are selling and supply is rising, prices tend to fall.8. A company’s board of directors decides whether to declare______________ from time to time to be paid out and distributed toshareholders on a payable date.Answer: D—A dividend.
The Big Picture
19
Discussion: A dividend is a part of a company’s profit that is passedon to the shareholders. When companies pay part of their profits toshareholders, those profits are called dividends. This amount is announced before it is paid and is distributed to shareholders of recordon a per share basis. The board of directors must declare all dividends. Growth companies usually do not offer dividends, as theboard of directors feels the capital is best put to work by investing itback into the company. Utility stocks and other slow moving stockstend to offer the highest dividends. The dividend yield is figured bytaking the amount of the dividend on an annualized basis and dividing it by the stock price.9. What are the four unofficial size classifications of stocks?Answer: Large caps (blue chips), mid-caps, small caps, and micro-caps.Discussion: Large-cap stocks represent companies with a capitalization of more than $5 billion. Also commonly referred to as bluechips, large caps are generally mature companies that are regardedas safe investments. They are traded on the major exchanges andprovide regular dividends to shareholders—perhaps their most appealing advantage. Mid-cap companies have a market capitalizationof between $500 million and $5 billion. Mid-caps typically experienceslower growth than small caps and faster growth than large caps.Small caps have a market capitalization of between $150 million and$500 million. They offer traders the opportunity for fast growth andare usually much cheaper than mid-caps or blue-chip stocks. Lowerprices give them the ability to generate dramatic price gains. Microcap stocks have a market capitalization of less than $150 million.They can be extremely risky investments because a significant percentage of companies fail early in the development cycle for a variety of reasons including poor management, defective marketingstrategy, or customer rejection of goods or services offered. Each ofthe four stock size classifications comes with a unique set of investing objectives.10. The ______________, which reports the performance of 30 majorcompanies representing key industries, is the most widely quotedindicator of market performance.Answer: D—Dow Jones Industrial Average.Discussion: The Dow Jones Industrial Average (DJIA or Dow) is stillthe quintessential barometer of stock market performance and isquoted daily on the evening news. While the DJIA has evolvedthrough the years, the information derived from it is essentially the
20
THE OPTIONS COURSE WORKBOOK
same. It gauges the stock prices of 30 U.S. companies and reflects developments within the U.S. economy. The Dow is a price-weighted index in that the average prices of all 30 components are addedtogether and one final average is computed. Though not the best representative of the broad stock market, the Dow is the most popularindex because it has been around the longest. However, though thereare just 30 stocks represented, this index mirrors the broader marketon a pretty consistent basis. There are times, though, that the Nasdaqand Dow will diverge, and these are important indicators for technical analysts.11. Name a few stock sectors.Answer: Technologies, defense, retail, health care, financials,consumer products.Discussion: There are dozens of different sectors and many subsectors. At times a new sector will be created, like Internet stocks. Analysts track various sectors to get a feel for what stocks are bullish andbearish. Not all sectors move in tandem, and analysts can often findleading indicators for the stock market as a whole by studying individual sectors. There are many exchange-traded funds (ETFs) and indexes that track individual sectors, and many of these are optionable.This allows a trader to choose a direction for an entire sector, ratherthan just one stock within the group.12. What is the difference between a futures contract and an optionscontract?Answer: A futures contract is a promise to actually deliver or takedelivery of the underlying commodity. In contrast, the purchase of anoption provides the right, but not the obligation, to buy (call) or sell(put) the underlying instrument.Discussion: Both futures and options can be used to make significant profits. Futures tend to be employed after a trader becomes familiar with options, but not always. Futures often are consideredmore complicated, but they really aren’t; they are just less understood. Many options traders use futures as the underlying instrumentfor their trades. The purchase of a futures contract comes with theobligation to receive delivery of the commodity, bond, or other instrument by a specific date. The sale of a futures contract comes with theobligation to deliver the commodity, bond, or other financial instrument to the buyer by a certain date. The purchase of an option provides the right, but not an obligation, to buy (in the case of a call) orsell (for a put) the underlying asset.
