August, September, and October 2005, andJanuary 2006.
• August and September are the next two months• October and January are the next two months of the 
quarterly cycle
IBM LEAPS expire in January 2007 and January 2008.
When there are only eight months remaining in the lifetime ofthe January 2007 LEAPS option, it becomes a “regular” IBM option,and a new LEAPS option, expiring in January 2009 is listed.
Strike prices are offered according to a fixed, but flexible, schedule:
• Options are offered with strike prices every 21⁄2 points from 5 through
25. Some less volatile stocks extend this range to 321⁄2.
• Stocks priced from 30 through 200 have strike prices every 5 points.• When the stock price is above 200, strike prices are 10 points apart.• A pilot program was initiated recently offering strike prices every 1 point
for some stocks priced under $20 per share.2
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FORMAT USED TO DESCRIBE AN OPTION
When a customer places an order to buy or sell an option, there must be auniform method of describing that option so everyone involved in the trans-action understands which specific option is being traded. Fortunately that’seasy to accomplish. To describe an option accurately, four pieces of infor-mation are required:
1. Underlying stock symbol2. Strike price3. Type of option (put or call)4. Expiration date
Options trade on a number of exchanges around the world, and each
uses the same format to describe an option.
Format Example 1:
GE Jun 35 call
This option represents an option to buy (call option) 100 shares of GE (un-derlying stock) at $35 per share (strike price) any time before the option ex-pires on the third Friday of June.
Each GE Jun 35 call option is identical to every other GE Jun 35 call op-tion. That means the options are fungible. Thus, if you sell an option andwant to repurchase it at a later date, it is not necessary to find the personto whom you sold the option originally. You can close your position simplyby  buying  any  GE  Jun  35  call  from  anyone,  for  all  such  options  are  thesame.
Format Example 2:
IBM Oct 95 put
This represents an option to sell (put) 100 shares of IBM at $95 per shareany time before the option expires on the third Friday of October.
ADDITIONAL OPTIONS TERMINOLOGY
It’s necessary to introduce a few new terms. In  the  money (ITM), at  themoney (ATM), and out of the money (OTM) are terms used to compare thestrike price of an option with the price of the underlying stock. The termsthemselves give clues to their meanings.
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A call option is in the money when the stock price is higher than the strikeprice of the option. When this occurs, the option owner has the right to buystock  (by  exercising  the  option)  at  a  discount  to  the  real-world  price.  Inother words, the option allows the call owner to purchase a bargain. Theterm used to describe this situation is in the money.
A put option is in the money when the stock price is lower than thestrike price of the option. When this occurs, the owner of the put option hasthe right to sell stock at a high, or premium, price.
When an option is in the money, it has an intrinsic value. The intrinsic
value equals the amount by which an option is in the money.
Examples
WXY is $34 per share.
• WXY Jul 30 call is in the money. It has an intrinsic value of 4 points, or
$400.
• WXY Nov 35 put is in the money, with an intrinsic value of $100.
Options Deep and Far
There is no exact definition for the term “far out of the money,” but it isused when the option is more than one strike price out of the money andunlikely to be in the money before expiration.
Example: A stock that is not very volatile is currently $42 per share.Call options with a strike price of 50 (and above) are considered to befar out of the money. Similarly, put options with strike prices of 35 andlower are also considered to be far out of the money. Since this stock isnot very volatile, there is little chance it can move sufficiently for theoption to go in the money before it expires.
However, if this $42 stock is very volatile and frequently undergoes largeprice  changes,  even  a  call  option  with  a  strike  price  of  60  may  not  bethought of as being far out of the money. There is a reasonable chance thestock could trade above the strike price if there are at least a few weeks re-maining before expiration.
The opposite of a far-out-of-the-money option is a deep-in-the-moneyoption. Again, there is no exact definition, but the term is used for an op-tion that is more than one strike price in the money and unlikely to be outof the money when expiration day arrives.
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XYZ is $32.75.
CREATE YOUR OWN HEDGE FUND
• The XYZ Oct 30 call is in the money. It has an intrinsic value of $275.• The XYZ Jan 50 put is in the money, (it is deep in the money; see Op-
tions Deep and Far box) with an intrinsic value of $1,725.
When expiration day arrives, an in-the-money option has value and is
either sold or exercised.
At-the-Money Options
An option is at the money when the strike price of the option is the same asthe stock price. At-the-money options have no intrinsic value. Sometimesthe definition is loosened to include options that are almost at the money.For example, an option with a strike price of 35 often is referred to as beingat the money when the stock is trading at $35.05.
