Dec

31

Options 101 # 64 Quiz

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Key Concepts
1) Stock + Put – Present value of the exercise price = Risk-free position (Conversion).
2) The opposite of a Conversion is a Reversal (Short stock – Put + Present Value of the exercise price).
3) The value of a put option equals the time value of the call (above the cost-of-carry).
4) Any synthetic position can be found by solving the formula S + P – C = Present value of E for a single variable.
5) Buying calls is synthetically equivalent to buying stock on margin and buying a put for insurance.

Chapter Five Questions

1) Which of the following represents a synthetic long call?
a) Long stock + short call
b) Short stock + long call
c) Long stock + short put
d) Long stock + long put

2) The put-call parity formula shows us that an at-the-money call will be priced higher than the at-the-money put. How much higher will the price of the call be?
a) Stock – Pv (E)
b) Stock + Pv (E)
c) Stock – call
d) Stock – put

3) A call option’s price can be broken down into three components. The first is the intrinsic value. The second is the cost of carry on the exercise price. What is the third component?
a) Present value of the exercise price
b) Short put
c) Long stock
d) Long put

4) Which of the following is a synthetic T-bill (or long bond)?
a) Long stock + long put + short call
b) Short stock + short put + long call
c) Long stock + long call + long put
d) Short stock + long put + short call

5) Which of the following is a synthetic long put?
a) Long stock + long call
b) Long stock + short call
c) Short stock + long call
d) Short stock + short call

6) Which of the following is synthetic long stock?
a) Short call + long put
b) Long call + short stock
c) Long call + long put
d) Long call + short put

7) Which of the following is synthetic short stock?
a) Short call + long put
b) Long call + short stock
c) Long call + long put
d) Long call + short put

8) Which of the following is a variation of the put-call parity equation?
a) S + P – C = Pv (E)
b) S + P + C = Pv (E)
c) S – P – C = Pv (E)
d) S – P + C = Pv (E)

9) Which of the following is one of the biggest advantages of the put-call parity equation? It can identify:
a) Guaranteed trades
b) Superior strategies
c) The most efficient trades
d) Market direction

10) When using the put-call parity equation, you will end up with plus and minus signs with each variation. What do these signs represent?
a) Plus = long position, Minus = short position
b) Plus = high probability trade, Minus = low probability trade
c) Plus = market ends up, Minus = market ends down
d) Plus = hedged position, Minus = unhedged position

11) In the put-call parity formula, what does S + P – C equal?
a) The present value of the exercise price
b) The exercise price
c) The future value of the exercise price
d) The present value of the stock price

12) Which of the following is the technical name for the three combined position: S + P – C?
a) Conversion
b) Reversal
c) Parity
d) Arbitrage

13) Which of the following is a synthetic short put?
a) Short call + long put
b) Long stock + short call
c) Long put + short stock
d) Long call + short put

14) Which of the following is a synthetic short call?
a) Short stock + short put
b) Short stock + short call
c) Long put + short stock
d) Long call + short put

15) Put-call parity shows that call options are really put options and vice versa depending on:
a) How the calls or puts are paired with the underlying stock
b) How the calls or puts are exercised
c) The length of time until expiration
d) Any arbitrage opportunities that may exist

16) Anytime you see the negative of the present value of the exercise price, – Pv (E), in the put-call parity formula that represents:
a) Loaning of funds
b) Borrowing stock
c) Shorting stock
d) Borrowing of funds

17) Before exercising a call early to collect a dividend, you should check the bid of the corresponding (same strike as the call) put. If the bid price is higher than the dividend, you should:
a) Exercise the call and short the stock
b) Buy the put and sell the call
c) Buy the put
d) Sell the put

18) Put-call parity can show us why it is not optimal to exercise a call option early. When you exercise a call option early, you are throwing away the value of the:
a) Put option
b) Stock
c) Interest that could be earned on the exercise price
d) Both a and c

19) Interest rates are 5%. You observe that ABC stock is trading for $20 per share. The one-year, $20 call is $3 and the one-year $20 put is $1. Using put-call parity, what would you expect to happen to the call and put prices?
a) Call prices should rise and put prices fall
b) Call prices should fall and put prices rise
c) Call prices and put prices should remain the same
d) Call and put prices will both fall

20) Interest rates are 5%. You observe that ABC stock is trading for $20 per share. The one-year, $20 put is $1. Using put-call parity, what would you expect to see the one-year $20 call trading for?
a) $1.95
b) $2.15
c) $0.85
d) $0.75

Answers will be presented in next issue.

Dec

30

Options 101 # 63

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Creating a Call Option
Synthetic options provide tremendous insights into the role of options in the marketplace. Assume you wish to buy a stock but are either afraid to because of the recent volatility or simply because you do not have enough money. So rather than buy the stock, you decide to buy a call option.

When your order is received, the market maker must create a call option. Remember, call options are simply contracts between two people; they do not exist in actual form such as shares of stock. In order to create that long call, the market maker must buy stock and buy a put, which is a synthetic long call. He can then transfer that over to you buy selling the call. Note what these actions by the market maker create:

Market maker buys stock
Market maker buys the put
Market maker sells you the call

Hopefully you remember these three actions – long stock, long put, short call – as a conversion, which is a risk-free, or “locked” trade. Because you did not want to take the risk of holding the stock, the market maker bought the stock for you and then bought a put to protect that downside risk. Doing so, he created a synthetic call. When he sells you the call, he has effectively transferred the long stock plus long put positions over to you.

So the reason you were able to buy a call is because the market maker was able to buy a put. The person who sold him that put must be willing to buy the stock (that’s the obligation of the short put). By purchasing the call, you have the right to buy the stock. This means that the market maker has a guaranteed sale of stock at expiration.

If the stock’s price is above the strike price, he will be assigned and required to sell the stock. If the stock’s price is below the strike, he will exercise his put and sell the stock. The market maker is fully protected from any adverse movements in the stock’s price. Notice that the option’s market created a sale of stock (to the market maker) when nobody wanted to buy it at that point in time. It was only because of the option’s market that stock was traded.

The options market creates more buyers of stock. If you buy a call option, somebody else is buying stock. The options market just creates an easy way to “find” these other people. If you want to buy a call, all you have to do is look at the quote board and see if the price is right. If you buy it, somebody somewhere in the world must be taking the other side of the trade and you will never know who that person is.

