home page and see if the stock has optionsexpiring in January 2006 or January 2007. If so, the stock does indeedhave long-term options available.
When long-term options become short-term options, they are subjectto a process known as melding. During that time, the terms of the optioncontract (the strike price, the unit of trade, expiration date, etc.) do notchange. The symbol assigned to the contract is the only thing that changesduring the melding phase. The exchanges generally assign different trad-ing symbols to long-term options to distinguish between the LEAPS andthe short-term contracts. Therefore, for bookkeeping purposes, the long-term option is converted to a short-term option and the symbol changesfrom  the  LEAPS  symbol  to  the  symbol  assigned  to  the  conventional  op-tions. This melding process occurs after either the May, June, or July expi-ration  that  precedes  the  ﬁrst  LEAPS  expiration.  After  that,  the  LEAPSstatus and special symbol are removed and the options begin trading likeregular short-term options. In sum, the terms of the options contract suchas  the  unit  of  trading,  strike  price,  and  expiration  date  do  not  changewhen LEAPS become short-term contracts. Therefore, neither will theoption’s price. It is merely a cosmetic change.
In trading, LEAPS can provide several advantages over short-term op-tions.  For  example,  when  protecting  a  stock  holding  through  the  use  ofputs, the investor can purchase the options and not worry about adjustingthe position for up to two and a half years—which means less in commis-sions.  At  the  same  time,  bullish  trades  such  as  long  calls  and  bull  callspreads can be established using out-of-the-money LEAPS. Doing so canprovide the investor a long-term operating framework similar to the tradi-tional buy-and-hold stock investor, but without committing as much trad-ing capital to the investment.
Another  difference  between  long-term  and  short-term  options  willbe  the  impact  of  time  decay,  which  refers  to  the  fact  that  options  losevalue  as  time  passes  and  as  expiration  approaches.  The  process  is  notlinear, however. Instead, time decay becomes greater as the option’s ex-piration approaches. Therefore, all else being equal, an option with two
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THE OPTIONS COURSE
years until expiration will experience a slower rate of decay than an op-tion with two months until expiration. As a result, LEAPS can offer bet-ter risk/reward ratios when implementing strategies that require holdinglong-term  options,  such  as  calendar  spreads  or  debit  spreads,  but  notstrategies  that  attempt  to  beneﬁt  from  the  impact  of  time  decay—likethe covered call.
I  love  LEAPS!  Remember  that  these  options  are  nothing  more  thanstock or index options with very distant expiration dates. These long-termoptions are available on the most actively traded contracts like Microsoft,General  Electric,  and  IBM.  They  allow  traders  more  time  for  trades  towork in their favor and have become among my favorite ways to play thelong-term  trends  in  the  stock  market.  Bottom  line:  Don’t  overlook  thepower of LEAPS.
OPTION CHAINS
In  order  to  view  the  various  option  prices  at  any  given  point  in  time,traders  often  use  a  tool  known  as  option  chains.  Not  only  do  optionchains offer the current market prices for a series of options, they also tellof an option’s liquidity, the available strike prices for the option contract,and  the  expiration  months.  In  fact,  option  chains  are  so  important  thatmany brokerage ﬁrms offer them to their clients with real-time updates.At the same time, while chains can be extremely helpful tools to the optionstrader, they are also fairly easy to understand and use.
Today, option chains are readily found. Not long ago, they were avail-able  mostly  to  brokerage  ﬁrms  and  other  professional  investors.  Now,however, individual investors can go to a number of web sites and ﬁnd op-tion  chains.  Most  online  brokerage  ﬁrms  provide  them,  as  do  severaloptions-related  web  sites.  For  instance,  at  the  Optionetics.com  homepage, pulling up an option chain for any given stock is simply a matter ofentering the stock ticker symbol in the quote box at the top of the screenand selecting “chain.”
An example of an option chain from Optionetics.com appears in Fig-ure  3.1.  It  is  a  snapshot  of  some  of  the  Microsoft  (MSFT)  options  withFebruary 2004 expirations. It is not a complete list of all the options avail-able at that time on MSFT. In fact, it is only a small fraction. Listing all ofMSFT options would take more than 100 rows and a couple of pages.
