Oct

12

The Collar Options Trading Strategy

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The Collar
First and foremost, the collar is a maximum protection strategy for a long stock position. The collar is also another options strategy that includes the participation of stock. Perhaps the best way to introduce the collar is to demonstrate its construction.
 
Long Stock + Long put + Short call
 
In a conversion, we look for corresponding options, but with the collar, we are looking in the same month for the put and call but the difference is now we’re not looking at the same strike. In other words, we aren’t looking for corresponding options and most of the time, we will be looking for out-of-the-money long put and short call.
 
Suppose you are in a situation where you are long stock but you don’t want to sell it. You might not be able to sell it for tax purposes or it might be restricted stock. For whatever reason, you need to hold on to the stock and protect what gains you have accumulated. You need to assume a defensive position. However, as you will find out if you take the Options University Mastery Course, that a collar can also be used as an offensive strategy. But for now, let’s examine the defensive collar position.
 
Now, you might be thinking that protection will be an outlay of capital but that is not necessarily true. In a purely hedged position, where you use long puts to balance the Deltas of the long stock, you understand that theta (time decay) will be eating away at the position and affecting the fully hedged position. The Deltas will constantly be changing with each movement of the stock.  In the case of the collar, we add a new component-the short call.
 
When we go long, we buy and there is an outlay of capital. When we short, we sell and there is a credit generated. The idea with the addition of the short call in the collar strategy is that the credits from a short call help to offset the cost of the long put. Yes, we will be giving up the upside potential but we are fully protected at much less cost than buying just all puts. We give up the upside, but we protect what we have at a much cheaper cost than allowing for any potential upside move. By selling calls, we create credits which offset the cost of buying puts. While hedging by being just long puts will provide the position with the ability to capture any upside potential, the collar has limited upside. In this scenario, the collar is purely defensive. Bottom-line, if the market is in a strong correction, the collar is an excellent way to protect our long stock positions.
 
For example, if we are long 100 shares of XYZ and want to put a collar on out position, we would buy one out-of-the-money put contract which would debit our account. Then we would sell one out-of-the money call contract, which would be credited to our account. If the put cost us $1 we would have a debit of $100 and if the call sold for $1.10 we would have a credit of $110 for a total credit of 10 cents per share, which is also the breakeven; stock price minus the credit equals the breakeven. This credit helps span the gap between the out-of-the-money strike of the put and the current stock price. Once the price moves into the money, the long put protects further downside movement.
 
For more information on learning about all things stock options, go to www.optionsuniversity.com

Oct

12

You can place an all-or-none (AON) restriction on your order when Trading Stock Options

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All-or-None (AON)
If you do not wish to get a partial fill, you can place an all-or-none (AON) restriction on your order. This is simply done by checking off the AON box at the order entry screen when you enter the trade. This just tells the market makers to not fill your order unless they can fill the entire number of contracts you requested. While this may sound like a good restriction to place on all orders, there are many drawbacks. First, your order is handled differently and market makers are not required to show your orders to the public if they are marked AON. This means that you may reduce your chance of getting filled. Second, multiple fills are not a possibility with AON orders. For instance, assume you place an order to buy 30 call options for $3. It’s possible that all 30 contracts could have been filled but at different times of the day. However, if you marked the trade AON, then you would get none of them filled unless all 30 could be filled at once. Third, you must ask yourself if a partial fill is really a bad outcome. Will you be upset that you only bought 25 out of 30 call options if the stock really takes off? There are times for AON restrictions but, for most traders, it acts as a hindrance. Also, all option quotes must be good for at least 20 contracts. For example, if you see an option that is bid $2.95 and asking $3.10 then you know that you can sell at least 20 contracts for $2.95 and can buy at least 20 contracts for $3.10. If your order is for fewer contracts than 20, the all-or-none restrictions can only hurt the order. Except for certain circumstances, we wouldn’t consider using an all-or-none restriction for fewer than 50 contracts. But just be aware of the AON restriction as it can be very useful at times.
 
 
Time Limits
In addition to setting a price when entering your order, you must also specify a time limit for which the order is good. This is true for any bid to buy or offer to sell. If you place a bid on a new home and the seller rejects it, he or she cannot come back a week later and force you to accept it. There is only so long that a bid or offer can stand. In the same way, when you place an order to buy or sell stock, you must specify for how long the order is valid. There are two basic choices for time limits: Day Order and Good ‘til Cancelled (GTC). There are two others, which are Immediate or Cancel (IOC) and Fill or Kill (FOK) but those are rarely used, especially if you are new to trading, so we’ll only consider the day order and GTC.
 
 
Day Orders
A day order is good only for the trading day. If you place a day order after the market close, then it will be good only for the following business day. Any market order can only be entered as a “day order” for the fact that market orders are guaranteed to fill. There is no reason that the order would roll over to another day. Most computer programs will automatically select the “day order” time limit if you enter a market order. However, if it doesn’t and you manually select GTC, the order will likely be rejected since it raises questions for the floor traders; they are not sure if you meant to use a limit order or meant to make the time period good for the day.
 
We just found out that a day order is the only acceptable time limit for a market order. However, if you enter a limit order, then the “day” time limit makes the trade only good for the trading day and is cancelled at the end if it is not filled. If you wish to reenter the trade, you must retype a new order and submit it. Rather than go through these motions everyday, the exchanges created the good-til-cancelled order.
 
 
Good ‘til Cancelled Orders (GTC)
Good ‘til cancelled orders may only be used for limit orders. A GTC order can be a handy tool that keeps you from having to retype orders that do not fill. If a GTC limit order does not fill today, it will automatically renew itself the following business day.
 
A GTC order can be good for a period of time not to exceed six months. However, it is up to your broker as to how long a GTC order lasts. Brokers are always allowed to make any rule stricter and most brokers only hold GTC orders for about 60 calendar days (and not trading days).
 
The quantity automatically adjusts if you get partial fills. For instance, assume you place an order for 30 call options at a limit of $3, GTC. If you get 10 filled today, the order will automatically reinstate tomorrow to buy 20 calls at a limit of $3. The time remaining on the new GTC order starts from when you place the original order; the time does not reset because of a partial fill.
 
At the end of the GTC time period, all remaining open orders are cancelled for good. If you wish to continue with the order, you would have to enter a new one, which you could elect to do as GTC again. Brokers generally require this because they do not want orders floating around the books for very long periods of time so that traders forget about them. That’s why most will only hold them for 60 days, which is probably in your best interest. We’ve seen many bad cases where investors forgot about open orders on the books.
 
Due to the rapid price changes of options, most traders use day orders so they know for sure that nothing is open the following day. If you use GTC orders, it’s important to check your account on a daily basis so you are aware of any new fills that may have occurred.
 
 
Stop and Stop Limit Orders
          As you start investing with options, you’ll find there are many types of conditional orders and order qualifiers that help you manage risks. Most of the orders that can be used for stocks can also be used for options. For example, stops, stop limits, all-or-none, not held, or-better, are all types of conditional orders that can be used with stocks and options. We’re not going to cover the numerous types of orders that can be placed with the exception of stop orders and stop limit orders, because there is probably more confusion, even among brokers, about the mechanics of these two orders. Further, there is a subtle difference for the way these orders work for options versus stocks and you need to be aware of that difference.
 
Stop orders are conditional orders to buy or sell “at market.” Your “stop price” is simply a price at which point the trade is "triggered" (technically called “elected”), which makes it a live market order. As with any market order, the execution is guaranteed but not the price. It is crucial to understand that your order will be triggered if the stock trades at or below your stop price.
 
Let’s take a look at an example of how stop orders work by considering a stock position. Assume you purchased 200 shares of Microsoft (MSFT) at $36 and later place an order to sell 200 MSFT at a stop price of $35.
 
This tells your broker that if Microsoft trades at $35 or lower, sell your 200 shares at market. Notice that stop orders convert to “market” orders, which means your shares are sold at the current prevailing price, which may be very different from your stop price. In other words, just because the stop price is $35 does not mean that’s the price you’ll receive for your shares.
 
For example, assume Microsoft closes at $35.50 tonight and then opens tomorrow morning at $27 on bad news. In that case, your stop price of $35 or lower has been reached, the order is activated, and your 200 shares are sold at the market price of $27. If the stock’s price slowly drifts lowers, stop orders can work great. But if the stock gaps down, stop orders may leave you with a large loss. Years ago, stop orders used to be called “stop loss” orders and you will still hear some investors refer to them as such. But as we just demonstrated, stop orders are not at all guaranteed to prevent losses. It is for this reason that the SEC (Securities and Exchange Commission) does not allow professionals to use the term “stop loss” anymore.
 
Stop orders do not in any way prevent losses.
 
Stop orders for options work the same way as they do for stocks with one exception. If you place a stop order on a stock, the “last” trade dictates whether the stop order is triggered or not. If you place a stop order on an option, it is the asking price that triggers the stop order. Once the order is triggered, the option is then sold at the bid price.
 
 
To be continued……………..

Oct

12

Options Trading Chapter 1 Questions

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How Are Options Similar to Stocks?
  • Options are securities.
  • Options trade on national SEC (Securities Exchange Commission)-regulated exchanges.
  • Option orders are transacted through market makers and retail participants with bids to buy and offers to sell and can be traded like any other security.
 
How Do Options Differ from Stocks?
  • Options have an expiration date, whereas common stocks can be held forever (unless the company goes bankrupt). If an option is not exercised on or before expiration, it no longer exists and expires worthless.
·         Options exist only as “book entry,” which means they are held electronically. There are no certificates for options like there are for stocks.
  • There is no limit to the number of options that can be traded on an underlying stock. Common stocks have a fixed number of shares outstanding.
·         Options do not confer voting rights or dividends. They are strictly contracts to buy or sell the underlying stock or index. If you want a dividend or wish to vote the proxy, you need to exercise the call option.
 
Key Concepts
1)      The intrinsic value of an option represents the “immediate benefit” in using the option.
2)      Any value in the option above the intrinsic value is the time value.
3)      In-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value.
4)      At-the-money options carry the highest time value.
5)       You only lose your time value at option expiration. Any intrinsic value must remain.
 