The Big Picture
21
13. ______________ were initially used by farmers and producers ofproducts to hedge themselves or lock in prices for a certain crop orproduct cycle.Answer: B—Futures contracts.Discussion: Individuals or corporations can use futures to get a certain price for a commodity. Farmers use futures to lock in the price ofcorn or wheat a year in advance, which makes it easier to run theirfarms. However, the vast majority of futures traders are now speculators who have no interest in making or taking delivery of a product—they are just trying to profit from a directional move in the underlyinginstrument.14. True or False: Hedgers use futures trading to lock in prices and protect themselves from market movement because they are primarily interested in actually receiving or selling the commodities themselves.Answer: True.Discussion: A hedger is an investor who uses the futures market tominimize the risk in his or her business. Hedgers may be manufacturers, portfolio managers, bankers, farmers, or others. For example, anoil company can sell its product with a futures contract before it isactually produced and ready for sale. By purchasing a futures contract, the oil company can lock in the prices of oil at a certain point toguarantee the price it will receive.15. _____________ do not expect to take delivery of a product; they are inthe futures market to try to make money on the price movement of afutures contract.Answer: B—Speculators.Discussion: Unlike hedgers, speculators are using futures to makeprofits, not limit their risk. In fact, these two types of futures tradersneed each other. Hedgers use futures to limit risk, while speculatorsuse risk to make large profits. The two have a symbiotic relationshipthat is necessary to keep the futures market working.16. If you believe soybean prices will rise over the next three months,based on whatever information you may have, you could______________ the corn futures three months out hoping to makea profit.Answer: A—Go long.Discussion: Futures work just like stocks or call options; we wantthe underlying to rise when we buy a futures contract. Of course, like
22
THE OPTIONS COURSE WORKBOOK
the stock market in general, futures will be priced based on the expectations for the commodity. If everyone expects it to be a toughwinter, then orange futures might drop in value. However, if you speculate that the winter won’t be as bad as expected, you would benefitfrom buying a future if your belief turns into reality.17. If you believe corn prices will fall during this same period, you could______________ the corn futures contract three months out hoping tomake a profit.Answer: B—Go short.Discussion: Going short involves selling a futures contract; this isvery risky, akin to shorting stock. However, for experienced traders,shorting a futures contract might make sense. Normally, if we want toparticipate in the down movement of a commodity or stock, we arebest served by buying puts. This strategy limits the position’s risk, butstill provides ample profit opportunities.18. Physical commodities are any bulk good traded on an exchange or inthe cash market; examples include grains, meats, metals, and energies. ______________ include debt instruments (such as bonds), currencies, and indexes.Answer: C—Financial commodities.Discussion: Financial commodities have become increasingly popular with options traders. A futures contract of a financial commodityis an obligation to buy or sell a specific quantity of currency or someother financial instrument for a predetermined price by a designateddate. Like any futures, those based on financial commodities aremostly used by speculators, though there are some hedgers who usethem to hedge other holdings. By using options, traders can hedge therisk that comes with the purchase (or sale) of a financial commodity.Other physical commodities include the raw materials used in mostretail and manufactured products. The five major categories aregrains, metals, energies, raw foods, and meats. Some are seasonal innature (heating oil, for instance), which causes demand to fluctuatebased on the time of year and climactic conditions. Others react tospecific events; a drought in the Midwest can send grain pricessoaring. Commodities are also highly leveraged investments. A smallamount of cash can control many times its face value in commoditiescontracts. But this works both ways, creating huge potential wins andlosses. Futures are used by farmers and holders to hedge prices inthe future, but futures on physical commodities still have plenty of
The Big Picture
23