When expiration day arrives, at-the-money options are usually allowedto expire worthless. However, because the option owner may have a goodreason to do so, the option is sometimes exercised.3
Out-of-the-Money Options
A  call  option  is  out  of  the  money  when  the  strike  price  of  the  option  ishigher  than  the  stock  price.  A  put  option  is  out  of  the  money  when  thestrike price of the option is lower than the stock price.An out-of-the-money option has no intrinsic value.
Examples
ABCD is $8.75.
• The Mar 10 call is out of the money.• The Feb 71⁄2 put is out of the money.
MNOP is currently $41 per share.
• The June 60 put is out of the money. In fact, it is far out of the money.
(See Options Deep and Far box.)• The Aug 40 put is out of the money
When expiration day arrives, an out-of-the-money option has no value
and is allowed to expire worthless.
Investors  who  buy  out-of-the-money  options  hope  the  underlying  stockmoves in the appropriate direction (higher for calls and lower for puts) and
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the option becomes in the money. For example, if JKL is trading at $43 pershare, the JKL Dec 45 call is out of the money. However, if the stock pricerises above 45, the call becomes in the money.
When  using  these  terms  (in,  at,  or  out  of  the  money),  the  expirationmonth  is  immaterial,  as  the  only  consideration  is  the  comparison  of  thestrike price with the stock price.
INTRINSIC VALUE AND TIME VALUE
The option premium (price) is composed of two parts: intrinsic value andtime value.
The intrinsic value of an option is the amount by which the option is inthe money. Another way to look at the intrinsic value of an option is to sayit is equal to the cash you can collect (ignoring trading expenses) by exer-cising the option and immediately selling (if the option is a call) or buying(if the option is a put) the underlying stock in the open market.
The easiest way to understand the time value of an option is to say thatit represents the rest of the value of an option. That is, time value is the por-tion of the option price that is not intrinsic value. If an option has no in-trinsic value, then the entire price of an option is its time value. The timevalue of the option equals the amount of profit you can earn when writ-ing that option.
Examples
XYZ is $42 per share.
The XYZ Oct 40 call is trading at $3.40.
• The Oct 40 call has an intrinsic value of $2 per share, or $200.• Thus, the time value of the option is $1.40, or $140.
The XYZ Jan 45 put is trading at $3.80.
• The intrinsic value is $300• Thus, the time value is $80
The time value of an option represents the opportunity value, and it’sthe amount buyers are willing to pay to acquire the rights that go with own-ing an option. The option buyer is hoping the option will increase in valueas a result of a change in the price of the underlying stock. If that happens,the option buyer can earn a profit. The opportunity to collect that futureprofit is the driving force behind an investor’s decision to buy an option.We’ll discuss why investors buy options in Chapter 9.
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The opportunity value for the buyer also represents the option seller’s
potential profit.
The important factors that contribute to time value are:
• Time. The more time in the life of an option, the more the option isworth, as there is more opportunity for the underlying stock to move inthe “correct” direction.
• Volatility. The underlying stock changes price on a daily basis. Morevolatile stocks undergo larger price changes, increasing the profit pos-sibilities for the option owner. Thus, the more volatile a stock,• the more buyers are willing to pay for its options.• the more sellers demand to sell its options.• the more its options are worth.
CHOOSING AN OPTION TO TRADE
Chapter  9  discusses  buying  or  selling  options.  Here  let’s  take  a  look  atwhich  specific  options  are  available  for  trading.  If  you  are  interested  intrading the options on a specific stock (note that options are not availablefor every stock), you always have a choice. The selection of available op-tions is not random. Instead, a protocol determines which strike prices andwhich expirations are listed for trading for each underlying stock.
Strike Prices
On the Monday following an options expiration, in addition to the optionsalready trading, new options are listed. A minimum of two strike prices ismade available for each stock (more volatile stocks offer a wider selectionof strike prices)—one above and one below the current stock price. Thus,customers always can always buy or sell an in-the-money call or put and anout-of-the-money call or put. If the stock price is near a strike price, thenthree new strike prices are added—one above, one below, and one near thestock price.
As time passes and the price of the stock changes, new strike prices areadded. When the stock price reaches an existing strike price, the next strikeprice is listed for trading (usually the next day).
Example
LMN has options with strike prices of 35, 40, and 45. If the stock trades ashigh as 45, the 50 calls and 50 puts are listed the following day. If the stocktrades as low as 35, then the 30 calls and 30 puts are listed the following day.
