THE BASIC APPROACH- Introduction

THE BASIC APPROACH


Introduction

What Is an Option?

Although options are typically bought and sold through security dealers and brokers, it is important to understand that options are not securities. Unlike stocks, warrants, or corporate bonds, options are not authorized or issued by any company on its behalf. Rather, an option is simply a contract between two parties, a buyer and a seller. The buyer is often referred to as the owner or option holder, and the seller is often referred to as the option writer. A call option gives the option holder the right to buy an asset at a set price within a certain time, while a put option gives the option holder the right to sell an asset at a set price within a certain time. In neither case is the option holder ever obligated to buy or sell.

For an example of an option contract, suppose you're in the market for a new car. Sitting there in the dealer's showroom is that spectacular model you'd love to own. Because it is popular, there is little discount from the sticker price of $40,000. You tell the salesman that you get your bonus in three months. Anxious to make a deal, he says, "Okay, the price may well go up between now and then, but if you give us a nonrefundable check for $250 today, I'll guarantee that price for the next 90 days. Not only that, but if the price goes down, you can back out of the deal." This sounds good to you, so you write the dealer a check for $250. Congratulations! You have just entered into a bona fide option contract.

Why did this seem like a good idea to you? By the terms of the deal, no matter how high the sticker price goes in the next 90 days, your effective purchase price will be $40,250, which includes the $250 premium you paid. If the sticker price increased by 10 percent, to $44,000, you would be $3,750 ahead of the game. On the other hand, if the sticker price dropped to $39,000 (and such things can happen), your effective price would be $39,250. This is because by the terms of the deal you are not obligated to buy the car for $40,000 and are free to buy it from that dealership or anywhere else at the market price of $39,000. In that situation, you would still be $750 better off than if you had purchased the car for $40,000 today.

But that's not all. After writing that check for $250, you are asked by the salesman if you would like to buy ''lemon'' insurance. "What's that?" you ask. "Well," says the salesman, "for just $100 more, I will give you the privilege of selling the car back to me at whatever price you paid for it within 30 days of purchase, no questions asked." This too sounds good, and you write the dealer a check for another $100. Congratulations again. You have just entered into your second option contract of the day.

The first option contract is a classic example of a call option because it gives you the right, but not the obligation, to buy the car. The second option contract is a classic example of a put option because it gives you the right, but not the obligation, to sell (i.e., put back) the car to the dealership. Notice that when used in this manner, both option contracts served to reduce risk. The call option protects you against an unanticipated price increase, and the put option protects you against buying a lemon. You may not realize it at first, but the second option also protects you against a significant price decrease right after buying the car. If the price did drop to $39,000 within 30 days of buying the car for $40,000, you could return the car to the dealer, get your money back, and buy an equivalent new one for $39,000. 

Whether it entailed a call or a put, the option involved was essentially characterized by three principal variables: (1) the buy/sell price of the underlying asset (the car), (2) the time period during which the option could be exercised (30 or 90 days), and (3) the premium involved ($100 or $250). One other important feature of at least the call option in this case is that it is likely transferable. If you decided not to buy the car within the 90-day period, you could have sold the option to a friend for whatever price the two of you agreed on. If the sticker price increased to $44,000, that right to buy the car for $40,000 would be worth more than the $250 you originally paid for it. On the other hand, if the price decreased or remained the same, the value of the right to buy the car for $40,000 would have shrunk to zero by the time the 90-day period expired.

Option contracts in which the underlying assets are corporate stocks do not differ in principle from the ones described above and are also characterized by the buy/sell price of the underlying asset (the stock), the period during which the option can be exercised, and the premium involved. The difference is that in the case of investment assets, option contracts are used for a much wider range of purposes, including risk reduction, profit enhancement, and leveraged control.

People often use option contracts to decrease the risk associated with stock ownership. Suppose you own 100 shares of Intel and want to protect yourself against a significant drop in value. Wouldn't it be nice to have someone else contractually promise to buy those shares from you for a guaranteed amount no matter what, even if the price fell to zero? That person will want a reasonable fee for providing that assurance, of course. As with fire or auto insurance, you hope never to file a claim. But if loss did occur because a house collapsed (or stock plummeted), financial disaster can be averted or substantially mitigated, depending on the terms of the policy and extent of the coverage elected. In this situation, an option contract is the exact analog of an insurance policy.

