However, European-style options can only be exercised at expiration. Most index options settle European-style. Options on stocks andETFs exercise American-style. Therefore, stock option sellers can be assigned any time before the option expires. Anticipating assignment is avery important factor when using strategies that involve selling optioncontracts.In sum, the probability of assignment increases as (1) the optionmoves in-the-money and (2) the time value of the option drops below 0.25.
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There are odd times that assignment will take place with slightly outof-the money options or options with time value remaining. These are theexception, however, and relatively low-probability events.
Assignment: A notice delivered to the option seller requestinghim/her to fulﬁll the terms of an options contract, which includes delivering the underlying security (for a call writer) or accepting deliveryof the underlying asset (for a put seller).
UNIQUE CHARACTERISTICS OF INDEX OPTIONSAlthough stock options were standardized and began trading in 1973, index options didn’t emerge until 10 years later. The CBOE listed options onthe S&P 100 Index ($OEX) on March 11, 1983. As we saw in Chapter 2, thenumber of tradable indexes has mushroomed since then. For example, inthe late 1990s, the American Stock Exchange developed and listed optionson exchange-traded funds, including the popular NASDAQ 100 IndexTrust (QQQQ).Over the years, other contracts have surpassed the OEX in terms ofpopularity. So, although it was the first index with listed options, todaymany traders prefer to trade the DJX, QQQQ, or SPY. Indeed, option volume on the once popular index has been declining steadily over the pastfew years. In 2001, in an effort to renew interest in OEX trading, theChicago Board Options Exchange launched options on a different versionof the S&P 100 under the symbol XEO (OEX backwards), which are different from OEX options in one important way.Like stock and ETF options, OEX options settle American-style. Thismeans that exercise can take place anytime prior to expiration. Most indexes (excluding a handful) settle European-style, meaning exercise cantake place only at expiration. Many option traders do not like the risk ofearly exercise when dealing with cash settlement. For instance, the threatof early exercise greatly increases the risks associated with the short sideof credit spreads (discussed in more detail in Chapters 5 and 6).Given the demand for index options with the European-style exercisefeature, the CBOE announced the launch of the European-style S&P 100options on July 23, 2001. Like the OEX, the index options are based on thevalue of the S&P 100 Index, but exercise can only take place in a specificperiod of time shortly before expiration. In other words, XEO settles European-style. According to a CBOE press release, “CBOE created the new
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product, XEO, in response to customer requests for an S&P 100 Index option that does not carry the possibility of early assignment.”*So another consideration when looking at an index options contractis whether the options settle American- or European-style. Most sector indexes settle European-style, but not all. Table 4.2 lists a variety of indexes,their ticker symbols, the exchange where the options trade, and whetherthe options settle European- or American-style. As you can see, most sector indexes have options that settle European-style, but not all. This tableprovides a summation of the more interesting sector indexes. Simplylooking at the name of the index will tell what specific industry group theindex represents. For example, the AMEX Airline Index is an index consisting of airline stocks—no surprises there.
Where Do Index Options Trade?Today, equity options trade on six U.S. options exchanges with the following four also active in index option trading:• American Stock Exchange (AMEX)• Chicago Board Options Exchange (CBOE)• Philadelphia Stock Exchange (PHLX)• International Securities Exchange (ISE)These four exchanges list index options and create new contractsbased on investor demand. In addition, product speciﬁcations for indexoption contracts can be found on their web sites (amex.com, cboe.com,phlx.com, and iseoptions.com, respectively).Figure 4.1 breaks down total (stock and index) options volume by exchange. The ISE and CBOE do most of the business. However, the AMEX,PCX, PHLX, and BOX also handle a large amount of options trading. Market share by exchange will change over time based on a myriad of factorsincluding products listed and technology upgrades.
*“CBOE Announces New S&P 100 Index Options with European-style Exercise(XEO) to Launch July 23, 2001,” CBOE press release (www.cboe.com), July 13,2001.
