.
32. ______________  gives  you  the  opportunity  to  move  in  and  out  of  a
market with ease.Answer: D—Liquidity.Discussion: If an option is illiquid it can result in bad ﬁlls and widebid-ask  spreads.  With  stocks,  we  want  to  see  volume  of  at  least300,000  shares  traded  on  a  daily  basis.  For  options,  volume  doesn’t
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necessarily have to be large, but there should be open interest of atleast 100 contracts. It’s easy to distinguish the options and stocks thathave low liquidity, as the bid and ask prices will be farther apart.
33. ______________  measures  the  amount  by  which  an  underlying  is
expected to ﬂuctuate in a given period of time.Answer: A—Volatility.Discussion: Volatility  is  a  percentage  that  measures  the  amount  bywhich the underlying stock or option is expected to change in a givenperiod of time. A stock’s volatility has a signiﬁcant effect on the priceof its options. A highly volatile stock has a better chance of making asubstantial move than a low-volatility stock. A more volatile asset offerslarger swings upward or downward in price in shorter time spans thanless volatile assets. Large movements, in turn, are attractive to optionstraders who are always looking for big directional swings to make theircontracts  proﬁtable.  Therefore,  the  options  of  a  high-volatility  stockgenerally  command  higher  premiums.  Implied  volatility  tells  a  traderhow much a stock is expected to move and is a crucial element in thepricing of an option. Understanding implied volatility is one of the mostcrucial factors in becoming a successful options trader.
MEDIA ASSIGNMENT
With  the  proliferation  of  new  indexes  and  ETFs,  take  the  time  to  viewcharts of these instruments. Look for volatile issues and get a feel for howthese securities move. Then choose a handful of stocks in various sectorsand  watch  them  to  see  how  they  react  and  perform.  Even  if  we  stickstrictly to individual stock options, learning to gauge the entire sector isan  important  part  of  choosing  the  appropriate  direction.  Looking  at  thevolatility of a sector can also provide us with a better understanding of thevolatility of an individual stock within that sector.
VOCABULARY DEFINITIONS
Asset: A balance sheet item expressing what an individual or a corporationowns.Assignment: Refers to the option writer’s (seller’s) obligation to sell orbuy a stock or other ﬁnancial instrument at the strike price for which
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the writer sold the contract. The buyer of an option has the right (butnot  the  obligation)  to  exercise  the  option—that  is,  buy  the  underlyingasset at the strike price of the contract (long call) or sell (deliver) theunderlying asset to the option writer at the strike price of the contract(long  put).  Assignment  means  the  options  writer  receives  an  exercisenotice by another options writer that requires him to sell (in the case ofa call) or purchase (in the case of a put) the underlying security at thespeciﬁed strike price.Bond: A debt obligation issued by a government (i.e., Treasury bond) orcorporation (i.e., corporate bond) that promises to pay its bondholders pe-riodic interest at a ﬁxed rate (the coupon), and to repay the principal of theloan at maturity (a speciﬁed future date). Bonds are usually issued with apar or face value of $1,000, representing the principal or amount of moneyborrowed. The interest payment is stated on the face of the bond at issue.Capital gain: The proﬁt realized when a capital asset is sold for a higherprice  than  the  purchase  price.  Your  costs  (when  you  buy)  include  thecommission  you  paid  your  broker  and  are  deducted  from  the  proceedswhen you sell. In a mutual fund, capital gains are created when the fundbuys and sells securities. These gains are then distributed to shareholdersat least annually. Shareholders can also earn capital gains by redeemingtheir units at higher prices than they originally paid.Commodity: Any bulk good traded on an exchange or in the cash market;examples include metals, grains, and meats.Dividend: When  companies  pay  part  of  their  proﬁts  to  shareholders,those payments are called dividends. A mutual fund’s dividend is moneypaid to shareholders that comes from the investment income the fundhas  earned.  This  amount  is  announced  before  it  is  paid  and  is  distrib-uted to shareholders of record on a per share basis. Dividends may bein the form of cash, stock, or property. The board of directors must declareall dividends.Exchange-traded fund (ETF): A fund that tracks an index, but can betraded like a stock. Many ETFs have options available allowing traders toproﬁt from moves within a sector.Exercise: To implement the right of the holder of an option to buy (in thecase of a call) or sell (in the case of a put) the underlying security. Whenyou exercise an option, you carry out the terms of an option contract.Futures: A  term  used  to  designate  all  contracts  covering  the  purchaseand sale of ﬁnancial instruments or physical commodities for future deliv-ery on a commodity futures exchange.Hedger: A trader who enters the market with the intent to protect a posi-tion in the underlying asset; an investor who uses the futures market to
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minimize the risk in his or her business. Hedgers may be manufacturers,portfolio managers, bankers, farmers, and so on. Hedgers also use optionsto  protect  stock  positions.  For  example,  an  investor  can  use  a  put  tohedge a stock or an index put to hedge a stock portfolio.