Another reason people use options is to enhance portfolio income. Those 100 shares of Intel you own are probably not paying a dividend worth writing home about. For a reasonable fee, you might grant someone else the right to purchase those 100 shares from you, within a specified period, at a price pegged above today's market value. Real estate operators and landowners do this all the time, offering tenants or developers the right to purchase property at a specified price by some future date in return for an up-front cash payment. If the right to purchase is exercised, it means the owner got his or her price. If the right to purchase expires without exercise, the extra cash augments whatever rental payments are being received—thereby increasing the effective yield rate. In either event, the up-front payment is retained by the property owner.

The third reason people use options is to control a large amount of stock without having to buy or own it. Suppose an investor feels that Intel (or any other stock) is about to rise significantly in price. Wouldn't it be nice to pay a current owner of that stock a reasonable fee for the right to purchase his or her shares at a mutually agreed on price within a certain period? In this situation, the potential purchaser is the exact analog of the real estate developer in the previous example who seeks to control a potential project without committing valuable cash resources until market conditions warrant.

Investors who believe a stock is about to "tank" also enter into option contracts for the right to sell a stock within a specified period a price reflecting its current value. This transaction is simpler and requires much less cash than taking on the potentially unlimited risk associated with short selling. (A short sale occurs when the investor borrows shares of a stock and sells them in the hope that they can be subsequently purchased back at a lower price and then returned to the original shareholder. Substantial collateral is required and numerous technical conditions must be met to conduct short sales.)

Features of Standardized Equity Options

If every component and clause had to be negotiated each time an option contract was set up, the options market would grind to a halt. To maintain a rapid but orderly options market, option contracts are assigned six standard parameters:

1. Product
2. Type
3. Unit of trade
4. Strike price
5. Expiration date
6. Style

Product.

Options are distinguished by the underlying product involved: If the underlying product is one of several market indexes, such as Standard & Poor's 100 (S&P 100), the option is called an index option. If the underlying product involves common stock, it is called an equity option. In addition to index and equity options, options are now available on interest rates, Treasury securities, commodities, and futures. 

Type.

Options are also classified by the type of privilege (either buying or selling) granted the option holder. As you have seen, a call option gives the option holder the right to purchase a specified number of shares, ordinarily 100, of the underlying security at a specified price at any time within a specified period. In contrast, a put option gives the option holder the right to sell a specified number of shares, ordinarily 100, of the underlying security at a specified price at any time within a specified period. The price specified in the option contract is referred to as the exercise or strike price, and the last day on which this right to purchase or sell can be exercised is called the expiration date. An example of a call option (or, simply, call) would be the right to buy 100 shares of Intel at $120 per share at any time up to and including the third Friday in April. 

An example of a put option (or, simply, put) would be the right to sell 100 shares of Intel at $60 per share during the same period. Note that the holder of a call does not have to exercise his or her right to purchase. Similarly, the holder of a put does not have to exercise his or her right to sell. This lack of obligation on the part of option holders is one of the major differences between an option and a futures contract. On the other hand, option writers (sellers) are obligated to sell (in the case of call options) or buy (in the case of put options) the agreed-on number of shares at the agreed-on price if the option holder exercises his or her rights within the period specified in the option contract.

Unit of Trade.

The number of shares specified in an option contract is called the unit of trade. As mentioned earlier, it is ordinarily 100 shares of the underlying equity. In the event of stock splits, mergers, and acquisitions, the unit of trade is adjusted accordingly. For example, when Travelers, Inc., split 4:3 in 1997, the unit of trade for existing option contracts became 133 shares. When 3Com Corporation (COMS) merged with U.S. Robotics (USRX) that same year, 1.75 shares of COMS were exchanged for each share of USRX; the unit of trade of the existing option contracts on USRX thus became 175 shares of 3Com (with corresponding adjustments in the exercise price). It is even possible for the unit of trade to be less than 100 shares, such as when reverse stock splits occur (wherein a greater number of shares is exchanged for a lesser number of shares of the underlying security).

