typically one futures contract. When a physical-delivery equityoption is exercised, the shares are purchased or sold at the strikeprice. A call exerciser becomes the buyer, and the assigned callwriter becomes the seller. In the case of physical-delivery equity puts,the put exerciser becomes the seller, and the assigned put writerbecomes the buyer.In contrast to physical-delivery options, when exercise of a cashsettled option occurs, then, as the name implies, only cash changeshands. Consider an SPX December 1500 Call that is exercised whenthe SPX Index is 1520. SPX is the symbol for cash-settled index optionson the Standard & Poor’s (S&P) 500 Stock Index. If this call wereexercised when the SPX Index is at 1,520, then the option writerwould deliver a cash amount equal to 20 index points to the option
8 • Trading Options As a Professional
owner. In the case of SPX Index options, each index point has a valueof $100. Therefore, if the index is 20 points above the strike priceof an exercised call, the seller delivers $2,000 (20 points times $100per point) to the buyer.
In-the-Money, At-the-Money, andOut-of-the-Money OptionsThe relationship of the price of the underlying to the strike price ofthe option determines whether the option is in the money, at themoney, or out of the money. A call is in the money if the price of theunderlying is above the strike price of the call. At the money for a callmeans that the price of the underlying is equal to the strike price, andout of the money indicates that the price of the underlying is belowthe strike price of the call. With a stock price of $100, for example,the 95 Call is in the money. Speciﬁcally, it is in the money by $5.00.The 100 Call is at the money, and the 105 Call is out of the moneyby $5.00.For puts, the relationship of the underlying price to the strike priceis opposite that for calls. A put is in the money if the price of the underlying is below the strike price of the put and out of the money ifthe price of the underlying is above the strike price of the put. With astock price of $100, the 95 Put is out of the money by $5.00, and the105 Put is in the money by $5.00. At the money has the same meaning for puts as it does for calls—the strike price equals the price ofthe underlying.Although an option can be truly called at the money only when theunderlying price exactly equals the strike price, traders commonlyrefer to an option as an “at-the-money option” when its strike price isclosest to the underlying price. Thus, when a stock price is $101 or$99, option traders typically refer to both the 100 Call and 100 Put asthe at-the-money options, even though one is slightly in the moneyand one is slightly out of the money.
Option Market Fundamentals • 9
Intrinsic Value and Time ValueThe price of an option consists of two components, intrinsic value andtime value. Intrinsic value is the in-the-money portion of an option’sprice, and time value is the portion of an option’s price in excess ofintrinsic value, if any. Consider a situation in which the stock price is$67, and the option prices exist as stated in Table 1-2Column 1 in Table 1-2 contains a range of strike prices and theoption types. Column 2 lists various option prices. Columns 3 and 4contain corresponding intrinsic values and time values, respectively.The price of 3.50 of the 65 Call, in the ﬁfth row, for example, consistsof 2.00 of intrinsic value and 1.50 of time value. The intrinsic valueof 2.00 is calculated by subtracting the strike price of the call of 65from the stock price of 67. The time value of 1.50 is calculated by subtracting the intrinsic value of 2.00 from the option price of 3.50.The option in the ﬁrst row, the 55 Call, is different from all theother options in this example because its price of 12.00 consists
Table 1-2 Intrinsic Value and Time ValueStock price: 67.00
Row 1Row 2Row 3Row 4Row 5Row 6Row 7Row 8Row 9Row 10
Column 1
Column 2
Column 3
Column 4
Strike Price andOption Type
Option Price
Intrinsic Value
Time Value
12.000.107.500.303.501.101.303.900.608.10
12.000.007.000.002.000.000.003.000.008.00
0.000.100.500.301.501.101.300.900.600.10
55 Call55 Put60 Call60 Put65 Call65 Put70 Call70 Put75 Call75 Put
10 • Trading Options As a Professional
entirely of intrinsic value. It has no time value. This option is said tobe trading at parity because, in theory, a trader would be indifferentbetween buying stock at 67.00 per share and buying this 55 Call at12.00 and exercising it. If this 55 Call were exercised, then the totalprice paid for the stock would be equal to the market price of 67, thestrike price of 55 plus the call premium of 12. In practice, given theseprices, transaction costs make buying the stock preferable to buyingthe call.A review of Table 1-2 shows that near-the-money options such as the65 and 70 Calls and Puts have the largest time values, whereas deeperin-the-money and farther-out-of-the-money options have less time value.This concept will be discussed further in Chapter 3 in connection withoption pricing.