Are Options Bad for the Market?
Put-call parity provides powerful insights for option traders. Despite this quality, there is perhaps a bigger problem that it solves. That is, put-call parity formula can shed some light on one of the most polarizing debates in finance: Are options bad for the market? One group adamantly says yes; the other says no with equal conviction. Can put-call parity help solve the debate?

There are many investors who adamantly refuse to buy or sell options because they hear how “speculative” they are. They insist on holding only stocks. However, if you refuse to use options, you are speculating. Options were created as hedging tools or as a way to decrease risk. Whenever you hedge your long stock, perhaps by purchasing a put or selling a call, you give up some upside profits in exchange for some downside protection. So if you buy stock and refuse to buy or sell options, you are speculating that nothing will go wrong with your long stock position. You are willing to hold out for more profit at the expense of downside exposure to a price of zero. It can be argued that investors who don’t use options are among the most speculative of all! However, if you’re still in doubt, would you believe that stock can be viewed as an option?

Valuing Corporate Securities as Options
Advanced option traders know to consult with an option pricing model of some kind before entering a trade. We’ll talk more about option pricing models and why we use them in Chapter Six. For now, just understand the most famous of pricing models is the Black-Scholes Option Pricing Model developed by Fisher Black and Myron Scholes. When Black and Scholes developed this option pricing model, they were certain there were many uses for it other than just valuing call options. One of the uses they suggested was in valuing corporate securities.

Consider a firm that has issued one zero-coupon bond that matures to a value of $1,000,000 in five years. A zero-coupon bond just means that the corporation doesn’t make quarterly payments; instead, they make one lump-sum payment of 1,000,000 in five years. In exchange, they receive less money than the 1,000,000 face value. With this money, the firm produces products and hopes to have a value in excess of this $1,000,000 in five years and pay off its debt, leaving the stockholders with whatever remains in value. However, if the firm’s value is less than $1,000,000 at maturity of the bond, the stockholders will simply turn over the assets to the bondholders and will be free of further liability.

Let’s look at the payoffs for stockholders and bondholders at maturity:

If the value of the firm is less than $1,000,000, say, $800,000:
Bondholders get: $800,000
Stockholders get: $0
Total value of firm = $800,000

If the value of the firm is greater than $1,000,000, say $1,200,000 at maturity:
Bondholders get: $1,000,000
Stockholders get: $200,000
Total value of firm is $1,200,000

We see with the above payoffs that the total value of the firm is partitioned between the stockholders and bondholders. Notice how the stockholders get nothing at expiration if the value of the firm is below the value of the matured debt. But if the value of the firm is greater than the matured debt, stockholders receive the excess value.

Now compare this bondholder and stockholder relationship to options. Assume you own 100 shares of stock and have sold, or written, a $100 call option against it. This means that you have been paid for the potential obligation to sell your shares. (If this sounds like a nice arrangement, it is a strategy called the “covered call” and we’ll talk much more about it in Chapter Seven.)

At expiration, if the value of the stock is less than $100, say $80:
You get: $80
Call buyer gets: $0
Total value of your position is $80

In other words, if the value of the stock is below the strike at expiration, you end up holding the stock at its current value of $80. The long call owner receives nothing since it expires worthless.

However, if the value of the stock is greater than $100, say $120 at expiration:
You get: $100
Call buyer gets: $20
Total value of positions is $120

If the value of the stock is above the strike at expiration, you will be assigned and receive the $100 strike price; that’s the most you will ever receive. The call owners will receive the stock and pay the strike for a value of the stock price minus the strike price. The call owners, in this case, receive what’s left over after you have been paid. If you look closely, you will see that the payoff for the call option above exactly resembles the payoffs to the stockholders for the corporation discussed earlier.

Using the Black-Scholes Model
Recall the put-call parity formula:

Stock + Put – Call = Present value of the exercise price

We can rewrite this for the above corporation as:

Stock + Put – Call = Present value of the debt

Which can be rewritten at maturity as:

Stock + Put – Call = Total value of debt

Stock – Call = Total value of debt – Put

So the Black-Scholes Option Pricing Model tells us the value of the covered call position (left side of equation) is equal to the debt at maturity with a put written against it (right side of equation).

This means the bondholders have, in essence, written a put against the firm. In other words, if the value of the firm is less than the debt that is due at maturity, the stockholders “put” the firm back to the bondholders and walk away losing only what you paid for the stock – just as when you buy a call option. The value of this “put” is part of what gives your stock its value.

If you like owning stocks for this reason then there’s no reason you should feel that options are bad for the market. In fact, Pricing Principle #5 from Chapter Two showed that the price of an option with a zero strike price and an unlimited time to expiration would equal the price of the stock. Options allow you to do what stockholders have always done – but for a lot less money. Why? Because they have strike prices. They allow you to partition the unlimited range of possible stock prices into segments that you wish to control. Options can also be used to create downside hedges in exchange for upside profits. Because of these uses, investors can create better risk-reward profiles that are simply not possible with stock alone.

To be continued…..

Dec

29

Options 101 #62

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Synthetic Short Stock
If synthetic stock is just a long call plus a short put what would synthetic short stock be? Once again, all we have to do is change the signs of our previous answer and find out that a long put plus a short call will behave just like a short stock position. This is great to know for all traders involved in short selling. With synthetic options, it is now possible to short stock without an uptick or when stock is not even available for shorting.

Question
You wish to short a stock, which is trading for $100. Your broker informs you that the stock is not marginable and therefore cannot be shorted. How can you effectively enter a short sale?

Answer
Enter a synthetic short by selling the $100 call and buying the $100 put.

How much will it cost to enter an at-the-money synthetic short stock trade? Think back to put-call parity. One variation was:

C – P = S – Present value E

This tells us that if we buy the call and sell the put (left side) it should be worth the difference between the stock price and present value of the exercise price (right side). Because we are doing the reverse and buying the put and selling the call, the transaction should result in a slight credit.

Realistically though, because of bid-ask spreads and commissions, the trade may result in a slight debit. Regardless, it will not be a major cash outlay to enter this position (please keep in mind that there will be significant margin requirements to do so). However, they should not exceed (and will usually be much less) than the 150% Reg T margin required to short a stock. So not only can synthetics allow trades that otherwise cannot be done, they usually allow it to be done in a more efficient way by requiring less capital to take the same position.

Example: Figure 5-16 shows a chart of the S&P 100 (OEX). Between May 17 and June 3, 2002 (the area to the right of the dotted vertical line), the OEX took another. While there is usually no way to short the OEX index through the stock market, you could have done it synthetically in the options market.