Strike Price.

Strike price intervals for standard equity options are set in increments of $2.50 when the price of the underlying equity (stock price) is between $5 and $25, $5 when the stock price is between $25 and $200, and $10 when the stock price is over $200. Options are ordinarily not available on stocks priced under $5. Strike prices are adjusted for splits, major stock dividends, recapitalizations, and spinoffs, when and if they occur during the life of the option.

Expiration Date.

At any given time there are four potential expiration dates available for standard option contracts: (1) the current or spot month, (2) the immediate following month, (3) an intermediate month, and (4) a far month (being not more than eight months away). Whichever expiration month is chosen, option contracts always expire at noon on the Saturday following the third Friday of that month. Because trading stops on the day prior to formal expiration (with Saturday morning activity reserved for broker corrections and clearing house operations), the effective expiration date for option contracts is the third Friday of the specified month. For this reason, investors usually speak in terms of "expiration Friday."

Style.

Option contracts are also classified by the basis of the window during which option holders may exercise their rights. American-style options give holders the right to buy or sell at any time prior to expiration of the option. Holders of European-style option contracts may exercise their rights during a very limited period, ordinarily on the day of or day before expiration. At present, all exchange-traded equity options are American style.

Puts versus Short Sales

It is certainly cheaper and ordinarily far less risky to buy a put option than to effect a short sale of a stock. For example, assume America Online (AOL) is at $120 a share and an investor believes it to be overpriced. The margin or collateral requirement to effect a short sale of 100 shares of AOL at $120 is 150 percent of the stock price—$18,000 in this case. The first $12,000 of this are the proceeds received from the sale of the stock. These funds must be left on deposit to ensure the short seller will return the borrowed shares. The additional $6,000 that must be deposited in this case helps to guarantee that the short seller will be able to replace the borrowed shares in the event that the price of AOL stock rises rather than falls. 

This additional amount also serves as the source of funds for any dividends that the original shareholder is entitled to along the way. On the other hand, suppose the AOL puts with a strike price of $120 command a premium of $8 a share. The margin requirement in this case will be the premium cost of $800 plus 20 percent of the stock value, or just $3,200 in all. Besides the greater margin required, short selling can be particularly risky because of the potential for unlimited loss should the stock rise rather than fall. In addition, the short seller must arrange for the borrowing of shares (often difficult in the case of thinly traded issues) and wait for an uptick in price, whereas the put buyer can act immediately.

Option Class and Series

All option contracts on the same underlying security having the same type (put versus call) and style (American versus European) are referred to as constituting an option class. Thus, all TWA (Trans World Airlines) calls comprise an option class, as do all Intel puts. Further, all option contracts within the same class having the same unit of trade (i.e., 100 shares), strike price, and expiration date are referred to as comprising an option series. Thus, the July 2001 AOL $100 calls constitute an option series, as do the April 2001 General Electric $85 puts.

The last parameter that distinguishes one option from another belonging to the same series is the particular stock exchange where the various options are traded. For example, TWA options are independently traded on the American, Chicago, and Philadelphia Stock Exchanges. Thus, an October 2001 TWA $10 call option contract purchased on the American Stock Exchange can be closed by a sale of the equivalent option contract on the Philadelphia Stock Exchange. The purchase and sale of these two option contracts will precisely offset each other because the contracts belong to the same option series.

Premiums

A common characteristic of all contracts, including options, is that they involve consideration. For option holders, this refers to the right to exercise the option at the price and terms specified. For option writers, it is the premium, or amount of money paid to them by the option buyers for those exercise rights. Whether or not the option is ever exercised by the option holder, the option writer retains the premium. It is universally acknowledged that there are seven factors that determine the premium:

1. Current stock price
2. Exercise or strike price
3. Time to expiration
4. Current risk-free interest rate
5. Cash dividends
6. Option style (European vs. American)
7. Volatility of the underlying equity



* The risk-free interest rate is regarded as the interest rate on U.S. Treasury bills of the same duration as the option.

