3 1 INTRODUCTION Why Options? hy should someone who invests or speculates in the marketlearn to use options?

The simple answer is that options cangreatly enhance your profit from stocks and/or provide themeans to protect your portfolio.The goal ofthis chapter is to familiar-ize the beginner with call and put options,and demonstrate some of the basic ways that options are used.Suppose you buy a stock for $30 a share and it goes to $33.The stockprice has risen by 10 percent and accordingly you have a 10 percent prof-it. T h a t s n ic e ! I f i ns te a d o f b uy ing th e s t o c k , y o u b uy a n a p p r o p r ia te option,you might make a 100 percent profit or even more for the same10 percent rise in the stock price.Thats better than nice.Thats fantastic!Ofcourse,there are risks associated with options,just as there are riskswith any investment.You need to understand the risks as well as theadvantages ofoptions in order to optimize your results.T h r o ug h o u t t h is b o o k , t h e us e o f c a l l a nd p ut o p t io ns a r e i l l us tr a te d th r o ug h a va r ie ty o f e x a m p le s . F o r s im p l ic i ty , t h e f o c us i s o n e q u i ty optionsthat is,options associated with individual stocks.With minorv a r ia ti o ns , th e s a m e c o n c ep ts a p p ly t o m o s t o th e r k i nds o f o p t io ns , such as those associated with an index such as the Dow or those thatrepresent an industry such as the semiconductor industry. T h e B a s i c C o n c e p t o f Op t i o n s To understand the basic concept ofoptions,lets start with a simplifiedlook at how they work. An (equity) option is linked to a specific stock.The price ofthe optioni s m u c h le s s t h a n th e p r ic e o f t h e un de r ly ing s to c k , wh i c h is a m a jo r r e a s o n f o r t h e a t t r a c t i v e n e s s o f o p t i o n s . I f t h e p r i c e o f t h e s t o c k c h a ng e s , t h e p r ic e o f th e o p t io n wi ll a ls o c h a ng e , a lt h o ug h b y a s m a l le r amount.As the price ofa stock goes through its daily ups and downs,the price ofan associated option will undergo related fluctuations. The price ofan option can be viewed and followed in much the sameway as a stock price.There are numerous online services,including thedata feed for your brokerage account,that provide the prices ofoptions.The Chicago Board Options Exchange (CBOE) offers a free online serv-ice for quotes on option prices that are 20 minutes delayed.F o r a c a l l o p t i o n , i f t h e s t o c k

p r i c e g o e s u p , t h e o p t i o n p r i c e a l s o increases.Ifthe s t o c k p r i c e g o e s d o w n , t h e p r i c e o f t h e c a l l d e c r e a s e s . For aput option,ifthe stock price goes down,the option price increases.Ifthe stock price goes up,the price ofthe put decreases.This sounds like owning a call option is similar to holding a long posi-tion in the stock,because you have the potential to make a profit whenthe stock price goes up.And owning a put option is similar to holdinga short position in the stock,because you have the potential to make aprofit when the stock price goes down.In a rough sense,this analogy istrue,but there are some significantdifferences. Major Differences Between Stocks and Options Leverage O p t io n s ty p ic a lly c o s t o n ly a f r a c t io n o f th e s to c k p r ic e . I f y o u t h ink XYZ stock,currently at $49 per share,is going up in price,you can pur-c h a s e 10 0 s h a r e s a t a c o s t o f $4 , 90 0 . I f i ns te a d y o u b uy 1 c a ll o p t io n contract (1 contract represents 100 shares ofstock),you might pay only $2 per share for a total ofonly $200 to participate in an upward pricem o ve m e n t o f X Y Z. Analogously,ifyou think XYZ is going down in price,you could short100 shares ofstock,but that creates a margin responsibility in your bro-k e r a g e a c c o u nt, wh i c h c a n b e c o m e c o s t l y if X Y Z g o e s up . I f i ns te a d y o u buy one put contract,you might pay just $2 per share for a total ofonly $200 to participate in a downward price movement ofXYZ. Time Limitation One reason options arecheap is that they are time limited.A long orshort position involving stock can be held indefinitely,but an optionexpires on a fixed date.The expiration date is typically the third Friday ofthe expiration month designated in the option contract.When youbuy an option,you can select from various expiration months,includ-ing the current month as well as other months going out possibly as faras two years.The longer you want to hold an option,the more expensive it will be.If a price of$1 per share applies to an option expiring in two months,asimilar option expiring in four months might be priced at $2 per share.For 12 months,the price could be as much as $7 per share,bu t even thiswould typically be a small fraction ofthe stock price.Another important aspect ofbeing time limited is that the value ofanoption will decrease with time when there is no change in the stockprice.Ifyou

