period of time.3. “at a fixed price . . .” This fixed price is called the strike price, or the price atwhich the stock underlying an option can be purchased (call) or sold (put).Options are available in several strike prices at 21/2- or 5-point intervals, depending on the current price of the underlying stock.4. “within a predefined time period . . .” Unlike stocks, options come with adeadline. An option must be exercised or sold to another option buyer beforeits expiration date or it will expire worthless and you will not recoup the premium paid for it. The existence of an expiration date is probably the most important distinction between options and stocks.5. “for a specific premium.” Getting this right to buy or sell at a strike price isnot free. But, because you always have the option not to exercise a call or put,the premium is the extent of your potential risk.In the past, options have received a bad rap. But learning to use them is a lot easier than it appears. If people lose money with options, it’s because most don’t reallyunderstand how they work. If you want to learn how to use them, you can start byunderstanding that options suffer from a phenomenon known as time decay. That is,options lose value with time, and lose it the fastest as they near expiration. But anoption also provides a trader with flexibility and strategic choices. For example, youget to decide in advance the exact price you are willing to buy (or sell) a stock for ata certain future date, then speculate on whether your option will increase in valueduring that time. For this privilege you pay a price (if you are a buyer) or receive acredit (if you are a seller) for the cost of the option. Without a doubt, options areversatile instruments and, for the student of the stock market, worthy of study.
A HISTORY LESSON
119
Time decay: Part of the premium paid for an option known as time value. Thisamount is nothing more than a payment to the seller of the option to tie up theobligation on the stock for the requisite time period—the longer until expiration,the higher the premium. Time value will decay, or disappear, as the option approaches the expiration date.
To summarize, options have a wide variety of uses including the followingapplications:• Options offer protection from a decline in the market price of a long underlying stock or an increase in the market price of a short underlying stock.• Call options enable you to buy a stock at a lower price by exercising an in-themoney call option.• Put options enable you to sell a stock at a higher price by exercising an in-themoney put option.• Options create additional income against a long or short stock position.• Options can be combined to create options strategies that offer limited risk approaches to taking advantage of bullish, bearish, and sideways markets.• Specific option strategies can profit from a move in the price of the underlyingasset regardless of market direction.
A HISTORY LESSONOptions have traded over the counter throughout the twentieth century. In the earlydays, option dealers would advertise open option positions in newspapers—an inefficient process at best. In April of 1973, the Chicago Board Options Exchange(CBOE) altered the nature of trading by formally listing options. Each stock optioncontract was standardized to represent 100 shares of stock, and expiration dateswere set at specific intervals.Chicago Board Options Exchange (CBOE): The CBOE is the largest options exchange in the United States. The CBOE’s web site offers new option listings, information on equities, options and leaps (long-term equity anticipationsecurites), and tutorials. Specialization includes calls and puts on NYSE stocks,the S&P 500, U.S. Treasury bonds, and other indexes (www.cboe.com).
Options have since experienced explosive growth, most recently driven by the advent of online trading. Currently the CBOE lists options on 680 stocks with more than700,000 option contracts traded daily—approximately 51% of all options traded domestically. The CBOE uses an auction market system, employing floor brokers andmarket makers to execute customers’ orders and inspire competition in the markets.
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THE VERSATILITY OF OPTIONSThere are several option trading exchanges that you can visit on the Web:• Chicago Board Options Exchange (CBOE): www.cboe.com• American Stock Exchange (AMEX): www.amex.com• Philadelphia Exchange (PHLX): www.phlx.com/index.stm• Pacific Exchange of San Francisco (PCX): www.pacificex.com
On May 26, 2000, a new all-electronic exchange was launched—the InternationalSecurities Exchange (ISE). It is the first new U.S.-based exchange to open for tradingin over 27 years. There are three main reasons why the launch of the ISE is significant:International Securities Exchange (ISE): A fully electronic exchange for tradingstock options. Unlike the other option exchanges, it does not have a tradingfloor, but instead offers members screen-based trading.