Historic volatility: Calculated by using the standard deviation of under-lying asset price changes from close-to-close of trading going back 21 to23 days. A measurement of how much a contract price has ﬂuctuated overa speciﬁc period of time in the past; usually calculated by taking a stan-dard deviation of price changes over a time period.
Implied volatility: The volatility computed using the actual market pricesof an option contract and one of a number of pricing models. For example,if the market price of an option rises without a change in the price of theunderlying stock or future, implied volatility will have risen.
Liability: A  legal  obligation  to  pay  a  debt  owed.  Current  liabilities  aredebts  payable  within  12  months.  Long-term  liabilities  are  debts  payableover a period of more than 12 months.
Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneysthat  may  be  required  on  short  notice,  whether  for  emergencies  or  forplanned purchases.
Option premium: The price of an option; the amount of money that theoption  holder  pays  for  the  rights  and  the  option  writer  receives  for  theobligations granted by the option.
Payable date: The date on which a declared stock dividend or a bondinterest payment is scheduled to be paid.
Speculator: An  investor  or  trader  who  is  willing  to  take  large  risks  for  achance to make large gains. For example, buying a very volatile stock andhoping to sell it a day or a week later at a higher price is speculative trading.Speculators  sometimes  buy  puts  and  calls  in  anticipation  of  a  short-termmove higher or lower in the underlying asset. In the futures market, a specu-lator is a trader who hopes to proﬁt from a directional move in the underly-ing instrument and attempts to anticipate price changes and, through buyingand selling futures contracts, aims to make proﬁts. A speculator doesn’t usethe futures market in connection with the production, processing, market-ing, or handling of a product. The speculator has no interest in making ortaking delivery.
Stock: A share of a company’s stock translates into ownership of part ofthe company. Thus, when you own any shares of a company’s stock, youown  part  of  the  company.  How  much  you  own  depends  on  how  many
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shares of stock you have. Holders of common stock are the last to be paidany  proﬁts  from  the  company  but  are  likely  to  proﬁt  most  from  anygrowth it has. Owners of preferred stock are paid a ﬁxed dividend beforeowners of common stock, but the amount of the dividend doesn’t usuallygrow if the company grows.Strike price: A price at which the stock or commodity underlying a callor put option can be purchased (in the case of a call) or sold (for a put)over  the  speciﬁed  period.  For  instance,  a  call  contract  may  allow  thebuyer  to  purchase  1,000  shares  of  ABC  at  any  time  in  the  next  threemonths at an exercise (strike) price of $75.
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CHAPTER 3
OptionBasics
SUMMARY
In order to become a successful options trader, one must also develop anunderstanding  of  basic  concepts  such  as  option  quotes,  symbols,  exer-cise  and  assignment,  types  of  brokerage  accounts,  and  the  key  factorsthat  determine  options  prices.  This  chapter  is  designed  to  help  build  afoundation for successful options trading by providing a primer on theseoption basics.
Simply put, options give you the ability to control an underlying stock(or  other  ﬁnancial  instrument)  that  the  option  is  written  on.  Each  stockoption controls 100 shares of the underlying stock. If you are buying an op-tion, you will have the right, but not the obligation, to buy (in the case of acall) or sell (in the case of a put) a stock at a speciﬁc price by a certaindate. Option sellers, in contrast, have the obligation to deliver (call) or pur-chase  (put)  the  underlying  stock  at  a  speciﬁc  price  by  a  certain  date.  Inother words, option buyers have rights, while option sellers have obliga-tions and the additional risk should the option holder exercise the option.If you ﬁnd a stock that you are interested in trading options on, simply askyour broker whether it has options, or access the Optionetics web site tosearch for option chains.