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TABLE 4.2 Sector IndexesSector Index
Symbol
Exchange
Settlement-Style
The Dow Jones Utility Average
DUX
CBOE
European
PHLX Bank Sector Index
BKX
PHLX
European
PHLX Box-Maker Index
BMX
PHLX
European
AMEX Biotechnology Index
BTK
AMEX
European
MS Consumer Products Index
CMR
AMEX
European
MS Commodity-related Index
CRX
AMEX
European
MS Cyclical Index
CYC
AMEX
European
AMEX Disk Drive Index
DDX
AMEX
European
PHLX Defense Sector Index
DFX
PHLX
European
PHLX Street.com Internet Index
DOT
PHLX
European
AMEX Pharmaceutical Index
DRG
AMEX
European
PHLX Fiber Optics index
FOP
PHLX
European
PHLX Forest & Paper Index
FPP
PHLX
European
GSTI Computer Hardware Index
GHA
CBOE
European
GSTI Computer Software Index
GSO
CBOE
European
CBOE Internet Index
INX
CBOE
European
MS Oil Service Index
MGO
CBOE
European
MS Biotechnology Index
MVB
CBOE
European
MS Retail Store Index
MVR
CBOE
European
PHLX Oil Service Index
OSX
PHLX
American
PHLX Semiconductor Index
SOX
PHLX
American
DJ Transportation Average
DTX
CBOE
European
AMEX Airline Index
XAL
AMEX
European
PHLX Gold Mining Index
XAU
PHLX
American
AMEX Broker/Dealer Index
XBD
AMEX
European
AMEX Natural Gas Index
XNG
AMEX
European
AMEX Oil Index
XOI
AMEX
American
PHLX Wireless Index
YLS
PHLX
European
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Options Volume by Exchange
American Stock ExchangePacific StockExchange
AmericanStockExchange
BostonStockExchange
Philadelphia StockExchange
International SecuritiesExchange
Boston Stock ExchangeChicago Board OptionsExchange
ChicagoBoard OptionsExchange
International SecuritiesExchangePhiladelphia StockExchangePacific Stock Exchange
FIGURE 4.1 Total Volume by Exchange
MOST ACTIVE BY OPTIONS VOLUMEFor the options trader, another item to consider when studying sectorindexes is the liquidity of its options. Some sector indexes do nothave any options linked to their performance at all. Others have optioncontracts available, but the options see little trading activity. For instance, many of the sector indexes that trade on the American StockExchange suffer from a lack of investor interest, trading volume, and,hence, liquidity.All else being equal, the greater the trading volume and open interest associated with a sector index, the better it is for implementingtrading strategies. Generally, when trading chip stocks the Semiconductor HOLDRs (SMH) are probably superior to the PHLX Semiconductor Index ($SOX) because the SMH sees a great deal more tradingactivity.Of all the index and exchange-traded funds, the QQQQ holds theposition for today’s most actively traded options contracts. Table 4.3lists the top 10 indexes in terms of options trading volume. The S&P500 ($SPX) and the NASDAQ 100 Index ($NDX) are among the moreheavily traded. The Semiconductor HOLDRS and the iShares Small CapFund (IWM) are also among the more actively traded index optionscontracts.