First, unlike other exchanges offering options trading—CBOE, AMEX, PHLX,and PCX—there is no trading floor, which reflects the trend toward increased electronic trading evident throughout the world.Second, ISE is proving instrumental in developing linkages among the variousexchanges. Prior to August 1999, each specific option was listed on only one exchange. For example, options on Dell Computer were available only on the CBOE.Since that time, exchanges have been moving toward multiple listings. Given thatISE anticipates trading options on over 600 stocks and ensuring that customers aregetting the best price offered on any of the exchanges, ISE is making the marketmore efficient and interdependent.Third, it is interesting to note that the last two exchanges to open in the UnitedStates are both designed for option investing. Since 1973, option trading hasemerged as a legitimate and popular method of achieving and protecting wealth.Shortly after the launch of the CBOE in 1974, the total number of options traded annually was 5.7 million contracts. By 1999, that figure had mushroomed to 444 million. There is ample evidence to suggest that this trend will continue and perhapsone of the most telling indications is the creation of the ISE.
WHY TRADE OPTIONS?Why has options trading grown so popular? For one thing, the amazing versatilitythat an option offers in today’s highly volatile markets is a welcome relief from thelimited directional profitability and uncertainties of traditional investing. Optionscan be used in a variety of ways to profit from a rise or fall in the market. Most ofmy favorite trading strategies employ options as insurance policies in a wide varietyof trading scenarios. You probably have insurance on your car or house because it isthe responsible and safe thing to do. Options provide the same kind of safety net fortrades and investments. They also increase your leverage by enabling you to control
DEFINING AN OPTION’S CHARACTERISTICS
121
the shares of a specific stock without tying up a large amount of capital in your trading account.Furthermore, options enable traders to capitalize on the bullish or bearish movesof an underlying market—usually with much less initial investment capital. Buyingan option offers limited risk and unlimited profit potential. In contrast, selling anoption (also known as writing an option) comes with an obligation to complete thetrade if the party who buys it chooses to exercise the option. Selling an option,therefore, presents the writer with limited profit potential and significant risk unlessthe position is hedged in some manner.It is vital to remember that an option has a limited shelf life. Every option contract is good up to a certain month and year. If you buy one call option on a stock,you can exercise your right to buy 100 shares of the underlying stock at any timeuntil market close on the third Friday of the option’s expiration month. If you do notexercise an option or sell it to another option buyer before its deadline, the optionexpires worthless and you will not recoup the premium paid for it—game over.The most important difference is that unlike stocks, options come with adeadline. When you buy options, you pay money and time is not on your side.When you sell options, you receive a credit and time decay is on your side.
DEFINING AN OPTION’S CHARACTERISTICSOptions have five main standardized terms by which they are defined:1. Type of option (call or put)2. Underlying asset3. Strike price4. Expiration date5. Option premiumThese five variables distinguish each individual option from every other available option. Each time you enter a trade using options, these five terms define theparameters of your trade. It is essential to understand how these factors affect thenature of each trade in order maximize your chances of success.
Type of OptionThere are two kinds of options—calls and puts—that can be bought (go long) orsold (go short):• A call option gives the buyer the right, but not the obligation, to buy a fixednumber of shares of an underlying stock at a specified price until the option’sexpiration date.
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THE VERSATILITY OF OPTIONS
• A put option gives the buyer the right, but not the obligation, to sell a fixednumber of shares of an underlying stock at a specified price until the option’sexpiration date.Call option: An option contract that gives the holder the right, but not the obligation, to buy a specified amount of an underlying security at a specified pricewithin a specified time in exchange for a premium. The call option buyer hopesthe price of the underlying stock will rise by the call’s expiration, while the calloption seller (or writer) hopes that the price of the underlying stock will declineor remain stable.Put option: An option contract giving the owner the right, but not the obligation, tosell a specified amount of an underlying security at a specified price within a specified time in exchange for a premium. The put option buyer hopes the price of theunderlying stock will drop by a specific date, while the put option seller (or writer)hopes that the price of the underlying stock will rise or remain stable.
Put and call options are absolutely separate transactions. They are not oppositesides of the same transaction. If you buy a call, you cannot get out of it by selling aput. You must exit the trade by selling the call or simply allow it to expire worthless.Here’s a basic summary of the process for closing out an option trade:1. If you bought a call, you have to sell a call.2. If you sold a call, you have to buy a call.3. If you bought a put, you have to sell a put.4. If you sold a put, you have to buy a put.
