the current price of the underlying contract. With a stock at$74 and $5 between exercise prices ($65, $70, $75, $80, etc.), the $75 call and the$75 put would be considered the at-the-money options. These are the call and putoptions with exercise prices closest to the current price of the underlying contract.
MARKET INTEGRITY
An important consideration for every market participant is the integrity of the market.No trader will want to trade in a market where there is a chance that the opposing traderwill default on a contract. If a trader purchases an option, he wants to be certain thatthe seller will fulfill the terms of the contract if the option is exercised.
In order to guarantee that the integrity of the market will be maintained, eachoptions exchange has established a progression of responsibility for the fulfillment of theterms of an option. The primary responsibility falls to the individual trader. If the sellerof an option is assigned, he must be prepared to take the required long or short positionin the underlying contract at the specified exercise price. In practical terms, this meansa trader must have access to capital at least equal to the option’s intrinsic value.
If an individual trader is unable to fulfill the terms of the contract, the responsibilityfalls to the trader’s clearing firm. A clearing firm isa member firm of the exchange whichprocesses trades made by an individual, and which agrees to fulfill any financialobligation arising from those trades. No individual may trade on an exchange withoutfirst becoming associated with a clearing firm.
If the clearing firm cannot fulfill the terms of the contract, the final responsibilityrests with the clearing house. Each exchange has established, or has become a memberof, a clearing house which guarantees the integrity of all trades. Once an option tradehas been made, the connection between the buyer and seller is severed, with theThe Language of Options 9
clearing house assuming the role of buyer from every seller, and seller to every buyer.jf there were no central clearing house, the buyer of an option would be totallydependent on the good faith of the seller or the seller’s clearing firm to fulfill the termsof the option in the event of exercise, Because the clearing house guarantees every trade,all buyers can be certain there will be an opposing party prepared to make or takedelivery if an option is exercised. The clearing process is shown in Figure 1-8.
This system of guarantees has proven effective in ensuring the integrity of optionsexchanges. While individual traders and clearing firms occasionally fail, a clearing househas never failed in the United States.
MARGIN REQUIREMENTS
When a trader makes an opening trade on an exchange, the exchange may require thetrader to deposit with the clearing house some amount of margin, or good faith capital.4Such deposits ensure that if the market moves adversely, the trader will still be able tofulfill any future financial obligations resulting from the trade.
In lieu of cash, margin requirements may often be met by depositing governmenttreastiry instruments or, less commonly, commercial securities. Clearing firms collectthese margin requirements from their traders and forward the funds to the clearing
Figure 1-8: The Clearing Process
If reports from both clearingfirms match, the trade
 
 
 
 
becomes official.ad Clearing House |If the reports do not match, A
they are returned to eachclearing firm, and from thereto the individual traders
for rectification.
Buyer's clearing firmteports trade toClearing house.
Seller's clearing firmreports trade toclearing house.
 
Buyer's Clearing Firm Seller's Clearing Firm
 
 
 
 
Buyer reports trade Seller reports tradeto his clearing firm. to his clearing firm.
 
 
~<4—_-_ Trading Floor | ————_j»»
 
 
 
Buyer and seller agreeon acontract, quantity,and price.
 