The Market—Deﬁnition 1Traders, ﬁnancial institutions, and the ﬁnancial media and press alluse the term the market loosely, but it has two different meanings.First, the market is a location, typically an exchange, where buyersand sellers meet to make trades. An exchange can be a physical location where people gather, or it can be a centralized computer systemto which traders connect through their brokers.Historically, the New York Stock Exchange, the American StockExchange, and the regional stock exchanges were physical locationswhere people came to trade in open outcry. Customers from all overthe world would telephone or wire their stockbrokers with buy and sellorders. These orders then would be forwarded to a representative atthe exchange known as a ﬂoor broker. The ﬂoor broker would negotiate verbally with traders on the exchange’s trading ﬂoor to buy or sellon a customer’s behalf.The over-the-counter (OTC) market was the ﬁrst stock market without a physical central location. Buyers and sellers, however, did negotiate verbally over the phone. Brokers sometimes would make several
Option Market Fundamentals • 11
phone calls to ﬁnd the best price for their clients, and sometimes,when the broker called back, the shares would no longer be available.Before the advent of listed options in 1973, options in the UnitedStates were traded by means of a telephone network known as theOver-the-Counter Put and Call Broker Dealer Association. A customerwanting to buy or sell an option would contact a put and call broker,who then would make phone calls until someone willing to take theother side of the trade was found. Once such a person was found, therecould be several back-and-forth phone calls—with the broker in themiddle—until a price agreeable to both parties was reached.Today, the necessary functions of exchanges are aided greatlyby technology. The role of human interaction to negotiate prices israpidly diminishing. Prices and quantities of stock shares and optioncontracts are available via computer, and buy and sell orders can beinitiated and conﬁrmed by the click of a mouse. Computers, however,have not replaced the need for human decision makers. This bookfocuses on how to understand the dynamics of options to improvedecision making.
The Market—Deﬁnition 2The second meaning of the term the market relates to the prices atwhich buyers and sellers want to trade. The bid price, or simply the bid,is the highest price that someone is currently willing to pay. The sizeof the bid, or simply the size, is the number of shares of stock or thenumber of option contracts that the person bidding is willing to buy.Over time, traders have developed a shorthand manner of referringto the bid and the size of an offer to buy or sell. For example, if TraderA bids $2.20 per share for 40 XYZ January 80 Calls, then traders commonly would say that his or her bid is “2.20 for 40.” Everyone understands that “2.20” is the dollar price per share price and that “40” isthe number of option contracts. The word for replaces bid for. Notethat the price is stated before the quantity when a trader is bidding.
12 • Trading Options As a Professional
The price at which shares or option contracts are offered for sale isknown as the ask price or the offer price, or simply the ask or the offer.If Trader B offers 20 XYZ January 80 Calls for sale at $2.30 per share,the shorthand reference would be “20 at 2.30.” Note that quantity isstated before price when a trader is offering.In the days of open outcry trading, when bids, offers, and tradesall were made verbally, a broker wanting to know the current statusfor a client might ask, “What is the market in XYZ January 80 Calls?”Trader A would then respond, “2.20 for 40,” and Trader B wouldfollow with “20 at 2.30.” The broker then would report to the clientthat, “The market is 2.20–2.30, 40 by 20.” “2.20–2.30” describes thebid and ask prices, and “40 by 20” describes the size, or quantity ofoption contracts bid for and offered.In the open outcry system, a trade occurs when a buyer and a selleragree on a price and a quantity. In the preceding example, it is possible that after some consideration, Trader B decides not to wait for someone to pay $2.30 for his or her 20 calls. Instead, he or she might lowerthe asking price to $2.20. If Trader A is still bidding $2.20 for 40 contracts, then Trader B can say, “Sell you 20 at 2.20.” If Trader A says, “I’llbuy them,” then a trade of 20 calls at 2.20 per share has occurred.In today’s world of computers, it is still necessary to know the shorthand language of open outcry trading. After all, people still talk to eachother! Money managers frequently work through brokers rather thanentering orders themselves, and many individual traders share information about their activities with other traders. Imagine a money manager telephoning his or her broker to ﬁnd out the status of an orderto sell 200 calls at a price of 4.10. “How are those calls?” asks themoney manager. “Sold 60 this morning. The market’s 3.90–4.00, 100by 50 right now,” is the reply. This response explains everything—ifthe language of trading is understood.