Underlying AssetEach option provides the right to buy or sell a specific stock also called the underlyingasset. Not all stocks have options. If options are available, they can be bought andsold at a fraction of the cost of the underlying stock. Thus, options provide a highleverage approach that in many instances can reap large rewards from minimum-risktrades in comparison to traditional buy-and-hold stock investing.
Strike PriceThe strike price is the fixed price at which the stock underlying an option can be purchased (call) or sold (put). Options are available in several strike prices at 21/2-pointintervals for stocks priced $25 and less, or 5-point intervals for stocks over $25.Strike price: All options have strike prices. They represent the price at which theunderlying stock can be purchased (call) or sold (put) at any time prior to theoption’s expiration date if the option is exercised.
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123
For example, if IBM is currently trading at 121, you may choose to buy a calloption at 110, 115, 120, 125, or 130. You then have the right (but not the obligation)to buy IBM at the strike price of your choice until close of business on the third Friday of the expiration month—regardless of how high or low the price of IBM risesor falls. If the price of IBM rises and you have the ability to buy it at a lower price,the value of your option increases. If the price of IBM falls and you have the right tobuy it at a higher price, your option will probably expire worthless and you will notrecoup the money spent buying the option.Exercising a call is accomplished as follows: Assuming you have purchasedthe 115 call option, you would call your broker on or before the third Fridayof the expiration month and say you want to exercise the 115 call optionon IBM. Then with the surrender of your option and the debit of $11,500($115 per share times 100 shares per option contract) from your account,you will own 100 shares of IBM regardless of the current price.
Expiration DateAn option’s expiration date designates the last day on which an option may be exercised. American-style stock options officially expire on the third Saturday of the expiration month and must be traded by close of business on the last trading day priorto expiration. Since American options can be exercised at any time, they tend to havea slightly higher value than their European counterparts. After an option expires, youlose the right to buy or sell the underlying instrument at the specified price.
Expiration date: The last day on which an option may be exercised. Americanstyle options can be exercised at any time before the expiration date. Europeanstyle options can be exercised only on the expiration date.
In order to decide which expiration months to use, you have to know whichmonths are available. All stocks with options have available expiration months forthe current month and the next month. When the front month options expire, the following month options become the front month and the next month options becomeavailable, and so on. In addition to the front and following months, each stock is assigned to one of three quarterly cycles: Cycle 1, Cycle 2, and Cycle 3 or alternatively January, February, and March.• Cycle 1 stocks have quarterly options representing the first month of the quarter (January, April, July, and October).• Cycle 2 starts with the second month (February, May, August, and Novemberexpirations).• Cycle 3 starts with the third month (March, June, September, and Decemberexpirations).
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THE VERSATILITY OF OPTIONS
Always confirm available expiration dates by asking your broker, reading the literature from the exchanges, or visiting an exchange’s web site.There are also longer-term option contracts called LEAPS (long-term equity anticipation securities) with expiration dates up to three years in the future. LEAPS always expire in the month of January and are also classified in one of the threecycles previously mentioned. They offer a terrific alternative to buying stocks andcome with the advantage of an expiration that is many months or years away.LEAPS: Long-term equity anticipation securities are long-term stock or index options with up to three years until expiration.
Option PremiumAn option’s premium denotes the actual price a trader pays to buy an option or receives from selling an option. The potential loss on a long option is limited to thepremium paid for the contract, regardless of the underlying stock’s price movement.That’s why the purchase of an option enables traders to control the amount of riskassumed. In contrast, the potential profit on a short option is limited to the premiumreceived, regardless of the underlying stock’s performance.Premium: The amount of cash that an option buyer pays to an option seller, orthat an option seller receives from the sale of an option.
UNDERSTANDING OPTION QUOTESThe Internet has made the process of reviewing option prices extremely easy. Thereare dozens of sites that provide quote services. Some of these services provide realtime quotes, but many more are delayed by at least 15 to 20 minutes. If you want toreceive streaming real-time data on a portfolio of stocks and options, you must bewilling to pay for it (check out eSignal at www.dbc.com). You can also visit theChicago Board Options Exchange (www.cboe.com) for a detailed list of delayedstock option quotes. Figure 5.1 shows a basic options quote for IBM.When you look up an option’s price, each quote is followed by several categoriesthat describe various values of an option’s price. Understanding these tiny numbersis essential to your success. Let’s review a few of the most popular quote terms.• Last sale: The last price that the option traded for at the exchange. For delayedquotes, this price may not reflect the actual price of the option at the time youview the quote. It could even be from a day or two prior for options that do nottrade that frequently.• Net: The amount that the option changed in price since the last price was quoted.