Margin requirements for a professional trader in an equity option market are referred to as a Aaircut10 Chapter 1
house. In theory, margin deposits at the clearing house still belong to the individualtrader and, as such, any interest or dividends accruing to the margin deposit also belongsto the trader. Some clearing firms, however, do not return this interest to the trader,claiming that it is part of the fee paid by the trader for the clearing services of the memberfirm. This can occasionally become a sensitive point between trader and clearing firm,and should be settled before an individual begins to trade.
Margin requirements for both options and underlying contracts are set by theclearing house, using as guidelines the current value of the position as well as thepotential risk. While an underlying position, particularly ifit is a futures contract, usuallyhas a fixed margin requirement, the margin for an option position can change over timesince the margin for an option often depends on the amount by which it is in- orout-of-the-money. Positions consisting of a combination of options, or options andunderlying instruments, may have reduced margin requirements because the risk to onecontract may be partially offset by the value of another contract. Additionally, traderswho are exchange members may receive professional consideration in the form ofreduced margin requirements. Every trader should become familiar with the marginrequirements for the market in which he is trading. Doing so will ensure that he hassufficient capital to initiate and hold positions as long as he deems necessary.
SETTLEMENT PROCEDURES
New option traders are often confused because settlement procedures may vary fromone exchange to another. Indeed, settlement procedures for an option and its underlyingcontract may differ. Two methods are commonly used to settle exchange-tradedcontracts—stock-type settlement and futures-type settlement.
Suppose a trader buys 100 shares of a $50 stock. The value of the stock is $5,000,and the buyer is required to pay the seller the full amount. If the stock rises to $60 pershare, the owner of the stock will show a profit of $10 per share, or a total profit of$1,000. Even so, he won't be able to actually spend this $1,000 profit until he formallyliquidates the position by selling his 100 shares at $60 per share. This type of settlementprocedure, where purchase requires full and immediate payment, and where profits orlosses are unrealized until the position is liquidated, is known as stock-type settlement.
In contrast to stock-type settlement, futures-type settlement requires no initial cashpayment from the buyer to the seller. Moreover, all profits or losses are immediatelyrealized, even if the position is not liquidated. If a trader buys a gold futures contractcovering 100 ounces of gold for $450 per ounce, the full value of the contract is$45,000. The buyer, however, is not required to pay the seller the full $45,000 valueof the contract. The buyer does not have to pay any money at all. He is only required todeposit with the clearing house some amount of good-faith margin. At the end of eachtrading day both the buyer and the seller will immediately realize any profits or lossesresulting from movement in the price of the gold futures contract. If gold rises from $450to $470 per ounce, $2,000 ($20 x 100) will be credited to the buyer’s account, and hewill have immediate use of these funds even if he does not liquidate the position. Ofcourse, if the price of gold drops to $430 per ounce, he will realize an immediate lossThe Language of Options I]
of $2,000. If he does not have sufficient funds in his account to cover this loss, theclearing house will issue a variation call.
There is an important distinction between a margin call and a variation call. Amargin Call is issued by the clearing house to ensure that a trader can fulfill futurefinancial obligations should the market move against him. Margin calls can be met withfunds which, even though deposited at the clearing house, still belong to the trader andconsequently can earn interest for the trader. A variation call is issued in order to fulfillcurrent financial obligations in the form of realized losses. A variation call must be metwith a cash payment which is immediately deducted from a trader’s account. If a traderhas deposited securities with the clearing house as margin and receives a variation call,he must either deposit the additional variation amount in cash, or the clearing housewill sell the securities in his account to generate enough cash to meet the variation call.If the remaining securities and cash in the account is not sufficient to meet the currentmargin requirements, the trader may be forced to liquidate his position.
We make this very important distinction between stock- and futures-type settle-ment because some options are settled like stock and some options are settled likefutures. It is important for a trader to know which he is trading. Currently allexchange-traded options in the United States, whether options on stock, futures,indices, or foreign currencies, are settled like stock. Options must be paid for immedi-ately and in full, and profits or losses are unrealized until the position is liquidated. Instock option markets this is both logical and consistent, since both the underlyingcontract and options on that contract are settled using identical procedures, However,on U.S. futures options markets, the underlying contract is settled one way (futures-typesettlement} while the options are settled in a different way (stock-type settlement). Thiscan sometimes cause problems when a trader has bought or sold an option to hedge afutures position. Even if the profits from the option position exactly offset the losses fromthe futures position, the profits from the option position, because the options are settledlike stock, are only paper profits. On the other hand, the losses from the futures positionwill require an immediate cash outlay to cover a variation call. If a trader is unaware ofthe different settlement procedures, he can occasionally find himself with unexpectedcash flow problems.
The settlement situation on many exchanges outside the U.S. has been simplifiedby making option and underlying settlement procedures identical. If the underlying isSubject to stock-type settlement, then so are the options on the underlying. If theUnderlying is subject to futures-type settlement, then so are the options. Under thisMethod a trader is unlikely to get a surprise variation call on a position which he thinks1S well hedged.
Before concluding this chapter, it will be useful to define the terms long and shorta8 they are used in option trading versus their use in trading an underlying contract. In4 long underlying position a trader will profit if prices rise and lose if prices fall. In a shortUnderlying position a trader will profit if prices fall and lose if prices rise. There is atendency to carry this terminology over into the option market by referring to anyPosition which will profit from a tise in the price of the underlying contract as a longPosition, and any position which will profit from a fall in price as a short position.12 Chapter |