Option chains like this one are split in two right down the middle. Onthe left side we have calls and on the right we see puts. On the left side ofthe table, each row lists a call option contract for MSFT, and on the right
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FIGURE 3.1 Microsoft Option Chain (Source: Optionetics © 2004)
side  each  row  reﬂects  a  different  put  option.  Separating  the  puts  andcalls, we have a column with the heading “strike.” This tells us the strikeprice of both the puts and calls. For example, in the ﬁrst row, we have theFebruary 2004 options with the strike price of 20. In this case, the strikesoccur at 2.5-point increments. So, as we move down the rows, we see thestrike  prices  of  22.5,  25,  27.5,  and  so  on.  Once  we  reach  the  end  of  theFebruary 2004 strike prices, the March 2004 options would appear nexton the chain.
Each column within the ﬁgure provides a different piece of informa-tion. On each side of the ﬁgure (call and put), the ﬁrst column lists the op-tion’s  symbol.  For  example,  on  the  left  half  of  the  ﬁgure,  the  ﬁrst  rowshows the February 20 call, which has the ticker symbol MQFBD (we willsee how to create options symbols shortly).
As with stocks, options have a bid price and an ask price, which ap-pear in columns two and three. The bid is the current price at which themarket will buy the option, and the ask is the price at which the optioncan  be  bought.  The  next  column  indicates  the  option’s  open  interest.Open interest is the total number of contracts that have been opened andnot  yet  closed  out.  For  instance,  if  an  option  trader  buys  (as  an  initialtransaction) ﬁve February 25 calls, the open interest will increase by ﬁve.When he or she later sells those ﬁve calls (to close the transaction), openinterest  will  decrease  by  ﬁve.  Generally,  the  more  open  interest,  thegreater  the  trading  activity  associated  with  that  particular  option  and,hence, the better the liquidity. Open interest is updated only once a day.
The  information  included  in  an  option  chain  will  differ  somewhatdepending  on  the  source,  but  the  variables  in  Figure  3.1  are  usuallyfound. Some chains will include the last price, the day’s volume, or otherbits of trading data. Regardless of the source, chains are important. Theyallow  traders  to  see  a  variety  of  different  contracts  simultaneously,which can help the trader sort through and identify the option contractwith the most appropriate strike, expiration month, and market price forany speciﬁc strategy.
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OPTION SYMBOLS
Before we move on to the next chapter and the discussion of actual trad-ing strategies, let’s discuss one more basic element of the options market:the option symbol. In the stock market, stocks on the New York Stock Ex-change and American Stock Exchange usually have symbols consisting ofone, two, or three letters. For example, the symbol for Sears is simply S,Coca-Cola  has  the  symbol  KO,  and  International  Business  Machines  iseasy  to  remember—IBM.  Nasdaq-listed  stocks  have  symbols  with  four(and on rare occasions ﬁve or six) letters. That’s why some traders referto Nasdaq stocks as the “four-letter stocks.”
Option  contracts  are  a  bit  more  complicated  than  stocks,  however,and the ticker symbols include three pieces of information. The ﬁrst partof  an  option  symbol  describes  the  underlying  stock.  It  is  known  as  theroot symbol and is often similar to the actual ticker of the stock. For in-stance, the root symbol for International Business Machines is straightfor-ward. It is the same as the stock symbol: IBM. Four-letter stocks, however,always  have  root  symbols  different  from  their  stock  symbols.  For  in-stance, while the stock symbol for Microsoft is MSFT, the option symbolis MSQ. Option root symbols can have one, two, or three letters, but neverfour.  In  the  case  of  a  stock  price  that  has  moved  dramatically  higher  orlower,  there  may  be  two  or  more  root  symbols.  For  example,  referringback  to  the  option  chain  for  Microsoft,  we  can  see  that  it  shows  rootsymbols of MQF and MSQ.
The  second  part  of  an  option  symbol  represents  the  month  and  de-ﬁnes whether the option is a put or a call. For example, a January call usesthe  letter  A  after  the  root  symbol.  Therefore,  the  IBM  January  call  willhave the root symbol IBM and then A, or IBMA. The February call is B,March C, and so on until December, which is the letter L (the twelfth letterin the alphabet). The expiration months for puts begin at the letter M. Forinstance, the IBM February put will have the letter N following the rootsymbol, or IBMN. Table 3.3 provides the symbol letter for each month.