On May 17, the index was trading at 550 and the 550 calls were $13.00 with the 550 puts at $11.80. As we showed earlier, an at-the-money synthetic short will usually result in a slight credit, which was the case here. Selling 20 calls and buying 20 puts would result in a net credit of 20 contracts * 100 * $1.20 credit = $2,400. Just 17 days later, at the close of the trading, the puts were worth $38.20 and the calls 0.80. The synthetic short position could have been closed out for a credit of $37.40 * 20 * 100 = $74,800. For no money down (in fact, a credit of $2,400) you could capture a $70,000 profit in a relatively short time. Of course, this trade does not come without risk. The risk is that the index traded higher, which would have left you with an equally big loss if the index had risen by the same amount. We’re just trying to show that synthetics allow you to initiate positions that others will tell you cannot be done. The more agile and efficient you are at establishing positions, the better trader and investor you will become. Synthetics give you those abilities.

Added Insights into Synthetics
All combinations of synthetics can be created by Formula 5-15 which is:

S + P – C = 0

Now that you understand synthetics, it is easier to see why the formula works. Assume you are long stock and also have another asset in your portfolio. You don’t know what this asset is but you are told that it makes your long stock position risk free. What does that tell you about the other asset? If you have no risk, then the other assets must be short stock. If you are long stock and short stock, then you are effectively flat and have no risk. Now think about our synthetic formula. If you are long stock and have other assets (shown by the box) and are also told that you have no risk then the boxed assets (long put + short call) must be equal to short stock and that’s exactly what we found out.

S + P – C = 0

To find any synthetic equivalent, all you need to do is isolate the variable(s) you’re trying to solve for and the answer will be immediately visible. Let’s try another. If you want to find out the synthetic equivalent to a long put, just isolate that +P position:

S + P – C = 0

If that long put is paired with other assets so that it has no risk, then the other assets must be equal to a short put. This immediately shows that long stock plus a short call must be equal to a short put.

It turns out that no matter which asset you pick, the other two are the synthetic opposite and fully hedge the risk. It should make sense, then, that we could also pick any two assets and know that the third will fully hedge those two.

All Combinations of Synthetics
It is great practice to run through Formula 5-15 and figure out the various combinations of synthetic trades. If you are really motivated, try to draw the corresponding profit and loss diagrams. All of the combinations are listed below for your reference. Note that the short positions are exactly the opposite of the long positions.

Asset Synthetic Equivalent
Long stock Long call + Short put
Short stock Short call + Long put
Long call Long stock + Long put
Short call Short stock + Short put
Long put Short stock + Long call
Short put Long stock + Short call

Synthetic trades may seem complex at first but, in reality, are actually quite simple. Many think they are a needless academic exercise and of no practical use but nothing could be further from the truth. If you plan to actively trade options, it is crucial to understand synthetics. Market makers make their living with the put-call parity relationship so don’t think it’s a waste of your time to gain a basic understanding. A little time invested will make option investing worth your time.

All combinations of synthetic positions are derived from the put-call parity equation.

Real Applications for Synthetics
Are synthetics really useful? In Chapter Four we found that it is never advantageous to exercise a call option early except to collect a dividend. When you exercise a call option, you give up the rights with the call option in exchange for the stock. If you exercise a call to gain the stock, you are holding all of the downside risk of the stock in exchange for collecting the dividend. Now that you understand synthetics, we can perhaps find a better way to do this. When you are long the call, rather than exercising it, you could, instead, sell the same strike put. This creates a synthetic long stock position (since you are long the call and short the put), which is effectively the same position you were going to have if you exercised the call. While the synthetic long stock position does not allow you to collect the dividend, it does let you collect the premium of the put. In many cases, this put premium will be of greater value than the dividend on the stock while either choice exposes you to the same downside risk. In addition, by choosing the synthetic long call position, you can hold onto the exercise value of the cash a little longer to earn interest. In other words, if you choose to exercise the call, you must pay for the stock today.

By entering the synthetic long stock position, you will end up buying the stock at the same price but at a later date. Why? For the synthetic long stock position, you are long the call and short the put. If the stock price is above the strike at expiration, you will exercise the call and buy the stock for the exercise price. If the stock’s price is below the strike, you will be assigned on the put and buy the stock for the strike price. No matter where the stock’s price is at expiration, you will pay the strike price and receive the stock, which is exactly what you would have done had you exercised the call only at a later date. This allows you to hold onto the cash for a longer period of time to earn interest. As long as the put premium plus interest earned exceeds the value of the dividend, you are better off with the synthetic long stock position. This means that it may still be advantageous to use the synthetic stock strategy even if the put premium is less than the dividend. You must compare the put premium plus interest earned to the dividend. Only when the dividend exceeds the value of the put plus interest should you exercise the call for the dividend. Please keep in mind that we are not saying that you should always capture either the dividend or put premium. In many cases, neither choice may warrant holding all of the downside risk of the stock whether synthetically or not.We just mean that if you have decided it is worthwhile, then you should consider the synthetic long stock version before exercising the call.

The mathematics behind put-call parity work no matter how you may choose to attack a particular problem. For example, we could have solved the problem of early exercise by considering what would happen if you actually exercised the call to get the dividend. If you exercise the call, you are buying stock and effectively selling your call. If you buy stock and sell a call, what have you done synthetically? You have sold a put. Different investors and traders see synthetics in different ways. But no matter how you view them, you’ll arrive at the same answer as long as you are properly applying the put-call parity formula.

To be continued…..

Dec

28

Options 101 # 61

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To find the synthetic version of any of these three assets, all we need to do is reference Formula 5-15 for the answer.

To start, we need to get the asset that we’re trying to replicate (either the stock, put, or call) by itself and with the correct sign. Let’s stick with our same example and find the synthetic equivalent value of a long but this time we’ll use Formula 5-15. To do so, we need to get a +C (remember, we are using “+” to denote a long position) on one side of the equation. Using some basic algebra, if we add C to both sides of the equation we get: S + P = C and there’s the answer; long stock plus long put (left side of the equation) will behave just like a long call (right side of equation). Therefore, if you hold long stock and a long put, you have a synthetic call position.