More generally, however, the terms long and short refer to the purchase or sale ofa contract, and this is the sense in which we apply these terms to option trading. A traderwho has purchased an option is long the option, and a trader who has sold the optionis short. There is no confusion when we refer to a long call position because the traderwho is longa call also has a long market position. Calls will, in theory, rise in value ifthe underlying market rises. But a long put position is a short market position. A traderwho has purchased a put wants the underlying market to decline because a put willtheoretically increase in value as the market declines. Throughout the text, wheneverthere is the possibility of confusion, an attempt will be made to distinguish between along or short market position versus a long or short option position.wo 2 &
Elementary Strategies
The trader who enters an option market for the first time may find himself subjected toa form of “contract shock.” Unlike a trader in equities or futures, whose choices arelimited to a small number of instruments, an option trader must often deal with apewildering assortment of contracts. With at least three different expiration months,with each month having several different exercise prices, and with both calls and putsavailable at each exercise price, it is not unusual for an option trader to be faced withas many as 40 different contracts.
Even if we eliminate the inactively traded options, a new trader may still have todeal with 15 or 20 different options. With so many choices available, a trader needssome logical method of deciding which options actually represent profit opportunities.Which should he buy? Which should he sell? Which should he avoid altogether? Thechoices are so numerous that many prospective option traders give up in frustration.
For the trader who does persevere, a certain logic in the pricing of options beginsto emerge. As he becomes familiar with this logic, he can begin to formulate potentiallyprofitable strategies. Initially he will concentrate on the purchase or sale of individualoptions. From there he will go on to combination strategies. Eventually he will becomecomfortable with complex strategies involving several different contracts.
How might a beginning trader assess an option’s value? One simple methoddepends on guessing where the underlying contract will be at expiration. If an optionPosition is held to expiration, the option will be worth either zero, if it is at- orout-of-the-money, or intrinsic value (parity), if it is in-the-money. The purchase of anoption will be profitable if its trade price is less than its value at expiration. The sale ofaN option will be profitable if its trade price is greater than its value at expiration.
SIMPLE BUY AND SELL STRATEGIES
For example, suppose the following options are available with two months remaining{0 expiration, and the underlying contract trading at 99.00:
85 90 95 100 105 110 115Calls 14.05 935 550 2.70 1.15 45 20Puts 10 45 155 3.70 710 11.35 16.10
Suppose we believe that the underlying contract will rise to at least 108 by€XPiration, We might then purchase a 100 call for 2.70. If we are correct, and theContract does in fact end at 108, our profit at expiration will be the option’s intrinsic
1314 Chapter 2
value of 8.00 less the 2.70 we originally paid, or 5.30. Given the above prices, if theunderlying market rises to 108 by expiration we will show a profit if we purchase anycall with an exercise price less than 110. The intrinsic value of each of these options atexpiration will be greater than its current price in the marketplace.
What about the 110 and 115 calls? If we believe that 108.00 is a reasonable upsidegoal for the underlying contract, but consider it unlikely that the price will rise above110, then we will prefer to be sellers of the 110 and 115 calls. If we sell the 110 callfor .45 and the underlying contract never rises above 110.00, the 110 call will expireworthless and we will get to keep the full premium of .45. We can also sell the 115 callfor .20, giving us an additional 5 point margin for error. If the underlying contract neverrises above 115,00, the 115 call will expire worthless and we will get to keep the fullpremium of .20.
We can use the same approach to assess the potential profit from the purchase orsale of a put. As with a call, a put’s intrinsic value at expiration must be greater than itstrade price in order for the purchase of a put to be profitable. If the underlying contractrises to 108.00 by expiration, any put with an exercise price of 105 or less will beworthless. If we sell any of these puts, we will profit by the full amount of the premium.If we sell the 110 or 115 puts, they will not be totally worthless at expiration because,with the underlying contract at 108.00, they will have intrinsic values of 2.00 and 7.00,respectively. However, this will still be less than their trade prices of 11.35 and 16.10.We will show a profit of 9.35 from the sale of the 110 put and 9.10 from the sale of the115 put.
As we change our assumptions about the likely price of the underlying contract atexpiration, we alter the likely profit or loss from any option position. If, instead of risingto 108.00, the underlying contract actually rises to 120.00, the purchase of the 100 callfor 2.70 will result in a profit of 17.30 rather than 5.30. On the other hand, if theunderlying contract falls to 90.00, the purchase of the 100 call will result in the loss ofthe full premium of 2.70. In the latter case, if we sell the 110 put for 11.35, instead ofmaking 9.35 as we would with the underlying contract at 108.00, we will actually lose8.65.
Using a value for an option of either zero or intrinsic value, we can graph the profitor loss at expiration from any option trade which we might make today. Such graphsnot only enable the new trader to assess the likely profitability of an option trade, butalso help him to understand some of the unusual characteristics of options. However,before looking at graphs of various option positions, we ought to look at the profit andloss graph of an underlying contract. Because it is a derivative instrument, an option’svalue is always dependent on the price of the underlying instrument. At expiration anoption’s value is totally dependent on the price of the underlying contract. Indeed, if wehave an opinion on the likely price of the underlying contract at some date in the future,we don’t need to trade options at all. We can simply buy or sell the underlying contract.
Figure 2-1 shows the value at expiration of both a long and a short position in ourexample underlying contract taken at the current price of 99.00. The horizontal (x) axisrepresents the price of the underlying futures contract, and the vertical (y) axisTepresents the profit or loss from our position. Note that each graph is a straight 45° lineElementary Strategies 15
 