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TABLE 4.3 Ten Most Active Indexes byOptions Trading VolumeIndex
Symbol
NASDAQ 100 Index TrustS&P 500Russell 2000 Small Cap FundNASDAQ 100Semiconductor HOLDRSMini-NASDAQ 100 IndexDow Jones DiamondsS&P 100Select Sector EnergyDow Jones Industrial Average
QQQQSPXIWMNDXSMHMNXDIAOEXXLEDJX
MAKING SENSE OF CASH SETTLEMENTWhen it comes to settlement, there are two different types of options: cashsettled options and physical delivery options. Stock options are an example of the latter. Specifically, an owner of a call option has the right toreceive delivery of a physical asset—a stock. The owner of a put stock option has the right to sell 100 shares of stock per option contract. Exchangetraded funds also settle for the physical delivery of shares.Index options, however, do not involve the physical delivery of anasset because it is not possible to buy and sell an index. Instead, cashsettled calls and puts give the owner the right to receive cash. In order todetermine how much, if any, cash the option holder is entitled to receiveone must consider the relationship between the exercise settlementvalue and the strike price of the option. Let’s consider an example usingthe PHLX Gold and Silver Mining Index ($XAU) to see how cash settlement works.Exercise settlement value: The value of the index at the time ofexpiration.Exercise settlement amount: The difference between the exerciseprice and the exercise settlement value of an index on the day theexercise notice is tendered, multiplied by 100.
The Gold and Silver Mining Index (XAU) is one of the more activelytraded sector indexes. It tracks a basket of gold mining stocks and is considered a tool for playing trends with respect to the price of gold. However, the relationship between the XAU and gold is not perfect.
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Nevertheless, suppose the strategist is bullish on the index, thinks itwill be above $95 by September, and decides to buy five of the September85 calls for $7.50 per contract. The cost of the trade is $3,750 ($7.50 × 100× 5) plus commissions. The breakeven for the call position is 92.50 (85strike price + $7.50). Therefore, at expiration (Saturday after the third Friday of September), the exercise settlement value must be above $92.50 forthe calls to yield a profit. If, at that point, the index options are exercised,the owner of the calls will receive cash equal to the difference betweenthe strike price and the exercise settlement value.Let’s assume the XAU rises to 95 and, therefore:Exercise settlement valueLess strike priceDifference/cash payment
9585$10
The profit from the position would equal:Amount received (5 contracts × 100 × $10)Less cost of callsProfit
$5,0003,750$1,250
If the index fails to move above the breakeven (92.50), the positionwill not yield profits. The maximum loss will occur at 85 or less, becauseat that point, the call options will expire worthless.Importantly, XAU options can be exercised any time prior to expiration. That is, XAU options settle American-style. The options do not haveto be held until expiration, and the position can be closed at any time byselling the same number of calls with the same strike price and expirationdate—five XAU September 85 calls. However, keep in mind that most index options settle European-style and, therefore, can only be exercised atexpiration. XAU is an exception to that rule.Put contracts work the same way. As we have seen, when a cashsettled option is exercised, the amount of the cash payment is equal to thedifference between the exercise settlement value and the strike price ofthe index option. With a cash-settled call, the owner has the right to receive cash if the value of the underlying index at expiration—the exercisesettlement value—exceeds the exercise price of the option. In contrast,the put owner has the right to receive a cash payment if the exercise settlement value is less than the option strike price.In order to determine the value of a cash-settled option at expiration,one must first consider the exercise settlement value and the strike priceof the index option. The underlying asset price is, of course, simply thevalue of the index and can be found at any time by pulling up a quote. The
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exercise settlement value is generally determined on the last business dayprior to expiration and is based on the first (opening) reported sale pricefor each component stock within the index.Expiration is the Saturday following the third Friday of the expirationmonth, but the last day to trade index options is often the Thursday priorto expiration. There are exceptions, however. For that reason, prior to entering a trade, the index strategist wants to carefully consider the contractspecifications, including:• How and when the index settlement value is computed.• The last day for trading the options (Thursday or Friday).• Whether the index options settle American- or European-style.
