Striking Prices. As mentioned earlier, each different type offutures contract has its own set of striking (or strike) prices for listedoptions. For example, soybean option strike prices are 25 points(cents) apart, corn options are 10 points apart, pork belly options are2 points apart, and so on. When first beginning to familiarize yourself with