 
Chapter One Questions
 
1)       Call options give buyers the:
a)       Obligation to buy stock
b)       Right to buy stock
c)       Obligation to sell stock
d)       Right to sell stock
 
2)       Put options give buyers the:
a)       Obligation to buy stock
b)       Right to buy stock
c)       Obligation to sell stock
d)       Right to sell stock
 
3)       Option sellers:
a)       Have rights
b)       Receive premiums
c)       Have obligations
d)       Both b and c
 
4)       One option contract generally controls how many shares of stock?
a)       25
b)       50
c)       75
d)       100
 
5)       You bought an Intel $25 call. The “$25” figure is called the:
a) Contract value
b) Moneyness
c) Strike price or exercise price
d) Intrinsic value
 
6)       The intrinsic value of an option represents the:
a) Time value
b) Immediate benefit
c) Contract value
d) Strike price
 
7)       You are long an ABC $40 call. How much will it cost to exercise the call?
a) $40
b) $400                 
c) $4,000
d) $40,000
 
Options Trading Chapter 1 Questions        If you are “long” options:
a) You are not required to ever buy or sell the stock
b) You are required to buy or sell the stock if assigned
c) You are obligated to buy stock at some time
d) You receive premiums
 
9)       Which of the following is true?
a) Long positions get assigned, short positions exercise
b) Long positions exercise, short positions get assigned                              
c) Long and short positions can exercise
d) Long and short positions can get assigned
 
10)   XYZ is trading for $74. The XYZ $70 call is trading for $4.50. What are the intrinsic and time values?
a) $4 intrinsic, 50 cents time
b) $4.50 intrinsic, $0 time                 
c) 50 cents intrinsic, $4 time
d) $0 intrinsic, $4.50 time
 
11)   ABC is trading for $107. The ABC $110 call is trading for $4. What are the intrinsic and time values?
a) $1 intrinsic, $3 time
b) $3 intrinsic, $1 time                       
c) $0 intrinsic, $4 time
d) $4 intrinsic, $0 time
 
12)   An option is bidding $3 and asking $3.20. What does this mean?
a) The highest price that someone will pay is $3 and the lowest price at which someone will sell is $3.20.
b) The highest price that someone will pay is $3.20 and the lowest price at which someone will sell is $3.
c) You can currently buy the option for $3.20 and sell it for $3
d) Both a and c
 
13)   The bid and ask represent the:
a) Lowest bidder and highest offer
b) Highest bidder and highest offer
c) Highest bidder and lowest offer
d) Lowest bidder and lowest offer
 
14)   Microsoft is trading for $29 and the $30 put is trading for $2.50. This put is:
a) $1 in-the-money
b) $1 out-of-the-money
c) $2.50 in-the-money
d) $2.50 out-of-the-money
 
15)   ABC stock is trading for $47. You just purchased an ABC $45 call for $3. If the stock remains at $47 at expiration, what is the amount, if any, you will lose on this option?
                a) $0
b) $1
c) $2
d) $3
 
16)   If you wish to exercise an option, you must:
a) Find a buyer or seller
b) Do so only at expiration
c) Submit assignment instructions
d) Submit exercise instructions
 
17)   The OCC:
a) Guarantees an option’s profit
b) Is the buyer to every seller and seller to every buyer
c) Acts as a mediator for disputes
d) Requires you to become a member before trading options
 
18)   Options trade in units called:
a) Contracts
b) Shares
c) Round lots
d) OCC units
 
19)   The last trading day for options is:
a) The second Thursday of the expiration month
b) The second Friday of the expiration month
c) The third Friday of the expiration month
d) Saturday following the third Friday
 
20)   Because a portion of an option’s value declines over time, options are referred to as:
a) Physical delivery assets
b) Wasting assets
c) Linear assets
d) Cash delivery assets
 
21)   Which “style” are all equity options?
a) Bermudan
b) Asian
c) European
d) American
 
22)   If you sell a put option, you have:
a) The potential obligation to buy stock
b) The potential obligation to sell stock
c) The right to buy stock
d) The right to sell stock
 
23)   If you sell a call option, you have:
a) The potential obligation to buy stock
b) The potential obligation to sell stock
c) The right to buy stock
d) The right to sell stock
 
24)   If you sell an option, you collect a premium. What happens to that premium if you are assigned? 
a) You only keep the premium if you are assigned
b) Option sellers do not receive the premium
c) You keep the premium regardless of whether you’re assigned or not
d) You only keep the premium if you are not assigned
 
25)   If you buy or sell an option, you can escape your obligations by: 
a) Entering a reversing trade in a different month
b) Entering a reversing trade at a different strike
c) Entering the same trade again
d) Entering a reversing trade
 
Answers will be given on the next part of Options 101……

Oct

11

Limit Orders When Trading Stock Options

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Despite the small risk of adverse price movements, if you must get in or out of a trade, then the market order is still your best choice. It is the only way to be sure you are in or out of the trade. However, there may be times when you want to ensure that your buy price does not rise past a certain point or that your sell order does not fall below a certain price. If so, then you can use another type of price called a limit order.
 
Limit Orders
A limit order is one where you specify a price. If you are buying options, your order cannot be filled at a price higher than your limit price. If you are selling options, your order cannot be filled at a price lower than your limit price. But if that limit price cannot be realized, then your order remains open, which means it is possible you never get filled. Limit orders guarantee the price but not the execution.
 
For example, if you place an order to buy 10 Intel $30 calls at a limit price of $3 then the order will only be filled if the market maker can fill it for $3 or less. If your order is to sell the 10 contracts at a limit price of $3 then the order can only be filled for $3 or higher.
 
Most traders use limit orders to buy options at a lower price (or sell it at a higher price) than the current market price. If the Intel $30 call is $3 and you think its price will fall in the near future, you might place a trade to buy contracts at a limit of $2.50, for example. That way you’ll have a standing order on the books if the price should hit $2.50. If the option never hits that price (or lower), the trade goes unexecuted. If you place the order with the limit price equal to the current market price, it is called a marketable limit order. In this example, if you place an order to buy the $30 calls at a limit price of $3, it is called a marketable limit order. This just means that you are willing to pay the current price or lower but will not get filled it if should move above $3 when your order reaches the floor.
 
Limit orders are a great tool for discipline. If you just purchased the 10 $30 calls for $3 and are willing to sell them for $4, you can immediately place an order to sell the contracts at a limit price of $4. The only way the trade will get executed is if the call option’s bid price hits $4 or higher. Limit orders are a handy tool since they allow you to have a standing order on the books, which keeps you from having to watch the prices at every moment of the day.
 
 
Tick Size
            Whenever you submit option orders, there are certain minimum amounts that a price can change. These minimum amounts are called the tick size. Currently, all option orders priced below $3 can be submitted in five-cent increments and all option orders above $3 must be submitted in ten-cent increments. In other words, all option limit orders must fall somewhere on the following list of possible prices:
 
.05, 0.10, 0.15, … $2.95, $3.00, $3.10, $3.20… etc.
 
This means that there is a five-cent tick size for option orders at $3.00 and below and a ten-cent tick size for all option orders above $3.00. If you try to submit an order above $3 in five-cent increments, such as $3.15, it would be rejected and returned to you! At the time of this writing, the Nasdaq has filed to list options trading in pennies, so these tick size rules are likely to be changed in the near future.
 
 
Why Can’t I Guarantee the Execution and Price?
It is important to understand that when you place orders you can either guarantee the execution (market order) or the price (limit order) but you cannot guarantee both. Why can’t a trader guarantee both the price and execution? That would be too good to be true. If we could guarantee both, we would be guaranteed to buy an expensive option for a very low price and guaranteed to sell it for a very high price, which is simply not possible. You only get one choice between price and execution. If you must have the order executed then use a market order and be flexible on price. If you must have a certain price, then use a limit order and accept the risk of not getting filled.
 
 
Or-Better Orders
The price risk associated with market orders leaves some traders uncomfortable, especially if they have a relatively small account and do not wish to risk having to send additional money to pay for a trade. Placing a limit order alleviates this risk, but then you run the risk of not getting filled. Is there some way to blend the two orders? Is there a way we can be reasonably certain of getting filled but, at the same time, not be at risk for a price we find unsatisfactory? Yes – we can do that with an “or-better” qualifier. An or-better qualifier is a type of limit order where your buy price is stated above the current market price and your sell limit is placed below the current market price.
 
For example, assume that the Intel $30 call is trading for $3 and you want to buy 10 contracts but do not want to be totally flexible on price. You could place an order, for example, to buy the 10 contracts at $3.20 or-better. By selecting the or-better designation, in this example, it means that you are willing to pay up to $3.20 per contract even though the current price is $3. This order qualifier gets its name from that fact that you are willing to buy the contracts at $3 or at a better price, which is lower. Some new traders think the “or better” qualifier is suggesting that you will buy the contracts at $3 “or higher” and that’s not true. That would be better for the seller, not you. You’re telling the broker you’ll buy for the $3.20 price “or better” for you. If they can fill the order for $3 they will certainly do it.
 
By using the or-better qualifier, if the price should move up a bit after you send the order, at least you’ll get filled assuming the price doesn’t move above $3.20. The or-better qualifier allows for some price fluctuation between the time you send the order and the time it is filled. Of course, this is still a type of limit order so it is possible (although less likely) that you will not get filled. By using the or-better qualifier, you have a much better chance of being filled as compared to a trader that places a marketable limit at $3 per share.
 
You can use or-better qualifiers on the sell side, too. If the Intel $30 call is $3 and you place an order to sell 10 contracts for $2.90 or-better, you could get filled for any price of $2.90 or higher. The or-better designation on the sell side just tells the broker you’re willing to take less than the current market price if necessary to get the trade executed.
 
When entering an or-better order online, most firms require that you check off a little box that says “or better” at the order entry screen so they know that you are willing to buy above the current price (or sell below the current price). The reason they require you to check off the box is because, otherwise, they’re not sure of your intentions. For instance, if the current price is $3 and you place an order to buy for $3.20, it appears that you might be trying to sell the option (since most traders will place a limit order above the current price if they are selling). By checking off the or-better box, it lets your broker know that you are not making a mistake in the order and that you are, in fact, willing to buy at a higher price than the current market price. If you do not see a check-box for the or-better qualifier, you can just enter the order and you will likely get a pop-up message that states something like this: “You have entered an order to buy at a price above the current market. If you wish to place this trade, it will be entered as an or-better order.”
 
Some traders find or-better orders a little unsettling to use. They feel that the market makers will take advantage of them and fill the order at the higher price. That’s not true since the market makers are bound by the time and sales, which is a recording of all sales (trades) and the times they occurred. Market makers cannot arbitrarily fill your order at the higher price just because you’re willing to pay it. They could only do so if the time and sales recording shows that was the going price for the option at the time your order was filled.
 
Another fact about limit orders is that you are really stating to buy or sell up to that many contract at the limit price. If you place an order to buy 10 Intel $30 calls, you could get filled for any number of contracts up to and including 10. If your order is filled for fewer contracts than you requested, it is called a partial fill.
 

To be continued……

Oct

10

Automatic Exercise When Trading Stock Options

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Automatic Exercise
While we’re on the topic of exercising options, there is a procedure that, while intended to be beneficial, can be potentially detrimental if you are not aware of how it works. That procedure is automatic exercise and the way it works is this: If an option is at least five cents in-the-money (one cent in-the-money for index options) at expiration, the OCC (Options Clearing Corporation) will automatically exercise the option for you unless you instruct your broker otherwise.
 
