. Logic dictates that only in-the-money options should be exercised, butin actual practice at-the-money options are occasionally exercised as well.To be assigned. If the writer of an option is assigned, he must fulﬁll the obligation he assumed when he wrote the option. Someone who writes an Intel (INTC) 30 put, for example, could beassigned on this contract and forced to purchase 100 shares ofINTC at $30. When an investor is assigned, he is usually notiﬁed by his broker. At that point it is too late to change his mind.He must purchase the underlying stock or, if he has written acall option, he must sell the stock under option. An assignmentoccurs when an investor with a long position decides to exercise her option. She advises her broker, who exercises theoption by notifying The Options Clearing Corporation (OCC).
Options 101: Basic Terms, Deﬁnitions, and Strategies
9
The OCC sends an assignment notice to one of its memberﬁrms (selected on a random basis), and the ﬁrm assigns one ofits clients, either randomly or on a ﬁrst-in, ﬁrst-out basis.Trading volume. As with stocks, the exchanges report the tradingvolume for each option series. Note that this is always reportedin contracts, not the number of underlying shares (100 percontract).Open interest. The number of options contracts that have beenopened and are still left open at the end of the trading day.When a new option series is ﬁrst listed, the open interest willbe zero and will remain so until the ﬁrst trade occurs. If aninvestor purchases 20 of this new series and still holds these 20options at the end of the trading day, the open interest will thenbe 20 (assuming no other trades took place). Open interest iscalculated only after each trading session and is not updatedduring the trading day. Some traders look at this number as anindirect indicator of option liquidity: if the open interest islarge, there must be a high level of interest in this option and itshould be fairly liquid. But you will see instances where openinterest is high and trading volume low or nonexistent. Thiscould happen if an institution took a huge position some timeago (creating high open interest) but trading has since dried up.Uncovered (naked) option. Refers to a short option position wherethe writer cannot immediately meet the obligation assumed.For example, if the writer of a call option (the obligation to sella stock) is assigned and the writer does not own the underlying stock, he would have to purchase the stock in the open market in order to deliver it, or borrow shares to establish a shortposition. Uncovered options must be margined.Margin. Another word of multiple uses. For stocks: an investorcan buy a stock on margin; that is, using funds borrowed fromhis broker to help ﬁnance the purchase. The margin requirement is the minimum amount the investor must provide, usually expressed as a percentage. “You can purchase this stock on50% margin.” When purchasing options, the buyer must paythe full amount: long options are not marginable. For shortoption positions: some short option positions must be margined, i.e., the writer must have funds or securities in heraccount to demonstrate that she can meet the obligation she has
10
The Options Strategist
assumed. Cash or securities (stocks, bonds, mutual funds) areacceptable as margin.Margin call. A demand by a broker to provide additional fundsto margin a position. If an investor purchased a stock using theminimum amount of margin required and the value of thestock drops, the brokerage ﬁrm may make a margin call. Ifreceived early enough in the morning, it becomes synonymouswith a wake-up call.
Options Pricing: The BasicsYou may have heard of the Black-Scholes option pricing model, orof binomials used to estimate the value of an option. This chaptergives just a general idea of the variables that impact option priceswithout getting into the mathematics involved. We will come backto this subject in more detail in Chapters 4 and 9.No matter how complicated an option pricing equation, one usually ﬁnds only ﬁve inputs to the formula. These are:■
Stock price. As the price of the stock moves up and down, thevalue of an option will change. An option that was out-of-themoney can become at-the-money or in-the-money, potentiallymaking it more valuable. A rule of thumb is that higher stockprices increase the value of calls and decrease the value of puts,while lower stock prices have the opposite effect.
■
Exercise price. On a given stock, and with the same time untilexpiration, a 40 call will always be worth more than a 45 call. Thismakes sense since the right to purchase a stock at $40 has got tobe worth more than the right to purchase the same stock at $45.The only exception is if two options are so far out-of-the-moneythat they are equally worthless (think of a 120 and a 125 callwhen the underlying stock is trading at $30; both of these optionswill likely have no value). Puts with higher strike prices will bemore valuable than those with lower exercise prices.