OPTION SYMBOLS
125
IBM (NYSE)
107 5/16 -35/8
May 31,2000 @ 19:55 ET (Data 20 Minutes Delayed)Calls
LastSale
Net
Bid
Ask
00 Jun 80 (IBM FP-E)
28 1/4
pc
00 Jun 85 (IBM FQ-E)
28 1/8
pc
00 Jun 90 (IBM FR-E)
17 7/8
00 Jun 95 (IBM FS-E)
15 1/2
00 Jun 100 (IBM FT-E)
8 3/8
-2 1/2
8 3/8
8 3/4
00 Jun 105 (IBM FA-E)
5 7/8
-1 3/8
4 5/8
4 7/8
Puts
LastSale
Bid N/A
Ask N/A
Net
Bid
Vol.
OpenInt
27 3/8 28 1/8
0
2
00 Jun 80(IBM RP-E)
1/8
pc
22 3/8
23
1/8
0
10 00 Jun 85 (IBM RQ-E)
1/8
pc
+1
7 5/8 18 1/8
5
49
00 Jun 90 (IBM RR-E)
3/16
pc
12 3/4 13 1/4
0
232
00 Jun 95 (IBM RS-E)
5/16
55
691
00 Jun 100 (IBM RT-E)
102
1927
00 Jun 105 (IBM RA-E)
Size N/AxN/A Vol 3732500Ask
Vo
OpenInt
0
1/8
0
62
0
3/16
0
128
pc
3/16
5/16
0
960
–
1/4
3/8
20
1508
3/4
+1/8
3/4
15/16
70
4748
2 1/16
13/16
2
2 1/4
530
4345
00 Jun 110 (IBM FB-E)
2 1/4
-1 1/2
2 1/8
2 3/8
853
7616
00 Jun 110 (IBM RB-E)
4 1/2
+1 5/8
4 1/2
4 3/4
688
5357
00 Jun 115 (IBM FC-E)
11/16
-1 1/16
11/16
13/16
726 12203
00 Jun 115 (IBM RC-E)
7 1/4
+5/8
8
8 3/8
70
1400
Figure 5.1
Closing Quote for IBM Options (Courtesy of cboe.com)
• Bid: The bid is the highest price a prospective buyer is prepared to pay for aspecified time for a trading unit of a specified security. If there is a high demand for the underlying asset, the prices are bid up to a higher level. Off-floortraders buy at the ask price.• Ask: The ask is the lowest price acceptable to a prospective seller of the samesecurity. A low demand for a stock translates to the market being offered downto the lowest price at which a person is willing to sell. Off-floor traders sell atthe bid price. Together, the bid and ask prices constitute a quotation or quoteand the difference between the two prices is the bid-ask spread. The bid andask dynamic is common to all stocks and options.• Volume: Option volume is the total number of contracts traded in the previous day.• Open interest: Open interest is the total number of outstanding contracts. Italso defines an option’s liquidity—the higher the number, the easier it is tomove in and out of a trade.
OPTION SYMBOLSTo understand quotes, you must be able to decipher option symbols. Option symbols vary depending on their source. However, all option orders are composed ofthe following components:IBM FB-E = IBM June 2001 110 CallRoot symbol = IBMExpiration month and type of option = F= June callStrike price = B = 110Exchange = E = CBOE
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THE VERSATILITY OF OPTIONS
• Root symbol: The symbol used to identify the underlying stock, future, index,or security instrument on which an option is based.• Expiration month and type of option: The month in which the option contractexpires and type (call or put) are represented by a letter of the alphabet. (SeeAppendix E for a comprehensive chart.) In futures markets, a C representscalls and P represents puts.• Strike price: The specific price at which the option holder has the right to buyor sell the underlying financial instrument. In futures, strike prices are usuallynumeric. In stocks, a letter of the alphabet represents strike prices. (See Appendix F for a list of strike price codes.)• Exchange: Some options are traded on more than one exchange. Each exchangehas its own unique prices and information. Some brokerages let you pick the exchange and others just place your order at the exchange with the best prices.Strike price codes: A system of alphabetical symbols that represent option strikeprices, used to describe an option when actually placing an order through anexchange.