According to Formula 5-15, an investor who owns stock and a put will share the same profit and loss diagram as one who is long a call. Remember, this does not mean that both investors will have the same portfolio values since we’re not accounting for the borrowed funds. But the two portfolios should respond the same way to stock price changes at expiration. Let’s assume one investor buys stock plus a $50 put for $5 while another buys a $50 call for $5 and check the profit and loss diagrams to see if we’re correct:

As you can see, there is no difference between long stock + long $50 put purchased at $5 (left chart) and the long $50 call purchased at $5 (right chart). The person holding the long stock and long put raised the cost basis of his stock from $50 to $55; that’s why his breakeven point is now $55. However, he still participates in all of the upside movement of the stock. What if the stock falls? The investor is protected for all prices below $50, which is the strike of the put. The worst that can happen is for the stock to fall to zero. This investor will exercise the put and receive $50, effectively only losing on the $5 he paid for the put; therefore the maximum loss is $5.

For the call holder (right chart), he paid $5 so his maximum loss is also $5 but he too participates in all of the upside of the stock. The stock will have to be $55 at expiration in order for the call holder to break even, since he has the right to buy stock at $50 but paid $5 for that right. This makes his breakeven price $55 as well.

We can use this information to gain some trading advantages. For example, most firms do not allow investors to buy call options in their IRA (Individual Retirement Account) but now you know that it can be done in a roundabout way with synthetics. You simply buy the stock and put, and you are effectively long a call option. Now, your return on investment will be much lower using long stock plus a long put as compared to the person who buys only the call. This is due to the difference in capital required to purchase the stock, but the two positions will behave the same in terms of net gains or losses at expiration.

Synthetics are useful for understanding option-pricing behavior as well. In Chapter Two we showed that out-of-the-money options respond slower to changes in stock prices because of the number of zeros used in the averaging process. Synthetics can show us another view as well. Assume that a stock is trading for $100. We can create an out-of-the-money call, such as the $105 strike, by purchasing the stock for $100 and also buying the $105 put. Remember that the “bend” in any profit and loss diagram occurs at the strike price, so a long stock position plus a $105 put will look exactly like a $105 call in a profit and loss diagram. As the stock rises from $100 toward $105, the long stock position will obviously make dollar-for-dollar. However, the long $105 put is losing intrinsic value nearly dollar-for-dollar up to the $105 stock price. The net result is that the long stock and long put positions nearly cancel each other out, and there is no change in value.

In other words, the long stock plus long $105 put combination will hardly budge in value as the stock climbs toward $105. But once the stock price rises above $105, then the put has no more intrinsic value to lose but only some time value. The stock, on the other hand, continues to increase dollar-for-dollar and the long stock plus long $105 put combination now starts to increase in value if the stock continues to climb above $105. This is exactly how a long $105 call would behave. The next time you’re tempted to buy an out-of-the-money call because it’s cheap, think about synthetics. If you’re really bullish and want to buy the stock, would you buy an in-the-money put (that’s going to lose dollar-for-dollar) to protect it? If not, then think twice about that out-of-the-money call because it is the same thing.

Using Formula 5-15, we can figure out any synthetic position. Notice that there are only three assets in the equation – stock, puts, and calls. A very simple property of synthetics is that the synthetic equivalent of any one asset will be some combination of the other two. In other words, stock can be formed by some combination of puts and calls. Calls can be replicated by some combination of stock and puts. The synthetic equivalent will never include the asset you’re trying to replicate. For example, a synthetic long call will not include a call option in the answer. If you come up with that, a mistake has been made. The only thing left now is to figure out whether those combinations are long or short, and that’s where Formula 5-15 helps.

Now that you have Formula 5-15, let’s work through some examples to see how to figure out – and understand – synthetic options.

Synthetic Long Stock
Can we use the basic put-call parity formula (Formula 5-15) to see if there’s a way to own stock synthetically? Without looking ahead, see if you can use the equation S + P – C = 0 and solve it for long stock.

Because we have +S on the left side already, let’s move the C and P to the other side, which changes their signs. Once we do, you will find that S = C – P. This tells us that a trader holding a long call and short put (right side of equation) is doing the same thing as someone holding stock (left side). That is, a long call plus a short put is synthetically equivalent to long stock.

Let’s check the profit and loss diagrams for each and see if we’re correct:

Again, we see there is no difference between the two positions. The long stock purchased at $50 (left chart) will gain and lose point-for-point to the upside as well as the downside. The same is true for the long $50 call and short $50 put (right chart). The $50 call will gain point-for-point at expiration while the short put will become a liability (loss) point-for-point if the stock should fall. Many traders wonder how these two positions can be exactly the same. Isn’t there some time premium on the call option and doesn’t that change the profit and loss diagrams? Refer back to Figure 5-10, which is reprinted below:

This showed that the time value of the call (over the cost-of-carry) is equal to the value of the put. If you buy the call and sell the put, you have eliminated the entire time premium in the call.

Another way to understand why the long call plus short put combination is equal to long stock is to think back to our lesson on the deltas of calls and puts. We determined that the absolute delta values must sum to one. If the call delta is 60, then the put delta is -40. So if you bought this call and sold the put, you are long 60 deltas and short 40 deltas, or +60 – (-40) = 100 deltas. The delta of stock is always 100 since it always gains and loses point-for-point with itself. Buying a call and selling a put is exactly the same thing as owning stock from a profit and loss standpoint. Of course, it is much different on a leveraged basis since we are not accounting for the cost of carry since we ignore the Pv (E) from our original put-call parity equation. In an earlier section, we mentioned that Gordon Gekko would have done much better had he purchased the calls and sold the puts. Now you see why; he would have been holding synthetic long stock.

To be continued………….

Dec

25

Options 101 #60

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Put-call parity lends many insights into option pricing and theory. But it goes far beyond theory because there is a practical application to the formula that is used by all professional traders. It is the formula that provides the foundation for synthetic options.

Synthetic Options
Synthetic options are not a type of option such as calls or puts. As the name implies, synthetic options are ways of creating positions that look, feel, and behave like one asset but are constructed from entirely different assets. By using the put-call parity equation, we can create one asset from another. The benefit to us is that one form may be more liquid or more efficient than another.

For example, let’s say we want to create a synthetic long call option. All we have to do is refer to any of our put-call parity formulas and algebraically solve for the call option. We might choose to use our original formula:

S + P – C = Pv (E)

If we are to solve for the call option, we must get C to one side of the equal sign with the other variables on the other. Using the above formula, in order to get the “C” by itself, we must add C to both sides and then subtract Pv (E) from both sides. This result is:

C = S – Pv (E) + P

This is the same formula we saw earlier in Formula 5-6. In other words, if you borrow the present value of the exercise price and buy stock plus buy a put, you have exactly created a call option – you have created a synthetic call option.