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On the Monday following expiration, one new expiration month is addedto replace the recently expired options, such that there are always optionswith at least four different expiration months available for trading for eachunderlying  stock.  Most  of  the  more  actively  traded  stocks  also  haveLEAPS.
When the price of the underlying stock changes sufficiently to causenew options to be listed for trading, those options are listed for each month(LEAPS are sometimes excluded), with one exception: The nearest expira-tion month is not included, unless there are at least 30 days remaining be-fore expiration.4
VALUE OF TIME IN THE PRICE OF AN OPTION
Now that you understand there is a choice of options from which you canchoose, let’s take a look at a typical out-of-the-money call option. Assumeit’s the first week of June and DEF is $19 per share. A bullish investor isconsidering  buying  a  call  option  with  a  strike  price  of  20  and  finds  fourchoices:
1. DEF Jun 20 call can be bought for $0.20 (20 cents per share, $20 per
contract).
2. DEF Jul 20 call can be bought for $0.50.3. DEF Sep 20 call can be bought for $0.95.4. DEF Dec 20 call can be bought for $1.25.
If you are new to the world of options, you may wonder why these op-tions are priced differently. After all, each gives its owner the right to buy100 shares of DEF at $20 per share. This difference is the amount of timeremaining before the option expires. The more time remaining, the more anoption is worth. That makes sense because additional time gives the un-derlying stock a greater opportunity to make a move favorable to the optionowner (who then can sell the option for a profit). The option buyer is will-ing to pay extra for that additional time. Of course, more time also gives thestock an opportunity to make a move unfavorable to the option owner. Butto the option buyer, only a favorable move is of importance.5
The same principle applies to all options, whether they are out of themoney, at the money, or in the money. The more time remaining until expi-ration, the more an option is worth. (See box on next page.)
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When Time Is Not Money
There are some exceptions to the rule that more time increases the valueof an option, but for our purposes they can be ignored. For the purist whowants to know the exceptions, here are two:
1. When  a  stock  pays  a  large  enough  dividend,  it  is  often  advanta-geous for the call owner to exercise a deep-in-the-money call op-tion  the  day  before the  stock  goes  ex  dividend.  (Without  thedividend. To receive the dividend you must own shares before thedate.) By doing so, the call owner becomes the stockowner and isentitled  to  receive  the  dividend.  If  the  dividend  is  high  enough(we’ll omit the other factors to consider to keep the discussion sim-ple),  options  with  a  month  or  two  remaining  before  expirationsometimes are exercised for the dividend. Thus, each option (withthe same strike price) that is subject to being exercised for the div-idend trades at the same price, and the extra time remaining in thelifetime of the option loses its value.
After the ex-dividend date, time value is reattached to optionsthat have a more distant expiration date (as there is no longer anyreason to exercise the option early), and the customary situation(more time equals a higher option price) returns.
2. If a put option is deep in the money, it is often a good strategy toexercise it, even if there is time remaining before expiration. A putowner who also owns stock often pays interest on the cash used tobuy stock. By exercising the put, the stock can be sold, eliminatingthe payment of interest. This exercise of deep-in-the-money put op-tions is common when interest rates are high (and borrowing cashis expensive). When it is mathematically attractive to exercise theseputs,  they  trade  at  their  intrinsic  values  and  lose  any  remainingtime premium.
In the next chapter we’ll look at why investors buy or sell options.
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C H A P T E R   9
Why Investors Buy and Sell Options
The term “option” is derived from the Greek word for choice. That’s ap-
propriate, because an option owner has choices to make. Before ex-amining  those  choices  and  how  one  goes  about  making  theappropriate decision, let’s consider why investors buy options in the firstplace and what they hope to achieve. Then we’ll look at why some investorsprefer to sell options and what motivates them.
Options are very versatile investment tools and provide benefits to bothbuyers and sellers. In this and the next two chapters, you’ll gain an under-standing of why the options markets exist and why options play such an im-portant role in today’s investment world.
Consider a stock (WXY) currently trading at $34 per share. If you wantto own the stock and are willing to pay that price, you can buy the shares.But  instead  of  buying  stock,  you  can  buy  a  call  option,  granting  you  theright to buy the stock. For example, you could buy a call option giving youthe right to buy 100 shares at $35 per share any time during the next threemonths.
If you never thought about options before, you might wonder why any-one would be willing to pay cash for the right to buy 100 shares of stock at$35  at  some  time  in  the  future  when  the  stock  can  be  bought  today  at  alower price ($34). You might conclude that it’s far better to buy stock nowrather  than  pay  someone  a  cash  premium  for  the  “privilege”  of  paying  ahigher  price  for  that  same  stock  in  the  future.  To  understand  why  it’sreasonable  for  both  buyers  and  sellers  of  options  to  exist,  let’s  take  acloser look.