Chapter 3 of the main text also provides an in-depth discussion of thedifference  between  put  and  call  options.  Particular  attention  is  paid  tostrike prices, premiums, expiration dates, and recognizing whether an op-tion  is  in-the-money,  at-the-money,  or  out-of-the-money.  These  topics  areextremely  important  to  the  active  options  trader.  Initially  such  concepts
31
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might seem a bit cumbersome, but through time, these basic concepts willbecome second nature to the experienced options trader.
QUESTIONS AND EXERCISES
1. A ______________ gives the buyer the right, but not the obligation, tobuy a speciﬁed number of shares or contracts of the underlying secu-rity at a predetermined price during a set period of time.
A. Futures contract.
B. Call option.
C. Stock.
D. Derivative.
2.
If you sign a 12-month lease agreement with an option to buy a houseat $200,000 and the seller charges $1,000 extra just for that 12-monthoption to buy the house, that charge is called the ______________.
A. Strike price.
B. Expiration.
C. Credit.
D. Premium.
3. True or False: Options are available on all stocks.
4. True or False: Once you own an option, you are obligated to buy or
sell the underlying instrument.
5. Once an option ______________, you lose your right to buy or sell the
underlying instrument at the speciﬁed price.
A. Moves in-the-money.
B. Moves out-of-the-money.
C. Expires.
D. None of the above.
6. Options when bought are done so at a ______________ to the buyer.
A. Debit.
B. Credit.
C. Margin.
D. None of the above.
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7. Options  when  sold  are  done  so  by  giving  a  ______________  to  the
seller.
A. Debit.
B. Credit.
C. Margin.
D. None of the above.
8. Options  are  available  at  numerous  ______________  based  on  the
price of the underlying instrument.
A. Premiums.
B. Margins.
C. Expiration dates.
D. Strike prices.
9. The  more  time  until  expiration,  the  more  ______________  the 
premium.
A. Expensive.
B.
Inexpensive.
10. True  or  False:  Strike  prices  for  stocks  and  indexes  come  only  in
multiples of 5.
11. Name the three possible relationships strike prices have to the current
price of the underlying asset.
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
12. What  is  the  main  difference  between  American-style  options  and
European-style options?
____________________________________________________________
____________________________________________________________
13. What are the three possible resolutions of an options contract?
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
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THE OPTIONS COURSE WORKBOOK
If the writer of an option receives ______________, the option has beenassigned and the writer is obligated to buy (or sell) the speciﬁed amountof underlying assets at the strike price from (or to) the assigned holder.
A. A margin call.
B. An assignment notice.C. An exercise notice.
D. None of the above.
15. A  stock  option  represents  the  right  to  buy  or  sell  ______________
shares of the underlying stock.
A. 50.
B. 100.
C. 250.
D. 500.
16. The stock option expiration date is always the Saturday following the
______________ Friday of the expiration month.
A. First.
B. Second.
C. Third.
D. Last.
17. Strike prices for stock options come in increments of ______________
for stocks over $25 per share.
A. $1.
B. $2.
C. $5.
D. $10.
18. True or False: The strike prices and expiration dates of options con-
tracts differ depending on the underlying instrument they represent.
19. Name the ﬁve components that make up option symbols:
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
4. _________________________________________________________
5. _________________________________________________________
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20. Name the two types of options.
1. _________________________________________________________
2. _________________________________________________________
21. A ______________ gives the buyer the right (not the obligation) to buy
the underlying stock shares or futures contract.
A. Call option.
B. Put option.
C. Futures option contract.
D. Stock option contract.
22.
If the market price is more than your strike price, your call option is______________.
A. At-the-money.
B.
In-the-money.
C. Out-of-the-money.
23.
If the market price is less than your strike price, your call option is______________.
A. At-the-money.
B.
In-the-money.
C. Out-of-the-money.
24.
If  the  market  price  is  the  same  as  your  strike  price,  your  option  is______________.
A. At-the-money.
B.
In-the-money.
C. Out-of-the-money.
25.
If you buy call options, you are ______________.
A. Going long.
B. Going short.
C. Going delta neutral.
D. Hedging.
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26.
If you sell call options, you are ______________.