■
Time until expiration. It stands to reason that a two-monthoption will be worth more than a one-month option, all othervariables being equal. More time increases the probability that
Options 101: Basic Terms, Deﬁnitions, and Strategies
11
an out-of-the-money option will become in-the-money; tradersand investors are usually willing to pay up for a longer term toexpiration.■
Volatility. Think of the most boring utility and of the riskiest technology stocks you ever purchased. This gives you an idea of whatvolatility is all about. Now think which of those two is morelikely to go up by $10 over a set period of time. And now youunderstand why options on high-tech stocks trade at higher premiums than those on utility shares.
■
Interest rates and dividends. This is the least important variable.The interest rate used in option pricing is usually the risk-freerate (i.e., that of Treasury bills). This lets option traders take intoaccount the time value of money (a dollar today is worth morethan a dollar tomorrow) and the opportunity cost of owning astock (the money used to purchase shares could otherwise beearning interest). Dividends reduce the cost of carrying a stock(I am not earning 4% on the cash I spent to buy these shares, butI am getting a 1% dividend).
The Four Basic Options StrategiesSince there are two types of options, puts and calls, and since anoption can either be bought or written, we obtain four basic optionstrategies: buying calls, buying puts, writing calls, and writing puts.These represent the building blocks that will be used in variouscombinations to create more complex strategies.
Buying Call OptionsPurchasing call options is the most basic bullish option strategy.Since investors tend to make their ﬁrst option trade during bull markets, it is also the point of entry to the world of options for manypeople. The basic mechanics of this strategy are best illustratedthrough an example.Start with Avon Products (AVP), trading at $50.60. A trader isbullish on these shares, expecting them to rise nicely over the next
12
The Options Strategist
few months. Of course, the most basic bullish investment strategywould be to simply buy 100 AVP shares. An alternative is to purchase one call option—for example, the July 50 call, a four-monthoption offered at $3.20. This would give the trader the right to purchase 100 shares of AVP at $50 until and including the third Fridayof July. Is one strategy better than the other? Let’s compare themfrom different angles.Risk. The stock buyer assumes a substantial amount of risk. In theory, a new technological development by one of Avon’s competitorscould make all current makeup products obsolete and send AVPspiraling down as sales evaporate. The option buyer has only $320at risk ($3.20 per share ⫻ 100 shares), the cost of the option purchased. The call buyer has a lower dollar risk than the stock owner.Upside potential. Owning shares of AVP theoretically offersunlimited upside potential. Since we have yet to observe an actualstock rising ad inﬁnitum, let’s be more realistic and say that stockownership offers signiﬁcant upside potential. The call buyer, byvirtue of his right to purchase shares of AVP, will be able to capturethis upside by transforming his option position into a stock position. This one looks like a tie.Breakeven point. The stock buyer’s breakeven point is the pricepaid for the shares. If in four months, or four years, AVP is still trading at $50.60, the stockholder breaks even (although he does incuran opportunity cost because his money could have been earninginterest income in a risk-free instrument). The call buyer has abreakeven of $53.20 at option expiration. This is calculated byadding the cost of the option ($3.20) to its strike price (50). If thestock remains unchanged over the next four months, the optionbuyer will end up with a loss. He faces a somewhat stiffer headwind. Better to own shares.Time constraints. For the buyer of a four-month call option tomake money the stock will have to increase in price some time overthe life of the option. If it does not, the call either will expire worthless or may be sold for less than its purchase price. The stock buyer
Options 101: Basic Terms, Deﬁnitions, and Strategies
13