Figure 2-1
 
10Ss long an underlying
contract at 99.00 va
  
85
     
o
Protit
 
 
Loss
   
short an underlying x
contract at 99.00 ZS
 
 
 
extending infinitely far in either direction.! The potential profit or loss to each positionis therefore unlimited. Note also that there is a continuous one-to-one relationshipbetween movement in the underlying contract and the value of the position. If we takea long position, for each point the underlying contract rises, we make a point; for eachpoint the underlying contract falls, we lose a point. If we take a short position theSituation is just reversed. For each point the underlying contract rises, we lose a point;for each point the underlying contract falls, we make a point.
Using the same evaluation method, Figure 2-2 shows the profit or loss at expirationfrom the purchase of a 100 call at 2.70. Note that in this case the graph is no longer aStraight line. If the underlying contract falls below 100 at expiration the 100 call will beout-of-the-money and therefore worthless, and we will lose the full 2.70 we paid for theCail, Above 100, the call will be in-the-money, and will increase in value at the sameTate as the underlying contract; the position will gain one point in value for each pointrise in the value of the underlying contract, If the underlying contract finishes at 102.70,the 100 call will be worth its intrinsic value of 2.70, and we will break exactly even.Above 102.70, the profit from the purchase of the 100 call is potentially unlimited, justlike a long position in the underlying contract.
—————
lof course, an underlying price cannot fall below zero, so the downside profit or loss is in theory limited.However, if the price of an underlyingcontract should go to zero, it will probably seem like an unlimitedProfit or loss to most traders.16 Chapter 2
 
Figure 2-2
 
10long a 100 call at 2.70
      
Profit
24 exercise price(100)maxium loss (-2.70) {
     
(102.70)break even
Loss
 
 
 