A. Going long.
B. Going short.
C. Going delta neutral.
D. Hedging.
27.
If  you  are  ______________  (believe  the  market  will  rise),  then  youwant to buy calls.
A. Bearish.
B. Bullish.
28.
If  you  are  ______________  (believe  the  market  will  drop),  then  youwant to buy puts.
A. Bearish.
B. Bullish.
29.
If you buy a call option, your risk is ______________.
A. Unlimited.
B. The price of the underlying.
C. The margin of the underlying.
D. The price of the premium.
30.
If you sell a call option, your risk is ______________.
A. Unlimited.
B. The price of the underlying.
C. The margin of the underlying.
D. The price of the premium.
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31.
If the current price of XYZ is $50, ﬁll in the blanks designating eachstrike as ITM, ATM, or OTM.
Strike Price of Option
Call Option Moneyness
70
65
60
55
50
45
40
35
30
32. Name the two ways proﬁts can be realized from purchasing a call
option.
1. _________________________________________________________
2. _________________________________________________________
33. All  the  options  that  have  the  same  unit  of  trading,  expiration  date,
and strike price are called an ______________.
A. Option class.
B. Option series.
C. Option division.
D. Option suit.
34. A ______________ gives the buyer the right (not the obligation) to sell
the underlying stock shares or futures contract.
A. Call option.
B. Put option.
C. Futures option contract.
D. Stock option contract.
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If the market price is less than your strike price, your put option is______________.
A. At-the-money.
B.
In-the-money.
C. Out-of-the-money.
36.
If the market price is more than your strike price, your put option is______________.
A. At-the-money.
B.
In-the-money.
C. Out-of-the-money.
37.
If the market price is the same as your strike price, your put option is______________.
A. At-the-money.
B.
In-the-money.
C. Out-of-the-money.
38.
If you buy put options, you are ______________.
A. Going long.
B. Going short.
C. Going delta neutral.
D. Hedging.
39.
If you sell put options, you are ______________.
A. Going long.
B. Going short.
C. Going delta neutral.
D. Hedging.
40.
If you buy a put option, your risk is ______________.
A. Unlimited.
B. The price of the underlying.
C. The margin of the underlying.
D. The price of the premium.
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41.
If you sell a put option, your risk is ______________.
A. Limited to the stock falling to zero.
B. The price of the underlying.
C. The margin of the underlying.
D. The price of the premium.
42.
If the current price of XYZ is $50, ﬁll in the blanks designating eachstrike as ITM, ATM, or OTM.
Strike Price of Option
Put Option Moneyness
70
65
60
55
50
45
40
35
30
MEDIA ASSIGNMENT
In order to better understand the basics of puts and calls, let’s go to theOptionetics.com web site and create an option chain. First, connect tothe Internet and type www.optionetics.com into the title bar of your Webbrowser. Next, type a symbol for the stock or index of your choice in thequote  box  that  appears  at  the  top  of  the  home  page.  For  instance,  usethe symbol QQQ. Finally, select “Chain” from the drop-down menu andclick “Go.”
After clicking “Go,” an option chain for the Nasdaq 100 QQQ will ap-pear inside your web browser. First, notice that the chain is clearly sepa-rated down the middle and consists of two groups of columns. In order tosee  the  latest  price  quotes  for  call  options  on  the  QQQ,  the  strategistneeds  to  look  at  the  left  side  of  the  chain.  To  ﬁnd  information  on  QQQputs, one would look to the right.
Next,  notice  that  the  ﬁrst  rows  of  options  list  the  options  with  theshortest  amount  of  time  remaining  until  expiration.  For  instance,  if  you
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create this chain on January 1, 2005, the January 2005 options will appearat the top of the table. In addition, these options will be sorted based onstrike price. As you move down the table, you will notice that the expira-tion dates change. The options with the most time remaining until expira-tion appear in the last rows of the table. The option chain also providesthe option symbol, the bid price, the asking price, and the open interestfor each option.