OPTION PRICING PROCESSOption pricing is a complex process. There are seven major components that affectthe premium of an option:1. The current price of the underlying stock.2. The type of option (put or call).3. The strike price of an option in comparison to the current market price of theunderlying stock (its intrinsic value).4. The amount of time remaining until expiration (the option’s 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 stock.Each of these factors plays a unique part in the determination of an option’s premium. The first four variables are relatively self-explanatory. The last three are often overlooked, although each variable is important. For example, higher interestrates will increase call option premiums and decrease put option premiums—andvice versa for lower interest rates. Dividends act in a similar way, increasing anddecreasing an option premium as they increase or decrease the price of the underlying asset.
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127
Intrinsic Value and Time ValueIntrinsic value and time value (also called extrinsic value) are the two determinantsof an option’s price. The formula is very simple:Option premium = Intrinsic value + Time valueIntrinsic value measures the amount by which the strike price of an option is inthe-money (ITM) in relation to the current price of the underlying stock. An out-ofthe-money (OTM) or at-the-money (ATM) call or put has an intrinsic value of zerobecause it has no real value. Hence, the option premium is made up entirely of timevalue. The intrinsic value does not vary with time. Any intrinsic value remains constant regardless of any changes in the option environment except for the price of theunderlying stock. If the underlying stock price doesn’t change, the intrinsic valuedoesn’t change, all the way through expiration.Intrinsic value: The amount by which an option is in-the-money. Out-of-themoney and at-the-money options have no intrinsic value. Calls = underlying security minus strike price. Puts = strike price minus underlying security.In-the-money (ITM): If you were to exercise an option and it would generate aprofit at the time, it is known to be in-the-money. A call option is in-the-moneyif the strike price is less than the market price of the underlying security. A putoption is in-the-money if the strike price is greater than the market price of theunderlying security.Out-of-the-money (OTM): An option whose exercise price has no intrinsic value.A call option is out-of-the-money if its exercise or strike price is above the currentmarket price of the underlying security. A put option is out-of-the-money if its exercise or strike price is below the current market price of the underlying security.At-the-money (ATM): When the strike price of an option is the same as the current price of the underlying instrument.
If an option is ITM (i.e., the stock price is above a call option’s strike price or below a put option’s strike price), then the time value is simply the option value lessthe intrinsic value. This extrinsic value is known as time value because as the optionapproaches expiration (loses time), the extrinsic value goes to zero. At expirationthe only value in an option, if any, is intrinsic value.Time value (extrinsic value): The amount that the current market price of aright, warrant, or option exceeds its intrinsic value. Time value = Option premium – Intrinsic value.
The time value portion of the option premium actually consists of a number of factors. Included in the time value is the number of days until expiration, the volatility of
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THE VERSATILITY OF OPTIONS
the underlying asset, the risk-free interest rate, and an adjustment for any dividendspayable by the firm, and the psychological bias of the investor. At any point in time, theextrinsic value would be affected by each of its components as shown in Figure 5.2.The following equations will allow you to calculate the intrinsic value of call andput options:• Call options: Intrinsic value = Underlying security’s current price– Call strike price.• Put options: Intrinsic value = Put strike price – Underlying security’s currentprice.If the calculation results in a negative number, then the intrinsic value is zero bydefinition. Since time value is the amount by which the price of an option exceedsits intrinsic value, time value is calculated by subtracting the intrinsic value fromthe option premium. For example, if a call option costs $5 and its intrinsic value is$1, the time value would be $4 ($5 – $1 = $4). Let’s calculate the intrinsic value andtime value of a few call options with XYZ trading at $68 per share.1. Strike Price = 60 Option Premium = 83/4Intrinsic value = 68 – 60 = 8 (Intrinsic value = Underlying security’s price– Strike price)Time Value = 83/4 – 8 = 3/4 (Time value = Call premium – Intrinsic value)2. Strike Price = 65 Option Premium = 65/8Intrinsic value = 68 – 65 = 3Time value = 65/8 – 3 = 35/8
Component ofTime Value
Calls
Puts
Time untilexpiration
Premium decreases as timeexpires.