For example, if you buy one ABC $50 call and the stock closes at $50.05 or higher on expiration Friday then that call option will be automatically exercised. You will be long 100 shares of ABC on Monday and your account will be debited for a total of $50 strike * 100 shares = $5,000 cash. Even if you do not have the cash in the account, the transaction will still occur and you would be required to either deposit cash or sell securities in the account to raise the cash. If you decide that you do not want the ABC shares, you could simply sell those shares and not have to come up with the cash. Incidentally, if you sell the ABC shares on Monday, you would not be required to deposit the 50% Reg T requirement that is normally required for any stock purchase. Any time you purchase stock in a margin account, you must deposit at least 50% of the stock’s value (subject to a $2,000 minimum). Automatic exercise is the only time investors are exempt from Reg T. However, the exemption only applies if you sell the shares on Monday (or the following day if Monday happens to be a holiday).
 
            Automatic exercise was designed to benefit the investor just in case you overlooked an in-the-money option at expiration. Presumably, you are better off from exercising the option rather than letting it expire unexercised but, as we will show, that is not always the case. In our example, your account would be debited $5,000 (plus commission) and, in exchange, would be credited with 100 shares of ABC worth $5,005. However, you are only better off at that instant as there’s nothing that states the stock must open at $50.05 on Monday morning. There have been many cases where investors gain shares of stock through automatic exercise only to see the price fall considerably on Monday morning thus leaving them worse off.
 
            Automatic exercise applies to put options as well. If you buy one ABC $50 put and the stock closes at $49.95 or lower on expiration Friday then you will sell 100 shares of ABC stock and will be credited with $5,000 cash. If you do not own ABC shares then your broker will create a short stock position in your account. In this case, if the stock price gaps higher on Monday morning you will be worse off from the automatic exercise.
 
            The most significant point to understand is that if you do not want any option (or all options) to be subject to automatic exercise then you must contact your broker and inform him of your intent. You can place these instructions monthly or on a permanent basis. Just because an option is out-of-the-money at 3:45pm does not mean that it will remain that way through the close. If you do not want any surprises on Monday morning, be sure to contact your broker before expiration Friday with your clear instructions.
 
Types of Option Orders
Once you decide to buy or sell an option, you must place an order online or with a broker. When we discuss strategies, we’ll show you specifics on how to enter the orders but for now we want to get some of the terminology out of the way. It is crucial that you understandthe many terms associated with placing orders, especially in today’s market where most people place trades online and there is no interaction with a broker. While trading online does provide you with a greatly reduced commission, the drawback is that you are 100% responsible for the trade. If you are not fully aware of what a particular order or qualifier means, you could end up with a very different outcome than what you were expecting.
 
Making the Trade
Whenever you buy or sell options, you must specify five basic pieces of information:
  • Action (Buy or Sell)
  • Quantity (Number of contracts)
  • Symbol
  • Price (Market or Limit)
  • Time (Day or Good-til-Cancelled (GTC))
 
The action, quantity, and symbol are all straightforward and really don’t need any detailed explanation. These fields simply tell your broker whether you wish to buy or sell, how many contracts, and of which option. But the price and time fields are the ones that create the most questions – and unexpected surprises – for new traders, so that’s what we’re going to focus on. Each of the possible orders carries a different set of possibilities and, depending on the situation, one will probably be a better choice than the other. We’ll go through each so that you understand them fully.
 
Price
When you place an order to buy or sell, you must provide some information about the price at which you’re willing to make the deal. There are two ways to provide price information: market order or limit order.
 
Market Order
A market order guarantees that your order will be filled but does not guarantee the price at which the transaction will be made. If you place an order to buy five $30 Intel calls “at market,” then you know for sure that you have purchased the five calls. But in order for this transaction to be guaranteed, it means that you must be flexible on the price. The reason you must be flexible on price is because option prices can change nearly every second of the day; they do not stay constant throughout the day like prices at a retail store!
 
If the option is trading for $3 when you place your order, it’s quite possible that your purchase price will come back at a different price (whether higher or lower) than $3 even though it may only take a few seconds for the trade to get filled. When you place a market order, you’re really stating that you want to be filled at the best price (which is the prevailing price at that moment) when your order reaches the trading floor. The simplest way to describe a market order is this: A market order guarantees the execution but not the price.
 
New traders often wonder why they cannot guarantee that the deal goes through at a predetermined price. After all, whenever you buy a house or car, you can guarantee the deal at a stated price. The reason for the apparent inconsistency is due to the fact that the stock market is one continuous live auction where traders place bids to buy and offers to sell. The stock’s price (and therefore the option’s price) depends on the supply and demand of the stock at that moment in time. If you place an order “at market,” you’re telling the broker to fill the order but the price at which the order is filled depends on the time your order arrives. There is no way to be sure to get the contracts while also stating a maximum or minimum price. Think about it this way: Imagine that you are a buyer for a multi-millionaire who sends you to an auction to purchase a specific Picasso painting. There is no way he can tell you to definitely come back with the painting but, at the same time, not to spend more than $10 million. If you must buy something at an auction, you must be flexible on price.
 
Multiple Fills
If you place a market order, it is possible that the order comes back filled at multiple prices. This just means the traders were only able to get a certain number of contracts at one price and had to fill the balance at one or more prices. For example, assume Intel $30 calls are trading for $3. If you place an order to buy 10 $30 calls at market, it is possible that your order comes back as follows: bought 7 contracts at $3 and bought 3 contracts at $3.10. When you are filled at more than one price, it is called a multiple fill. These happen for the sheer fact that market orders must fill and, just as there’s no guarantee on the price, there’s also no guarantee that the price will be the same for all contracts (or shares for that matter) traded.
 

To be continued……

Oct

9

The Stock Settlement Process

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Continuing with our previous example, if you want to own the stock as of a June 10 record date, you need to purchase it on June 7 or before. If you purchase the stock on June 7, the stock transaction will settle on June 10 and you will be owner of record as of June 10. If you purchase the stock on June 8 or later, you will not be owner as of the record date. In this example, June 8 would be the ex-date. Now you can see where all the confusion comes from. It all has to do with the timing of the settlement period. Many investors think that you just need to purchase the stock on or before the record date in order to collect the dividend, and that is not true. You must purchase the stock three full business days before the record date.
 
The ex-date is an artificial creation by brokerage firms to mathematically figure out the purchase date that makes you owner by the record date. In the previous example, we figured out that June 8 would be the ex-date. If you purchase on June 8 or later, you will not be owner of record by June 10 and will not get the dividend. (Of course, you would be entitled to the following dividend assuming you were still holding the stock.)
 
Corporations are not stockbrokers and they are not, in many cases, even aware of the three-business-day settlement period. They only publish the record date. This is why most corporations will not even be able to tell you when the ex-date is even if you call their investor relations department. Hopefully you see how much easier it is if you just focus on the ex-date, which you may have to call your broker to get.
 
Now that you understand the stock settlement process, adding call options to the picture is not difficult. If you have a call option and wish to exercise it in order to collect a dividend, you must exercise the call the day before the ex-date. This is exactly the same as if you were buying the stock in the open market. In our example, that would be June 7. Once you submit exercise instructions, the Options Clearing Corporation (OCC) has you listed as of that date. If you submit exercise instruction on June 7, the OCC recognizes that you bought stock on June 7 and it will settle on the June 10 record date. This is sometimes referred to as “E+3” settlement, which just designates that the settlement date is “exercise date plus three business days.”
 
Does It Really Matter If Stock Holders Get the Dividend?
While some stock investors are adamant about collecting a dividend, it doesn’t really matter mathematically if you get the dividend or not. Many new to investing find this hard to believe. After all, it certainly seems like you’d be better off buying the stock and getting the dividend rather than not getting the dividend.
 
The reason there is not a mathematical difference is that the stock price is reduced by the amount of the dividend on the ex-date. We saw this effect when we explored stock splits and stated that any payment made by the company must be deducted from the price of the stock. Whether the company pays stock dividends (stock split) or cash dividends, the stock price must be reduced.
 
For instance, say a stock closes at $100 on June 7 and is scheduled to pay a $2 dividend with the ex-date being June 8. On June 8, the stock will open at $98 unchanged to reflect the $2 dividend that was paid. The reason the stock will show its price as unchanged is because the drop in price from $100 to $98 was due to the dividend and not changes in supply and demand for the stock.
 
Let’s compare two investors each starting with $100 cash in their account. One buys one share of stock before the ex-date and another buys one share on the ex-date.
 
The investor who buys before the ex-date will pay $100 for the stock and receive a $2 dividend. The stock, however, will trade for $98 on ex-date and the total value of the account will still be $100 ($98 in stock and $2 in cash). This investor is down $2 in the value of the stock, which is offset by the $2 dividend.
 
The second investor buys the stock on ex-date will only pay $98 for the position and not receive the dividend. While he did not receive the $2 dividend, he paid $2 less for the stock. His account has stock worth $98 and $2 in cash. Both investors are holding $98 in stock and $2 in cash so it doesn’t really matter mathematically whether they get the dividend or not (although there could be tax benefits to one choice over the other).
 
Rules Violation: Selling Dividends
Many brokers take advantage of investors by touting an immediate return on your money by purchasing stock just before the ex-date. Using the previous example, a broker may call saying if you buy this stock for $100, you will get an immediate 2% return on your money the very next day. By now you should see why this is not true.
 
If you buy the stock for $100, it will be worth $98 the next day and you will have $2 in cash for a total position value of $100, which is neither a gain nor loss. If this were really an immediate return of 2%, the total position would be worth $102 the following day.
 
Further, buying the stock just to get the dividend is a bad idea for tax reasons. If you buy one share of stock for $100, you are paying with after-tax dollars; you do not owe taxes on the $100. However, if you buy the stock, the very next day your position is still worth $100, yet you owe taxes on $2. Basically, the dividend represents an immediate taxable return of capital (where previously there was none) and not a return on your money.
 
For these reasons, the NASD (National Association of Securities Dealers) prohibits brokers from selling you stock solely for the reason of getting the dividend. Obviously, if the broker thinks the stock is going to be much higher in the next day or two and recommends buying it for that reason, that’s okay. They just cannot sell you the stock based solely on the immediate return of the dividend. If they do, they are guilty of “selling dividends” and in violation of NASD rule 2830, which states:
 
NASD Rule 2830 (e): No member shall, in recommending the purchase of investment company securities, state or imply that the purchase of such securities shortly before an ex-dividend date is advantageous to the purchaser, unless there are specific, clearly described tax or other advantages to the purchaser, and no member shall represent that distributions of long-term capital gains by an investment company are or should be viewed as part of the income yield from an investment in such company’s securities.
 
This NASD rule is further proof that collecting a dividend is not mathematically better for an investor who waits until after the ex-date to purchase the stock. The only reason to exercise a call option early is to collect the dividend in order to offset a (usually) small loss, and even that must be questioned when you consider all of the other negative features that are attached with early exercise.
 