Public Traders and Market MakersA public trader is an individual or organization that is not a memberof an exchange and is not a broker-dealer. In the brokerage industry,
Option Market Fundamentals • 13
public traders are referred as retail investors. The term public traderrefers to a wide range of market participants from mutual funds, pension funds, and other professionally managed money to individualinvestors and traders. Professionally managed pools of money, knownas hedge funds, also can be public traders. The distinguishing aspectof public traders is that they are subject to standard margin requirements that are established by Regulation T, a stock or bond exchange,or the Options Clearing Corporation. Public traders can make bidsand offers and withdraw them sporadically as their changing marketforecasts motivate them to do so.A market maker is an individual or organization that is a memberof an options exchange and is registered with the Securities andExchange Commission (SEC) as a broker-dealer. As an exchangemember, a market maker agrees to maintain bid and ask prices at nomore than speciﬁc maximum spreads and to bid for and offer optionsin at least minimum quantities. This requirement for market makersapplies only to normal market conditions and varies by exchangeand class of market maker. The role of the market maker is to ensurethe existence of a market for public traders who want to open or closepositions. In return for assuming the obligation of being continuouslypresent in the market, market makers have lower margin requirementsthan public traders.
National Best Bid and Best OfferIn most stock, options, and futures markets in the United States, manypublic traders and market makers may be bidding and offering at thesame time. In the stock and options markets, more than one exchangealso will be open at any given time. It is therefore a complicated technical problem to identify all the bids and offers and to disseminate andprioritize them so that a new participant can ﬁnd the highest bid priceand the lowest offer price.Table 1-3 presents a hypothetical example of the market in XYZ 50Calls. The table has ﬁve columns, the ﬁrst of which lists the exchange
14 • Trading Options As a Professional
and the nature of the participant, the market maker or public traderwho is participating in the market for the XYZ 50 Calls. In this scenario, three exchanges are participating in the market. Exchange 1has two market makers that are bidding and offering and one publictrader that is only offering. Market Maker 1–1 is bidding 3.60 for 50contracts and offering 50 contracts at 3.90. Market Maker 1–2 is bidding 3.60 for 30 contracts and offering 30 contracts at 4.00. PublicTrader 1–1 is offering 5 contracts at 4.20.Exchange 2 has one market maker and one public trader. MarketMaker 2–1 is bidding 3.70 for 20 contracts and offering 20 contractsat 4.00. Public Trader 2–1 is bidding 3.70 for 5 contracts. Finally, atExchange 3, Market Maker 3–1 is bidding 3.70 for 50 contracts andoffering 50 contracts at 4.00, Public Trader 3–1 is offering 10 contractsat 4.10, and Public Trader 3–2 is offering 10 contracts at 3.90.Based on the information about the bids and offers by all marketmakers and all public traders at the three exchanges, the bottom row
Table 1-3
Determining the NBBO Market for the XYZ 50 Call
Col 1
Col 2
Col 3
Col 4
Col 5
Bid Price Bid Quantity Ask Price Ask QuantityExchange 1Market Maker 1–1Market Maker 1–2Public Trader 1–1Exchange 2Market Maker 2–1Public Trader 2–1Exchange 3Market Maker 3–1Public Trader 3–1Public Trader 3–2National best bid best offer(NBBO)
3.603.60
5030
3.90*4.004.20
50*305
3.70*3.70*
20*5*
4.00
20
3.70*
50*
4.004.103.90*
501010*
3.70
75
3.90
60
* Indicates participation in the national best bid and offer (NBBO).
