Chapter 2

Basic Principles of
Stock Options

1 © 2004 South-Western Publishing

 Outline
 What options are and where they come
from
 Why options are a good idea
 Where and how options trade
 Components of the option premium
 Where profits and losses come from with
options

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 What Options Are and Where
They Come From
 Call and put options
 Categories of options
 Standardized option characteristics
 Where options come from
 Opening and closing transactions
 The role of the options clearing corporation

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 Call and Put Options
 Call Options
– A call option gives its owner the right to buy; it is not a
promise to buy
 For example, a store holding an item for you for a fee is a
call option
 Put Options
– A put option gives its owner the right to sell; it is not a
promise to sell
 For example, a lifetime money back guarantee policy on
items sold by a company is an embedded put option

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 Categories of Options
 An American option gives its owner the
right to exercise the option anytime prior to
option expiration

 A European option may only be exercised

at expiration

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 Categories of Options (cont’d)
 Options giving the right to buy or sell
shares of stock (stock options) are the best-
known options
– An option contract is for 100 shares of stock

 The underlying asset of an index option is

some market measure like the S&P 500
index
– Cash-settled

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 Standardized Option
Characteristics
 Expiration dates
– The Saturday following the third Friday of certain
designated months for most options
 Striking price
– The predetermined transaction price, in multiples of
$2.50 or $5, depending on current stock price
 Underlying Security
– The security the option gives you the right to buy or sell
– Both puts and calls are based on 100 shares of the
underlying security

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 Standardized Option
Characteristics (cont’d)

 The option premium is the amount you pay

for the option

 Exchange-traded options are fungible

– For a given company, all options of the same
type with the same expiration and striking price
are identical

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 Identifying An Option

Expiration (3rd Friday in October) Type of option

Microsoft OCT 80 Call

Underlying asset Strike price

(Microsoft common stock) ($80 per share)

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 Where Options Come From
 Unlike more familiar securities, there is no
set number of put or call options
– The number in existence changes every day

10
 Opening and Closing
Transactions
 The first trade someone makes in a
particular option is an opening transaction
for that person

 When the individual subsequently closes

that position out with a second trade, this
latter trade is a closing transaction

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 Opening and Closing
Transactions (cont’d)
 When someone buys an option as an
opening transaction, the owner of an option
will ultimately do one of three things with it:
– Sell it to someone else
– Let it expire
– Exercise it
 For example, buying a ticket to an athletic
event

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 Opening and Closing
Transactions (cont’d)
 When someone sells an option as an
opening transaction, this is called writing
the option
– No matter what the owner of an option does, the
writer of the option keeps the option premium
that he or she received when it was sold

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 The Role of the Options
Clearing Corporation (OCC)
 The Options Clearing Corporation (OCC)
contributes substantially to the smooth
operation of the options market
– It positions itself between every buyer and seller
and acts as a guarantor of all option trades
– It sets minimum capital requirements and
provides for the efficient transfer of funds
among members as gains or losses occur

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 Why Options Are a Good Idea
 Increased risk
 Instantaneous information
 Portfolio risk management
 Risk transfer
 Financial leverage
 Income generation

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 Where and How Options Trade
 Exchanges
 Over-the-counter options
 Standardized option characteristics
 Other listed options
 Trading mechanics

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 Exchanges
 Major options exchanges in the U.S.:
– Chicago Board Options Exchange (CBOE)
– American Stock Exchange (AMEX)
– Philadelphia Stock Exchange (Philly)
– Pacific Stock Exchange (PSE)
– International Securities Exchange (ISE)
 Foreign options exchanges also exist

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 Over-the-Counter Options
 With an over-the-counter option:
– Institutions enter into “private” option
arrangements with brokerage firms or other dealers
– The striking price, life of the option, and premium
are negotiated between the parties involved
 Over-the-counter options are subject to
counterparty risk and are generally not
fungible

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 Some Exotic Options

 As-You-Like-It Option
– The owner can decide whether it is a put or a
call by a certain date
 Barrier Option
– Created or cancelled if a prespecified price level
is touched
 Forward Start Option
– Paid for now, with the option becoming effective
at a future date

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 Other Listed Options
 Long-Term Equity Anticipation Security
(LEAP)
– Options similar to ordinary listed options,
except they are longer term
 May have a life up to 39 months
– All LEAPs expire in January
– Presently available on only the most active
underlying securities

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 Other Listed Options (cont’d)
 FLEX option
– Fundamentally different from an ordinary listed
option in that the terms of the option are flexible
– Advantage of user flexibility while eliminating
counterparty risk
– In general, a FLEX option trade must be for at
least 250 contracts

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 Trading Mechanics
 Bid Price and Ask Price
– There are two option prices at any given time:
 Bid price: the highest price anyone is willing
to pay for a particular option
 Ask price: the lowest price at which anyone if
willing to sell a particular option