 
A Real Life Example
The following is an excerpt from a Business Wire news article. Notice that they mention the payable date, record date, and ex-date.
 
FAIRFIELD, Conn.–(BUSINESS WIRE)–Dec. 14, 2001–The Board of Directors of GE today raised the Company’s quarterly dividend 13% to $0.18 per outstanding share of its common stock and increased its share repurchase program to $30 billion from $22 billion.
 
“GE has paid a dividend every year since 1899,” said GE Chairman and CEO Jeff Immelt. “Today’s increases, in both our dividend and our share repurchase program, signal our confidence in our ability to extend this track record of returning value to shareowners.”

The dividend increase, from $0.16 per share, marks the 26th consecutive year in which GE has increased its dividend. The dividend is payable January 25, 2002, to shareowners of record on December 31, 2001. The ex-dividend date is Thursday, December 27.
 
If you own a call option and wish to receive an upcoming dividend, you should wait as long as possible and exercise the call option the day before the ex-date date and no sooner. If you’re unsure as to when that date is, ask your broker. Also remember that collecting a dividend doesn’t really change your overall portfolio value since the value of the stock is reduced by the dividend. If you do exercise that call to get the stock, you’re letting go of the downside protection that call options provide, which is usually a bigger benefit than the value of the dividend. However, for those times that you wish to get the dividend, especially a large one-time payment, make sure you understand the mechanics of the ex-dividend date otherwise you may end up missing the payment simply due to the mechanics of the market. When we get to Chapter Five, we’ll talk about synthetic positions and show you a potentially better way to collect a dividend.
 
To be continued……

Oct

8

Mechanics of Exercising a Call to Collect a Dividend

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Put Options
Hopefully you’re now convinced that exercising a call option early is not a healthy decision for your account. However, the opposite may be true for put options. For puts, if the stock is sufficiently in-the-money, then it does make sense to exercise early. Why the difference between calls and puts? When you exercise a call, you receive the risky stock and give up the secure cash. With puts, however, you get rid of the risky stock and receive cash. It’s the opposite set of transactions, so it has the opposite characteristics.
 
Imagine that you are holding stock along with a $50 put that you bought as insurance. The stock is now $35 and you see no hopes of it moving above $50 before expiration. If you did, you’d be better off holding the stock hoping that it shoots above $50 and letting the put expire worthless. But if you don’t see the possibility, then you have two choices: Exercise now and collect the money or exercise at expiration and collect the money. Obviously, take the money now. What stock price is satisfactory for early exercise? Mathematically, it will occur where the delta equals one, where the put is gaining dollar-for-dollar with each fall in the stock’s price. Of course, this doesn’t mean you must wait for the delta to equal one in order to exercise, but it should serve as a precautionary check. Even though you may not think that the stock has a chance of coming back, the delta may reflect something different. Delaying the exercise of a put only costs you the interest that you could have earned on the cash; you will always be able to get the strike price no matter how long you wait. And if interest rates are low, there’s not much of an advantage to exercising the put early. So if you’re in doubt about exercising the put option early, check the delta. If it’s not close to one (say 95 or higher), then you’re probably better off waiting.
 
For example, assume you are holding 100 shares of stock plus a $50 put with three months to expiration. The stock has fallen to $45 and your broker pays you 3% on cash balances. You decide to exercise early, sell your stock and take the $5,000 today, which will then earn interest and grow to $5,037 in three months. However, at a later time, the stock is trading for $51, which means you would have been better off holding the stock and letting the put expire worthless. In fact, we can even calculate a breakeven point for the decision. If the best you can do is $5,037 in three months with the cash, where does the stock’s price need to be at expiration to make the two choices equal? It needs to be at $50.37. At a stock price of $50.37, the $50 put is worthless and we can sell the stock for $5,037, which is exactly what we’d have from exercising early and earning interest. If you think the stock has a decent chance of rising to $50.37 by expiration, you’re probably better off to not exercise the put. Remember, you will always be able to get the $5,000 by exercising the put. The only difference is that you may collect something less than the $37 of interest if you delay your decision, which should obviously not be a critical point. On the other hand, if interest rates are high and you have 20 $100 puts, then that’s a different story. Just always be aware what the tradeoffs are and make your choices appropriately.
 
We’ve shown that exercising a call option early is never to your advantage with the exception of collecting a dividend. If that’s true, then why are so many traders tempted to do so? It is usually the result of strong desire to pay a low price for the stock that is trading relatively high above the strike. For example, if a hot stock is suddenly trading for $65 and you’re holding the $50 call, it just seems like you should take advantage of that “deal” before the stock falls. And it’s that mindset that causes traders to buy the stock while not realizing exactly what happened in the exchange. If you want to buy the stock, you can either pay $65 or pay $50 by exercising the call. The higher the stock price is above the strike, the better the deal. So once the stock seems to be getting relatively high, many traders erroneously think they had better exercise to take maximum advantage of the call option. But they never realize that they just increased the downside risk – and paid money to do so. Even with something as simple as exercising a call, traders can stumble in making the right decision. This is why it is so important to understand profit and loss diagrams, the price behavior of options, and market mechanics if you’re going to get involved in options. What appears to be a simple decision can easily be clouded by a number of factors that are not so easy to see.
 
There are many persistent myths in options trading. They survive because many of the technicalities seem so obvious that it’s hard to change our perception. Early exercise is perhaps one of the most difficult viewpoints to shake. Hopefully, this section has changed your perception.
 
Mechanics of Exercising a Call to Collect a Dividend
We previously learned that it is not optimal to exercise a call option early in order to gain the stock with the exception of collecting a dividend.
 
If you wish to collect a dividend you must exercise the call to gain control of the stock and only then can you get the dividend. However, you cannot just exercise it at any time and be assured of getting the dividend. The reason is that the dividend is only paid to those stock holders as of a specific date called the record date. If you are the owner of stock after the record date, you will not receive the dividend. For this reason, it is important to understand the mechanics of how dividends are paid and when to exercise the call option if you should decide to collect a dividend.
 
As with any exercise of a call, you do not want to exercise it any earlier than you must, and this standard still applies when exercising to get the dividend. Exercise too early and you’ll expose yourself to unnecessary downside risk. At the same time, if you exercise too late, you will miss out on the dividend. The key to collecting the dividend is to exercise the option on the correct date. In order to understand when that correct date is, you must understand the ex-dividend date.
 
What Is the Ex-Dividend Date?
The ex-dividend date, also called the ex-date, is the date the stock trades without the dividend. Just remember that “ex” means “without” and you will not be prone to one of the most common mistakes made by investors and brokers.
 
For example, let’s say a stock is about to pay a dividend and the ex-date is June 8. If you buy the stock on June 8 or later, you will not get the dividend. Remember, “ex” means without. If you buy the stock on the ex-date (or later), you are buying the stock without that dividend. On the other hand, if you buy the stock on June 7 (or earlier) you will get the dividend. On the flip side, if you sell stock on the ex-date or later, you will get the dividend. If you sell stock before the ex-date, you will not collect it. If investors would just focus on the ex-date, it is very easy to determine who gets the dividend and who does not.
 
Why Is There So Much Confusion in Practice?
Although it appears to be an easy task to figure out who gets the dividend, many investors find that it’s not so easy. Many times they buy the stock in anticipation of the dividend only to find that they are not entitled to it. The reason for the confusion is that when a dividend is announced, there are usually three dates associated with it:
 
·         Record date
·         Payable date
·         Ex-date
 
Corporations usually only publicize the record date and payable date in newspapers, financial websites, and television shows. The record date is the only date that matters to the company. Before the company pays the dividend, they look up a list of names of all investors who are owners of their stock as of the record date and pay the dividends to those names. Using the previous example, if a company announces a June 10 record date and your name is on the list, then you get the dividend. The payable date is when the payment is actually made, which may be a week or more after the record date. They may announce, for example, that they will pay a 20-cent dividend to all stock holders as of record of June 10 and payable on June 15.
 
Here’s where the confusion sets in for most investors… 
 
In order to be the owner of record, the stock transaction must be settled by the record date. There is currently a three-business-day settlement period, which is also called “T+3” settlement and stands for “trade date plus three business days.” In order to find the settlement date, you just add three full business days to your purchase date, not counting the trade date. For instance, if you buy stock on Monday, it will settle on Thursday since Thursday is three full business days from the trade date (assuming none of the days in between are holidays). If you buy stock Wednesday, it will settle on Monday.
 

To be continued……

Oct

7

Exercising a Call to Collect a Dividend When Trading Stock Options

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Let’s take a look at a real example. Below are actual option quotes on September eBay calls with 32 days to expiration. The last trade on the stock is $79.21:
 
Strike
Bid
Ask
$70
9.90
10.10
$75
5.90
6.10
$80
2.90
3.00
 
If you were holding the $70 call and exercised early, you’d receive stock worth $79.21 by paying $70, which nets a gain of $9.21. However, if you just sold the call, you’d get the bid of $9.90, which is certainly better than $9.21 and it keeps you from holding the downside risk of the stock. If you were holding the $75 call, you’d gain $4.21 by exercising early but $5.90 by selling to close. As an extreme example, if you were holding the $80 call and exercised, you get stock worth $70.21 by paying $80, which leaves you in for a loss of 79 cents. Selling the $80 call to close, though, would bring in $2.90. It doesn’t matter how you cut it; it does not pay to exercise a call early. Early exercise only causes you to lose the time premium and take additional risk by holding the stock.
 
If that’s not enough to convince you, there is yet a third reason for not exercising a call early: You are giving up the time value of money. If you exercise 10 $50 calls that have three months remaining on them, you will pay $50,000 today in order to gain that stock. If, instead, you wait until expiration, you’ll hold on to that $50,000 for an additional three months on which you’ll earn interest. In either case, your purchase price does not change, so there is no rush to pay for it early.
 
 
Mathematical Examples
So far, we have covered three rationales for not exercising early:
1)      Increase your risk
2)      Discard the time value in the option
3)      Lose interest by paying for the stock early
 
While these are pragmatic arguments, there are some people who like to see the math behind the arguments. While mathematical proofs are convincing, they are often difficult to follow. But for those who are mathematically inclined, we’ll show you a mathematical proof for not exercising early.
 
Start by considering two traders. One holds the stock while the other holds a call option plus some cash. How much cash does he hold? He holds just enough so that, after the interest has been paid on that cash balance, he will have exactly the amount of the strike price. For example, if interest rates are 5% and the trader is holding a one-year $50 call, then he would need to hold $47.62 in cash. In one year, he will have $47.62 + 5% interest = $50 in cash. He could then take this $50 and buy the stock by exercising his call option. This amount of cash is the present value of the $50 strike. While the trader must pay $50 to exercise the call in the future, that payment is worth only $47.62 today if interest rates are five percent. If, instead, he were holding a three month, $50 call he would need $49.38 in cash since that amount would grow to $50 in three months at five percent interest. The two important points to understand are:
 
1) The cash held by the trader will always equal the exercise price at expiration.
2) The amount of cash necessary to hold is always less than the exercise price.
 