WEEKLYSIn October 2005, while we were writing this book, the Chicago Board Options Exchange launched a new type of index contract called weeklys. Thenew contract has a short life of only one week. It is listed on Friday andexpires the following Friday. The first weekly was an option on the S&P500 Index ($SPX).This new short-term contract allows strategists to place short-termtrades on the stock market. For instance, traders expecting the stock market to rally throughout the week might buy SPX weekly calls on Mondayand then sell them before expiration Friday. Additionally, strategists worried about a market slide can buy puts on the index and then close the position at a profit if the market tanks.Since the weekly options have such a short life, they will have relatively little time value in the options contract. In addition, any time valuethat exists on the first Friday when the weekly is listed will quickly erodedue to the impact of time decay. Remember, options with only a few daysleft until expiration see a greater rate of time decay when compared tolonger-term options. This can create opportunities, as well as challenges,which are discussed in more detail later in this book.
EXPIRATIONLESS OPTIONSNot too long before weeklys arrived, the Philadelphia Stock Exchangestarted trading expirationless options, or XPOs for short. XPOs are similar to American-style options in that they come in the form of both calls(the right to buy) and puts (the right to sell), and can be executed by the
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buyer at any time; they do not, however, have an expiration date. Theyhave various strike prices just like an American-style option, and thepremium is based on the same factors (type of option, strike price,price of the underlying asset, volatility of the underlying asset, and therisk-free interest rate). XPOs form a bridge between the expiring andnon-expiring markets. They provide for the equitization of futures contracts because the XPO provides the right to buy or sell without thedual liability of futures contracts or the expiration and delivery risk associated with these products. Hence, XPOs provide all the benefits ofan option contract without the risk of expiration. They also offer a reduction in trading costs by eliminating the market inefficiencies that exist when options or futures contracts need to be rolled over. Therefore,XPOs really are expirationless. You can find out more about XPOs atwww.xpotrade.com.
INDEX FUTURES VERSUS OPTIONSFutures are agreements to take delivery of (for the futures buyer) or to deliver (for the seller) an asset at some point in the future. Stock index futures contracts expire quarterly in March, June, September, andDecember. Futures traders can go long or short futures contracts. Forexample, a speculator expecting the S&P 500 Index to move higher canbuy S&P 500 futures; a hedger looking to protect a portfolio from a movelower in the S&P can sell short S&P 500 futures.One important characteristic that differentiates futures from options is that, with futures, no money changes hands when the futurescontract is established. As a result, when an investor goes long or shorta futures contract, the amount of funds required in the account willequal the margin requirements. Then, at the end of each trading day, theaccount will be marked-to-market and funds will be added or subtractedfrom the account depending on the final value of the position at the endof the trading day.Futures and options on futures can also be used to trade the indexmarket. Many of the ideas presented later in this book can be implemented using futures and futures options. However, futures contracts areregulated separately from stock and index options and therefore require aseparate type of trading account. The focus of this book and our earlierbooks is not on futures and options on futures, but rather on options forstocks, indexes, and exchange-traded funds. A link to a list of brokers thatprovide trading accounts for the stock and index option contracts is givenin Chapter 16.
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QUOTES, SYMBOLS, AND CHAINSOption quotes and chains are tools that traders use to find prices andplace orders. Similar to stocks, option price quotes can be found usingsymbols. Option chains, meanwhile, provide strategists with a wealth ofinformation concerning an options contract. Not only do option chains offer the current market prices for a series of options, but they also providean option’s liquidity, the strike prices available, and the expirationmonths. In fact, option chains are so important that most reputable brokerage firms offer them to their clients with real-time updates.Not long ago, option chains were available mostly to brokerage firmsand other professional investors. Today, however, individual investors cango to a number of web sites and find option chains. Most online brokeragefirms provide them, as do several options-related web sites. For instance,at the Optionetics.com home page, pulling up an options chain for anygiven stock is simply a matter of entering the ticker symbol in the quotebox at the top of the screen and selecting “chain.”Table 4.4 shows an option chain snapshot of some SemiconductorHOLDRs options taken from Optionetics.com. Notice first that like anyother option chain, it is split down the middle to provide informationabout both calls and puts. On the left half of the table the call option contracts for SMH are listed, and on the right side, put options are sorted bystrike price. Because there are a large number of puts and calls available