85 90 95 100 105 110 115
RISK/REWARD CHARACTERISTICS
The profit and loss graph of a long call position at expiration will always have the samegeneral shape as the graph in Figure 2-2. The position will always have limited downsidetisk and unlimited upside profit potential. The exact point at which the maximum losswill occur is determined by the exercise price (the point at which the graph bends) andthe price of the option. Graphs of long positions in the 95, 100, and 105 calls are shownin Figure 2-3.
Figure 2-4 represents the profit and loss from a short position in the 95, 100, and105 calls. These are simply inversions of the long call graphs. The positions now haveprofit potential limited to the amount of the premium for which they were sold, andunlimited upside risk similar to a short position in the underlying contract.
Figure 2-5 represents long positions in the 95, 100, and 105 puts. The risk/rewardcharacteristics of these positions are similar to long call positions, but now the limitedrisk is on the upside and the unlimited profit potential is on the downside. The positionwill break even if the underlying contract falls below the exercise price by exactly theamount of the option’s trade price. Below that break-even price the potential profit tothe position is unlimited, increasing by one point for each point drop in the price of theunderlying contract.Elementary Strategies
17
eeFigure 2-3
Profit
Loss
 
10
87
64
44
long a 95 call at 5.50 — ———long at 100 call at 2.70long at 105 call at 1.15 -----r~
 
 
 
 
 
 
90 95 100 105
110
Bi115
 
Profit
Loss
 
short a 95 call at 5.50short a 100 call at 2.70
short a 105 call at 1.15 - ~~
 
 
 
 
 
 18 Chapter 2
 
 
 
 
 
 
 
 
Figure 2-5
10
8-4 long a 95 put at1.55  ---------
long a 100 put at 3.70
64 long a 105 put at 7.10 — ——— -ge 42oO 24
0 | L
. S100 105 } 1.55
2 See ee a ae ee 3.700 \o ‘\2 4! — “7.10
‘,-65 ‘~rs —>-85-10 pe T T 485 90 95 100 105 110 115
The short put positions in Figure 2-6 are inversions of the graphs in Figure 2-5. Eachposition has upside profit potential limited to the amount of the trade price, and apotentially unlimited loss similar to a long position in the underlying contract.
Figures 2-3 through 2-6 illustrate two of the most important characteristics ofoptions: buyers of options have limited risk and potentially unlimited reward; sellers ofoptions have limited reward and potentially unlimited risk. More specifically, net buyers(sellers) of calls have unlimited upside reward (risk), and net buyers (sellers) of puts haveunlimited downside reward (risk).
At this point, new traders tend to have a common reaction. Why would anyoneever want to do anything other than buy options? After all, a buyer of options has limitedtisk and unlimited profit potential, while a seller of options has limited profit potentialand unlimited risk. Who in their right mind would choose the latter over the former?
The prospect of unlimited risk certainly seems a good reason to avoid a trade.However, if a trader gives some thought to the matter, he will realize that almost anytrade in a stock or commodity market carries with it unlimited risk. A violent adversemove which does not give a trader time to cover his position is always possible. Yettraders take long and short positions in stocks and commodities all the time. The onlyexplanation must be that they believe the chances of sustaining a catastrophic loss mustbe small, so small that the potential profit justifies the risk of unlimited loss,
Option traders learn that the limited or unlimited risk/reward characteristics of atrade are not the only considerations. At least as important is the probability of thatElementary Strategies 19
_——Figure 2-6
 
10short a 95 put at 1.55 ~----~~-8+ short a 100 put at 3.70short a 105 put at 7.10 ———— a
 
+7.10
Profit
 
Loss
 
 
 
 
unlimited profit or loss. As an example, suppose a trader is considering a trade whichhas only two possible outcomes. In one case the trader will double his money; in theother case he will go broke. It may seem that a rational trader will avoid such a tradebecause the reward does not appear to justify the risk. But suppose the probability ofthe second outcome is only one chance in a million. Suppose in fact that the exactcircumstances which will cause the trader to go broke have never before occurred. Nowhow does the trade look? The reward is still limited and the risk unlimited. Yet mosttraders would probably make the trade in spite of the potentially disastrous results.
In addition to the potential risk and reward associated with any trade, a trader mustalso consider the likelihood of the various outcomes. Is the reward, even a limited one,Sufficient to offset the risk, albeit an unlimited one? Sometimes it is; sometimes it isn’t.
COMBINATION STRATEGIES
When considering an option trade we need not restrict ourselves to the purchase or saleOf individual options. We can also combine option positions to form new positions withtheir own unique characteristics. Figure 2-7 shows the profit and loss at expiration fromthe combined purchase of a 100 call for 2.70, and a 100 put for 3.70. Here we havePaid a total of 6.40, which will be our maximum loss if both options expire worthless.This will happen only if the underlying contract is right at 100 at expiration. If theUnderlying contract is above 100 at expiration the put will be worthless, but the call20 Chapter 2
 