Keeping these points in mind, the two portfolios are as follows:
 
Trader #1: Stock
Trader #2: Call option + present value of the exercise price in cash
 
Now, at expiration, the value of the first trader’s position is always the value of the stock, which we can write as Trader #1 = S. No matter what happens to the stock’s price, Trader #1 is always worth S at expiration.
 
What about Trader #2? At expiration, this trader will be holding a call option plus cash that has grown to the exercise price, or +E. This trader has a choice. If the stock’s price happens to be above the strike price, then the second trader will exercise the call and will pay the exercise price, -E. His portfolio with then be worth S – E + E = S. In other words, no matter how high the stock’s price might be trading, Trader #2 can always gain the stock by simply paying the exercise price. That is, Trader #2 can always match the performance of Trader #1 for high stock prices.
 
However, prior to expiration, Trader #2 has cash that is worth Pv (E). This means that if he exercises early, his portfolio is worth (S-E) + Pv (E), which is less than S. (Remember, the Pv (E) is less than E so S-E + Pv (E) must result in a number less than S.) So if the second trader exercises early, he underperforms Trader #1. This means the second trader is better off not exercising until expiration.
 
Also notice what happens to the second trader by keeping the present value of the cash as long as possible. If the stock should fall below the strike, the second trader loses the value of the call but always has the cash. In the worst case, the stock could become nearly worthless, but the second trader will always walk away with the full exercise price in cash. We can’t say the same for the first trader. He will have lost everything.
 
We could also view the early exercise error in another light. Let’s say the second trader exercises early and does not have the cash in the account. He would need to borrow the exercise price and will owe the future value of the exercise price (E + interest). He buys the stock on borrowed funds, which means his portfolio is immediately worth S – future value of E after the exercise. However, this value is always less than the value of the call, since an in-the-money call must be worth at least S – E at any time. Remember, the future value of E is a bigger number than just E. Therefore S – future value of E must be a smaller value than S – E. Our goal is to make our positions worth more money, not less. By exercising early, the trader decreases the value of the call.
 
Hopefully you’re convinced that it is not to your advantage to exercise a call early. But it is still one of the biggest mistakes in option trading. While working for an active trading team for a large firm, I received a call from a client who had an account value of $124,000 at the close of trading and $120,000 the very next morning. All of his stocks were basically unchanged and certainly not down enough to create a $4,000 shortfall. He wondered what happened to the money. I found out that he exercised 10 call options the day before. When I looked up the previous day’s quotes, I found those options had four points of time premium in them. By exercising the 10 calls early, he literally threw away the $4,000. There is no way to get that money back. It’s gone for good.
 
 
Exercising a Call to Collect a Dividend
The previous section showed that exercising a call option early for the sole reason of gaining the stock is never to your advantage. However, exercising a call to collect a dividend is a viable strategy despite the fact that it is designed to offset a loss and not for a financial gain. To understand why, consider a simple example where the option is trading at parity (intrinsic value). Assume that the stock is trading for $50 and pays a $1 dividend. You own a $40 call that is trading at parity for $10. The day the dividend is paid, the stock price drops to $49 and the call option immediately becomes worth the $9 intrinsic value, which causes a $1 loss in value for you.
 
If you exercise the call, you will receive stock worth $50 and pay $40, so you will gain $10 of unrealized value. When the dividend is paid, your stock position becomes worth $49 but you also collect the $1 dividend, which still provides $10 of value for you ($9 unrealized plus a $1 dividend). So if you do not exercise your option, your value falls from $10 to $9. If you exercise the option, you maintain the $10 value. If you wish to collect a dividend to offset a loss, then only do it if the value of the dividend exceeds the time value of the call you are sacrificing.
 
Despite the advantage of collecting a dividend, you must consider whether offsetting a small loss is worth holding the downside risk of the stock.
 
 
Do not exercise a call option early except to capture a dividend. Even in this case, be sure the size of the dividend is worth letting go of your downside protection!
 
 

To be continued……

Oct

6

Early Exercise on a Non-Dividend Paying Stock When Trading Stock Options

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Open interest is generally used as a liquidity guide for trading purposes, especially if you are placing large dollar amounts into a particular option. For example, McDonald’s is currently $29.02 and the July $30 call (one week to expiration) has an open interest of 6,692, which is a relatively large number when comparing absolute open interest figures. It might appear as though this option is very liquid. However, a better method is to take the 669,200 shares that it represents and multiply it by the market price of the option. Whether you use the bid, ask or last trade usually won’t make a huge difference unless there is a very high bid-ask spread. The asking price on this July contract is five cents. In terms of total dollars represented in the contract, that’s only 6,692 open interest * 100 shares per contract * $.05 = $33,460, which by market standards is not too liquid.
 
Conversely, the Nasdaq 100 Index (NDX) is currently trading around 1,550 with the December $1,550 call trading about $108 (yes, this index is extremely expensive due to the volatility!). There open interest is “only” 1,578, which doesn’t appear to be too liquid, especially when compared the 6,692 for McDonald’s. But if we take 1,578 * $108 * 100, we see there is more than $17,000,000 represented in this option. When you compare this number to the $33,460 in the McDonald’s contract, you can see that total dollar value is probably a better measure of true liquidity in an option. If you are placing a large order, you may wish to check the open interest figure to gauge the liquidity. In other words, if your order is substantially large relative to the amount of contracts at that strike, it is possible that your order could significantly move the market price. If that looked possible, we would say the option doesn’t appear to be too liquid. This is why many traders wish to check the actual number (by looking at the open interest column) as well as the total dollars represented in that option.
 
However, despite the apparent justification for checking open interest, you must realize that market makers and others stand by ready, willing, and able to provide liquidity. Just because an option may appear to be illiquid does not mean that it is. Chances are any order will get executed quickly and within reasonable limits of the current price. The reason we make this clarification is because we find that many new traders get caught up in deciding if the open interest is sufficiently large for their order. Unless you are entering an order for 50 or more contracts, we wouldn’t even suggest considering the open interest; it’s just not going to matter.
 
 
Early Exercise
Equity options (options on stock) are an American-style option, which means they can be exercised at any time prior to expiration. To many traders, the exercise restriction that comes with European options seems like a negative feature. It seems sensible that there must be times when you would like to exercise a call option early to gain the stock. For example, what if you’re holding a call option and the stock makes a sudden large move up above the strike price? Wouldn’t it be to your advantage to exercise the option and then sell the stock for a sure profit? Many traders believe this, so they do it every day. But it is one of the biggest mistakes in options trading. Traders who exercise call options early end up with more risk while literally throwing money away, which is certainly not a winning strategy. When the drawbacks to early exercise are mentioned in many of our seminars, it is often met with heated debates but the participants quickly find that there are better choices once we give a few examples. The point is that it is instinctual at times to want to exercise a call option early but it is, in most cases, the wrong move to make.
 
To further confuse the early exercise issue, traders who exercise put options early may actually be better off at times. This section fully explains the differences to make sure you are not throwing money away due to illusory beliefs about options and early exercises.
 
 
Call Options
With only one exception, we can say that it is never advantageous to exercise a call option early. The exception would be for those investors who wish to collect an upcoming dividend on a stock. Because option holders do not collect dividends, if they wish to collect it, they must exercise the option in order to take control of the stock. However, most dividends are relatively small and are usually not worth the risk of holding the stock – even if just overnight. For the few times when early exercise might be warranted, we’ll show you when to exercise in the next section.
 
For now, let’s just concentrate on why it’s usually not in your best interest to exercise a call option early if no dividend is being paid.
 
 
Early Exercise on a Non-Dividend Paying Stock
We’ll compare two investors: One buys stock for $50 while the other buys a $50 call for $2. There is no limit as to the amount of money that either trader could make. Each trader’s windfall depends on how high the stock’s price rises above $50. Of course, the call option trader’s profit will always be $2 less than the stock holder since the call trader pays $2 for the right to buy stock at $50, which would make his cost basis $52 if he uses the call to buy the stock. But aside from that difference, both traders have unlimited upside potential.
 
If the stock is trading for $60 at expiration, the stock holder makes $10 while the $50 call is worth $60 – $50 = $10 as well. After subtracting the $2 cost, the $50 call trader makes $8. No matter how high the stock’s price may rise above $50, both traders continue to profit dollar-for-dollar with the underlying stock near expiration. At no point near expiration is one trader better off than the other when considering stock price increases. But now let’s look at the downside, that is, for all stock prices below $50. If the stock falls, the stock holder loses dollar-for-dollar all the way down to a stock price of zero. The $50 call holder, on the other hand, can only lose $2, so there is a very big difference in the way the $50 call and long stock positions behave for decreasing stock prices. Call options have a very small, limited downside risk (the price paid for the option) when compared to that of the stock trader. At expiration, call options win dollar-for-dollar to the upside, but do not lose dollar-for-dollar to the downside.
 
The second chapter showed that this asymmetrical property is one of the main reasons that traders buy calls in the first place. In other words, traders buy call options to avoid holding the risky stock. Traders are naturally drawn to this beneficial feature of calls. They should be. Short-term traders and speculators survive by using stop orders or other types of risk-management techniques and the asymmetrical payoffs of call options provide an automatic risk management tool; the most you can lose is the amount you paid for the option.
 
Traders are completely disregarding this benefit when they exercise a call early. Once you submit exercise instructions, you are swapping the call option for the stock and are now accepting the full downside risk of the stock. That alone should be enough to convince you to not exercise a call early. But there’s more to the early exercise story than just increasing your downside risk.
 
The second part has to do with the time value remaining in the option. Chapter Two (Pricing Principle #3) showed us that an option’s price must always contain the intrinsic value, or S – E. However, prior to expiration, the call option must be worth at least S – E plus some time value (Pricing Principle #4). When you exercise an option, you are only left holding the value between the stock and exercise price, or S – E. For example, if the stock is $53 and you exercise a $50 call, you are better off by $3. However, we know that the option’s price must be worth more than $3. So if you just sell the call rather than exercise it you would be better off.
 
By exercising a call option early, not only do you accept full downside risk in the stock but you also throw away the time value of that call option. To put it in a more distressing way, you throw money away in exchange for accepting more risk! It does not matter how short of a time period you intend to hold the stock, either. Even if you plan to sell the stock the next day, you’re still at risk of some serious negative news announced before the opening bell. It’s important to remember that, with a call option, your purchase price is locked in. It doesn’t matter how high the stock’s price may rise; you will always be able to purchase it for the strike price, so there really is no need to take delivery of the stock early.
 
