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CHAPTER 15Stock Options At a very exclusive party, a high-

class, finely-clad woman slinked up to the CEO of a Fortune 500

company and said, “I will do anything – anything you want.”

The CEO flatly responded, “Re-price my options.”

Chapter Sections:Options on Common StocksThe Options Clearing CorporationWhy Options?Stock Index OptionsOption Intrinsic Values and “Moneyness”Option Payoffs and ProfitsUsing Options to Manage RiskOption Trading StrategiesArbitrage and Option Pricing BoundsPut-Call Parity

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What is an Option Contract? A security that gives the holder the right to

buy or sell a certain amount of an underlying financial asset at a specified price for a specified period of time Financial asset examples: Stocks, bonds, etc. Options contracts are not investments They are contracts between two investors

Buyer of the option contract gets the right to buy (or sell) the financial asset at a given price for a given period of time

Seller of the option contract must buy (or sell) the asset according to the terms of the contract

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What is an Option Contract? Options contracts are part of a class of

securities called derivatives Derivatives are securities that derive their value

from the price behavior of an underlying real or financial asset

Options contracts have no voting rights, receive no dividends nor interest, and eventually expire

Their value comes from the fact that they allow the holder of the option to participate in the price behavior of the underlying asset With a much lower capital outlay

(continued)

By the way, options contracts are usually just referred to as options.

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What is an Option Contract? Options allow an investor to leverage their

outlay of capital Leverage – the ability to obtain a given equity

position at a reduced capital investment, thereby magnifying returns (review)

With options, you can make the same amount of money from a stock or other security as if you bought it for full price But only come up 1/10th or less of the money

(continued)

Sounds too good to be true, huh? Well, you are right. It is too good to be true. Much of the time, you lose the entire outlay.

Options have a time limit. Most options expire worthless.

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What is the Rational for Options? Instead of buying a stock, buy an option to buy

a stock (or an option to sell a stock) If the stock goes up, your option will go up (almost

always much, much faster) and you can sell the option for a handsome profit

There is only one catch – The option expires in three, six or nine months If the stock does not go up, the option is worthless Most options expire worthless (Surprise!)

There are some scenarios where options can be worthwhile but they are few and far between!

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Option Contracts Example Stock currently selling for $20

You buy a share of the stock for $20 If it goes up to $30, you have earned $10 on a $20

investment You buy an option to purchase a share of the stock

at $20 currently selling at $20 It might only cost you $1 for the option If the stock goes up to $30, your option price will

probably go up to around $11 You have earned $10 on a $1 investment That is “leverage” in action Congratulations! Pat yourself on the back!

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Option Contracts Example But what if the stock price stays at $20

Your option expires worthless at the end of three, six, or nine months

And, of course, after your option expires, the stock price zooms to $40 You were so sure that this stock was going to hit

the big time and you were absolutely right But because you bought an option that expired, you

lost the ability to share in the success of the stock

(continued)

My advice? Forget about the option and just buy the stock! But since this is an Intro to Investments class, we need to become

proficient in the concepts, terms, and techniques of options. So…

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Call Option Contract – a.k.a. “Call” A negotiable instrument that gives the buyer of the

option the right to buy the underlying security at a stated price within a certain period of time (The previous example was a “call” option)

When people talk about options, they are usually talking about call options

Put Option Contract – a.k.a. “Put” A negotiable instrument that gives the buyer of the

option the right to sell the underlying security at a stated price within a certain period of time

Opposite of a call option

Two Main Types of Options

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“Where did the terms ‘call’ and ‘put’ come from and how will I remember which is which?” The term “call” comes from the idea that when you

buy a call option, you get the right to “call the stock away” from the seller of the option

The term “put” comes from the idea that when you buy a put option, you get the right to “put the stock to” the seller of the option

Two Main Types of Options(continued)

Get the idea? A “call” allows you to “call away the stock” from someone (buy it from them).

A “put” allows you to “put the stock” to someone (sell it to them). Let us look at each in detail.