The ﬁnal element to an option symbol reﬂects the strike price. Gener-ally, the number 5 is assigned the letter A, 10 to the letter B, 15 the letter C,and so on until 100, which is given the letter T. Therefore, the IBM January95 call will have the symbol IBMAS. Table 3.3 provides the letters assignedto each strike price.
In conclusion, the symbol for any option contract will consist of threepieces of information. The ﬁrst is the root symbol. It is often similar to theticker  symbol  of  the  underlying  stock,  but  not  always.  The  root  symbolcan also vary based on the strike prices available for the option; whetherit is a one-, two-, three-, or four-letter stock; and if it is a LEAPS or not. Thesecond part of the symbol simply deﬁnes the expiration month. The ﬁnal
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THE OPTIONS COURSE
element indicates the strike price of the option. Taken together the threepieces of information deﬁne the option symbol, which is used to pull upquotes and place orders.
EXPIRATION CYCLES REVISITED
Not all stocks have options available to trade. Among other rules, newlypublic  companies—low-priced  stocks  and  ﬁrms  that  do  not  have  muchtrading  volume  in  their  stock—will  not  have  options.  Tradable  options,those listed on the exchanges, are solely the creations of the exchanges.Companies have no ability to either create or eliminate options for theirﬁrms. Firms do create unique options as incentives for their key employ-ees and sometimes as sweeteners or bonuses for the purchase of stock.Such options, which are issued by companies to their employees, are dif-ferent from the options discussed throughout this book. Instead, we aretalking about options that trade on the organized options exchanges andcan be bought and sold through a brokerage ﬁrm.
The standard, tradable options on the options exchanges are all cre-ated by the exchanges themselves. To determine whether options exist forthe  stock  you  are  contemplating  trading,  you  can  check  out  numerousweb sites (including www.optionetics.com or the Chicago Board OptionsExchange site, www.cboe.com); look in the option tables of the newspa-per; or call your broker. Once you have determined that options are avail-able,  you  can  retrieve  a  quote  or  an  option  chain  (see  Figure  3.2).  Let’sreview this now and consider the six issues that deﬁne an option.
1. Contract size.2. Month of expiration.3. Underlying stock.4. Strike price.5. Type of option (put or call).6. Bid and ask price of the option.
The  distinguishing  factor  of  options  is  that  they  expire;  unlike  equi-ties, options have a ﬁnite life. Thus, knowing the expiration date is criti-cal.  One  of  the  great  keys  to  the  success  of  tradable  options  is  thestandardization  of  expiration  dates.  All  stock  options  ofﬁcially  expire  at10:59 P.M. Central time on the Saturday following the third Friday of thedesignated month. However, for all practical purposes, the options expireat the close of business on the third Friday of the month because that is
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Options Chains
63
Symbol:  AMZN 
Option Chain 
>
get info  Symbol Lookup
Amazon.com Inc (AMZN)
Miniquote (delayed)
last: 21.36 
chg: 0.17 
%chg: 0.80%
Calls Symbol 
ZQNBQ 
ZQNBC 
ZQNBQ 
ZQNBD 
ZQNBS 
ZQNBC 
ZQNBR 
ZQNBF 
ZQNBZ 
Bid 
Ask 
Op. Int. 
            Strike 
8.800 
9.000 
6.300 
6.500 
3.800 
4.000 
1.300 
1.450 
15 
616 
2468 
6181 
0.000 
0.050 
15386 
0.000 
0.050 
4966 
0.000 
0.050 
0.000 
0.050 
0.000 
0.050 
507 
241 
0 
Feb03-12.500 
Feb03-15.000 
Feb03-17.500 
Feb03-20.000 
Feb03-22.500 
Feb03-25.000 
Feb03-27.500 
Feb03-27.500 
Feb03-27.500 
PutsSymbol 
Bid 
Ask 
Op. Int.
ZQNNO 
0.000 
0.050 
281
ZQNNC 
0.000 
0.050 
5114
ZQNNO 
0.000 
0.050 
10695
ZQNND 
0.000 
0.050 
22688
ZQNNE 
ZQNNE 
1.100 
1.200 
5042
3.500 
3.700 
749
ZQNNR 
6.000 
6.200 
ZQNNF 
8.500 
8.700 
ZQNNZ  11.000 
11.200 
90
14
0
FIGURE 3.2 Option Quote for Amazon.com (AMZN) February Call and PutOptions (Source: Optionetics © 2004)
usually the last time to trade them. The ﬁnal accounting (except for rareerrors) is completed early Saturday morning.