The first three parameters (stock price, strike price, and expiration date) are part of every option contract and are readily understood. The next three parameters (risk-free interest rate,* dividends, and option style) certainly have an effect on premiums but only in a relatively minor way. The final parameter, volatility, measures the degree to which the price of the stock fluctuates from day to day. It is important to understand that the greater the volatility and the longer the time to expiration, the higher the premium. This is because the greater the daily fluctuation in stock price and the longer the duration of coverage, the greater the uncertainty as to where the stock price will be at any subsequent moment. Equally crucial is the fact that option premiums do not ordinarily reflect the expected rate of growth of the stock price. 

Exercise and Assignment

If and when an option holder decides to exercise his or her option to buy or sell, the brokerage firm sends a notice to exercise to the Options Clearing Corporation (OCC), which in turn assigns fulfillment of that option to a current option writer of the same series, on either a random or a first-in, first-out basis. The OCC, created in 1972, serves not only as a clearing house for option trades but also as the ultimate guarantor of contract performance. On receipt and verification of the terms of the option contract at the time it was made between buyer and seller (and checking that they match in all respects), the OCC steps in and severs the contractual relationship between the parties, thus becoming the "buyer" to every option writer and the "writer" to every option holder. Owing to this, it does not matter that the original option writer (or every writer for that particular series) may have disappeared from the face of the earth.

Option Codes

To facilitate trading, options are symbolized by a three- to five-character trading symbol made up of a root symbol designating the underlying equity, a single letter designating the expiration month, and a single letter designating the strike price. I keep a copy of these tables pinned on the wall by my telephone.

Let's consider some examples. For most stocks listed on the New York and American Stock Exchanges, the root symbol for the option (no matter where the option itself is traded) is the same as its ordinary trading symbol. Thus, March $45 Gillette calls would be coded as G (for Gillette) + C (March call) + I ($45), or GCI. February $30 Boeing puts would be coded as BA (for Boeing) + N (February put) + F ($30), or BANF. And June $67.50 America Online puts would be coded as AOL (for America Online) + R (June put) + U ($67 1/2), or AOLRU.


Table  Expiration Month Codes

             Jan    Feb    Mar    Apr    May    Jun    Jul    Aug    Sep    Oct    Nov    Dec
Calls     A        B         C        D        E          F        G       H        I         J        K         L
Puts      M       N        O        P         Q         R        S        T       U        V        W       X

Table  Strike Price Codes (Whole Dollars)

A       $5       $105      $205       $305       $405       $505       $605       $705
B       10       110         210         310          410         510         610         710
C       15       115         215         315          415         515         615         715
D       20       120         220         320          420         520         620         720
E       25       125         225         325          425         525         625         725
F       30       130         230         330          430         530         630          730
G       35       135         235         335          435         535         635         735
H       40       140         240         340          440         540         640         740
I         45       145         245         345          445         545         645         745
J        50       150         250         350          450         550         650         750
K       55       155         255          355         455         555         655         755
L        60       160         260         360          460         560         660        760
M       65       165         265         365          465         565         665        765
N       70       170         270          370         470          570        670        770
O       75       175         275          375         475          575        675        775
P       80       180         280          380         480          580        680        780
Q       85       185         285          385         485          585        685        785
R       90       190         290          390         490          590        690        790
S       95       195         295          395         495          595        695        795
T      100       200        300          400         500          600        700        800

Table  Strike Price Codes (Half Dollars)

U      7 1/2      37 1/2    67 1/2      97 1/2     127 1/2     157 1/2    187 1/2    217 1/2
V    12 1/2      42 1/2    72 1/2    102 1/2     132 1/2     162 1/2   192 1/2    222 1/2
W   17 1/2      47 1/2     77 1/2    107 1/2     137 1/2     167 1/2   197 1/2    227 1/2
X   22 1/2      52 1/2     82 1/2    112 1/2     142 1/2     172 1/2   202 1/2   232 1/2
Y    27 1/2      57 1/2     87 1/2    117 1/2     147 1/2      177 1/2   207 1/2   237 1/2
Z    32 1/2      62 1/2    92 1/2    122 1/2     152 1/2     182 1/2   212 1/2   242 1/2

In the first example for Gillette, the option trading symbol GCI happens to coincide with the stock trading symbol that is used for the Gannett Company. In the second example for Boeing, the option trading symbol BANF happens to coincide with the stock trading symbol for BancFirst Corporation. Because of such potential conflicts, brokerage houses and options exchanges preface option trading symbols with some sort of character that unambiguously signals that what follows is an option, not a stock. 