is in no hurry, although the sooner the stock rises, the better. Buttime is deﬁnitely against the option buyer.Dividends, annual meetings, and corporate literature.The yield on AVP is 1.5%, and over the next four months the stockholder will be entitled to one of the quarterly dividends. Stockholders also have the right to attend the annual meeting (free coffeeand maybe free samples), to vote their shares, and to receive copiesof annual and quarterly reports. The option buyer is not entitled toany of these privileges.Proﬁtability at option expiration. To compare the profitability of the long stock and long call positions at option expiration, refer to Table 1.1, which illustrates the dollar per share gainsor losses for various AVP prices. This is just another tool in ourcomparison.A few comments on the table below are in order. The proﬁt andloss on the stock position assumes a purchase cost of $50.60. Thevalue of the call at expiration will be its intrinsic value. For instance,if AVP is trading at $56, the 50 call will be worth $6, or its in-themoney amount. Since it was purchased for $3.20, selling the call at$6 will leave the trader with a $2.80 proﬁt. The numbers from thistable are presented in another form in Figure 1.2, in what is com-
Table 1.1AVP Priceat Expiration
Proﬁt/(Loss)on Stock
Value of50 Call
Cost of50 Call
Proﬁt/(Loss)on Call
$44
($6.60)
$0
($3.20)
($3.20)
$47
($3.60)
$0
($3.20)
($3.20)
$50
($0.60)
$0
($3.20)
($3.20)
$53
$2.40
$3
($3.20)
($0.20)
$56
$5.40
$6
($3.20)
$2.80
$59
$8.40
$9
($3.20)
$5.80
$62
$11.40
$12
($3.20)
$8.80
14
The Options Strategist
$15
Profit/(Loss)
$10$5AVP
$0
50 Call
($5)($10)($15)$41
$44
$47
$50
$53
$56
$59
$62
AVP Price at Expiration
Figure 1.2 Long AVP vs. Long 50 Call
monly known as a proﬁt-and-loss diagram, a payoff diagram, or ahockey stick diagram.Figure 1.2 clearly illustrates the lower dollar risk of the long callposition, along with its higher breakeven point. And there lies themajor trade-off that all call buyers must accept: the lower risk comesat the cost of a higher breakeven. It should not come as a surprisethat neither the long stock nor the long call position is better. If onewere better than the other, there would be no need for the “worse”one.In fact, investors will face this type of trade-off with any optionstrategy: there will be pluses and minuses when compared to astraight stock position. And as we will see in later chapters, thereare also trade-offs among the various option strategies: the sixmonth option, for example, does give us twice as long as the threemonth one, but the breakeven is further away from the current stockprice.The buyer of a call option will at some point have to take one ofthree follow-up actions: sell the option, exercise it, or let it expire.The buyer of our AVP July 50 call could sell this option at any pointin time after buying it, just as a stock can be sold after it has beenpurchased. If the price of the option has risen to the point where atrader wants to take his proﬁt, he simply sells his long position. Thisis referred to as a closing sale because the trader is liquidating anexisting position. After the sale is executed, he will no longer havea position in this option.
Options 101: Basic Terms, Deﬁnitions, and Strategies
15
The trader’s second alternative is to exercise the option. He woulddo so only if he wanted to own the underlying shares. Most calls areexercised on or very close to their last trading day since there is verylittle incentive to exercise a call option early. If it is May and a traderowns an AVP July 50 call, he has the right to purchase 100 shares ofAVP today at $50. But he will have the same right tomorrow, so whyspend the money today when the purchase can be deferred? The $50can be left in a bank or money market account to earn interest overnight. Of course tomorrow the same reasoning will apply: why paynow, when we can pay later? And so on until the option is about toexpire and the investor who truly wants to own the shares mustthen exercise. Note that if the call is exercised, the effective purchaseprice of the stock will be $53.20, the call’s premium plus the option’sstrike price, which is the breakeven point calculated above.The last alternative is to let the call expire worthless. If the forecast of a higher AVP price has proven to be off the mark and byoption expiration the stock is trading at $48, $46, or $36, the call willbe worthless (and will therefore be impossible to sell) and it willmake no economic sense to exercise it. Would you pay $50 for astock now worth $44? No, and if you still wanted to own shares ofAVP you would simply go out and purchase them at $44. So the lastchoice is to take no action and see the option expire worthless.This section has looked at the purchase of a call option at onlytwo points in time: the day the position was initiated and at expiration. In Chapter 3 we will return to this strategy and look at itsperformance in the intervening dates.Buying Put OptionsIf purchasing a call option is the most basic bullish option strategy,then buying a put has to be classiﬁed as the most basic bearishoption strategy. And if the most basic bullish investment strategy isbuying a stock, its bearish equivalent is shorting a stock. And so,before we look at purchasing puts, a quick note on shorting stocks.Assume a trader is convinced that shares of FedEx (FDX) willdecline over the next few months, either because of an economicslowdown or because of a dubious claim that someone is on thebrink of developing a machine that will be able to send small objectsover great distances using existing phone lines. This trader borrows