To be continued……

Oct

5

How Do You Calculate Open Interest

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Open Interest
In the first chapter, we mentioned that the column labeled “Open Int” in Table 1-1, which has been reprinted below as Table 4-1, represented open interest. Now it’s time to take a closer look at what those numbers represent.
 
Table 4-1: EBAY Option Quotes
 

How Do You Calculate Open Interest

Because of the way options are traded, the OCC (Options Clearing Corporation) must account for the total number of outstanding contracts. This is because options are created out of thin air when two traders enter into opposite sides of the agreement. There is not a fixed number of option contracts like there is for shares of stock. Because there is a fixed number of shares of stock, you only need to use the words “buy” or “sell” when you trade shares of stock. However, when you trade an option, the OCC needs to know if you are entering into the contract or getting out of it. So if you are buying a call option to enter (or increase) the position, you need to enter the order as “buy to open.” When it comes time to exit (or reduce) that position, you would enter an order to “sell to close.”
We can also enter into an option contract by selling it first. If you sell a call option to enter (or increase) the position, you would enter the order as “sell to open.” When closing (or reducing) the position, the words “buy to close” would be used.
 
This can be a little confusing to new traders but it is actually quite simple. Just remember the key words “entering the contract” or “exiting the contract.” If you are entering, you are “opening” the contract. If you are exiting the contract, you are “closing.” When you enter an option order online, the computer will prompt you to either “buy” or “sell” and another section will ask you to specify “to open” or “to close.” You will need to check off one from each section.
 
Let’s take a look at a few examples. Let’s say you currently have no Intel options in your account and you buy 5 Intel $30 calls. You would enter the order as “buy to open.” Now assume that, at a later date, you wish to buy two more contracts. This is still an opening transaction since you are increasing the size of the position. You have simply “opened” or entered into two additional agreements. At this point, you would be long 7 Intel $30 calls. Now let’s say you decide to sell 4 contracts. Because you are reducing the size, this would be entered as “sell to close.” At a later time, if you sell the remaining 3 contracts, it would also be a “closing” trade since you are exiting or eliminating the position. It’s important to understand that “buying” does not necessarily mean you are entering the position. The reason is that you could enter an option position by selling it first. For example, if you sell a call to open, you are accepting money in exchange for the potential obligation to sell shares of stock. This is a common strategy called the “covered call” and one we’ll look at in depth in Chapter Seven. The point is that you can enter into an option agreement by either buying it or selling it. It just depends on whether you want to pay money for the right to buy or sell or receive money for the obligation to buy or sell.
 
The “open interest” column in Table 4-1 keeps track of how many open contracts there are for that particular option. To do so, one could either tally all long positions or all short positions to get the total number of outstanding contracts. This is because each contract has a buyer and a seller (a long and a short position). Some people mistakenly believe that the open interest is the total number of long and short positions. However, this would double count the actual number of open contracts.
 
For example, let’s say today is the first day a particular call option starts trading so that the open interest is zero. You wish to buy 10 calls and another trader wishes to sell 10 calls. You would enter the order as “buy to open” while the other trader would enter an order to “sell to open.” 
 
The total open interest is now 10 contracts. Note that we can get this answer by either counting all 10 long positions or all 10 short positions. But if we count all long and short positions then we get a total of 20, which exactly doubles the correct answer. The reason 20 is not correct is because each contract requires two people. Think of it like buying a house. If you buy a house then someone else must sell that house to you. You have two “traders” but only one house has been sold. For the same reason, if you buy 10 contracts and another trader sells 10 contracts then only 10 contracts changed hands and not 20.
 
Whenever both traders are entering “opening” transactions then open interest will increase. This is because both traders are “entering the positions” so open interest must be increasing.
 
Now let’s assume that you wish to sell five of your contracts. You would enter an order to “sell to close.” The trader on the other side must be buying since a buyer is required to complete your sales transaction. But depending on whether he’s opening or closing will determine what happens to open interest. For example, if the trader is buying to close, then open interest will decrease by five since both of you are closing positions. However, if the other trader is buying to open, then one trader is opening while the other is closing and open interest remains unchanged.
 
Table 4-2 will help to summarize what happens to open interest based on the actions of both traders:
Table 4-2
 
Trader #2
Trader #1
Opens
Closes
Opens
Increases
Unchanged
Closes
Unchanged
Decreases
 
 
Another way to interpret the chart is that if both traders are opening, then open interest will increase. If both are closing then open interest will decrease. And if one is opening and the other closing then open interest remains unchanged.
 
Let’s now go back to Table 4-1 and interpret the open interest numbers. The first call option listed is the July $32.50, which shows an open interest of 7,319. This means that there are 7,319 open contracts for this month and strike existing at this time. Because each contract represents 100 shares of stock, we know there are really 7,319 * 100 = 731,900 shares of stock being controlled by this one contract.
 
We see from Table 4-1 that the volume for this contract today (so far) is five. Assuming this is the total volume by the close of trading, what will be the new open interest tomorrow? Many new traders believe that the open interest must be 7,319 + 5 = 7,324. However, from what we previously learned, we know that is not necessarily true. This is because we have no idea whether the five contracts were “opening” transactions or “closing” transactions. If one trader bought five contracts “to open” and the other sold five contracts “to open,” then open interest will, in fact, increase to 7,324 tomorrow. But if one trader bought five contracts “to close” and the other sold five contracts “to close,” then open interest will decrease to 7,319 – 5 = 7,314. And if one trader bought “to open” and the other sold “to close,” then open interest will remain at 7,319 tomorrow (it would also remain unchanged if one trader bought “to close” and the other sold “to open”).
 
Open interest tends to be highest for the at-the-money contracts. In Table 4-1, we would probably consider the $37.50 calls the at-the-money but, in this case, they do not have the highest open interest. Part of the reason is that traders were very bullish on eBay at this time and were buying the higher strike $40 call. For the puts, the highest open interest doesn’t match with the $37.50 contracts either. Instead, the highest open interest contracts are the $35 and $32.50 puts. This is often typical for puts if they are used for insurance. Remember, most traders were bullish on eBay at this time, so relatively few were buying at-the-money puts as a bearish bet. However, when traders and investors use puts for insurance reasons, they typically buy out-of-the-money contracts because they are cheaper and still protect a significant part of their holdings. But generally speaking, you will find the highest volume and open interest for the at-the-money contracts.
 
Here’s an interesting question: Why do you suppose that the open interest is zero for all of the August calls and puts? The reason is that the last trading day for the June options was June 17 (third Friday of that month). From our lesson on expiration cycles, you know that once the June contracts expire we must have July and August contracts traded (current month plus following month). This means that August must not have been trading and they were rolled out on the same date that these option quotes were taken (July 20). In other words, July 20 is the first trading day for the August options and that’s why their open interest is zero.
To be continued……

Oct

4

Contract Adjustments for Special Dividends When Trading Stock Options

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As with any option adjustment, there is nothing you need to do, since all adjustments and symbol changes will automatically take place in your account.
 
There is nothing necessarily wrong with trading adjusted options; in fact, in some situations you have no choice. If the ABC $180 call undergoes a 2:1 split, it will be adjusted to a $90 strike. This is technically an adjusted option because it was once a $180 strike and it is now the $90 strike. However, it still controls 100 shares and in all other ways behaves just like a regular unadjusted option. If you wish to trade the $90 strike, you may have no choice but to trade the “adjusted” contract. Just be sure that you understand what that contract represents and that it matches your goal.
 
Stock splits are not the only event that causes option adjustments. Mergers, acquisitions, special dividends, and other forms of corporate activity and restructuring will cause adjustments. Under these scenarios, some adjusted options can get complex and control differing amounts of shares plus shares of another company plus cash. For example, in 2004, Motorola (MOT) announced that all owners of record on November 29 would receive a distribution of Freescale Semiconductor (FSL.B). All options affected by the distribution would be adjusted to control 100 shares of Motorola, 11 shares of Freescale Semiconductor, and 76 cents cash. Most traders avoid adjusted options that control numerous assets like this because the liquidity (the number of contracts available in the market) tends to be low. After all, why would you want the right to buy or sell 100 shares of Motorola, 11 shares of Freescale Semiconductor, and 76 cents in cash? So as a general rule, avoid entering into adjusted options with complex structures unless there is a very good reason you need that specific contract.
 
 
Contract Adjustments for Special Dividends
Many stocks pay a dividend, which is simply a cash payment to shareholders usually made on a quarterly basis (sometimes it is paid semiannually). In some cases, dividends may cause strike price adjustments so it’s important to understand when and why these adjustments occur.
 
If a stock pays an eight-cent dividend, that really means eights cents per share per year. If you own 100 shares, you’d receive a total cash deposit of $.08 * 100 = $8 per year. But because dividends are usually paid on a quarterly basis, you’d actually receive four payments of $2. Dividend payments are usually deposited electronically to your brokerage account.
 
The stock’s price is always reduced by the amount of the dividend on the date the dividend is paid, which is called the ex-date. The ex-date is simply the date that the stock trades “ex,” or “without” the dividend. For example, assume a $100 stock pays a $1 dividend tomorrow. The stock will open tomorrow for trading at $99 unchanged. Even though the stock’s price is technically lower, that is due to the payment of the dividend and not a factor between supply and demand. Think about it this way: If you have a jar of 100 one-dollar bills, it is worth $100. If you take one dollar out, the jar is now worth only $99. This is exactly what happens with corporations when they pay a dividend. The value of the stock is comprised of all assets of the company, one of which is cash. If one dollar is paid to each stockholder, the total value of the stock must be reduced by the amount of that payment, which means the stock would now be worth $99. Just remember that the value of the stock is always reduced by the amount of the dividend on the ex-date.
 
Most companies that pay dividends pay them on a regular basis. These regular dividends do not cause option strikes to be adjusted. The reason is that the market knows about these dividends well in advance and they automatically get factored into the option’s price.
 
Sometimes, however, corporations pay a special one-time dividend and, in these cases, they do cause adjustments to option strikes. Whenever a special dividend is announced, all call and put strikes are reduced by the amount of the dividend. For example, on July 20, 2004 Microsoft announced a special $3 cash dividend. This was a special one-time dividend so the option strikes – calls and puts – were adjusted downward by the amount of the dividend. If you were holding the $30 call, it became a $27 strike. If you were holding the $30 put, it also became a $27 strike. Why does this happen? Again, any adjustment in option strikes is done to assure that option investors are not financially hurt (or unfairly rewarded) because of a corporate action such as a split, merger, or even a special dividend.
 
By reducing all strike prices by the amount of the dividend, calls and puts retain all of their intrinsic value after the split. To show how, imagine that Microsoft is trading for $35 and that you own the $30 call that is worth exactly the $5 intrinsic value just prior to the payment of the $3 dividend. On the ex-date, the stock’s price will be reduced by the dividend and will open for trading at $32. With the stock at $32 though, your $30 call will only be worth $2, which means the value of your call dropped from $5 to $2 for no reason other than the fact that a special dividend was paid (call prices fall with a drop in stock price). In order to keep the $30 call holders from unfairly losing $3, the strike is reduced by the amount of the dividend to $27. With the strike at $27, your option is still worth the $5 intrinsic value when the stock opens at $32.
 