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Buyer of the call option contract The Call Option Buyer of the contract is the

person who will do the “calling away” They buy the right to “call the stock away from” (buy

it from) the call seller They do not have to exercise the right

In fact, often the options contract expires worthless

Seller of the call option contract a.k.a. Option writer, Option maker The Call Option Seller of the contract is the

person who must sell the stock (“called away from”) The call option seller is legally bound to sell the stock

to the call buyer In return, they get the option price from the call option buyer

The Two Parties of a Call Option

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“What is the Call Option Buyer Hoping For?” The call option buyer is hoping that the price of the

stock will go up – a call option buyer is bullish If an option buyer has a call option to buy at $20 and

the price goes to $30, the buyer can buy a $30 stock for only $20

“What is the Call Option Seller Hoping For?” The call option seller is hoping that the price of the

stock will go down or stay the same – a call option seller is bearish (or at least not very bullish) If the stock stays around $20 or goes down, the call

option buyer will not want to exercise the option and it will expire worthless And the call option seller gets to keep the price of the option

(continued)The Two Parties of a Call Option

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Call option buyer Call option sellerCall Option ContractThe call option buyer wants the price of the underlying stock to go up.He is bullish.No matter what happens to the price of the stock, he can buy it from (“call it away from”) the call option seller for $20.

The call option seller wants the price of the underlying

stock to go down.He is bearish.

No matter what happens to the price of the stock, he

must sell it to (“called away from”) the call option buyer for $20 if exercised.

$20call

price

The call option contract is tied

to the underlying

stock. It will vary up &

down as the stock varies.

Call Option Example

Pays $1 Gets $1

Ed Ted

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Buyer of the put options contract The Put Option Buyer of the contract is the

person who will do the “putting to” They buy the right to “put the stock to” (sell it to) the

put option seller Again, they do not have to exercise this right

Recall: Often the options contract expires worthless

Seller of the put options contract a.k.a. Option writer, Option maker The Put Option Seller of the contract is the person

who must buy the stock (“put to”) The put option seller is legally bound to buy the stock

from the put option buyer In return, they get the option price from the put option buyer

The Two Parties of a Put Option

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“What is the Put Option Buyer Hoping For?” The put option buyer is hoping that the price of the

stock will go down – a put option buyer is bearish If an option buyer has a put option to sell at $20 and

the price goes to $10, the buyer can sell the $10 stock (“put it to the option seller”) for $20

“What is the Put Option Seller Hoping For?” The put option seller is hoping that the price of the

stock will go up or stay the same – a put option seller is bullish (or at least not very bearish) If the stock stays around $20 or goes up, the put

option buyer will not want to exercise the option and it will expire worthless And the put option seller gets to keep the price of the option

(continued)The Two Parties of a Put Option

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Put option buyer Put option sellerPut Option ContractThe put option buyer wants the price of the underlying stock to go down.He is bearish.No matter what happens to the price of the stock, he can sell it to (“put it to”) the put option seller for $20.

The put option seller wants the price of the underlying

stock to go up.He is bullish.

No matter what happens to the price of the stock, he

must buy it from (“put to”) the put option buyer for $20

if the option is exercised.

$20put

price

The put option contract is tied

to the underlying

stock. It will vary up &

down as the stock varies.

Put Option Example

Pays $1 Gets $1

NedFred

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“Options are confusing, aren’t they?” In fact, the section on options is one of the hardest

parts of the Series 7 Stockbroker exam “Options sound like gambling. I am right?”

Yes. Options are a form of gambling. It is a zero-sum game. Someone wins, someone loses.

A family acquaintance once called me. “Hey, Frank. I hear you can make a lot of money investing in options!”

I said, “Wait a minute. Yes, you can make a lot of money; you can also lose a lot of money. But you can’t invest in options. You can speculate in options. You can not invest in something that has a 60% chance of being worthless in three months! That is not investing.”

Time for Questions on Options

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Strike Price – a.k.a. Exercise PriceThe contract price between the buyer of an option and the seller of the option

The stated price at which you can buy a security with a call option or sell a security with a put option

Listed options traditionally sold in…$2.50 increments for stocks selling for less than $25$5.00 increments for stocks selling between $25 & $200

$10.00 increments for stocks selling for greater than $200

But pricing is more flexible nowThere are some stock options that sell in $1 increments

Option Attributes

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Expiration Date The date at which an option expires Listed options always expire at the close of the

market on the third Friday of the month of the option’s expiration The hour before close of the market on the third

Friday is sometimes called the “witching hour”

Option Attributes(continued)

As well as stock options, there are also stock index options and stock index futures which we will discuss later. When all three – stock options, stock index options, and stock futures – expire

on the same day, then it is called the “triple-witching hour.”

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Exercise Style American options

Can be exercised at any time before the expiration European options

Can only be exercised at expiration

Option Attributes(continued)

Normally, if you wanted to take a profit from an option that had done well and there was still significant time until the expiration

date, you would simply resell the option instead of actually exercising the option. However, with an American-style option, if you really wanted the stock, you could exercise the option and

buy (or sell) the stock before the expiration date. By the way, there are several other types of options with various provisions.