When we say that one position is the synthetic equivalent of another, we really mean that the two positions have exactly the same profit and loss profiles at expiration. Let’s see if these two positions are truly equal. Assume one investor buys a $50 call while another holds Portfolio A, which contains long stock at $50, long $50 put, and borrows the present value of the $50 exercise price. The borrowed funds mature to $50, which means the investor holding Portfolio A owes $50 at expiration. According to Formula 5-6, the profits and losses to either investor should be identical at expiration regardless of the stock’s price. Table 5-11 compares the two investors:

For example, if the stock price is $35 at expiration, the $50 call is worthless. Portfolio A has stock worth $35 and a long put worth $15 for a total of $50. However, the holder of Portfolio A must also repay $50 at expiration, which leaves him with zero. Notice that the two bolded columns have exactly the same values. No matter which stock prices we might try, both columns will always match. This shows that a call option can be synthetically created by borrowing the present value of the exercise price to buy stock and then protecting that investment with a put option. So if the two positions are equal, which should we choose? That all depends on which is more cost effective.

For instance, in Figure 5-12, Google (GOOG) was trading for $293 and the January $290 calls with 529 days to expiration (1.47 years) were asking $58. The $290 put was asking $39.40.

Our synthetic relationship tells us there is no difference between the long call and long stock + long put + borrowed funds portfolio. However, many investors get trapped into thinking that the $290 call is obviously a better deal at $58 rather than spending $293 for the stock plus $39.40 for the put. If you do not plan to purchase the stock at expiration then it may be best to spend less money and buy the $290 call. However, if you are planning to buy the stock at expiration, we need to find out which is our most efficient method. If you buy the call and the stock price is greater than $290 at expiration, you will pay $58 today for the call and $290 in 1.47 years when you exercise the call. Alternatively, you could buy the stock for $293 and the $290 put for $39.40 today and accomplish the same thing. While it may appear that the call is the better deal, we need to consider the financing rates.

If you buy the stock plus put combination it will cost you $293 + $39.40 = $332.40 today. If you buy the call, it will only cost $58 today. However, if plan to buy the stock at expiration, you will have a payment of $290 due in 1.47 years. The question we need to answer is this: Is it cheaper to pay $332.40 today or $58 today and $290 nearly a year-and-a-half in the future? In order to compare these two cash flows, we need to line them up at the same time. In this example, it’s easiest to line them up at today’s prices. We know the stock + put will cost $332.40 today and the call will cost $58, which is a difference of $274.40. Now we just need to figure out which interest rate makes a future payment of $290 equal to $274.40 today. In other words, if we deposit $274.40 into a risk-free account today, what risk-free interest rate is necessary for our money to grow to $290 at expiration?

We can solve this from the basic principle and interest relationship:

interest = principal * rate * time

In this example, the interest is the difference between the $290 future value and the $274.40 present value, or $15.60:

$15.60 = $274.40 * r * 1.47

r = $15.60 / ($274.40 * 1.47)

r = .0387, or 3.87%.

If your broker pays a risk-free rate of 3.87% on cash balances then there is no difference between buying the call or the stock plus put combination. If your broker pays more than 3.87%, you should keep your cash and buy the call. If your broker pays less, you should buy the stock and put combination. So while the cheapest combination today may seem to make the most sense, that may not be true once we consider the financing rates.

Whenever we consider a true synthetic equivalent, we must consider all four variables in the put-call parity equation. However, in the world of trading, synthetic positions usually ignore the present value of the exercise price. This means that synthetic positions are usually not calculated on total values but, instead, they are figured out on net changes between the two positions. For instance, let’s look at our previous positions but this time we’re not going to account for the borrowed funds.

In other words, we’re going to make Portfolio A the combination of long stock and a long put and forget about the borrowed funds. Table 5-13 shows that the two portfolios are not equal in terms of total value. Read the first row. If the stock price is $35 at expiration, the $50 call is worth zero while the stock plus put combination of Portfolio A is worth $50. Read the last row. If the stock is $65, the $50 call is worth $15 while the stock and put combination for Portfolio A are worth $65 so they are clearly not equal. However, look at the “total value” column for Portfolio A. If you consider the net changes for this column in relation to the “total value” column, you’ll find they match the expiration values for the $50 call and are shown in the last column:

So if our only concern is to make the net changes of two positions behave the same then we can forget about the borrowed funds. This means that any synthetic position can be calculated by only considering the stock, put, and call in the put-call parity equation.

Our first version of put-call parity was:

S + P – C = Pv (E)

We can rewrite this by subtracting Pv (E) from both sides:
Formula 5-14:
S + P – C – Pv (E) = 0

Formula 5-14 is just another variation of put-call parity. It tells us that if we buy stock, buy a put, sell a call, and borrow the present value of the exercise price, we are effectively doing nothing. This also means this portfolio should cost nothing. If we are going to ignore the borrowed funds portion, we can just drop off the Pv (E) variable to get:
Formula 5-15:
S + P – C = 0

And it is Formula 5-15 that provides our basic synthetic option formula. Notice that the combination of long stock, long put, and a short call is a conversion and are the same assets used by the market maker to create the risk-free position that we started with in this chapter. Consequently, this is sometimes referred to as a synthetic T-bill (Treasury Bill). If you buy stock, buy a put, and sell a call, you are guaranteed to receive more money than you spent – just as if you purchased a T-bill.

To be continued…….

Dec

24

Options 101 #59

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How can we get Portfolio A to equal that of the call option? We must insure the stock prices below $50 by purchasing a $50 put. If we purchase the put, the two portfolios are now equal and we’re right back to Formula 5-7:

C = S – Pv (E) + P
Formula 5-7 shows that an in-the-money call option’s minimum value is S – Pv (E). The difference between the exercise price and the Pv (E) contributes to the time premium of the call, E – Pv (E). Now we see that the remaining time premium comes from the value of the put.
Put-call parity can show us the most efficient ways to trade based on the confidence in our outlook on the stock. For example, if you were absolutely 100% certain that a stock’s price was going to rise, what would you do? (Perhaps you’re Gordon Gekko from the movie Wall Street.) Most investors would just buy the stock and be happy with that. Some that are familiar with options would just buy the calls. But if you really understand options and the put-call parity formula, you’d see a different angle. Formula 5-7 has been reprinted below; let’s take a closer look at what it’s telling you:
C = S – Pv (E) + P