VOCABULARY LIST
American-style
Assignment
At-the-money
Automatic exercise
Credit
Debit
European-style
Exercise
Expiration date
In-the-money
SOLUTIONS
Intrinsic value
Long
Moneyness
Near-the-money
Out-of-the-money
Root symbol
Series
Short
Strike price
Symbol
1. A ______________ gives the buyer the right, but not the obligation, tobuy a speciﬁed number of shares or contracts of the underlying secu-rity at a predetermined price during a set period of time.Answer: B—Call option.Discussion: A  call  is  a  type  of  options  contract  that  can  be  pur-chased  or  sold.  The  owner  of  a  call  option  purchases  the  right,  butnot the obligation, to buy a speciﬁed amount of the underlying secu-rity  (e.g.,  100  shares  of  XYZ  stock)  at  a  predetermined  price  for  aspeciﬁed period of time.
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2.
If you sign a 12-month lease agreement with an option to buy a houseat $200,000 and the seller charges $1,000 extra just for that 12-monthoption to buy the house, that charge is called the ______________.Answer: D—Premium.Discussion: The  premium  is  the  amount  paid  by  the  option  buyerand the amount received by the option seller when entering into thecontract. There are seven major components that affect the premiumof an option:
1. The current price of the underlying ﬁnancial instrument.
2. The type of option (put or call).
3. The strike price of the option in comparison to the current market
price (intrinsic value).
4. The amount of time remaining until expiration (time value).
5. The current risk-free interest rate.
6. The volatility of the underlying ﬁnancial instrument.
7. The dividend rate, if any, of the underlying ﬁnancial instrument.
3. True or False: Options are available on all stocks.
Answer: False.Discussion: Options  are  not  available  on  every  stock.  Check  withyour broker or look for an option chain using www.optionetics.comto see if a stock you are interested in trading has available options.
4. True or False: Once you own an option, you are obligated to buy or
sell the underlying instrument.Answer: False.Discussion: An option holder is not obligated to buy or sell the un-derlying instrument. The purchase of an option gives you the right—but  not  the  obligation—to  buy  or  sell  the  underlying.  If  you  choosenot to exercise it, you can simply let the option expire worthless.
5. Once an option ______________, you lose your right to buy or sell the
underlying instrument at the speciﬁed price.Answer: C—Expires.Discussion: After  expiration,  the  option  ceases  to  exist.  Therefore,the owner then has no rights and the seller has no obligation associ-ated with the contract.
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6. Options when bought are done so at a ______________ to the buyer.
Answer: A—Debit.Discussion: If  a  trader  buys  an  option,  the  cost  of  the  option—thepremium—is debited from the trader’s account.
7. Options  when  sold  are  done  so  by  giving  a  ______________  to  the
seller.Answer: B—Credit.Discussion: If  a  trader  sells  an  option,  the  cost  of  the  option—thepremium—is  credited  to  the  trader’s  brokerage  account.  For  exam-ple, the call’s premium is the maximum proﬁt available on a short op-tion position and shows up as a credit in the trader’s account.
8. Options  are  available  at  numerous  ______________  based  on  the
price of the underlying instrument.Answer: D—Strike prices.Discussion: Options are assigned various strike prices that are basedon the current market price of the underlying asset. The strike priceis  the  ﬁxed  price  at  which  the  asset  underlying  an  option  can  bepurchased (call) or sold (put).
9. The  more  time  until  expiration,  the  more  ______________  the 
premium.Answer: A—Expensive.Discussion: An options contract with many months or years remain-ing until expiration will be worth more than an options contract withonly a few days or weeks remaining. Stated differently, the more timeremaining in the option’s life, the greater the option’s value and there-fore the greater the option premium.
10. True  or  False:  Strike  prices  for  stocks  and  indexes  come  only  in
multiples of 5.Answer: False.Discussion: Strike  prices  may  vary  for  stocks  and  indexes.  In  gen-eral,  however,  options  are  available  at  various  strike  prices  at  2 1/2-point intervals for stocks priced $25 and less, or 5-point intervals forstocks over $25.
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11. Name the three possible relationships strike prices have to the cur-
rent price of the underlying asset.Answer: In-the-money (ITM), at-the-money (ATM), out-of-the-money(OTM).Discussion: Moneyness refers to the option’s strike price relative tothe  price  of  the  underlying  asset.  If  the  strike  price  is  equal  to  theprice of the underlying asset, the option is said to be at-the-money. Ifthe strike price is higher or lower than the underlying asset price, theoption  is  either  out-of-the-money  or  in-the-money  depending  onwhether the option is a put or a call.
12. What  is 