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WHY WOULD ANYONE BUY A CALL OPTION?
Let’s look at an example of how a real option is valued in the marketplace.Assume:
• It’s the middle of January, and April expiration is 13 weeks in the future.• WXY stock is currently trading at $34 per share.• WXY April 35 call is trading at $2.
• The option premium is $2 (per share, or $200 per option contract).
An Investor Wants to Own a Long Position in WXY
Let’s assume you’re a traditional investor who wants to own 100 shares ofWXY.  The  usual  method  is  to  purchase  100  shares  of  stock  at  a  cost  of$3,400. If the stock price goes higher, you make money. If it goes lower, youlose money. Let’s assume you buy your 100 shares of stock and it’s now 3months later.
Investment Results for the Stockholder
If the stock increases in value to $40 per share, you have a profit of $600.That’s a return of 17.6 percent on your $3,400 investment. If the stock doeseven better and runs to $50, your profit is $1,600 (47.0 percent).
If the stock is unchanged and is still trading near $34 per share, you
have neither profit nor loss.
If you are unlucky and the stock drops to $30, your loss is $400, or 11.8percent of your investment. If the bottom falls out from under this stockand it drops to $20, your loss is $1,400, or 41.2 percent of your investment.These results are straightforward. When you own an asset, you eithermake or lose money depending on how that asset is valued at some time inthe future.
Results When Owning Options
Options offer an investment alternative. Instead of buying stock, you cangain control of those same 100 shares by buying a call option. The reasonyou have “control” of those 100 shares is that you, the owner of a call op-tion, can exercise your option to buy those 100 shares any time you choose(as  long  as  it’s  before  the  option  expires).  That  places  you,  the  optionowner, in position to profit if the stock increases in value.
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Using the same example as above, let’s look at the results when youbuy one WXY Apr 35 call, at a cost of $200. This option gives you the right(expiring in 13 weeks) to buy 100 shares of WXY at $35 per share. Note:Much less cash is required ($200 vs. $3,400). This is one of the major at-tractions  for  those  who  buy  options.  Sometimes  investors  do  not  haveenough cash to buy 100 shares and can gain control of the shares with amuch smaller amount of money. (This is an example of using leverage—less money is invested to control the same amount of stock.)
Let’s examine the five results discussed above from the perspective ofthe  option  owner.  Assume  three  months  pass.  It’s  expiration  day,  or  thethird Friday of April.
If the stock rises to $40, the Apr 35 call is worth $500 (see box below).Since you paid $200 for the option, your profit is $300, or a 150 percentreturn on your investment. This illustrates the second reason why investorsbuy options: It’s possible to earn a large percentage return on a small in-vestment.
If the stock rallies all the way to $50, the option is worth $1,500 (i.e., it’sin the money by 15 points and has an intrinsic value of $1,500). That’s aprofit of $1,300, or 650 percent, on your $200 investment.
If  the  stock  remains  unchanged  at  $34,  then  the  option  is  worthless(see box on next page), and you lose your entire investment of $200. This isone of the major disadvantages of buying an option. If the stock does notmove as you hoped, you can lose your entire investment.
If the stock drops to $30 or $20 (the sample prices used when discussingowning stock), the option is also worthless. Any time the option is out of themoney when expiration arrives, the option has no value. The option buyerloses 100 percent of the amount invested. Note that the option owner neverloses more than the cost of the option. That’s the third reason why investorsbuy options: Losses are limited to the amount paid for the option.
The Valuable Option
Why is the option worth $500? If you own this option, you have the rightto exercise it, buy 100 shares at $35, and immediately sell those shares inthe  market  at  $40,  collecting  $500  in  the  process.  The  option  is  worth$500 because anyone who owns the call option can do the same.
The option is in the money by $500, has an intrinsic value of $500,
and is worth $500.
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The Worthless Option
Why  does  the  option  have  no  value  when  the  stock  is  $34?  Weren’t  in-vestors willing to pay $200 for this option when the stock was the sameprice 13 weeks ago?