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Go online to www.marketwatch.com Search for the stock and choose [Options] from the

stock menu just above the quote data You can still try finance.yahoo.com

When you are viewing the quote of a stock, choose the Options link on the left hand side of the screen But lately, the quotes for options have been very

unreliable Yahoo! seems to be intent on destroying what is left of their

once-fabulous Finance page. Oh, well …

Quotations of Listed Options

The list of available options contracts and their prices for a particular security is called an option chain.

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Buying & Selling (writing, making) Options Contracts We have discussed options contracts as if they

were traded just as stocks are traded In most ways, they are very similar

But there is one major difference Options are sold as “contracts”

Each contract represents one hundred shares of underlying security

There are no odd-lots on the options exchanges

Options Contracts

So if the listed price of the option is $5, then one contract will cost $500 ($5 * 100 shares). Two contracts will cost $1,000, etc.

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Option Premium The quoted price the option buyer pays to buy a

listed put or call option The seller (a.k.a. writer, maker) receives the premium

immediately and gets to keep it whether or not the option is ever exercised (Did I mention that most options expire without being

exercised? That most options expire worthless?)

Options Contracts

To make it more confusing, the term premium is also used in a more precise manner when valuing options. For this reason, most

people always refer to the price of the option instead of the premium of the option.

(continued)

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Valuations of Options “In-the-money” Call Option

A call option with a strike price less than the market price of the underlying security

Example: Call Strike Price $50 Market Price $54 $4 “In-the-money”

“Out-of-the-money” Call Option A call option with no real value because the strike

price exceeds the market price of the stock Example: Call Strike Price $50

Market Price $47 $4 “Out-of-the-money”

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Valuations of Options “In-the-money” Put Option

A put option with a strike price greater than the market price of the underlying security

Example: Put Strike Price $50 Market Price $46 $4 “In-the-money”

“Out-of-the-money” Put Option A put option with no real value because the

market price exceeds the strike price of the stock

Example: Put Strike Price $50 Market Price $52 $2 “Out-of-the-money”

(continued)

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Valuations of Options: Example Call Option Example (Strike price $50, Option price $10)

Theoretically, for every $1 above the strike price, the call buyer earns a dollar and the call seller (a.k.a. call writer) loses a $1.

Call Option

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Valuations of Options: Example Call Option Example (Strike price $50, Option price $10)

But the previous graph ignored the price of the option. The call buyer had to pay $10 and the call seller received $10.

(continued)

Call Option

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Valuations of Options: Example Put Option Example (Strike price $50, Option price $10)

(continued)

Put Option

Again, theoretically, for every $1 below the strike price, the put buyer earns a dollar and the put seller (a.k.a. put writer) loses a $1.

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Valuations of Options: Example Put Option Example (Strike price $50, Option price $10)

(continued)

Put Option

But again, the previous graph ignored the fact the put buyer had to pay $10 for the option and the put seller (a.k.a. put writer) earned $10.

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Time Premium The amount by which the option price exceeds the

option’s “in-the-money” value In general, the longer the time to expiration, the

greater the size of the time premium If an option is “out-of-the-money,” then the entire

price of the option is due to the time premium

Valuations of Options (continued)

In other words, an option that is “in-the-money” will sell for more than the amount it is “in-the-money” because of the time

remaining until the expiration date. Often, an option that is “out- of-the-money” will still have time value. The option still has time

to become worth more (as the underlying stock price changes).

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And Do Not Forget Commissions! In the previous examples, we did not include the

cost of the commissions A commission is charged whenever an option is

bought or sold Both buyer and seller pay a commission

And a commission is charged when and if the buyer exercises the option and buys or sells the stock Again, both buyer and seller pay a commission

When you include the commissions, it makes it that much harder to make money in options

Commissions on Option Contracts

But if you are a broker, you would simply love to have your clients get hooked on options. P.S. None of my clients trade

options. I would do my best to talk them out of it if they asked to!

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Speculating – You will often hear… “If you feel the market price of a particular stock is

going to move up…” “If you anticipate a drop in price within the next six

months…” “It is a highly risky investment strategy, but it may

be suited for the more speculatively inclined.”

Option Strategies

The flaw in these arguments is this: There has never been a successful method to predict stock prices in the short term. You may “feel” or “anticipate” that the price will go up or down, but

that does not mean that it will. It is not investing, it is gambling. Plus, you may be correct but your option may expire

before you are proven correct.