It says that if you buy a call, you’re really buying stock with borrowed funds and then buying a put option for insurance. If you’re certain that a stock is going to rise and wish to use stock, then buy the stock with borrowed funds (S – Pv (E)). In other words, buy the shares on margin as it will provide financial leverage (you’ll be able to buy more shares with the same amount of money). However, if you plan to buy call options, notice that you’re also implicitly buying a put option, which is an unnecessary expense if you’re sure the stock is going to rise. Instead, buy the call and sell the put. Purchasing the call is the same as borrowing money to buy the shares, but it also includes the insurance value of the put in its price, and there’s no sense in paying for that. In the movie Wall Street, Gordon Gekko purchased 1,500 July $50 calls once he gained insider knowledge that Anacott Steel was being acquired. He would have done much better if he had also sold 1,500 of the July $50 puts. We can look at these put-call parity relationships graphically:

Figure 5-9 shows the call price prior to expiration. Notice that it is curved rather than the “hockey stick” formation we are used to seeing. That’s because that this chart is drawn prior to expiration rather than at expiration. Figure 5-9 also shows the values for the stock price minus the exercise price (S-E) as well as the stock minus the present value of the exercise price, E – Pv (E).

Now let’s see what the various sections between the curves represent. The value for any space between two curves in Figure 5-9 can be found by simply subtracting the curve below from the curve above as in Figure 5-10:

For example, the space labeled “C” is found by taking the curve above it, S – E, and subtracting the horizontal axis, 0, below. This is S – E – 0, which is simply, S – E, the intrinsic value of the call.

Distance B is also found by the difference between the two lines above and below it. This distance is (S – Pv (E)) – (S – E), which factors out to S – Pv (E) – S + E. The positive and negative S cancels out thus leaving E – Pv (E), which is simply the interest that can be earned on the exercise price. In reality, the distance between these two lines (above and below Area B) is very small. Figure 5-10 is drawn for a 20% risk-free rate just so we could get some separation between the two lines.

Area C is the space between the call price and the S – Pv (E) line. The value of this area is found by the call price, C, minus the S – Pv (E) line. This is C – (E – Pv(E)), which factors out to C – E + Pv (E). We know from put-call parity that this is the value of the put option.

We can see from the diagram that the total value of the call option is composed of these three areas:

Of course, Areas B and C make up the time value of the option, since these are the areas above and beyond the intrinsic value of S – E. This shows that the time value portion of a call option’s price is really comprised of two components. One is the cost-of-carry and the other is the value of the put. Once they’re gone, we’re just left with Area A, which is the intrinsic value, or S – E. If there is no value to the put, this shows that the minimum time value of the call option is comprised of the cost-of-carry on the exercise price (Area B). Once again, this minimum value is S – E + E – Pv (E), which is simply S – Pv (E), which is what we said previously. Any additional time premium must be equal to the value of the put (Area C).

Notice the curved line in Figure 5-10 that represents the price of the call option. If the stock rises sufficiently, that curved line eventually runs parallel to the line represented by S – E. At that point, the call option is behaving like stock. The reason is that S – E obviously runs parallel to the profit and loss line for just plain stock (not shown in diagram) because that line is simply stock reduced by the value of the exercise price. Another way of understanding it is that if the call is in-the-money at or very near expiration, it will be worth S – E and gains point-for-point with the underlying stock. If the call option is deep enough in-the-money prior to expiration, the curved line runs parallel to the S – E line, so it must also gain point-for-point with the stock. This is a graphical representation drawing the same conclusion as our simplistic mathematical model we found in Chapter Two. The point to understand is that deep in-the-money calls behave like stock.

Now look at Area C. It shows the value of the put option, which is the same as the time value of the call (remember that the call price is bounded by zero and S – E). As the stock rises, the value of the put decreases, which is equal to saying that the time value of the call decreases. This observation is handy for trading applications. For example, say you wish to find a call option with a delta near one, which means that it is effectively behaving like stock at that point. All you need to do is look at the option quotes for a put option that it bidding zero. If the corresponding put is bidding zero then that call must have a delta near one. This agrees with the relationship between call and put deltas we discovered in Chapter Two and will be important once we discuss strategies for buying long calls and puts.

To be continued……

Dec

23

Options 101 #58

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If call and put prices are separated by the cost of carry on the exercise price then they must be separated by the difference between the stock and exercise price at expiration. The reason is that, by definition, the present value of the exercise price must grow to the exercise price at expiration. Remember, the negative Pv (E) on the right side of the equation tells us that the investor sold the present value of the exercise price, which means he receives the present value of the exercise price in cash and must repay the strike price at expiration. This is similar to the issuance of Treasury bills. The government sells them at a discount from face value and receives cash. In return, the government must pay the holder the face value at maturity. So any time we see a negative Pv (E) in a put-call parity equation that just means the investor borrowed money and must repay the strike price at expiration. For example, if the exercise price is $50 and the risk-free rate is 5% then the present value is $50/1.05 = $47.62. The investor would borrow $47.62 and owe $50 at expiration.

Conversely, any time we see a positive Pv (E) that means the person has deposited cash into a risk-free account and will receive the strike price at expiration. Using the previous example, the investor would deposit $47.62 into a risk-free account and receive $50 at expiration.

At expiration, the value of the right hand side of Formula 5-4 must always be the stock price minus the exercise price, or S – E. This is evident since the Pv (E) always grows to E at expiration. The left hand side is not so easy to see but let’s step through the actions. If the stock price is above the exercise price at expiration then the investor will receive stock (+S) by exercising the call and paying the exercise price (-E). In other words, his portfolio will be worth S – E.

But if the stock price is below the exercise price, the investor will be assigned on the short put and buy stock (+S) and pay the exercise price (-E). If the stock price is below the strike price at expiration, the portfolio is still worth S-E. No matter what happens to the stock’s price at expiration, the left and right hand sides of Formula 5-4 are worth S – E.

Let’s test the formula and see if it works. We’ll assume two portfolios. Portfolio A contains a long call and short put (left side of Formula 5-4) while Portfolio B contains long stock and the borrowing of the present value of the exercise price in cash (right side of Formula 5-4), which means the investor owes $50 at expiration:

In Table 5-5, you can see that the “total value” columns for either portfolio are equal at expiration. The total value for Portfolio A is found by taking the “$50 call” column minus the “$50 put” column, which is what the left hand side of Formula 5-4 tells us to do. The “total value” for Portfolio B is found by taking the “long stock” column minus the “Repay $50” column, which is what the right hand side of Formula 5-4 says to do at expiration. Notice that the total values for Portfolio A and B are worth the stock price minus the $50 exercise price, or S – E, which is what we calculated.