buy an option for $1 per share with two months until expiration,for example,it might be worth only $.65 with one month to goi f t h e s t o c k p r i c e h a s no t g o ne up . T h is is o ne o f t h e r is k s o f o wn ing a n option,namely that its value diminishes over time when the stock priceremains unchanged. Price Movement As the stock price changes,the option price also changes,but by a lesseramount.How closely the change in the option price matches thechange in the stock price depends on the reference price designated inthe option contract.This reference price is called the strike price .When you decide to purchase an option,there will be several strikeprices from which to make a selection.For most stocks,the strike pricesofits options are set at $5 increments within the broad trading range of the stock.For some lower- and medium-priced stocks,strike prices areoffered in increments of$2.50,whereas options on some high-pricedstocks only have strike price increments of$10. There is a terminology used by options traders to describe the relativerelationship between the stock price and the strike price ofan option.If the strike price ofeither a call or a put is close to the price ofthe stock,the option is said to be at-the-money . I f t h e s t r i k e p r i c e o f a c a l l ( p u t ) i s above (below) the stock price,the option is said to be out-of-the-money .I f th e s t r ik e p r ic e o f a c a l l ( p u t) is b e lo w ( a b o ve ) th e s to c k p r i c e , t h e option is said to be in-the-money .For an at-the-money option,the price ofthe option will change by about50 percent ofthe amount ofchange in the stock price.For an out-ofthemoney option,the price ofthe option will change by less than 50 percentofthe change in the stock price.The price ofan in-themoney optionwill move by more than 50 percent ofthe change in the stock price.For example,suppose XYZ stock is priced at $49 and a call option witha $50 strike price is purchased for $2 per share.Ifthe price ofXYZ stockrises by $2 up to $51 soon after purchasing the option,the price ofthecall would typically increase by about $1,raising its price by up to$ 3 p e r s h a r e . S u p p o s e ins te a d, a c a l l

o p t io n w it h a $5 5 s tr ik e p r i c e w a s purchased for $.75 per share.Then the same $2 move in the stock pricemight increase the price ofthe call by only $.20,up to $.95 per share.On the other hand,a call option with a $45 strike price and a co st of $5per share might see an increase in the price ofthe call by as much as$1.60,up to $6.60 per share.O f c o ur s e , i f X Y Z f e ll $2 f r o m $4 9 do wn to $ 4 7 , th e c a ll o p ti o n wi t h a $50strike price could be expected to lose about $1 per share,reducingits price from $2 down to $1.This illustrates how the leverage ofoptionsworks in both directions. Financial Risk When you buyan option,your maximum risk is limited to your origi nal cost ofthat option.The worst outcome is that you hold the optionuntil expiration,at which time it has become worthless because thestock price failed to move in a beneficial manner.For example,ifyou buy one option contract for a price of$2 per share, your cost is $200 (2 100 = 200).This is the most that you can lose.Compare that dollar risk with the risk ofeither owning or shorting 100shares ofstock.When the stock price undergoes a substantial moveagainst your long or short position in the stock,the dollar loss will bemuch greater than the cost ofa call or put option.A major risk with options is that you invest heavily by purchasingnumerous contracts and then allow them to expire worthless.This rep-r e s e n ts a 10 0 p e r c e n t l o s s o n a s ig n if ic a n t i nve s tm e n t. O f c o u r s e , it is rarely necessary to lose all ofyour original investment when the stockdoes not move as expected.Typically,you can sell your options beforeexpiration and recover some part ofyouroriginal cost. A De t a i l e d Ex p l a n a t i o n o f Op t i o n s Additional insight into options from both the owner and seller view-points is provided in the more detailed explanation that follows here. The Option Contract An (equity) option represents a contract between a buyer and a seller.This contract is an agreement concerning the buying or selling ofastock at a reference price during a stipulated time frame.You will neversee any written document for this contract,just as you do not see actu-al