Figure 2-7105
 
84 long a 100 call at 2.70long a 100 put at 3.70
Profit
93.60 100 106.41
 
Loss
7
 
 
 
will act like a long underlying position, gaining one point in value for each point theunderlying contract rises. If the underlying contract is below 100 the call will beworthless, but the put will act like a short underlying position, gaining one pointin valuefor each point the underlying contract falls. In order for the position to do no worse thanbreak even, it must be worth at least the 6.40 we originally paid. This will occur if eitherthe 100 call or the 100 put turns out to be worth 6.40. At expiration, the underlyingcontract must be at or above 106.40, or at or below 93.60. Outside of this range, thepotential profit is unlimited.
Under what conditions might we initiate the position in Figure 2-7? Such a positionmight be sensible if we thought a large move in the underlying contract would takeplace in the near future, but were uncertain as to the direction of that move. If the movewere sufficiently large (above 106.40 or below 93.60} the position would be profitable.Of course we might also take the opposite view, that the underlying contract wasunlikely to either fall below 93.60 or rise above 106.40. Under these conditions weMight prefer to sell both the 100 call and 100 put (Figure 2-8). Now our profit is limitedto the total premium of 6.40, while our risk in either direction is unlimited. But if wefee] strongly that the underlying contract is likely to stay in the 93.60-106.40 rangethrough expiration, the risk might be worth taking.
Suppose we take a view similar to that in Figure 2-8, that the underlying contractis unlikely to make a big move in either direction. But because there is always a chanceFlementary Strategies 21
eeeFigure 2-8
 
short a 100 call at 2.7085 short a 100 put at 3.70
Profit
 
Loss
 
 
 
 
we could be wrong, we might want to increase our margin for error by increasing ourrange of profitability beyond the 93.60-106.40 range. Instead of selling a 100 call anda 100 put, we might sell a 95 put for 1.55 anda 105 call for 1.15. This position (Figure2-9) will realize its maximum profit of 2.70 anywhere within the 95-105 range, whereboth options will expire worthless. We won’t lose money unless the underlying contractfinishes below 92.30 or above 107.70 at expiration. In the former case the 95 put willbe worth at least 2.70, and in the latter case the 105 call will be worth at least 2.70.There is, as always, a tradeoff for this increased range of profitability. Our maximumProfit now is only 2.70, whereas in Figure 2-8 it was 6.40. In return for a reduced risk,we must be satisfied with a reduced profit potential. Option traders are constantlyTequired to make these types of tradeoffs between risk and reward. If a potential rewardis big enough, it may be worth taking a big risk. But if the potential reward is small, theaccompanying risk should also be small.
The positions in Figures 2-7, 2-8, and 2-9 all have either unlimited reward orUnlimited risk because they are either net long or net short options. If we purchase andsell equal numbers of options of the same type, we can create positions which have bothlimited risk and limited reward. For example, we might buy a 90 call for 9.35 and sell4 100 call for 2.70, for a total debit of 6.65 (Figure 2-10). If the underlying contractfinishes below 90.00 both options will expire worthless and we will lose our totalInvestment of 6.65. If the underlying contract finishes above 100, the 90 call, which22 Chapter 2
Figure 2-9
10
 
87 short a 95 put at 1.55short a 105 call at 1.15
Profit
 
 
Loss$
 
 
-10 T T T T T85 90 95 100 105 110 115
 
we own, will be worth exactly 10 points more than the 100 call, and we will realizethe maximum profit of 3.35. Between 90 and 100 the position will be worth someamount between zero and 10 points. In order to do no worse than break even we mustrecoup our original investment of 6.65. We will be able to do this if the underlyingcontract is at 96.65 or higher at expiration. The 90 call will then be worth at least 6.65.Like the outright purchase of a call, this position wants the market to rise so that wewill realize our maximum profit of 3.35. Here, however, we are willing to give up theunlimited upside profit potential associated with the outright purchase of a 90 call,