speculators as well. The Chicago Board of Trade (CBOT) is the majorexchange for these commodities.19. The value of ______________ primarily depends on interest rates.Answer: D—All of the above (bonds, debt instruments, Eurodollars).Discussion: All of these commodities depend on interest rates.For example, when interest rates go up, bond (loan) prices fall.Conversely, when interest rates fall below the interest rate guaranteed on a specific bond, that bond increases in value. Since interestrates can change the value of these instruments drastically, holdersof these instruments will hedge their risk by using options andfutures on interest rates and individual commodities like bonds orcurrencies.20. Typically, there is an inverse relationship between ______________and most foreign currencies.Answer: A—The U.S. dollar.Discussion: Money is greatly affected by international rates of exchange. The value of a country’s currency fluctuates in relation tovalues of foreign currencies. An inverse relationship usually existsbetween the dollar and other currencies. If the dollar falls, foreigncurrencies may increase in value. For example, if the U.S. dollar isweak in comparison to the yen, the prices of Japanese products imported to the United States will increase. If the dollar is high in comparison to the euro, the prices of American products exported toEurope will rise. An inverse relationship is created because of thelarge amount of imports and exports that the United States participates in. Currencies are traded by large financial institutions lookingfor the best rate of exchange. Since a change in the exchange ratecan create such a huge variance for multinational firms, many ofthese corporations use futures to hedge their risk. Of course, thosetraders who have a strong understanding of foreign currencies canalso speculate on future changes in the value of the dollar as opposedto other currencies.21. A/an ______________ is an indicator that is used to measure andreport value changes in a specific group of stocks, commodities, ordifferent sectors of the marketplace.Answer: C—Index.Discussion: An index is a select group of stocks that measures andreports value changes to the group as a whole. A variety of indexes
24
THE OPTIONS COURSE WORKBOOK
are tailored to reflect the performance of many different sectors ofthe marketplace, such as the S&P 500 ($SPX) or the New York StockExchange Composite Index ($NYA). While these indexes are used togauge trends within the stock market, some indexes are designed tomeasure the price changes of specific industry groups. Indexes havebecome increasingly popular over the past 20 years, partly due to theincreased volume of shares traded on the exchanges and the ease ofcreating an index with the proliferation of computers. Regardless ofwhy there are so many indexes, their use has become widespread.Most major exchanges have options and futures available on them, allowing a knowledgeable trader plenty of opportunities to hedge riskand make large profits.22. By combining futures with ______________, you can create trades inwhich you limit your risk and maximize your potential profits.Answer: A—Options.Discussion: Options are the perfect trading instrument for leveragingyour capital and hedging stocks and futures against risk. They act toprotect your investments just as buying insurance would for your caror home. Many of us probably could have done a better job “insuring”our portfolios against losses, but only hindsight is 20/20. To be successful in today’s markets, you need to evaluate your current positionsto see what you can do to be more successful moving forward.23. ______________ are contracts between two parties that convey to thebuyer a right, but not an obligation, to buy or sell a specific commodity or stock at a specific price within a specific time period for a premium.Answer: C—Options.Discussion: The key to this definition is that the buyer has the right,but not the obligation, to buy or sell the underlying asset by a certaintime. This varies from a futures contract where there is an obligation.Options are unique and very versatile instruments that can be used tohedge risk and make substantial profits. However, like all professionals, options traders need to learn their craft and use discipline.24. The price of an option is referred to as the ______________.Answer: A—Premium.Discussion: This is a fitting name, as the same term is also used for insurance. This makes sense since options are often used as insurance
The Big Picture
25
to protect long-term holdings. When buying a call option, we have theright to buy the underlying security at a future date at a specific price.We do not have to use this right, just as we don’t always use our insurance policies (i.e., file a claim), but the option is there if we dowant to use it.25. The ______________ is referred to as the price at which the stock orcommodity underlying a call or put option can be purchased or soldover the specified period.Answer: B—Strike price.Discussion: The strike price has a distinct relationship to the priceof an option. If the strike price is a long ways away from the currentvalue of the security, the premium will be low. However, if there already is value in the option because it is in-the-money (ITM), the premium will be much higher.26. An option is no longer valid after its ______________.Answer: B—Expiration date.Discussion: Once an