Now let’s work through an example with a put option. Think about a $40 put that is trading for the intrinsic value of $5. On ex-date, the stock price is reduced from $35 to $32, and the option’s price jumps to the $8 intrinsic value. In this case, the put holder unfairly benefits from the reduction in the stock’s price (put options benefit from a drop in the stock’s price). However, if that strike is reduced by the dividend to $37, it will be worth $5 with the stock at $32.
 
In both cases, the calls and puts are worth $5 before the ex-date and after due to the adjustment. In other words, the special dividend does not affect their pricing. When you think about it, the special dividend should not affect option prices since it doesn’t really affect the holder of the stock. While it appears that the owner of 100 shares of Microsoft gets a nice $3 “bonus,” you must remember that the price of Microsoft will also fall by $3 on ex-date. The owner of Microsoft receives $300 cash but loses $300 in stock value, which is a wash. In other words, stock holders were not really affected negatively or positively but only the form of their wealth has changed. If stock holders are not really affected by the special dividend then why should option holders be subjected to unfair increases or decreases in wealth? Of course, they shouldn’t be, and that’s why the strike prices are adjusted.
 
You might be wondering if there’s a way to get some “free money” from the markets by buying a call and then exercising it to collect the dividend. The answer is no, since you will always pay a time premium for the call. Once you exercise the call, you lose the time premium so you’d always be better off just buying the stock in the open market. For instance, let’s assume the Microsoft $50 call is trading for $2. If you pay $2 and then immediately exercise it, you will pay $50 and receive 100 shares of stock. However, you paid $2 for the option, which means you effectively paid $52 to gain the stock. You could have just purchased the stock in the open market for $50 and paid one commission to do so. Whenever special dividends are announced, especially large ones, you will hear all kinds of option “strategies” that allow for some type of arbitrage. These are simply false rumors, and the reason they won’t work is twofold. First, time premiums make it more costly to buy the stock. Second, the strike prices are reduced on ex-date.
 
Just remember that stock prices are always adjusted when dividends are paid. In the case of special dividends, option strike prices will be adjusted too. The previous section talked about stock splits, which we said are technically dividends. Rather than receiving cash though, investors receive shares of stock. If a stock does a 2:1 split that is really recorded through the brokerage firm as a one-share dividend for every share owned. What does that do to the stock’s price? Just as with cash dividends, it reduces the price of the stock. If you receive one share of stock for every share you have, the company has, in fact, paid half of its value back to shareholders and that means the share price must fall by half.
 
To be continued……

Oct

3

Trading Stock Options – Chapter One Answers

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Chapter One Answers
 
 
1)       Call options give buyers the:
b) Right to buy stock
Long options always give the buyer some type of right. You will never incur an obligation by purchasing an option. Call options give buyers the right, not the obligation, to buy stock. If you buy a call, you can purchase 100 shares of the underlying stock at any time for the strike price.
 
2)       Put options give buyers the:
d) Right to sell stock
Put buyers have the right, not the obligation, to sell stock. The put owner can sell 100 shares of stock and receive the strike price at any time through expiration.
 
3)       Option sellers:
d) Both b and c
ellers receive a premium for accepting an obligation. The seller of a call has the potential obligation to sell shares of stock for the strOption sike price while the put seller has the potential obligation to buy shares of stock for the strike price.
 
4)       One option contract generally controls how many shares of stock?
d) 100
When options are first issued, they generally control 100 shares of stock.
 
5)       You bought an Intel $25 call. The “$25” figure is called the:
c) Strike price or exercise price
The price at which you are contracting to trade shares of stock is the exercise price. It is also called the strike price because that’s where the deal was “struck.”
 
6)       The intrinsic value of an option represents the:
b) Immediate benefit
For call options, the intrinsic value is found by taking the stock price minus the strike price, assuming it is a positive amount. For put options, we take the strike price minus the stock price, assuming it is positive. With the stock at $55, a $50 call has $55 – $50 = $5 of intrinsic value. A $60 call has no intrinsic value since $55 – $60 = negative $5. Likewise, a $50 put has no intrinsic value since $50 – $55 = negative $5. The intrinsic value represents the amount of “immediate benefit” to the owner. If the stock is $55, the $50 call owner is better off by $5 since he can pay $50 for the stock rather than $55. The $60 put holder can sell his stock for $5 more than the current market price of $55 so he is better off by $5 as well. Whenever you are trying to figure out the intrinsic value, think if there is an immediate benefit in owning that option. If there is, it has intrinsic value. The intrinsic value is also the amount that the option is in-the-money.
 
7)       You are long an ABC $40 call. How much will it cost to exercise the call?
c) $4,000
                Each contract controls 100 shares of stock and you have the right to buy it for $40 per share. Therefore, it will cost 100 shares * $40 per share = $4,000 to exercise the call. In return, you will receive 100 shares of ABC.
 
Trading Stock Options Chapter One Answers        If you are “long” options:
a) You are not required to ever buy or sell the stock
If you are long options, whether calls or puts, you have rights. This means you are not required to ever buy or sell stock. You can buy or sell stock if you choose. It is your option to do so.
 
9)       Which of the following is true?
b) Long positions exercise, short positions get assigned                         
Long positions have the rights. It is the long position that decides whether or not to exercise. If the long position exercises then the short position must oblige. The short position has the obligation.
 
10)   XYZ is trading for $74. The XYZ $70 call is trading for $4.50. What are the intrinsic and time values?
a) $4 intrinsic, 50 cents time
There is an immediate advantage in owning this call since it gives the buyer the right to pay $70 for a stock that is trading for $74. Specifically, there is a $4 advantage so that is the intrinsic value. The remaining 50 cents of value is due to time.
 
11)   ABC is trading for $107. The ABC $110 call is trading for $4. What are the intrinsic and time values?
c) $0 intrinsic, $4 time
There is no immediate benefit in holding this call since it gives the buyer the right to pay $110 for a stock that is currently trading for $107. Therefore, there is no intrinsic value to this option. However, this does not mean the option has no value. Because time remains on the option, the stock does have a chance of rising above $110. All of this option’s value is due to the fact that time remains on the option.
 
12)   An option is bidding $3 and asking $3.20. What does this mean?
d) Both a and c
The bid represents the highest price that someone is willing to pay. In other words, it represents the highest bidder. The asking price represents the lowest price at which someone will sell. Because someone is willing to pay $3, this means we can sell to that person if we wish to sell this option. Likewise, because someone is willing to sell for $3.20, we can buy the option for this price.
 
13)   The bid and ask represent the:
c) Highest bidder and lowest offer.
 
14)   Microsoft is trading for $29 and the $30 put is trading for $2.50. This put is:
a) $1 in-the-money
Put options give the holder the right to sell stock. Because this put allows the holder to sell for $30 when the stock is trading for $29, there is a $1 immediate benefit in holding this put. Therefore, this put is $1 in-the-money.
 
15)   ABC stock is trading for $47. You just purchased an ABC $45 call for $3. If the stock remains at $47 at expiration, what is the amount, if any, you will lose on this option?
                b) $1
This call has $2 intrinsic value and $1 time value. If the stock is $47 at expiration, this option will be worth the $2 intrinsic value so the most you could lose is the $1 time value. Remember, the key to this question is that the stock remains at $47 at expiration. It is true that the most you could ever lose on this (or any) option is the amount paid, or $3 in this example. But the question is assuming the stock remains at $47. The only way you could lose more than the $1 time value is if the stock’s price falls below $47.
 
16)   If you wish to exercise an option, you must:
d) Submit exercise instructions
You are free to exercise an equity option at any time and the OCC guarantees the performance so there’s no need to find a buyer or seller. The only thing you must do is submit exercise instructions to your broker which is done with a simple phone call.
 
17)   The OCC:
b) Is the buyer to every seller and seller to every buyer
The OCC acts as a middleman to every transaction. If you buy an option, you are really buying it from the OCC. If you sell an option, you are selling it to the OCC.
 
18)   Options trade in units called:
a) Contracts
Options trade in units called “contracts” because that’s what they are – contracts between two people to buy and sell shares of stock. Stock trades in “shares” while options trade in “contracts.”
 
19)   The last trading day for options is:
c) The third Friday of the expiration month
The last trading day is the third Friday of the expiration month. Technically, options expire on Saturday following the third Friday but the last “trading” day is the third Friday.
 
20)   Because a portion of an option’s value declines over time, options are referred to as:
b) Wasting assets
A wasting asset is one whose price declines with the passage of time. Some options decline very little while others decline much more and much faster. Regardless, all options are classified as a wasting asset.
 
21)   Which “style” are all equity options?
d) American
All equity options are American style, which means you can exercise them at any time prior to expiration. Bermudan and Asian options are actually styles too but they fall under the category of exotic options.
 
22)   If you sell a put option, you have:
a) The potential obligation to buy stock
Put sellers have the potential obligations to buy stock. They must buy the stock only if the long put holder decides to exercise.
 
23)   If you sell a call option, you have:
b) The potential obligation to sell stock
                Call sellers have to sell stock only if the long call holder exercises.
 
24)   If you sell an option, you collect a premium. What happens to that premium if you are assigned? 
c) You keep the premium regardless of whether you’re assigned or not
Option sellers always keep the premium regardless of what happens. That is their fee for accepting some type of obligation (risk).
 
25)   If you buy or sell an option, you can escape your obligations by: 
d) Entering a reversing trade
You can always get out of an option contract by entering a reversing trade of the same month and strike. If you originally purchased an ABC $50 call you would enter a reversing trade by selling an ABC $50 call.
 
 
 
To be continued…

Oct

2

Options University’s Options 101 – Part 12

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Options 101
Part 12- Chapter 1 Questions
How are Options Similar to Stocks?
  • Options are securities.
  • Options trade on national SEC (Securities Exchange Commission)-regulated exchanges.
  • Option orders are transacted through market makers and retail participants with bids to buy and offers to sell and can be traded like any other security.
 
How Do Options Differ From Stocks?
  • Options have an expiration date, whereas common stocks can be held forever (unless the company goes bankrupt). If an option is not exercised on or before expiration, it no longer exists and expires worthless.
·         Options exist only as “book entry,” which means they are held electronically. There are no certificates for options like there are for stocks.
  • There is no limit to the number of options that can be traded on an underlying stock. Common stocks have a fixed number of shares outstanding.
·         Options do not confer voting rights or dividends. They are strictly contracts to buy or sell the underlying stock or index. If you want a dividend or wish to vote the proxy, you need to exercise the call option.
 