16
The Options Strategist
500 shares from her broker and places an order to sell the sharesshort. Her order is ﬁlled at $60.11. (Note that borrowing the stock ofcompanies with a relatively high number of outstanding shares isusually not a problem as most brokers will have access to these. Borrowing shares of a lightly traded small cap stock may be much moredifﬁcult.) If FDX drops to $50, our trader will purchase 500 shares atthat price and return these to her broker, generating a $10.11 proﬁt.The short seller essentially reverses the traditional order of buyingand selling: instead of buying a stock at $50, waiting for it to go up,and selling it at $60, she ﬁrst sells the (borrowed) shares, waits forthe stock to go down, and then buys in the shares at $50. Of course,if a trader shorts FDX, there is always the possibility that the pricewill start rising, to $65, $70, or higher. The trader is now in a difﬁcultsituation: she sold shares at $60.11 and will have to buy them backat a higher price, creating a trading loss. And since there is theoretically no ceiling to the price of FDX or any other stock, the losses canescalate as the stock hits new highs. Short sellers need nerves of steeland/or a bottomless bank account. Most of us don’t ﬁt that proﬁle.An alternative to selling shares short is to purchase a put option.With FDX trading at $60.11, the May 60 put was offered at $2.90.Purchasing this two-month option gives its holder the right to sellshares (which she does not currently own) at $60 until the option’sexpiration date. Look at a long put position as the right to shortstock, even though this right is rarely invoked. We can now compare a short stock position in FDX to a long put position.Risk. The put buyer cannot lose more than the $2.90 premiumpaid. As noted, the risk of a short stock position is theoreticallyunlimited, although it is more accurate to say the risk is substantial.Advantage put buyer.Proﬁt potential. A virtual tie, as for every dollar FDX drops, theshort stock generates $1 in proﬁt and the put’s intrinsic valueincreases by $1.Capital required. Shorting a stock actually generates cash asthe proceeds from the short sale are credited to the trader’s account.But additional funds are required to margin the position, usually
Options 101: Basic Terms, Deﬁnitions, and Strategies
17
50% of the value of the shorted stock. And if the stock starts climbing, additional margin may be required. Unlike a long stock position, which can be paid for in full up front, there is always thepossibility that a short stock position will require additional funds.The put buyer pays the $2.90 and no more. A plus for the put buyer.Breakeven point. The short stock position starts generatingproﬁts as soon as FDX drops below $60.11. For the put buyer tomake money at option expiration the stock has to be below $57.10.The downside breakeven on a long put position is calculated by subtracting the premium ($2.90) from the put’s exercise price (60). Theshort stock position has the higher breakeven, which is a netadvantage.Time constraints. A trader could maintain a short stock position ad inﬁnitum, provided he pays all the dividends declared andhas the capital required to maintain the position in rising markets.The put buyer has only until the option’s expiration date.Dividends. A trader who shorts a stock becomes liable for anydividends paid. This is a minor issue with FDX, which only pays a$0.05 quarterly dividend. But if a trader maintains a short positionin FDX over the next ex-dividend date, she would have to pay this$0.05 dividend to the broker from whom the shares were borrowed.This is to compensate the broker who would otherwise still be longthe shares and entitled to this dividend. Put buyers have no dividend liabilities, so a small plus in their favor.Suitability. Obtaining approval at your brokerage ﬁrm to shortstocks may be a long tedious process involving numerous forms andvarious ﬁnancial requirements such as account size, net worth, andmaybe others. Getting approved for buying puts is usually straightforward, this being one of the strategies brokerage ﬁrms allow tonewcomers to the options market. Advantage put buyer.Proﬁtability at expiration. To complete the comparison,Table 1.2 calculates the proﬁtability of both strategies for variousFDX prices at option expiration.