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Hedging A transaction or series of transactions made to

reduce the risk of adverse price movements in an asset

Hedging can be thought of as insurance And although insurance can be useful in some

circumstances, it is not free You pay for the insurance via the price of the option

and the commissions

Option Strategies

Investors can use hedging strategies when they are unsure of what the market will do. A perfect hedge reduces your risk to

nothing (except for the cost of the option and the commissions).

(continued)

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Hedging Example You own 100 shares of Butterfly.com and it is

currently selling for $50 You are afraid the price will plummet within the

next 3 months to $10 You purchase a put at $50 No matter what happens, you can sell the stock for

$50 … but only until the option expires Then you must go out and buy more insurance

This is called a “protective put”

Option Strategies

Insurance is not free. Using options as insurance is one way to keep your broker very happy. If you are sure the stock will

fall, why not just sell the darned thing?

(continued)

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Straddle The simultaneous purchase (or sale) of a put and a

call on the same underlying financial asset If the price is volatile in either direction, up or down,

you will make money (providing you pass the break-even point for both purchases plus the commissions)

If the stock price is not volatile, you would sell (a.k.a. write, make) the straddle and hope that the price does not change greatly

Option Strategies

Two commissions at the same time! Your broker is gonna’ really love you!

(continued)

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Straddle Example Butterfly.com is selling for $50 but its price is

extremely volatile You purchase a call for $50 and a put for $50

The price of the call option is $4 and the price of the put option is $5

Now, no matter which way the price goes, one of your options will be in-the-money

Option Strategies

But the call cost you $4 and the put cost you $5, so the price has to move at least $9 either way before you break-even. And we did not

include the cost of the commissions. You paid two commissions for the straddle and possibly one more for exercising the option.

Brilliant strategy, huh? Wait, it gets better.

(continued)

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Spread The simultaneous purchase and/or sale of two or

more options with different strike prices and/or expiration dates

Example: Stock selling for $50 Buy a call at a strike price of $50 Sell a call at a strike price of $55 You paid for the call at $50, you got paid for the call

at $55 If the stock price rises, you make money

Option Strategies

The possibilities are endless. And so are the commissions.

(continued)

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Selling Options – a.k.a. Writing Options, Making Options Selling options allows the individual investor to play

the part of the casino You become the Las Vegas casino and the option

buyers are betting against you “More often than not, the option writer is right.” Most options expire worthless

Have I mentioned this yet? No matter what happens, the option seller gets the

buyer’s premium – the price of the option

Option Strategies

If and when I ever begin trading options, it will be as an option writer. But that does not mean you still can not lose big.

(continued)

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Selling Options (continued) Covered Options

Options written against stock owned (or sold short) by the writer

Naked Options – a.k.a. Uncovered Options Options written on securities not owned (or sold

short) by the writer

Option Strategies

The amount of return to the option writer is always limited to the amount of option premium received. But the loss can be substantial, even unlimited in the case of a naked call, a.k.a.

uncovered call.

(continued)

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Selling Options (continued) Covered Call

You own a stock and you are considering selling You write a covered call and receive the premium If the stock price jumps substantially, the stock will

be called away from you (You will be forced to sell) If the stock price stays the same or goes down, the

option will expire worthless And you can then write another covered call

In either case, you get to keep the premium

Option Strategies(continued)

This strategy is only one of two option strategies I personally would ever consider.

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Selling Options (continued) Covered Call Example

You own Butterfly.com and it is currently selling for $50 a share – You bought it at $40 and want to sell

You write a covered call at $55 and receive $500 since the premium for a $55 call is currently $5

If the stock price jumps over $55, it will be called away from you at $55 It is as if you actually sold it for $60 ( $55 + $5 )

If the stock prices stays below $55, you can write another covered call

Option Strategies(continued)

This strategy allows you to make extra money from a stock that you already own. Do you see any disadvantages?

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Selling Options (continued) Naked Put

You are considering purchasing a stock and you have the cash to make the transaction

You write a naked put and receive the premium If the stock price falls substantially, the stock will be

put to you (you will have to purchase it) If the stock price stays the same or goes up, the

option will expire worthless And you can then write another naked put

In either case, you get to keep the premium

Option Strategies(continued)

This is the only other option strategy that I would personally consider.