Key Concepts
1)    The intrinsic value of an option represents the “immediate benefit” in using the option.
2)    Any value in the option above the intrinsic value is the time value.
3)    In-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value.
4)    At-the-money options carry the highest time value.
5)    You only lose your time value at option expiration. Any intrinsic value must remain.
 
 
Chapter One Questions
 
1)    Call options give buyers the:
a) Obligation to buy stock
b) Right to buy stock
c) Obligation to sell stock
d) Right to sell stock
 
2)    Put options give buyers the:
a) Obligation to buy stock
b) Right to buy stock
c) Obligation to sell stock
d) Right to sell stock
 
3)    Option sellers:
a) Have rights
b) Receive premiums
c) Have obligations
d) Both b and c
 
4)    One option contract generally controls how many shares of stock?
a) 25
b) 50
c) 75
d) 100
 
5)    You bought an Intel $25 call. The “$25” figure is called the:
a) Contract value
b) Moneyness
c) Strike price or exercise price
d) Intrinsic value
 
6)    The intrinsic value of an option represents the:
a) Time value
b) Immediate benefit
c) Contract value
d) Strike price
 
7)    You are long an ABC $40 call. How much will it cost to exercise the call?
a) $40
b) $400                       
c) $4,000
d) $40,000
 
Options Universitys Options 101 Part 12     If you are “long” options:
a) You are not required to ever buy or sell the stock
b) You are required to buy or sell the stock if assigned
c) You are obligated to buy stock at some time
d) You receive premiums
 
9)    Which of the following is true?
a) Long positions get assigned, short positions exercise
b) Long positions exercise, short positions get assigned                   
c) Long and short positions can exercise
d) Long and short positions can get assigned
 
10)    XYZ is trading for $74. The XYZ $70 call is trading for $4.50. What are the intrinsic and time values?
a) $4 intrinsic, 50 cents time
b) $4.50 intrinsic, $0 time                   
c) 50 cents intrinsic, $4 time
d) $0 intrinsic, $4.50 time
 
11)    ABC is trading for $107. The ABC $110 call is trading for $4. What are the intrinsic and time values?
a) $1 intrinsic, $3 time
b) $3 intrinsic, $1 time            
c) $0 intrinsic, $4 time
d) $4 intrinsic, $0 time
 
12)    An option is bidding $3 and asking $3.20. What does this mean?
a) The highest price that someone will pay is $3 and the lowest price at which someone will sell is $3.20.
b) The highest price that someone will pay is $3.20 and the lowest price at which someone will sell is $3.
c) You can currently buy the option for $3.20 and sell it for $3
d) Both a and c
 
13)    The bid and ask represent the:
a) Lowest bidder and highest offer
b) Highest bidder and highest offer
c) Highest bidder and lowest offer
d) Lowest bidder and lowest offer
 
14)    Microsoft is trading for $29 and the $30 put is trading for $2.50. This put is:
a) $1 in-the-money
b) $1 out-of-the-money
c) $2.50 in-the-money
d) $2.50 out-of-the-money
 
15)    ABC stock is trading for $47. You just purchased an ABC $45 call for $3. If the stock remains at $47 at expiration, what is the amount, if any, you will lose on this option?
            a) $0
b) $1
c) $2
d) $3
 
16)    If you wish to exercise an option, you must:
a) Find a buyer or seller
b) Do so only at expiration
c) Submit assignment instructions
d) Submit exercise instructions
 
17)    The OCC:
a) Guarantees an option’s profit
b) Is the buyer to every seller and seller to every buyer
c) Acts as a mediator for disputes
d) Requires you to become a member before trading options
 
18)    Options trade in units called:
a) Contracts
b) Shares
c) Round lots
d) OCC units
 
19)    The last trading day for options is:
a) The second Thursday of the expiration month
b) The second Friday of the expiration month
c) The third Friday of the expiration month
d) Saturday following the third Friday
 
20)    Because a portion of an option’s value declines over time, options are referred to as:
a) Physical delivery assets
b) Wasting assets
c) Linear assets
d) Cash delivery assets
 
21)    Which “style” are all equity options?
a) Bermudan
b) Asian
c) European
d) American
 
22)    If you sell a put option, you have:
a) The potential obligation to buy stock
b) The potential obligation to sell stock
c) The right to buy stock
d) The right to sell stock
 
23)    If you sell a call option, you have:
a) The potential obligation to buy stock
b) The potential obligation to sell stock
c) The right to buy stock
d) The right to sell stock
 
24)    If you sell an option, you collect a premium. What happens to that premium if you are assigned? 
a) You only keep the premium if you are assigned
b) Option sellers do not receive the premium
c) You keep the premium regardless of whether you’re assigned or not
d) You only keep the premium if you are not assigned
 
25)    If you buy or sell an option, you can escape your obligations by: 
a) Entering a reversing trade in a different month
b) Entering a reversing trade at a different strike
c) Entering the same trade again
d) Entering a reversing trade
 
Answers will be given on the next part of Options 101……

Oct

2

The Moneyness For Calls And Puts When Trading Stock Options

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Table 1-4 describes the moneyness for calls and puts:
 
Table 1-4
Call Options
Moneyness
Relationship to Stock
In-the-money
Stock price > Strike price
At-the-money
Stock price = Strike price
Out-of-the-money
Stock price < Strike price
 
Put Options
Moneyness
Relationship to Stock
In-the-money
Stock price < Strike price
At-the-money
Stock price = Strike price
Out-of-the-money
Stock price > Strike price
 
Most option exchanges, such as the CBOE, always provide at least one in-the-money and one out-of-the-money option for each month. This means that as the stock moves to new highs (or lows) then new strikes will be added to each expiration month.
 
The moneyness of an option affects the amount of time premium present. In general, in-the-money and out-of-the-money options will have the smallest time premiums. At-the-money options have the greatest amount of time premium. In other words, at-the-money options contain the highest amount of time value, and that value shrinks as we move toward the in-the-money or the out-of-the-money strikes.
 
The at-the-money option has the highest time value. Time value shrinks as we move in-the-money or out-of-the-money.
 
For example, Table 1-5 shows the time values for the July calls and puts in Table 1-1:
 
Table 1-5
Strikes
Call Time Value
Put Time Value
$32.50
0.29
0.20
$35
0.59
0.50
$37.50
1.05
1.01
$40
0.35
0.31
 
Notice that the time values are relatively small for the in-the-money strikes ($32.50 call, $35 call, $40 put). The time values are also relatively small for out-of-the-money strikes ($40 call, $32.50 put, $35 put). It is the at-the-money strike ($37.50) that has the highest time value. Figure 1-6 shows the intrinsic and time values for only the call options in Table 1-4. You can see that the time value is very small for the $32.50 call because it is so far in-the-money. As we increase the strike price, the time premium gradually increases as well until we’re only left with pure time premium.
 
Figure 1-6

The Moneyness For Calls And Puts When Trading Stock Options

 
 
Parity
An option that is trading for purely intrinsic value (i.e., no time value) is trading at parity. For instance, assume that the underlying stock is trading for $46. If the $40 call is trading for $6 then it is comprised totally of intrinsic value and is therefore trading at parity. Options generally only trade at parity when there is little time remaining (usually a matter of hours).
 
 
Wasting Assets
We’ve learned that if you want a call or put option you must pay money for it. We also know that options expire at some time and that leads to an interesting question. Do options lose all of their value at expiration? After all, if the option is no longer good, how can it have any value?
 
While it is true that an option loses some of its value with each passing day, there is often a big misconception about how much of that premium is lost at expiration. There are traders who will tell you that all options become worthless at expiration, and that is simply not true. In an earlier section “Intrinsic Values and Time Values,” we said that all options must be worth at least their intrinsic value – and expiration time is no different. At expiration, all options lose only their time value but not their intrinsic value. It is only the time value portion of their price that slowly bleeds away with time. The intrinsic value remains intact. This is one of the reasons why it is so important to understand how to decompose an option into its intrinsic and time values. Certain strategies rely on the use of intrinsic values, while others make use of the time values. If you want to trade, hedge, or invest with options, you need to know how much of each value is present at each strike price.
 
To make sure you understand this concept, let’s look at the August $35 call in Table 1-1, which is trading for $3.60. We know there is $37.11 – $35 = $2.11 worth of intrinsic value and that means that the remaining value, or $3.60 – $2.11 = 1.49 worth of time value. If you were to buy this call and eBay closed at the same price of $37.11 at expiration, the $35 call would still be worth the intrinsic value of $2.11. It would not be worth zero. The only amount you would lose is the $1.49 worth of time premium. Remember, traders are paying the additional $1.49 over and above the immediate value because there is time remaining. Once time is gone (option is expired), then there can be no time value on the option, but the intrinsic value will remain. In Figure 1-6, the intrinsic value is bold and the time value is shaded. It is only the shaded portion that erodes with time. (Bear in mind this doesn’t mean that you cannot lose the intrinsic value. However, that value can be lost due to adverse stock movement only and not the passage of time.)
 
Because options lose some value with each passing day, they are called wasting assets. There are some traders who reject the use of options since part of the option’s price deteriorates simply by the passage of time, but that is a thoughtless reason. The car you drive loses value over time. The same is true for the fruits and vegetables you buy. What about the computer you use? It doesn’t make sense to say that it’s not worthwhile to invest in assets whose value depreciates over time. You just have to be careful in the way you use them. Nearly all assets deteriorate over time, so don’t back away from options just because a portion of their value depreciates over time. Even the expensive factories that General Motors, Dell Computer, or Intel have built all lose value with each passing day, but the CEOs will tell you they have been very productive assets.
 
Time Decay
Time decay does not occur in a straight line over time. In other words, an at-the-money option with 30 days to expiration does not lose 1/30 of its value each day. Instead, it loses value slowly at first, which then progressively accelerates more and more each day. This is called exponential decay. Figure 1-7 shows the price of a 90-day option where we assume that nothing changes except the passage of time. You can see the rapid acceleration of decay as time gets near expiration – especially in the last thirty days.
 
Figure 1-7
 

The Moneyness For Calls And Puts When Trading Stock Options

 
Some texts will show this chart in the reverse order with the numbers on the horizontal axis increasing from 0 to 90, which is probably more mathematically correct since the numbers are ascending as we move left to right. However, it makes it awkward to read since you must make time move from right to left as we approach expiration. It’s usually easier for people to visualize time moving forward by moving from left to right. It’s a matter of preference as to which type of chart you use. Just realize that as you continue reading about options that you may encounter time decay charts that appear backwards but it’s just due to two different styles of presenting the same concept. The important point is that you understand that time decay is not linear. Because of this, it is usually to your advantage to buy longer periods of time and sell shorter periods of time. We will revisit this concept later but just realize for now that an option’s value does not decay in a straight line.
 
Before we leave this section, you might be wondering if there are any similarities between stocks and options. You might be surprised that options are similar to stock in many ways.
 
To be continued……..
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