option hits its expiration date, which is close ofbusiness prior to the Saturday following the third Friday of eachmonth, it can no longer be exercised. If an option is out-of-the-money(OTM) at expiration, it will no longer have any value. However, if it isITM, the option holder will need to either sell it for its current valueor exercise the option to fulfill the contract. Most options contractsare bought and sold before expiration.27. True or False: Options are available on all stocks.Answer: False.Discussion: Options are not always available on every stock. Options are often added to new stocks, but only about 40 percent of current stocks traded on the major exchanges or optionable. If a stockhas little liquidity, there is very little reason to start trading options onthe stock. The CBOE web site has a list of new optionable stocks thatcan be viewed or e-mailed to you each day.28. Each stock option (call or put) represents ______________ shares ofa stock.Answer: B—100.Discussion: Generally a stock option represents 100 shares of stock.Thus, if a call option is quoted at $2, the total cost for one contract
26
THE OPTIONS COURSE WORKBOOK
would be $200. If the stock is trading for $20, this means we are controlling $2,000 worth of stock for $200, which is leverage of 10-to-1.This allows options traders to make large profits without an overwhelming amount of risk.29. True or False: Each futures contract has a set of unique specifications.Answer: True.Discussion: You are responsible for understanding the specificationsfor each futures market. Each commodity has different specificationswhen it comes to futures. This makes sense, as different commoditiesare measured in different ways. With stock, we have a share; withgold, we measure it by the ounce. Thus, each futures contract canhave a different ratio that needs to be calculated to come up with thepremium and underlying value.30. You must be cautious trading indexes, for a few of them do not havemuch ______________.Answer: B—Liquidity.Discussion: We need to be cautious not only with indexes that donot have much liquidity, but with any underlying security that is illiquid. A lack of liquidity creates higher bid-ask spreads and also leadsto a great deal of volatility. When there is little interest in a security orindex, it is more difficult to get a good fill when you are ready to sell.31. The most important factors for determining opportunity in a marketare ______________.Answer: D—Liquidity and volatility.Discussion: Liquidity is the measure of trading volume of an investment security. As a general rule, the more trading volume associatedwith an investment, the more liquid, and the better the market.Volatility is a measure of the speed or movement in a market. A veryvolatile market moves fast and can provide a trader with a greaternumber of profit-making opportunities.32. ______________ gives you the opportunity to move in and out of amarket with ease.Answer: D—Liquidity.Discussion: If an option is illiquid it can result in bad fills and widebid-ask spreads. With stocks, we want to see volume of at least300,000 shares traded on a daily basis. For options, volume doesn’t
The Big Picture
27
necessarily have to be large, but there should be open interest of atleast 100 contracts. It’s easy to distinguish the options and stocks thathave low liquidity, as the bid and ask prices will be farther apart.33. ______________ measures the amount by which an underlying isexpected to fluctuate in a given period of time.Answer: A—Volatility.Discussion: Volatility is a percentage that measures the amount bywhich the underlying stock or option is expected to change in a givenperiod of time. A stock’s volatility has a significant effect on the priceof its options. A highly volatile stock has a better chance of making asubstantial move than a low-volatility stock. A more volatile asset offerslarger swings upward or downward in price in shorter time spans thanless volatile assets. Large movements, in turn, are attractive to optionstraders who are always looking for big directional swings to make theircontracts profitable. Therefore, the options of a high-volatility stockgenerally command higher premiums. Implied volatility tells a traderhow much a stock is expected to move and is a crucial element in thepricing of an option. Understanding implied volatility is one of the mostcrucial factors in becoming a successful options trader.
MEDIA ASSIGNMENTWith the proliferation of new indexes and ETFs, take the time to viewcharts of these instruments. Look for volatile issues and get a feel for howthese securities move. Then choose a handful of stocks in various sectorsand watch them to see how they react and perform. Even if we stickstrictly to individual stock options, learning to gauge the entire sector isan important part of choosing the appropriate direction. Looking at thevolatility of a sector can also provide us with a better understanding of thevolatility of an individual stock within that sector.