TABLE 4.4 SMH Options ChainCalls
Bid
SMHAD 17.60
Ask
OpenInterest Strike Price
Puts
Bid
Ask
17.70
3944
SMHMD
0.00
0.050 10049
Jan06 20.00
OpenInterest
SMHAX
15.10
15.30
1966
Jan06 22.50
SMHMX
0.00
0.050
SMHAE
12.60
12.80
3984
Jan06 25.00
SMHME
0.00
0.050 10014
4
SMHAY
10.10
10.30
2068
Jan06 27.50
SMHMY
0.00
0.050
0.050 50829
1553
SMHAF
7.60
7.80
24705
Jan06 30.00
SMHMF
0.00
SMHAZ
5.20
5.30
6394
Jan06 32.50
SMHMZ
0.050 0.10
27431
SMHAG
2.90
3.00
53081
Jan06 35.00
SMHMG
0.20
0.25
73847
SMHAU
1.05
1.10
52177
Jan06 37.50
SMHMU
0.85
0.90
63736
SMHAH
0.20
0.25
84281
Jan06 40.00
SMHMH
2.45
2.55
11857
SMHAV
0.00
0.050 46493
Jan06 42.50
SMHMV
4.80
5.00
1263
SMHAI
0.00
0.050
Jan06 45.00
SMHMI
7.30
7.50
183
Source: Optionetics.com.
4595
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for this fund, it is important to keep in mind that only a fraction of theavailable options are listed in the table. In this case, the table includesonly the January options.The first factor to understand when considering an option chain is themanner in which the options are sorted. Again, calls are generally on theleft half of the table and puts are on the right. Each row, then, representstwo different contracts. These contracts are first sorted by month. Therefore, at the top of the chart, the front month (or the next expiration) appears first. Since this option chain was taken December 20, 2005, the frontmonth is January 2006 and it appears at the top of the option chain. February 2006 would appear second (only January is included in this table), andeach expiration month available would then follow in order. In the case ofSMH, the option chain ends with the January 2008 long-term equity anticipation securities (LEAPS) with the 45 strike price.Within each month, option contracts are sorted by strike price. Theoptions in this table begin at a strike price of 20 and end with a strikeprice of 45 (again, not all of the strike prices for SMH options are listed onthe table). So the option chain listed here includes 11 call option contractsand 11 put option contracts, all of which expire in January. Most optionchains are sorted in this manner and include a list of all expiration datesand strike prices for that index or exchange-traded fund.Each column within the table provides a different piece of information. On each side of the table (call and put), the first row lists the option’ssymbol. For example, on the left half of the table, the third row from thebottom shows the January 40 call, which has the ticker symbol SMHAH.“SMH” is the root symbol for the Semiconductor HOLDRS options, “A”represents the month of January, and “H” represents the strike price.As with stocks, options have a bid price and an asking price, whichappear in columns 2 and 3. The bid is the current price at which the market will buy the option and the ask is the price at which the market willsell the contract. Since this table is delayed and not real-time, we wouldnot necessarily use this bid and offer as a guide when entering orders.Instead, we would want live data, which is usually available through thebroker placing the order.The final column indicates the option’s open interest. Open interest isthe total number of contracts that have been opened and not yet closedout. For instance, if an option trader buys (as an initial transaction) 5 February 65 calls, the open interest on that call will increase by five. When thetrader later sells those five calls (to close the transaction), open interestwill decrease by five. Generally, the more open interest, the greater thetrading activity associated with that particular option and, hence, the better the liquidity. Open interest is only updated once a day.
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The information included in an option chain will differ somewhat depending on the source, but the variables described earlier are the mostcommon. In addition, many brokerage firms offer option chains with realtime quotes. As the options trade, each row will blink as the last price isupdated, or when the bid and offer change. In this way, it becomes easy toview the price movement of a variety of different contracts simultaneously, which can help the trader sort through and identify the option contract with the most appropriate strike, expiration month, and market pricefor any specific strategy.