Option Market Fundamentals • 15
of Table 1-3 shows that the national best bid and best offer (NBBO) is3.70 bid for 75 contracts and 60 contracts offered at 3.90. An asteriskby a price or quantity indicates participation in the NBBO. The bestbid of 3.70 for 75 contracts consists of the bid of Market Maker 2–1for 20 contracts, the bid of Public Trader 2–1 for 5 contracts, and thebid of Market Maker 3–1 for 50 contracts. The best offer of 60 contracts at 3.90 consists of the offer of Market Maker 1–1 of 50 contractsand the offer of Public Trader 3–2 of 10 contracts.The fact that not all exchanges are participating in the NBBO raisesa question for public traders. What if a new public trader, call himor her Public Trader 2–2, entered the market and bid 3.90 for 30 contracts at Exchange 2? Public Trader 2–2 clearly deserves to be sold30 contracts at 3.90 because the national best offer is for more than30 contracts at that price. At Exchange 2, however, there are nocontracts offered at 3.90 and only 20 contracts offered at 4.00. Whatwill happen?An SEC rule prohibits exchanges from allowing trades outsidethe NBBO. Therefore, Public Trader 2–2 cannot pay 4.00 for anycontracts. Two potential resolutions to this situation will enablePublic Trader 2–2 to buy the desired 30 contracts at the national bestoffer of 3.90.The ﬁrst possibility is that Market Maker 2–1 at Exchange 2 couldlower the offer price and increase the quantity and sell 30 contracts at3.90 to Public Trader 2–2. The second possibility is that the order fromPublic Trader 2–2 could be forwarded to another exchange, where thecontracts are offered on the NBBO and where Public Trader 2–2would buy the contracts. In this case, more than 30 contracts are beingoffered at 3.90 at Exchange 1, so that is where the order would be forwarded. If neither Exchange 1 nor Exchange 3 could sell 30 contactsindividually, but they could in total, then the order from Public Trader2–2 could be divided between the two exchanges.Both resolutions just described enable the order from Public Trader2–2 to be ﬁlled at the NBBO. With today’s advanced electronic trading systems, public traders should not be overly concerned about
16 • Trading Options As a Professional
which exchange gets their orders because they must be ﬁlled at a priceno worse than the NBBO.
Margin Accounts and Related TermsOption traders need to be aware of margin account procedures becauseSEC regulations require some option strategies to be established inmargin accounts. The following overview merely summarizes marginaccounts and related terms.A cash account is an account at a brokerage ﬁrm in which all purchases are fully paid for in cash. In a margin account, the brokerage ﬁrmmay lend money to the customer to ﬁnance certain types of positionscalled marginable transactions. Different types of marginable transactions, according to regulations, require different amounts of equity capital from the customer. This equity capital is called a margin deposit or,simply, margin.For example, the account equity balance of an investor who purchases stock “on margin” will be less than the value of the stock. Thebrokerage ﬁrm lends the balance of the purchase price to the investor,who, of course, pays interest on the loan. The use of margin debt willhave a signiﬁcant impact on an investor because market ﬂuctuationswill change the account equity balance at a greater percentage ratethan the same ﬂuctuation would cause in the equity balance of a cashaccount. This is called leverage.Another common marginable transaction is selling stock short. Inthis transaction, the brokerage ﬁrm borrows stock on behalf of the customer, who sells it at the current market price with the hope of buyingit back later at a lower price. The stock loan is “repaid” with purchasedshares when the short stock position is covered. In a short stock transaction, the customer actually pays nothing when initiating the position(except commissions), but the brokerage ﬁrm will require a margindeposit to guarantee that the customer will cover any potential losses.Some option transactions are marginable transactions, and someare not. Also, certain option transactions are required to be conducted
Option Market Fundamentals • 17
in a margin account, and others may be conducted in either a cashaccount or a margin account. Before engaging in option transactions,an investor should be thoroughly familiar with the type of accountrequired for the transactions that are planned. A simple formula toremember isAccount equity  margin debt  account valueAccount value is the total market value of owned securities. The margin debt is the loan to the investor from the brokerage ﬁrm, and theaccount equity is the investor’s share after the securities are sold andmargin debt is repaid.