VOCABULARY DEFINITIONSAsset: A balance sheet item expressing what an individual or a corporationowns.Assignment: Refers to the option writer’s (seller’s) obligation to sell orbuy a stock or other financial instrument at the strike price for which
28
THE OPTIONS COURSE WORKBOOK
the writer sold the contract. The buyer of an option has the right (butnot the obligation) to exercise the option—that is, buy the underlyingasset at the strike price of the contract (long call) or sell (deliver) theunderlying asset to the option writer at the strike price of the contract(long put). Assignment means the options writer receives an exercisenotice by another options writer that requires him to sell (in the case ofa call) or purchase (in the case of a put) the underlying security at thespecified strike price.Bond: A debt obligation issued by a government (i.e., Treasury bond) orcorporation (i.e., corporate bond) that promises to pay its bondholders periodic interest at a fixed rate (the coupon), and to repay the principal of theloan at maturity (a specified future date). Bonds are usually issued with apar or face value of $1,000, representing the principal or amount of moneyborrowed. The interest payment is stated on the face of the bond at issue.Capital gain: The profit realized when a capital asset is sold for a higherprice than the purchase price. Your costs (when you buy) include thecommission you paid your broker and are deducted from the proceedswhen you sell. In a mutual fund, capital gains are created when the fundbuys and sells securities. These gains are then distributed to shareholdersat least annually. Shareholders can also earn capital gains by redeemingtheir units at higher prices than they originally paid.Commodity: Any bulk good traded on an exchange or in the cash market;examples include metals, grains, and meats.Dividend: When companies pay part of their profits to shareholders,those payments are called dividends. A mutual fund’s dividend is moneypaid to shareholders that comes from the investment income the fundhas earned. This amount is announced before it is paid and is distributed to shareholders of record on a per share basis. Dividends may bein the form of cash, stock, or property. The board of directors must declareall dividends.Exchange-traded fund (ETF): A fund that tracks an index, but can betraded like a stock. Many ETFs have options available allowing traders toprofit from moves within a sector.Exercise: To implement the right of the holder of an option to buy (in thecase of a call) or sell (in the case of a put) the underlying security. Whenyou exercise an option, you carry out the terms of an option contract.Futures: A term used to designate all contracts covering the purchaseand sale of financial instruments or physical commodities for future delivery on a commodity futures exchange.Hedger: A trader who enters the market with the intent to protect a position in the underlying asset; an investor who uses the futures market to
The Big Picture
29
minimize the risk in his or her business. Hedgers may be manufacturers,portfolio managers, bankers, farmers, and so on. Hedgers also use optionsto protect stock positions. For example, an investor can use a put tohedge a stock or an index put to hedge a stock portfolio.Historic volatility: Calculated by using the standard deviation of underlying asset price changes from close-to-close of trading going back 21 to23 days. A measurement of how much a contract price has fluctuated overa specific period of time in the past; usually calculated by taking a standard deviation of price changes over a time period.Implied volatility: The volatility computed using the actual market pricesof an option contract and one of a number of pricing models. For example,if the market price of an option rises without a change in the price of theunderlying stock or future, implied volatility will have risen.Liability: A legal obligation to pay a debt owed. Current liabilities aredebts payable within 12 months. Long-term liabilities are debts payableover a period of more than 12 months.Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneysthat may be required on short notice, whether for emergencies or forplanned purchases.Option premium: The price of an option; the amount of money that theoption holder pays for the rights and the option writer receives for theobligations granted by the option.Payable date: The date on which a declared stock dividend or a bondinterest payment is scheduled to be paid.Speculator: An investor or trader who is willing to take large risks for achance to make large gains. For example, buying a very volatile stock andhoping to sell it a day or a week later at a higher price is speculative trading.Speculators sometimes buy puts and calls in anticipation of a short-termmove higher or lower in the underlying asset. In the futures market, a speculator is a trader who hopes to profit from a directional move in the underlying instrument and attempts to anticipate price changes and, through buyingand selling futures contracts, aims to make profits. A speculator doesn’t usethe futures market in connection with the production, processing, marketing, or handling of a product. The speculator has no interest in making ortaking delivery.Stock: A share of a company’s stock translates into ownership of part ofthe company. Thus, when you own any shares of a company’s stock, youown part of the company. How much you own depends on how many
30
THE OPTIONS COURSE WORKBOOK
shares of stock you have. Holders of common stock are the last to be paidany profits from the company but are likely to profit most from anygrowth it has. Owners of preferred stock are paid a fixed dividend beforeowners of common stock, but the amount of the dividend doesn’t usuallygrow if the company grows.Strike price: A price at which the stock or commodity underlying a callor put option can be purchased (in the case of a call) or sold (for a put)over the specified period. For instance, a call contract may allow thebuyer to purchase 1,000 shares of ABC at any time in the next threemonths at an exercise (strike) price of $75.