18
The Options Strategist
Table 1.2FDX PriceProﬁt/(Loss) onat Expiration Short Stock
Value of60 Put
Cost of60 Put
Proﬁt/(Loss)on Put
$48
$12.11
$12
($2.90)
$9.10
$51
$9.11
$9
($2.90)
$6.10
$54
$6.11
$6
($2.90)
$3.10
$57
$3.11
$3
($2.90)
$0.10
$60
$0.11
$0
($2.90)
($2.90)
$63
($2.89)
$0
($2.90)
($2.90)
$66
($5.89)
$0
($2.90)
($2.90)
$69
($8.89)
$0
($2.90)
($2.90)
Profit/(Loss)
The table above assumes FDX was shorted at $60.11 and the May60 put was purchased for $2.90. One can observe that as the price ofFDX drops the put value at expiration increases, generating higherand higher proﬁts. On the upside, the put buyer’s risk is limited tothe premium paid, whereas the losses on the short stock will continue to increase as FDX hits new highs. These numbers are presented in a different form in Figure 1.3.Once again the trade-offs between a position in options and onein the underlying stock are clearly seen: higher breakeven for the
$12$10$8$6$4$2$0($2)($4)($6)($8)($10)
Short FDX60 Put
$51
$54
$57
$60
FDX Price at Expiration
Figure 1.3 Short FDX vs. Long 60 Put
$63
$66
$69
Options 101: Basic Terms, Deﬁnitions, and Strategies
19
short stock position (this is a positive for a bearish strategy) versuslimited risk for the long put position.As with call options, the put buyer will have to take one of threecourses of action at some point before option expiration: sell thelong option, exercise it, or let it expire worthless. If at expirationFDX has increased in price, the put will be worthless and logic dictates that the trader let it expire worthless. On the other hand, if thestock has dropped to the trader’s target price at or prior to expiration, she may want to take proﬁts by selling her option. The thirdavenue will be taken by very few traders in very limited circumstances: exercising this put would create a short position in FDXstock and would be done only by those traders who have a shortaccount and who wish to maintain a bearish position past the optionexpiration date. Most traders sitting on a proﬁtable trade will behappy simply to liquidate their long option position.Investors who want to take a long equity position have two basicstrategies: purchase the stock or buy a call option. Traders lookingto take a short position in a stock will for the most part be limitedto the purchase of put options. This may in the end be all for the better: stock buyers at times look to establish longer-term positionswhere the time-limiting nature of options may eliminate these as aviable alternative. Traders looking to go short a stock rarely do sowithin a multiyear time horizon. Their focus is usually on the shortto mid-term, where options work best and where their limited riskaspect may actually permit sticking with a bearish position for alonger period of time. Too many traders who short stocks cover theirpositions at the ﬁrst hint of a rally, not wanting to get caught in amajor up move, just to see the stock head south days after they cuttheir losses. Options may actually give these traders added stayingpower.Writing Options: Covered and UncoveredWhenever an option is written, an obligation is assumed. If theoption writer is in a position to fully meet this obligation, the optionwill be considered covered. Otherwise, it will be treated as uncovered, or naked.The writer of a call option has assumed the obligation to sell sharesof the underlying stock. The short option position will be covered if
20
The Options Strategist
the writer owns sufﬁcient shares of stock to deliver if she is assigned.An investor who is required to sell shares she owns does not face aproblem (although she may not be happy with the selling price), butan investor who does not own the shares will have to scramble andpurchase them, which may be an expensive proposition.The writer of a put has assumed the obligation to purchase astock. If obligated to buy shares, an investor must pay, i.e., mustdeliver cash. So a short put option is considered covered if theinvestor has sufﬁcient cash set aside for the eventual purchase ofthese shares. (Not everyone in the industry agrees with our use ofthe expression covered put; some prefer the phrase cash-secured put.)Because of the substantial risks associated with uncovered shortoptions, we will limit our discussion to covered options in this ﬁrstchapter, where our goal is to establish a ﬁrm foundation.Writing Covered CallsThe writer of a call option assumes the obligation to sell shares ofthe underlying stock; the call is covered if the writer owns sufﬁcientshares of stock to deliver in the event of an assignment. Calls can bewritten on shares held in a portfolio, or they can be written simultaneously with a stock purchase. The latter strategy is known as abuy/write. Both of these call writing strategies are explained ingreater detail in Chapter 2.To understand the basics of covered calls let’s start with the following example:Dell Computers (DELL):May 27 1⁄2 call:May 30 call:May 32 1⁄2 call:
$25.92$1.30$0.55$0.20
An investor holding DELL shares decides to write the May 27 1⁄2calls against his stock position. (May options have nine weeks untilexpiration). When an investor writes an option, the premium iscredited to his account on the next business day. If the option is covered, as it is in our example, the investor is free to withdraw thesefunds or reinvest them elsewhere. So the immediate impact of writ-
Options 101: Basic Terms, Deﬁnitions, and Strategies
21
ing covered calls is that it generates positive cash ﬂow. The longerterm impact is that the investor may be forced to sell his shares atthe option’s exercise price, $27.50 in our example. We may appearto be stating the obvious, but no investor should write covered callsunless he or she is comfortable selling the shares under option at thestrike price. Why would anyone commit to selling a stock at a pricethat seems inadequate? So let’s compare the results of this strategyto those obtained by another investor who holds shares of DELL butdoes not write calls against them.Risk. Both the stockholder and the covered writer are long sharesand have to bear the full downside risk of the stock position. Thecovered writer gets paid $1.30 per share when writing the call, soone could rightfully claim that his overall risk has been reduced bythis amount. In our example the option premium represents 5% ofthe stock price, so the covered writer ends up with 95% of the riskof the stock owner. Slight advantage to the covered writer.Proﬁt potential. This issue is more complex than it may appear.Looking strictly at the absolute upside potential, the stockholder isthe obvious winner. If DELL goes to $30, $35, and $40 she sees herproﬁts increasing with every up-tick in the stock price. The coveredwriter has agreed to sell his shares at $27.50 and so will participatein the stock appreciation only up to that point.But under less bullish assumptions, the covered writer comes outahead ﬁnancially. Start with an unchanged stock price scenario: innine weeks DELL is still trading in the neighborhood of $26. Thestockholder has neither made nor lost any money, but the coveredcall writer sees the option expire worthless and gets to keep theoption premium of $1.30. He ends up holding his DELL shares, butis ahead of the stock owner by $1.30. Even in moderately bullishscenarios, the covered writer comes out ahead: with DELL at $27 thecalls still expire worthless and the covered writer remains ahead by$1.30. At $28 the short calls will be assigned and the shares sold at$27.50, so the covered writer has a $0.50 opportunity loss, but the$1.30 option premium keeps him ahead on an overall basis. The verdict: mixed, as the two strategies’ proﬁtability will be a function ofthe stock price at option expiration.
22
The Options Strategist
Table 1.3Proﬁt/(Loss)DELL PriceProﬁt/(Loss)on Stock forat Expiration on Long Stock Covered Write
OptionPremium
Proﬁt/(Loss)on CoveredWrite
$20
($5.92)
($5.92)
$1.30
($4.62)
$22.50
($3.42)
($3.42)
$1.30
($2.12)
$25
($0.92)
($0.92)
$1.30
$0.38
$27.50
$1.58
$1.58
$1.30
$2.88
$30
$4.08
$1.58
$1.30
$2.88
$32.50
$6.58
$1.58
$1.30
$2.88
Dividends. Since the stockholder and the covered writer are bothfull-ﬂedged stock owners, they both receive dividends, companyﬁnancial statements, and other goodies. A tie.Table 1.3 gives a detailed picture of the performance of the covered write strategy relative to a long stock position for various DELLprices at option expiration.A few comments are in order. First, on the downside, the coveredwriter’s total losses are lower by $1.30 when compared to the stockowner’s. On the upside, the covered writer’s total proﬁt keeps pacewith the long stock position up to a stock price of $28.80, which represents the call’s exercise price plus the option premium received.Table 1.3 also shows the proﬁt on the stock for covered write reaching its maximum of $1.58 at the option’s strike price of $27.50. Thisis simply because it is assumed that if the stock rises above this pricethe short call position will be assigned, the shares will be sold at$27.50, and the proﬁt on the stock will thus be limited to $1.58. Thesenumbers are presented in another form in Figure 1.4.We can now clearly see the range over which the covered callswork best: from $24.62 (the downside breakeven) to $28.80 (abovewhich price owning unhedged shares is more proﬁtable). And thisgives us a clear indication as to when investors should considerwriting covered calls: if the underlying stock is expected to movestrongly, either to the upside or to the downside, avoid writing covered calls. But when a stock is expected to remain within a relatively
Options 101: Basic Terms, Deﬁnitions, and Strateg