Let’s put Formula 5-4 to the test and look at some real option quotes using Affymetrix (AFFX) in Figure 5-6:


When these quotes were taken, interest rates were low (about 3.5%) and there were 16 days until expiration, so the interest value of the options is not too great. Formula 5-4 states that the difference in call and put prices should equal the stock price minus the present value of the exercise price. But because there is not a lot of time remaining and interest rates are low, the present value of the exercise price will not be too different from just the exercise price. We should therefore expect that the difference in the call and put prices to be roughly the difference between the stock and exercise price, or C – P ≈ S – E.

Take a look at the August $40 call and put prices in Figure 5-6. To make our calculations a little more precise, we’ll split the bid and ask prices since the bid price tends to be below theoretical value and the asking price tends to be above. The August $40 call is $6.80 and the August $40 put is 10 cents. The difference is $6.80 – 0.10 = $6.70. This difference should be roughly equal to the stock price minus the exercise price, or $46.70 – $40 = 6.70. In this case, it’s a perfect match.

Now look at the August $45 calls and puts. They are $2.35 and 0.575 respectively, which is a difference of 1.77. The difference between the stock and exercise price is $46.70 – $45 = $1.70, which is pretty close.

Let’s try one more. The August $50 calls and puts are 0.30 and $3.50 respectively, which is a difference of -$3.20. The stock price minus the exercise price is $46.70 – $50 = -$3.30, which again is pretty close. There are many reasons why we’re not coming up with exact matches but it’s partly due to the fact that we don’t know the true theoretical prices. For example, the August $45 calls are bid $2.25 and asking $2.35, which has a midpoint price of $2.30. It may seem reasonable to think that the theoretical price is $2.30 with the bid five cents below and the asking price five cents above. However, it’s also possible that the theoretical price is $2.32 or any other number between the bid and ask. It’s difficult to know since options below $3 must trade in five-cent increments.

Another reason we’re not coming up with exact matches is because the time premium gets bigger as we approach the at-the-money calls and then diminishes again. That’s why we got an exact match for the $40 strike, we were off by seven cents for the $45 strike, and off by 10 cents for the $50 strike. Even though these options are close to expiration and interest rates are low there is still some cost of carry (interest that could be earned on the strike price). Since we’re not accounting for interest, we will be off by a little in our calculations.

The important point to see is that call and put prices are definitely tied together by the invisible force of put-call parity. These prices are not arbitrarily chosen by the market makers. Once a put price is determined by the market, the call price is automatically determined and vice versa.

Put-call parity can also show us some invaluable insights as to why investors and traders are attracted to options. Let’s rearrange the put-call parity formula to solve a long call option:

Formula 5-7:
C = S – Pv (E) + P

Formula 5-7 shows us that a long call option is the same thing as owning stock (+S), borrowing money, -Pv (E), and also owning a put (+P). In Chapter Three, we said that call options provide downside protection and Formula 5-7 shows why. When you buy a call, you are borrowing money to buy stock and also buying a put option! The total value of the put option is really the time value of the call option over and above the cost of carry on the exercise price. In Chapter Two, we also said that in-the-money call options contain intrinsic value plus an interest component, which are shown by S – Pv (E). Now you see that there is a third component to a call option’s value, and that is the value of the put option.

Of course, there’s nothing that says the put must have value. Let’s assume the put is worthless. If the put has no value then Formula 5-6 reduces to S – Pv (E), which is what we previously found to be the bare minimum price for a call option. We can show why by comparing a long $50 call with a portfolio of long stock at $50 and the borrowing of the present value of the exercise price as shown in Table 5-8:

Table 5-8 shows that the $50 call performs the same as Portfolio A for stock prices above $50 at expiration (shown in bold). However, the $50 call performs better if the stock is below $50 at expiration since it does not lose dollar-for-dollar with the stock. So we know that the call option’s value is either greater than or equal to Portfolio A. In other words:

C ≥ S – Pv (E)

This tells us that an in-the-money call option’s minimum price is the intrinsic value plus the cost of carry, which is exactly what we found in Chapter Two (Pricing Principle #4). The call’s price must be at least this great otherwise arbitrage is possible.

To be continued….

Dec

22

Options 101 # 57

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The Put-Call Parity Equation
We have shown that the market maker’s three-sided position (conversion) is guaranteed to be worth the present value of the exercise price. No matter what happens to the stock’s price, the market maker is guaranteed to receive the $50 exercise price at expiration. Because he’s guaranteed the $50 exercise price, the long stock + long put + short call position must be worth the present value of the exercise price ($50 in this example).

If we use S for stock price, P for put price, C for call price, and Pv (E) for the present value of the exercise price, then we can write the relationship of long stock + long put + short call equals the present value of the exercise price more concisely:

Formula 5-1:
S + P – C = Pv (E)

Notice the use of plus and minus signs. The long positions are denoted by a plus sign while any short positions are indicated by a minus sign. (If no sign precedes a letter such as with the “S” then it is assumed to be a plus sign.) This formula is stating that values of long stock + long put + short call are equal to the present value of the exercise price. Using our previous example, Formula 5-1 states that $50,000 + $3,000 – $3,980 = $49,020. Formula 5-1 is one variation of the put-call parity. If Formula 5-1 or any of the upcoming algebraic variations do not hold in the real world then arbitrage is possible.

Let’s see if the formula works by using the above example. If we have a portfolio consisting of stock purchased at $50, a long $50 put, and a short $50 call, what will happen at expiration to the value of the portfolio at different stock prices?
The last column in Table 5-2 shows the total value of the portfolio at expiration, which is found by adding the “stock” column to the “$50 put” column and then subtracting the “$50 call” column, which is what Formula 5-1 tells us to do. Reading the top row, for example, if the stock price is $35 at expiration (column one) then your stock position must also be worth $35 (column two). The $50 put would be worth $15 (column three) and the $50 call would be worthless (column four). This means that your total portfolio would be worth $35 + $15 + $0 = $50 if the stock closes at $35.

The “total value” column shows us that this portfolio always sums to $50 no matter what happens to the stock’s price at expiration, and that is exactly what we expected to happen. Of course, these are not the only stock prices that could occur at expiration. But you can check for yourself that any stock price results in a final portfolio value of exactly $50.

If the value of this package of long stock, long put, and short call is guaranteed to be worth $50 at expiration then today, that package must be the present value of $50, which is what Formula 5-1 tells us.