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 Trading Mechanics (cont’d)
 Types of orders
– A market order expresses a wish to buy or sell
immediately, at the current price
– A limit order specifies a particular price (or
better) beyond which no trade is desired
 Typically require a time limit, such as “for the day” or
“good ‘til canceled (GTC)”

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 Trading Mechanics (cont’d)
 Trading Floor Systems
– Under the specialist system, there is a single
individual through whom all orders to buy or
sell a particular security must pass
 Used at the AMEX and the Philly
 The specialist keeps an order book with limit order
from all over the country
 The specialist’s job is to maintain a fair and orderly
market

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 Trading Mechanics (cont’d)
 Trading Floor Systems (cont’d)
– Under the marketmaker system, the specialist’s
activities are divided among three groups of
people:
 Marketmakers
 Floor brokers
 Order Book Official

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 The Option Premium
 Intrinsic value and time value
 Option price quotations

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 Intrinsic Value and Time Value
 Intrinsic value is the amount that an option
is immediately worth given the relation
between the option striking price and the
current stock price
– For a call option, intrinsic value =
stock price – striking price
– For a put option, intrinsic value =
striking price – stock price
– Intrinsic value cannot be < zero

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 Intrinsic Value and Time Value
(cont’d)
 Intrinsic value (cont’d)
– An option with no intrinsic value is out-of-the-
money
– An option whose striking price is exactly equal
to the price of the underlying security is at-the-
money
– Options that are “almost” at-the-money are
near-the-money

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 Intrinsic Value and Time Value
(cont’d)
 Time value is equal to the premium minus
the intrinsic value
– As an option moves closer to expiration, its time
value decreases (time value decay)
 An option is a wasting asset

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 Option Price Quotations
 Every service that reports option prices will
show, at a minimum, the
– Striking price
– Expiration
– Premium

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 Option Price Quotations  

(cont’d)
Intraday Prices from September 15, 2003
Microsoft Stock Price = $28.51
Call Put

Strike Expiration Volume Last Open Interest Volume Last Open Interest

20 SEP 03 8.60 462 0 0 51

0

20 OCT 0 8.62 3079 0 0 13013

22.50 SEP 0 6.04 781 0 0 5920

22.50 OCT 0 6.06 7050 2 0.05 35024

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 Profits and Losses With
Options
 Understanding the exercise of an option
 Exercise procedures
 Profit and loss diagrams
 A note on margin requirements

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 Understanding the Exercise of
an Option
 An American option can be exercised
anytime prior to the expiration of the option
– Exercising an American option early amounts
to abandoning any time value remaining in the
option
 A European option can only be exercised
at maturity

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 Exercise Procedures
 Notify your broker
 Broker notifies the Options Clearing
Corporation
– Selects a contra party to receive the exercise
notice
– Neither the option exerciser nor the option
writer knows the identity of the opposite party

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 Exercise Procedures (cont’d)
 The option premium is not a down payment
on the purchase of the stock
 The option holder, not the option writer,
decides when and if to exercise
 In general, you should not buy an option
with the intent of exercising it

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 Profit and Loss Diagrams
 Vertical axis reflects profits or losses on the
expiration day resulting from a particular strategy
 Horizontal axis reflects the stock price on the
expiration day
 Any bend in the diagram occurs at the striking
price
 By convention, diagrams ignore the effect of
commissions that must be paid

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 Buying a Call Option (“Going
Long”)
 Example: buy a Microsoft October 25 call
for $3.70
– Maximum loss is $3.70
– Profit potential is unlimited
– Breakeven is $28.70

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 Buying a Call Option (cont’d)

Breakeven = $28.70

0 20 40 60 80 100
Maximum
loss = $3.70

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 Writing a Call Option (“Short
Option”)
 Ignoring commissions, the options market
is a zero sum game
– Aggregate gains and losses will always net to
zero
– The most an option writer can make is the
option premium
 Writing a call without owning the underlying
shares is called writing a naked (uncovered)
call

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 Writing a Call Option (cont’d)

Breakeven = $28.70

Maximum
Profit = $3.70
0 20 40 60 80 100

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 Buying a Put Option (“Going
Long”)
 Example: buy a Microsoft April 25 put for
$1.10
– Maximum loss is $1.10
– Maximum profit is $23.90
– Breakeven is $23.90

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 Buying a Put Option (cont’d)
$23.90
Breakeven = $23.90

0 20 40 60 80 100
$1.10

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 Writing a Put Option (“Short
Option”)
 The put option writer has the obligation to
buy if the put is exercised by the holder

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 Writing a Put Option (cont’d)

Breakeven = $23.90

$1.10

0 20 40 60 80 100

$23.90

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 A Note on Margin Requirements
 A margin requirement is analogous to
posting collateral and can be satisfied by a
deposit of cash or other securities into your
brokerage account

 The margin system is to reduce the

likelihood that option writers will be unable
to fulfill their obligations

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