As  previously  mentioned,  optionable  stocks  are  assigned  to  one  ofthree  expiration  cycles  (January,  February,  or  March)  by  the  exchangewhen the options are ﬁrst created for the ﬁrm. The cycles, and their stan-dard expiration months, are listed in Table 3.4.
All stocks with options have active options for the current month, thenext  month  out,  and  then  the  next  two  cycle  months.  For  instance,  onMarch 30, a stock in each of the cycles would have options expiring on thethird Friday of the months in Table 3.5.
In  addition  to  the  four  months  listed  in  Table  3.5  for  all  optionablestocks, the most active stocks also have LEAPS that will expire on Janu-ary of the next two years. Those LEAPS become regular options when theJanuary date is within nine months of expiration. A new LEAPS option iscreated each May, June, or July, depending on which cycle the particularstock is located in, for the subsequent year out.
TABLE 3.4 Cycles and Expiration Months
Cycle
January
February
March
Expiration months
JanuaryAprilJulyOctober
FebruaryMayAugustNovember
MarchJuneSeptemberDecember
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TABLE 3.5 Four Expiration Months for 
Optionable Stocks
Cycle
January
February
March
Current monthNext monthNext cycle monthSecond cycle month October
AprilMayJuly
AprilMayAugustNovember
AprilMayJuneSeptember
To  further  complicate  matters,  a  given  stock  may  not  have  optionscreated if there will be some dramatic change in the stock that is knownby  the  exchanges.  For  instance,  if  the  ﬁrm  is  about  to  be  acquired  ordelisted, the exchange may not create a particular set of options for thenext normal month, awaiting events. In all cases, check with your broker,the CBOE, or even the Optionetics.com web site to be sure that a particu-lar option exists.
The strike price, or exercise price, is designed to provide options thatwill  attract  trading  volume.  Thus,  options  are  created  that  closely  sur-round the current stock price. The norm is to set the strike prices in thefollowing increments:
• For stock prices under $25, strikes will be $2.50 apart, starting at $5
(5, 7.5, 10, etc.).
• For stock prices between $25 and $200, strikes will be $5 apart (25, 30,
35, etc.).
• For stock prices greater than $200, strikes will be $10 apart (200, 210,
220, etc.).
• In  2003,  options  with  one-point  increments  between  strike  pricesstarted trading on some actively traded low-priced stocks. For exam-ple, a $5 stock might have strike prices of 5, 6, 7, and so on.
As  the  stock  price  moves  up  or  down,  new  options  are  createdaround the new stock prices. However, the old options will remain in ef-fect  until  expiration  (they  are  not  eliminated  just  because  the  stockprice has moved).
As with most things in life, these rules are not absolute. Stock splits,for  instance,  can  cause  some  strange  strikes.  If  a  company  institutes  asplit, the option prices and numbers of contracts will also be affected. A 2-for-1 split would cause an option with a strike of 85 to turn into two op-tions with a strike of 42.50. Similarly, a 3-for-1 split would cause the sameoption to become three options, each with a strike of 28.33.
Also,  for  stocks  that  move  rapidly  up  and  down,  like  the  volatile 
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technology  stocks,  there  are  often  options  only  at  10-point  increments,even though the stock is selling well under $200. This is particularly trueof options that are several months from expiration. The reasoning is thatwith rapid stock price movements, if options were created for every stan-dard strike, there could easily be 30 or 40 strikes for both puts and calls onthat stock for each expiration month. The problem is that every time thestock price moves each of those options must be repriced, and the calcu-lations and tracking required become humongous. Likewise, with a givenvolume of option trading for a particular stock, the more option choicesavailable,  the  less  volume  any  one  option  will  likely  have,  resulting,  ofcourse, in decreased liquidity.
INTRINSIC VALUE AND TIME VALUE
Intrinsic value is deﬁned as the amount by which the strike price of an op-tion is in-the-money. It is a very important value to determine, since it isthe portion of an option’s price that is not lost due to the passage of time.For a call option, intrinsic value is equal to the current price of the under-lying asset minus the strike price of the call option. For a put option, in-trinsic  value  is  equal  to  the  strike  price  of  the  option  minus  the  currentprice of the underlying asset. If a call or put option is at-the-money, the in-trinsic  value  would  equal  zero.  Likewise,  an  out-of-the-money  call  orput option has no intrinsic value. The intrinsic value of an option doesnot depend on how much time is left until expiration. It simply tells youhow  much  real  value  you  are  paying  for.  If  an  option  has  no  intrinsicvalue, then all it really has is time value, which decreases as an optionapproaches expiration.