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Selling Options (continued) Naked Put Example

You are considering purchasing Butterfly.com and it is currently selling for $50 and you have the cash

You write a naked put at $45 and receive a $300 premium since the cost of a $45 put is currently $3

If the stock price falls below $45, the stock will be put to you at $45 It is as if you bought it at $42 ( $45 - $3 )

If the stock price stays the same or goes up, you can write another naked put

Option Strategies(continued)

This strategy allows you to make extra money from a stock that you want to purchase. Do you see any disadvantages?

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Employee Stock Options (a.k.a. ESOs)An option granted to an employee by a company

giving the employee the right to buy shares of stock in the company at a fixed price for a fixed time

Usually have some significant differences from normal call options

Cannot be sold Expire in many years (up to 10 years) Usually have a vesting period (typically 3 to 7 years)

If you leave before the vesting period is over, you lose your stock options

Employee Stock Options

During the tech boom of the late 1990’s, ESOs were used extensively to attract employees to start-up companies.

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Employee Stock Options (a.k.a. ESOs) During the 2000-2002 bear market, ESOs were the

subject of much controversy There is still some fall-out and publicity as

companies and the SEC continue to wrangle over how and even if they should be used

Currently, companies can give ESOs to their employees and not have to pay anything They do not reduce the company’s earnings

Many companies have agreed to expense stock options Unfortunately, how do you come up with a price for

something that is currently worthless?

Employee Stock Options(continued)

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Employee Stock Options (a.k.a. ESOs)To make matters worse, while some people

became fabulously wealthy through ESOs during the Internet mania,

Example: John Moores of Padres & Peregrine fameMany other people were socked with crippling tax

burdens on worthless pieces of paper when their companies collapsed!

How can that be, you ask? The AMT (Alternative Minimum Tax) does not care if you

never exercise the options You still owe the tax on the paper gain

Even if you never were able to realize the gain – Bizarre!

Employee Stock Options(continued)

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“Wait a minute. Did you ask, ‘How do you come up with a price for something that is currently worthless?’” Yes, that is correct. Since many ESOs are “out-of-

the-money”, often by a large amount, or can not be exercised for a long time, or both, how does the company put a price on it?

The financial world currently uses a system called the Black-Shoales Option Pricing Model It may sound impressive, but it is really very silly

In my humble opinion…

Valuations of Options – Revisited

Chapter 16 is devoted to the Black-Shoales model. We are going to ignore it, if you do not mind.

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Example: The Black-Shoales Option Pricing Model Stock currently selling for $7.50 per share Employee stock option has an exercise price of $10

It is currently “out-of-the-money” Plus the option can not be exercised for 3 years The Black-Shoales model might say that the

employee stock option is worth $2.50

Valuations of Options – Revisited

Huh? You can not sell it. You can not exercise it for 3 years. It is “out-of-the-money.” How is it worth $2.50? The stock price

might never go over $10. And if you are unfortunate enough to be affected by the AMT, you might have to pay taxes on it!

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A put or call option written on a specific stock market index, such as the S&P 500 A stock-index option allows an investor to purchase

or sell an option that responds to a stock market index Can hedge a portfolio by purchasing a put on a

stock-index option that represents the portfolio Acts as insurance against a large loss (until it expires)

Over 75 indices represented Large, mid, small cap stocks Domestic, international, regional, country-specific

Stock-Index Options

Whether speculating or hedging, it is still risky and expensive.

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Interest Rate Options Put and call options written on fixed-income

securities such as bonds Currency Options

Put and call options written on foreign currencies Can be an important tool for foreign investors and

multi-national corporations who must periodically convert U. S. Dollars to and from other currencies

LEAPS Long-term Equity Anticipation Securities Long-term options – 9 months to 3 years (?)

Other Types of Options

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A long-lived option that gives the holder the right to buy stock in a company at a price specified on the warrant Warrants are usually issued by the same company

that issues the underlying stock Often as accompanying securities to bonds Or as compensation to employees (like ESOs)

Unlike options where each contract represents 100 shares of stock, one warrant represents the right to buy one share of stock

Warrants are always call options There are no put warrants

Warrants

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Final Comments on Options?

The possibilities are endless, and so are the commissions.(Wait! Let’s hear what Optionetics has to say about options!)

STAY AWAY FROM THEM!

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CHAPTER 15 – REVIEW

Stock Options

Next week: Chapter 14, Futures Contracts

Chapter Sections:Options on Common StocksThe Options Clearing CorporationWhy Options?Stock Index OptionsOption Intrinsic Values and “Moneyness”Option Payoffs and ProfitsUsing Options to Manage RiskOption Trading StrategiesArbitrage and Option Pricing BoundsPut-Call Parity