Premium decreases as timeexpires.
Volatility ofunderlying asset
Premium increases asvolatility increases.
Premium increases as volatilityincreases.
Risk-free interest
Premium increases asinterest rates increase.
Premium decreases as interestrates increase.
Dividendspayable
Premium decreases if there areone or more dividends payablebefore expiration.
Premium increases if there areone or more dividends payablebefore expiration.
Psychological bias Premium increases ifinvestors are suddenly bullishon the underlying stock.
Premium increases ifinvestors are suddenly bearishon the underlying stock.
Figure 5.2Premium
The Influence of Various Factors on the Time Value Portion of an Option
OPTION PRICING PROCESS
129
3. Strike Price = 70 Option Premium = 51/2Intrinsic value = 68 – 70 = – 2 = Zero intrinsic valueTime value = 51/2 – 0 = 51/2 = All time valueAn option’s intrinsic value is also called the minimum value because it tells youthe minimum amount the option should be selling for. This means that the cheaperthe option, the less real value you are buying. It is important to note that the intrinsic value of an option is the same regardless of how much time is left until expiration. Since theoretically an option with three months until expiration has a betterchance of ending up in-the-money than an option expiring in the present month, options with more time until expiration are usually priced higher.The prices of OTM options are cheap, and they get even cheaper as you get further out-of-the-money. That’s because an OTM option consists of nothing but timevalue, and the more out-of-the-money an option is, the less chance it has of movingin-the-money. To many traders, OTM options appear to be a great deal because oftheir inexpensive prices. However, the probability that an extremely OTM optionwill turn profitable is really quite slim.Time value has a snowball effect. If you have ever bought options, you mighthave noticed that at a certain point close to expiration, the price of the option stopsmoving completely. That’s because option prices are exponential—the closer an option gets to expiration, the more money is lost if the market doesn’t move in a direction that puts the option in-the-money. On the expiration day, all an option is worthis its intrinsic value. It’s either in-the-money or it isn’t. The deeper in-the-money acall or put is, the less time value and more intrinsic value the option has. Since youare paying less for time, an in-the-money option’s premium moves more like theprice of the underlying asset. This is also referred to as the delta of an option. Thedelta of an option is the key to creating delta neutral strategies and is the foundationfor many of my favorite options strategies.Delta: The amount by which the price of an option changes for every dollarmove in the underlying instrument.Delta neutral: A position arranged by selecting a calculated ratio of short andlong positions that balance out to an overall position delta of zero.
VolatilityVolatility is not only a primary determinant of an option’s price, but it also helps todefine which strategy can best be used to make money in a specific market. Specifically, volatility is a percentage that measures the amount by which an underlyingstock or market is expected to change in a given period of time. This sounds quiteimposing, so I prefer to think of it as the speed of change in a market. For example,if a stock is trading at 100 and has a volatility of 25%, in one year the stock shouldbe trading between 75 and 125. It is important to note that volatility does not have a
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THE VERSATILITY OF OPTIONS
directional bias—a high-volatility stock has the propensity to move quickly in either direction, while a stable market moves more slowly.Volatility: The amount by which an underlying instrument is expected to fluctuate in a given period of time. Options often increase in price when there is a risein volatility even if the price of the underlying security doesn’t move anywhere.
A stock’s volatility has a significant effect on the price of its options. A highlyvolatile stock has a better chance of making a substantial move than a low-volatilitystock. In other words, a more volatile asset offers larger swings upward or downward in price in shorter time spans than less volatile assets. Large movements, inturn, are attractive to option traders, who are always looking for big directionalswings to make their contracts more profitable. Therefore, the options of a highvolatility stock generally command a higher premium because they have a greaterchance of making a big move and being in-the-money by expiration.There are many reasons and events that trigger high volatility. For example, onthe third Friday of each month, the government releases the Employment Report,which often triggers a fluctuation of prices in the bond market. This often producesa simultaneous vol