Quotation requests submitted to the  Chicago Board Options Exchange (CBOE) use a period so that .GCI and .BANF designate the particular options quotes on Gillette and Boeing, while GCI and BANF are used for the stock quotes on Gannett and BancFirst. Because the decimal point is sometimes hard to see, some brokerage houses use the prefix "Q" in transmitting orders to their trading desks, thus coding the examples given as QGCI, QBANF, and QAOLRU. (The letter Q can be safely used this way because no stock symbols on any of the exchanges where options are traded begin with that letter.)

Because the trading symbols for Nasdaq stocks have at least four characters in them, they are all assigned three-letter option symbols that often have no relation to the trading symbol. For example, Intel (INTC) has the option symbol INQ, Inktomi (INKT) has the option symbol QYK, and Madge Networks (MADGF) the option symbol MQE. Because very few stock symbols contain the letter Q, this letter is often utilized in the creation of option symbols to avoid conflict with already existing trading symbols. Thus, October $100 Intel calls are coded as INQ (for Intel) + J (October call) + T ($100), or INQJT, and March $30 Inktomi puts are coded as QYK (for Inktomi) + O (March put) + F ($30), or QYKOF.

The system described seems pretty simple at first blush. A difficulty, however, arises when a stock is so volatile that the spread in strike prices would require more than one occurrence of the same price code for the same expiration month. In those circumstances, the various exchanges that set up trading symbols are sometimes forced to adopt an alternative option symbol for the underlying stock, or even to assign price code symbols that bear little relation. Thus, the January 1998 Intel $45 puts were coded by the American Stock Exchange at the time as NQMI (rather than INQMI); the August 1997 Intel $67.50 calls were coded as INQHW (rather than INQHU); and the July 1997 Intel $87.50 puts were coded as INQSB (rather than INQSY).

Half-dollar amounts typically arise as a result of 2:1 stock splits. For stock splits other than 2:1 (for example, 3:1 or 4:3), the resulting trading symbols can often be even more arbitrary. In view of this, utmost care must be given to determining the proper option codes before transacting trades or submitting such requests to brokers. Because of the large number of options available and the fact that new strike positions and expiration months are continually being created, no printed list of symbol tables could possibly be kept timely enough. One of the best online sources for obtaining accurate trading symbols (and with them, bid and ask quotations on a 20-minute delayed basis) is from the Chicago Board Options Exchange. Access to CBOE is free, and a wealth of material is available in addition to delayed quotes and the trading symbols for the calls or puts you are interested in.

Option Cycles

When listed options began trading for the first time, they were each assigned four quarterly expiration dates throughout the year. Cycle 1 options expired in the months of January, April, July, and October. Cycle 2 options expired in the months of February, May, August, and November. And cycle 3 options expired in the months of March, June, September, and December. The system was subsequently modified so that every equity option has four expiration dates consisting of the nearest two months and two additional months taken from one of the original quarterly cycles. 

The spot month begins the Monday after expiration Friday and ends on the following expiration Friday, thus spanning parts of two calendar months. As the spot month opens, options for that month and two other months will have already been trading. If options for the next nearest month do not exist, options for that month will be opened for trading. If options for the two nearest months have already been trading, the fourth option opened for trading will be the next one in sequence from the respective quarterly cycle.

Table  Standard Options Available


A handbook that is particularly useful for dealing with options is the Directory of Exchange Listed Options, available without charge from the Options Clearing Corporation by calling 800-OPTIONS (678-4667). This directory contains much useful information, including a list of option trading symbols, option cycles, and the exchange (s) where each option trades.

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