Time value (theta) can be deﬁned as the amount by which the price ofan option exceeds its intrinsic value. Also referred to as extrinsic value,the time value of an option is directly related to how much time the optionhas until expiration. Theta decays over time. For example, if a call costs$5 and its intrinsic value is $1, the time value would be $5 – $1 = $4. Let’suse the following table to calculate the intrinsic value and time value of afew options.
Call Strike
January
February
Price of IBM = 86
808590
6.402.60.90
7.503.901.60
May
8.254.752.75
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Here are the calculations for the IBM February 85 calls if IBM is now
trading at $86:
• Intrinsic value = underlying asset price minus strike price: $86 – $85 =
$1.
• Time value = call premium minus intrinsic value: $3.90 – $1 = $2.90.
Now  let’s  look  at  the  intrinsic  value  of  each  option  relative  to  its
time value.
• The January 80 call has a minimum value of 6; therefore, you are pay-
ing .40 point of time value for the option (6.40 – 6 = .40).
• The  February  80  call  has  a  minimum  value  of  6;  therefore,  you  are
paying 1.50 points of time value for this option (7.50 – 6 = 1.50).
• The May 80 call has a minimum value of 6; therefore, you are paying
2.25 points of time value for this option (8.25 – 6 = 2.25).
As you can see, the intrinsic value of an option is the same, no matterwhat  time  is  left  until  expiration.  Now  let’s  look  at  some  options  withinthe same month, but with different strike prices:
Strike
707580
Price of IBM = 86
January
16.2511.506.40
• The January 70 call has 16 points of intrinsic value (86 – 70 = 16) and
.25 points of time value (16.25 – 16 = .25).
• The January 75 call has 11 points of intrinsic value (86 – 75 = 11) and
.50 points of time value (11.50 – 11 = .50).
• The January 80 call has 6 points of intrinsic value (86 – 80 = 6) and .40
points of time value (6.40 – 6 = .40).
Obviously, an option with three months till expiration is worth morethan  an  option  that  expires  this  month.  Theoretically,  the  option  withthree  months  till  expiration  has  a  better  chance  of  ending  up  in-the-money  than  the  option  expiring  this  month.  That’s  why  an  OTM  optionconsists of nothing but time value. The more out-of-the-money an optionis, the less it costs. However, since it has no real (intrinsic) value, all youare paying for is time value (i.e., the time to let your OTM option becomeproﬁtable due to a swing in the market). The probability that an extremely
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OTM option will turn proﬁtable is quite slim. To conﬁrm this, just go toyour local library and look up some options’ prices in previous copies ofa  ﬁnancial  newspaper,  such  as  Investor’s  Business  Daily.  Compare  thepresent-day  price  of  a  particular  option  to  prices  in  back  issues  of  thesame publication.
Since  you  can  exercise  an  American-style  call  option  anytime  youwant, its price should not be less than its intrinsic value. An option’s in-trinsic  value  is  also  called  the  minimum  value  primarily  because  it  tellsyou the minimum the option should be selling for (i.e., exactly what youare  paying  for  and  how  much  time  value  you  have  left).  What  does  thismean?  Most  importantly,  it  means  that  the  cheaper  the  option,  the  lessreal value you are buying. Intrinsic value acts a lot like car insurance. Ifyou buy a zero-deductible policy and you have an accident, even a fenderbender,  you’re  covered.  You  pay  less  for  a  $500-deductible  policy,  but  ifyou have an accident the total damage must exceed $500 before the insur-ance company will pay for the remainder of the damages.
The  prices  of  OTM  options  are  low,  and  get  even  lower  furtherout-of-the-money.  To  many  traders,  this  inexpensive  price  looksgood.  Unfortunately,  OTM  options  have  only  a  slim  probability  thatthey  will  turn  profitable.  The  following  table  demonstrates  this  slimchance of profitability.
Call Strike
January
Intrinsic Value
Time Value
Price of XYZ = 86
7075808590
17.0013.5010.756.503.00
16.