Initial Margin, Minimum Margin, MaintenanceMargin, and Margin CallInitial margin is the minimum account equity required to establish amarginable transaction. Initial margin requirements are frequentlyexpressed in percentage terms of the market value of a position or itsunderlying security. Purchasing stock, for example, is a marginabletransaction that currently has an initial margin requirement of 50 percent: Purchasing 100 shares of a $50 stock requires an initial marginof $2,500 plus commissions, or 50 percent of the purchase price pluscommissions. The loan made to the buyer would equal $2,500, or theremaining 50 percent of the purchase price.If a margined position loses money, the account equity willdecrease both absolutely and as a percentage of the total accountvalue. Minimum margin is the level, expressed as a percentage ofaccount value, above which account equity must be maintained. Ifaccount equity falls below the minimum margin level, the brokerageﬁrm will notify the investor in a margin call that the account equitymust be raised to the level of maintenance margin. Maintenance margin is a level of account equity greater than minimum margin and generally below initial margin. On receiving a margin call, a customer
18 • Trading Options As a Professional
may either deposit additional funds or securities or close the position.In the preceding case, a stock price decline from $50 to $35 wouldcause a decline in equity to $1,000 because the margin loan of $2,500remains constant. This $1,000 equity would represent only 28 percentof the account value (1,000 divided by $3,500  0.28). If the minimum margin were 35 percent, the account equity would be under therequirement, and the customer would receive a margin call.Although many option strategies are marginable, the importantpoint to understand here is that the amount of equity supporting aposition is a key element in capital management, and how an investormanages capital is a decisive factor in determining the risk level of astrategy—that is, whether a particular strategy is speculative or conservative in nature. The application of this concept will be developedthroughout the coming chapters.
Short Stock RebateWhen stock is sold short, the purchaser pays cash for the shares, justas with a normal stock purchase transaction. In the case of shares soldshort, however, the cash goes to the stock lender rather than to thestock seller. The stock lender holds the cash as collateral and investsit in Treasury bills or other cashlike, liquid investments. In the unlikelyevent that the stock borrower defaults, the stock lender could use thecash held in escrow to repurchase the shares and thereby repay thestock loan.The existence of cash held in escrow is signiﬁcant because of theinterest it earns. Public traders do not share in this interest income;the brokerage ﬁrm and the stock lender divide it between themselves.Professional traders registered as broker-dealers, including option market makers, however, do receive a portion of the interest income. Shortstock rebate is the portion of interest income generated by short stockpositions that professional traders receive.The interest income from short stock rebate affects the pricing ofoption arbitrage strategies discussed in Chapter 6. Typically, an option
Option Market Fundamentals • 19
market maker receives 80 percent of the net interest generated from ashort stock position, and the stock lender receives 20 percent. Therefore, if 100 shares are shorted at $90, then $9,000 of cash is generated,which, if invested at 4 percent annually, earns $6.92 per week ($9,000 0.04  52  $6.92), and an option market maker would receive80 percent of this, or $5.53. While this sum may seem inconsequentialat ﬁrst glance, consider that option market makers can accumulate positions involving thousands of options and millions of shares. With complicated details, sufﬁce it to say, for option market makers, this interestamounts to an important source of income or expense—because theyalso borrow.The guiding principle governing interest income from short stockrebates is that cash held in escrow by the lender must equal 100 percent of the current stock price. Cash transfers, therefore, are madeeach day between stock borrowers and stock lenders as the stock pricesﬂuctuate. Declining stock prices lead to lower escrow deposits, whichfrees up capital and lowers costs for option market makers. Rising stockprices, however, increase escrow requirements. If a market maker mustborrow more to meet these escrow demands, then costs can rise fasterthan interest income.