A NOTE ABOUT RISK GRAPHSSince options are derivatives, their values will depend on the price of another asset. For example, the prices of put and call options on the S&P 500Index ($SPX) are derived from the value of the S&P 500 Index. In this case,the index is considered the underlying asset. As its value changes, so willthe value of the options. For that reason, many option strategists like toconsider what will happen to the value of their options under different scenarios—in other words, assuming price changes in the underlying asset.There are two primary ways option strategists can view the outcomeof a given option strategy assuming price changes in the underlying stock.The first method is to create a table. For example, Table 4.5 considers calloptions on the Semiconductor HOLDRs (SMH). In this example, the SMHis the underlying asset. At the time of this example, shares of the fund aretrading near $35, and one December 35 call can be purchased for $1.25 (or$125 per contract).Table 4.5 was created in order to see the risk and reward of holding theSMH December 35 calls. The prices are those that can exist at expiration,
TABLE 4.5 Potential Proﬁt and Loss from SMH December 35 Call PurchaseSMH atExpiration
Dec 35 Call at Expiration
Proﬁt/Loss (Intrinsic Value)
$30.00
$0.00
–$125.00
$32.50
$0.00
–$125.00
$35.00
$0.00
–$125.00
$37.50
$2.50
$125.00
$40.00
$5.00
$375.00
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or at close of business on the third Friday in December. Notice that if thestock falls below $35 a share, the position loses $125. In other words, theoption expires worthless below $35 a share and yields no profit. On theother hand, if the stock climbs to $37.50, the options are worth $2.50 andthe profit totals $1.25 per contract, or $125. At $40 per share, the profitequals $375 ($5.00 – $1.25 = $3.75, multiplied by 100 shares). Notice thatthe position breaks even at $36.25 because the call is worth $1.25, or equalto the initial cost when purchased.A second way to see the potential profit or loss from an option trade iswith a risk graph, which plots the profit from the option on one axis alongwith the price of the stock on the other axis. Figure 4.2 is an example of arisk graph using the same SMH December 35 call with the fund tradingnear $35.11 a share and 43 days left until expiration. The cost of the optionis $1.25 per contract, or $125.00.The potential profit from being long this call is plotted along the horizontal axis and the price of the stock is on the vertical axis. The chart wascreated using Optionetics.com Platinum, and we use many of these chartsthroughout this book. Notice the line that is the farthest to the left. It plotsthe same information as the table. In other words, that line considers thepotential profit and loss of the SMH December 35 call at expiration. Justas we saw on the table, the profits begin to accrue when SMH reaches
FIGURE 4.2 SMH Price Chart and Risk Graph for SMH December 35 Call Option(Source: www.Optionetics.com Platinum)
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$36.25 a share. In other words, at expiration, $36.25 is the breakeven, orthe point where the trade yields no profit or loss (excluding commissions). A vertical line is drawn at zero on the risk graph to mark thebreakeven point. Notice that prior to the stock reaching $36.25, the profit(black line) is to the left of zero and the position is showing a loss.Unlike the table, the risk graph in this example also considers timeframes prior to expiration. The other lines, which appear as different colors when looking at a computer monitor, show the risk/reward with various days left until expiration. The one that is the farthest to the rightshows the profit and loss in the call option with 52 days until expiration;the farthest to the left shows the call at expiration.Risk graphs are helpful because they give the option strategist a better idea of the profit and loss potential, not just at expiration, but also asthe option premium loses time value. In addition, risk graphs are simpleand convenient because they can be created quickly and easily usingOptionetics.com Platinum or other options trading software.Finally, risk graphs are not limited to simple calls and puts but can alsobe created for more complex strategies such as spreads and straddles. Doing so provides the options trader with a quick visual presentation of theprofit and loss potential of any option strategy, which can save a substantial amount of time when screening for the next potential winning trade