CHAPTER 3
OptionBasics
SUMMARYIn order to become a successful options trader, one must also develop anunderstanding of basic concepts such as option quotes, symbols, exercise and assignment, types of brokerage accounts, and the key factorsthat determine options prices. This chapter is designed to help build afoundation for successful options trading by providing a primer on theseoption basics.Simply put, options give you the ability to control an underlying stock(or other financial instrument) that the option is written on. Each stockoption controls 100 shares of the underlying stock. If you are buying an option, you will have the right, but not the obligation, to buy (in the case of acall) or sell (in the case of a put) a stock at a specific price by a certaindate. Option sellers, in contrast, have the obligation to deliver (call) or purchase (put) the underlying stock at a specific price by a certain date. Inother words, option buyers have rights, while option sellers have obligations and the additional risk should the option holder exercise the option.If you find a stock that you are interested in trading options on, simply askyour broker whether it has options, or access the Optionetics web site tosearch for option chains.Chapter 3 of the main text also provides an in-depth discussion of thedifference between put and call options. Particular attention is paid tostrike prices, premiums, expiration dates, and recognizing whether an option is in-the-money, at-the-money, or out-of-the-money. These topics areextremely important to the active options trader. Initially such concepts31
32
THE OPTIONS COURSE WORKBOOK
might seem a bit cumbersome, but through time, these basic concepts willbecome second nature to the experienced options trader.
QUESTIONS AND EXERCISES1. A ______________ gives the buyer the right, but not the obligation, tobuy a specified number of shares or contracts of the underlying security at a predetermined price during a set period of time.A. Futures contract.B. Call option.C. Stock.D. Derivative.2. If you sign a 12-month lease agreement with an option to buy a houseat $200,000 and the seller charges $1,000 extra just for that 12-monthoption to buy the house, that charge is called the ______________.A. Strike price.B. Expiration.C. Credit.D. Premium.3. True or False: Options are available on all stocks.4. True or False: Once you own an option, you are obligated to buy orsell the underlying instrument.5. Once an option ______________, you lose your right to buy or sell theunderlying instrument at the specified price.A. Moves in-the-money.B. Moves out-of-the-money.C. Expires.D. None of the above.6. Options when bought are done so at a ______________ to the buyer.A. Debit.B. Credit.C. Margin.D. None of the above.
Option Basics
33
7. Options when sold are done so by giving a ______________ to theseller.A. Debit.B. Credit.C. Margin.D. None of the above.8. Options are available at numerous ______________ based on theprice of the underlying instrument.A. Premiums.B. Margins.C. Expiration dates.D. Strike prices.9. The more time until expiration, the more ______________ thepremium.A. Expensive.B. Inexpensive.10. True or False: Strike prices for stocks and indexes come only inmultiples of 5.11. Name the three possible relationships strike prices have to the currentprice of the underlying asset.1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________12. What is the main difference between American-style options andEuropean-style options?________________________________________________________________________________________________________________________13. What are the three possible resolutions of an options contract?1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________
34
THE OPTIONS COURSE WORKBOOK
14. If the writer of an option receives ______________, the option has beenassigned and the writer is obligated to buy (or sell) the specified amountof underlying assets at the strike price from (or to) the assigned holder.A. A margin call.B. An assignment notice.C. An exercise notice.D. None of the above.15. A stock option represents the right to buy or sell ______________shares of the underlying stock.A. 50.B. 100.C. 250.D. 500.16. The stock option expiration date is always the Saturday following the______________ Friday of the expiration month.A. First.B. Second.C. Third.D. Last.17. Strike prices for stock options come in increments of ______________for stocks over $25 per share.A. $1.B. $2.C. $5.D. $10.18. True or False: The strike prices and expiration dates of options contracts differ depending on the underlying instrument they represent.19. Name the five components that make up option symbols:1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________4. _________________________________________________________5. _________________________________________________________
Option Basics
35
20. Name the two types of options.1. _________________________________________________________2. _________________________________________________________21. A ______________ gives the buyer the right (not the obligation) to buythe underlying stock shares or futures contract.A. Call option.B. Put option.C. Futures option contract.D. Stock option contract.22. If the market price is more than your strike price, your call option is______________.A. At-the-money.B. In-the-money.C. Out-of-the-money.23. If the market price is less than your strike price, your call option is______________.A. At-the-money.B. In-the-money.C. Out-of-the-money.24. If the market price is the same as your strike price, your option is______________.A. At-the-money.B. In-the-money.C. Out-of-the-money.25. If you buy call options, you are ______________.A. Going long.B. Go