Yes, they were. And this illustrates a crucial point in understanding op-tions. Options have an expiration date, and the amount of time remainingbefore that expiration date arrives is critical in determining the value of anoption. Before an option expires, there is an opportunity for the underlyingstock to make a move favorable to the option owner. More time translatesinto more opportunity. More opportunity translates into additional valuefor the option. As time passes and expiration day nears, the value of an op-tion decreases. Thus, an option is a wasting asset. When the market closeson expiration day, there is no time remaining, and out-of-the-money op-tions become worthless and in-the-money options are worth no more thantheir intrinsic values.
The  option  owner  must  make  a  decision  before  the  stock  marketcloses for business on expiration Friday. One of the choices the call ownercan make is to exercise the right to buy stock at the strike price. But no onedoes this when stock can be bought at a lower price. In our example, youhave the right to buy stock at $35 per share today when the current priceis $34. Thus, the option has no value. It is going to expire worthless.
Comparing Stock Ownership with Call Ownership
Table 9.1 compares these results.There are several important points to consider when comparing the results.
When the Stock Increases in Value
• The  stock  owner  makes  a  larger  profit (when  measured  in  dollars)than the option owner because no premium ($200 in this example) ispaid to own the stock.
• The option owner has the potential to make a much higher rate of re-turn on an investment. Compare the 150 percent return with the 17.6percent return when the stock increases to $40.
When the Stock is Unchanged
• The stock owner breaks even.• The owner of the option loses the entire investment.1
When the Stock Declines in Price
• The stock owner can lose a substantial sum (the entire investment if
the company goes bankrupt).
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• The option owner’s loss is limited to the relatively small amount paidfor the option, even though that represents the entire investment.
TABLE 9.1 Comparing Ownership: 100 Shares of Stock @ 34 vs. One
Call Option (Strike Price, 35) 13 on Expiration Day
EndingStock Price
Stock Owner
Call Owner
P/L
% P/L
P/L
% P/L
5040343020
$1,600$600$0($400)($1,400)
47.06%17.65%0.00%–11.76%–41.18%
$1,300$300($200)($200)($200)
650.00%150.00%–100.00%–100.00%–100.00%
Is It Better to Buy Stock or an Option?
Because you never know the result of an investment in advance, it’s neces-sary to understand why some investors prefer to buy options and othersprefer to buy stock. Some results favor the stockholder and some favor theoption owner. Thus, two reasonable questions are:
1. Who should consider buying call options instead of stock?2. Is option buying a sound investment strategy?
This author does not recommend the strategy of buying options. Theevidence presented so far may make buying options seem to be an attrac-tive strategy, and there are good reasons for certain investors to buy op-tions, but it is difficult to make money consistently with an options-buyingstrategy.
Rationale for Buying Options
• Loss is limited to the cost of the option.• Less money is required for an initial investment, compared with buying
stock.
• An option buyer has the opportunity to earn a large profit from a small
investment (leverage).
• Some investment gurus advise their clients to buy options.
Despite these advantages of owning options, the odds of success arestacked against option buyers. Before discussing why this writer stronglyrecommends writing, or selling, options, instead of buying them, let’s con-sider why it’s so difficult to make consistent money when buying options.
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At first glance, buying options may appear to be an attractive invest-ment alternative. You like a stock and expect it to move higher, so you buya call option. For a relatively small amount of money, you gain control of100 shares of the stock you want to own. If the stock moves higher, as youhope it will, there is the opportunity to earn a big profit. Who wouldn’t likethat scenario? Well, you shouldn’t like it. It’s a very unlikely outcome, un-less  you  are  a  very  skilled  stock  picker.  If  you  have  the  ability  to  knowwhich  stocks  are  about  to  undergo  a  significant  price  movement  beforethat movement occurs, then you are in position to conquer the investmentworld  with  no  further  help  from  anyone.  Because  very  few  people  havethese abilities, buying options is not as attractive as it first appears.
Rationale for Not Buying Options Although some advisors suggestbuying  options,  they  fail  to  mention  that  to  profit  from  an  option-buyingstrategy,  you  must  not  only  correctly  predict  the  direction  in  which  thestock will move (up for call buyers and down for put buyers), but the movemust occur quickly, as the option is a wasting asset with a limited lifetime.As if that’s not enough, the movement must be sufficiently large to over-come the cost of the option. Three examples follow showing how buying anoption results in a loss, even though the stock moves as predicted. Thesesituations  are  common  and  represent  a  very  unpleasant  surprise  to  theoption-buying novice.
Assume it is mid-February and PQR is trading at $45.
Example 1: Bullish investor 1 pays $100 for an out-of-the-moneyoption, the PQR Jun 50 call. The investor is successful in predictingthe stock will go higher, as PQR slowly rallies to $49 over the nextfour months. However, the invest