Proﬁt/Loss DiagramsFigures 1-1 through 1-12 illustrate basic to advanced option strategiesthat all experienced option traders should understand. Proﬁt and lossdiagrams show three important aspects of a strategy: the maximumproﬁt potential, the maximum risk, and the break-even point. Highlighting these aspects helps a trader make the subjective decision asto whether or not the underlying has a sufﬁcient chance of passing ornot passing the break-even point and therefore whether or not thepotential proﬁt is worth the monetary risk created by the strategy.Figures 1-1 through 1-4 present the four basic strategies of long andshort calls and puts, the four building blocks of more complicatedstrategies. These ﬁgures each contain three lines. The lower line
20 • Trading Options As a Professional
8
Profit And Loss
6420
–2–4–690
Figure 1-1
92
94
96
98100 102Underlying
104
106
108
110
Long Call
(straight) illustrates the proﬁt and loss of the strategy at expiration. Theupper and center lines (curved) show proﬁt and loss at 60 and 30 daysprior to expiration, respectively.Figure 1-1 illustrates the long call strategy, which has unlimitedproﬁt potential, limits risk to the premium paid, and breaks even atexpiration at a stock price equal to strike price plus premium paid. Forexample, a 100 Call purchased for 4.00 per share carries a maximumrisk of 4.00, and the break-even point at expiration is a stock price of104. Above the break-even point, the long call has the potential forunlimited proﬁt.Figure 1-2 shows that the short call strategy is the mirror imageof the long call. The proﬁt potential is limited to the premiumreceived, whereas the risk is unlimited. The short call also breaks evenat expiration at a stock price equal to strike price plus premiumreceived. If a 100 Call is sold for 4.00 per share, then the maximumproﬁt is 4.00, and the break-even point at expiration is a stock price104. Above the break-even point, the short call has the potential forunlimited loss.
Option Market Fundamentals • 21
6
Profit And Loss
420–2–4–6–890
92
94
96
98
100
102
104
106
108
110
UnderlyingFigure 1-2
Short Call
The long put is illustrated in Figure 1-3. A long put holds the promise of substantial proﬁt because the underlying price can drop to zero,whereas it limits risk to the premium paid. Buying a put breaks evenat expiration at a stock price equal to strike price minus the premiumpaid. The risk of a 100 Put purchased for 3.00 per share, for example,is limited to that 3.00 per share, and the break-even point at expiration is a stock price of 97. Below the break-even point, however, thelong put has substantial proﬁt potential as the underlying stockdeclines toward zero.Figure 1-4 shows the short put strategy, which holds limited proﬁtpotential but carries substantial risk. A short put breaks even at expiration at a stock price equal to strike price minus premium received.If a 100 Put is sold for 3.00 per share, for example, then the maximumproﬁt is 3.00, and the break-even point at expiration is a stock priceof 97. Below the break-even point, the short put has the potential forsubstantial loss.Figures 1-5 and 1-6 show long and short variations of a basic twopart option strategy known as a straddle. Buying both a put and a call
22 • Trading Options As a Professional
Profit And Loss
876543210–1–2–390
Figure 1-3
92
94
96
98100 102Underlying
104
106
108
110
96
98100 102Underlying
104
106
108
110
Long Put
Profit And Loss
3210–1–2–3–4–5–6–7–890
92
94
60 Days Profit And Loss30 Days Profit And LossFigure 1-4
Short Put
0 Days Profit And Loss
Option Market Fundamentals • 23
Profit And Loss
6543210–1–2–3–4–5–690
92
94
96
98
100
102
104
106
108
110
UnderlyingFigure 1-5
Long Straddle
with the same underlying, the same strike price, and the same expiration date creates a long straddle, as depicted in Figure 1-5. Thereare two break-even points. Strike price plus total premium marks theﬁrst break-even point, and strike price minus total premium marks thesecond. A long straddle has unlimited proﬁt potential as the price ofthe underlying stock rises above the upper break-even point and substantial proﬁt potential as it falls below the lower break-even point.Risk is limited to the two premiums paid. This is known as a highvolatility strategy because a “big” stock price movement—either up ordown—is required for a straddle to earn a proﬁt.A short straddle is the mirror image of a long straddle, as shown inFigure 1-6. Selling both a put and a call creates a short straddle. Aswith the long straddle, there are two break-even points, strike priceplus total premium and strike price minus total premium. In the caseof the short straddle, however, the proﬁt potential is limited to the twooption premiums received. This is a low-volatility strategy because if
24 • Trading Options As a Professional
Profit And Loss
6543210–1–2–3–4–5–690
Figure 1-6
92
94
96
98
100 102Underlying
104
106
108
110
Short Straddle
the price of