shares ofstock that you purchase in your brokerage account.Theexistence ofthe option contract is implied as soon as you buy or sell anoption through your broker.We will continually refer to the buying and selling ofoptions.In case you are wondering where all this buying and selling takes place,thereare exchanges for trading options similar to the exchanges for tradingstocks.Your broker routes your order to buy or sell an option to one of those option exchanges,just like he sends your order to buy or sell stockto a stock exchange.There are rights and obligations associated with an option contract,which need to be understood.Options associated with individualstocks trade in a manner called American style,which permits theowner ofthe option to exercise the rights ofthe contract at any timebefore the option expires.To better comprehend the implications of a no p t io n b e ing e x e r c is e d, we e x a m ine t h e c a ll o p t io n a nd t h e p ut o p t io n f r o m t h e v ie wp o i n ts o f b o t h th e b uy e r ( o w ne r ) a n d t h e s e l le r (writer). The Call Option The buyer (owner) ofa call option has the right to purchase 100 sharesofstock at the strike price designated in the contract.This right to pur-chase can be exercised anytime before the contract expires.Typically,th e ti m e f r a m e o f t h e o p ti o n e x te n ds t h r o ug h t h e th ir d F r i da y o f t h e expiration month stipulated in the contract.T h e s e l l e r ( w r i t e r ) o f a c a l l o p t i o n h a s t h e o b l i g ationtosupply100shareso f s t o c k f o r p u r c h a s e a t thestrikeprice,ifsorequestedbytheownerof theoption.Thisobligationtosupplythestoc kmayberequiredatany timebeforethecontrac texpires.Asapracticalmatter,ifthestockpricei sbelowthestrikeprice,thestockisalmostnevercal ledawayfromtheseller.Evenwhenthestockpric egoesabovethestrikeprice,theassignmentofacallrarelyhappensuntilneartheexpira tiondate. B UYINGA C ALL O

PTION The motivation to buy a call option could be based on your expectationthat the price ofXYZ stock will soon rise above its current level.Letsset up a possible trade,clarify its risk,and examine some possible outcomes resulting from the trade: Trade. In early February,with XYZ trading at $49,you decideto buy one call contract to benefit from the expected rise in thestock price.To allow a reasonable amount oftime for XYZ toadvance,you select a contract with an April expiration.You alsoselect a strike price of$50.Option prices are quoted on a per-share basis,and lets suppose that this call option costs $2 pers h a r e . Be c a us e th e o p t io n c o ve r s 10 0 s h a r e s o f s to c k , t h is m e a ns you pay $200 to own this particular call contract.In the jargon ofoptions,you are long one XYZ Apr 50 call.Now you have the right to purchase 100 shares ofXYZ stock at$50 per share anytime before the close oftrading on the thirdF r i da y o f A p r i l. This right to purchase XYZ stock for $50 per share does notlook so good at the moment,because the stock is priced in themarket at only $49.Indeed,why have you paid $2 per share forsomething that presently has no intrinsic value? Because theexpression time is moneyis most appropriate as it applies tooptions.You paid $2 per share as a cheap way to participate inthe movement ofthe price ofXYZ stock until the call expires intwo months. Risk. Your risk on this trade is limited to the $200 paid for onecall contract. Outcome. Lets examine a few scenarios to see how this trademight work out:1.Suppose your faith in XYZ stock is validated as its pricereaches $54 by the end ofMarch.Now your right to pur-chase XYZ at $50 looks good,and you decide it is time to take your profit.Should you call your broker and tell him toexercise your right to purchase this stock at $50? No,because you will do much better ifyou just sell the option.Theoption you bought for $2 is likely to now be worth $5.50.So,the contract for which you paid $200 can now be sold for$550,giving you a nice $350 profit.That represents a175percent profit on the option,whereas the stock price hasrisen only 15

percent.Why is this option worth $5.50 when its intrinsic value isonly $4 (54 50 = 4)? Again,because time is money,andthe person who buys your call option is paying the extra$1.50 per share over its intrinsic value in hopes that XYZstock will go even higher before the April expiration.Lets see why selling the option is more profitable thanexercising it.Ifyou had exercised your option to buy XYZstock at $50 and then immediately sold the stock at $54,thatwould be a $400 gain on the stock,less the $200 costo f t h e o p t io n f o r a ne t p r o f i t o f o n ly $ 20 0 . S o , e x e r c is i ng t h e option yields only a 100 percent profit as compared withthe175 percent profit received from selling the option.Also