As stated before, Formula 5-1 is just one variation of the put-call parity formula. We can rearrange it algebraically and come up with other forms that will provide different views of the pricing connections between calls and puts. We will present some of the more interesting forms but, as you read through these, don’t worry so much about the formulas as much as the insights they provide. Formula 5-3 shows an algebraic rearrangement of Formula 5-1 that was created by adding the call option (C) to both sides of the equation:

Formula 5-3:
S + P = C + Pv (E)
This formula tells a very interesting story. The left-hand side of the equation represents an investor who owns stock plus a protective put. The right-hand side represents an investor who owns a call option plus a deposit of cash, Pv (E), which will grow to the exercise price at expiration by earning the risk-free rate. You can think of the deposit of cash as an investment into a Treasury bill or CD or other guaranteed security. Formula 5-3 tells us that an investor who buys stock and a put is financially doing the same thing as someone who buys a call and deposits sufficient cash to grow to the exercise price at expiration by earning the risk-free rate. In other words, owning stock with the right to sell it is financially the same thing as someone who has enough cash at expiration with the right to buy stock.
Let’s see if that’s true by comparing two investors; one owns the stock + put (left side of equation), while the other owns a call plus the present value of the exercise price in cash (right side). If the stock is above the exercise price at expiration the investor on the left side of the equation will let the put expire worthless and be left with the stock. The investor on the right side will exercise the call and pay for the stock with the cash that has grown to the exercise price. In other words, both investors will be holding the stock. However, if the stock price is below the exercise price at expiration, the investor on the left-hand side of the equation will exercise the put and receive the strike price in cash. The investor on the right side will let the call expire worthless and be left holding an amount of cash equal to the exercise price. No matter what happens to the stock’s price, both investors are equal at expiration.
What’s most interesting about Formula 5-3 is that it refutes one of the most persistent myths in options trading. That is, most brokerage firms view investors who buy stock and a put as insurance (left hand side of equation) as being responsible, conservative investors while those who buy calls (right hand side of equation) as being risk takers and reckless. Formula 5-3 shows that as long as the call buyer has enough cash to buy the stock at expiration, both investors are doing exactly the same thing. Both investors must be conservative or both must be reckless but not one of each. Yet most brokerage firms maintain a split view on each even though they are identical strategies.
Let’s take a look at another variation:
Formula 5-4:
C – P = S – Pv (E)

Formula 5-4 is saying that the difference between the same-strike call and put prices (left side of equation) must be separated by the same difference as the stock and present value of the exercise price (right side). In Chapter Two, Pricing Principle #4 showed us that the right hand side, S – Pv (E), is the minimum value for a call option. This variation tells us that the call and put prices must be separated by an amount equal to the minimum value for a call option.

For example, assume the stock is $50 and interest rates are 5% with one year to expiration. The cost of carry on the stock is $50 * .05 = $2.50. In other words, if you buy the stock, you will miss out on $2.50 worth of interest in one year. In turn, the value of this missed opportunity is $2.50/1.05 = $2.38 today.

Formula 5-4 tells us that the difference between the call and put prices must be at least $2.38. If you were looking at a $50 call and a $50 put with one year to expiration and 5% risk-free interest rates, you would find that the call price is $2.38 higher than the put price. The volatility of the underlying stock changes the total prices but their difference will be exactly $2.38. For instance, if the put were priced at $2 then the call must be $2 + $2.38 = $4.38. If the put were worth $10 then the call must be worth $10 + $2.38 = $12.38.

What happens if the stock and strike prices are not equal? Assume the stock is $55, the strike is $50 ($5 intrinsic value), and interest rates are 5% with one year to expiration. Formula 5-4 tells us that the difference between the call and put prices must be $55 – ($50/1.05) = $7.38. This price arises from the fact that we must immediately pay for the $5 intrinsic value plus the cost of carry, or $5 + $2.38 = $7.38. Hopefully, you’re starting to see that call and put prices are tied together.

Formula 5-4 shows that all call options must be priced higher than the puts by the cost of carry on the exercise price. New traders often confuse this relationship and think that call options are priced higher by the cost of carry on the stock price. The reason it is the cost of carry on the exercise price and not the stock price is because it is the exercise price that is effectively being borrowed when you buy a call option. If you buy a call and exercise it to get the stock then you get to defer the payment of the exercise price until expiration. It is the exercise price that determines the cost of carry.

To be continued…….

Dec

21

Options 101 # 56 Chapter Five Put-Call Parity & Synthetic Options

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Up to this point, calls and puts appear to be polar opposites. Calls represent the right to buy while puts represent the right to sell. And if you look at option quotes, there doesn’t appear to be any connection between the price of the call and the same-strike put. However, call and put prices are highly dependent and are not arbitrarily chosen. Although it may not appear possible, there is a strong, mathematical relationship that describes the connection between calls and puts known as put-call parity. This is one of the most important concepts for beginning and advanced option traders alike, so we will devote an entire chapter to it. Once you understand put-call parity, you’ll find that calls and puts are really one in the same; it just depends on how they’re paired with the underlying stock. So, strange as it may sound, calls are really puts and puts are really calls if properly paired with the underlying stock. In fact, when options were first introduced in 1973, only call options were traded on 16 stocks. Put options did not appear until 1977. The reason is that puts were created by “put-call brokers” who created puts by properly pairing calls with the underlying stock and put-call parity show them how to do just that.

The word “parity” means “equivalence.” There are many types of parity relationships in the financial world such as purchasing power parity and interest rate parity, for example. Parity relationships simply show the connections between two or more variables. As stated before, put-call parity just shows that calls and puts are “equivalent” when properly paired with the underlying stock. Once you understand put-call parity, you will have increased insights into the mechanics of the options market and how options are priced. As you gain experience, you will also find more efficient ways of trading options by using this simple relationship between calls and puts.

There are many ways to present the put-call parity relationship. But perhaps the easiest way to understand it is by looking at how option orders are filled on the floor of an exchange. Once we get the basic put-call parity relationship, we can alter it to get some intriguing looks at how call and put prices are connected.

Filling an Option Order
Let’s say you want to buy 10 calls to open of the ABC $50 strike at market. ABC stock is also trading at $50. In order to make the calculations easy, we’ll assume there is one year to expiration.

When this buy order is received on the floor, the market maker must become the seller so that the transaction can be completed. This means the market maker must be willing to be short a call. While you may be totally comfortable in speculating by buying 10 calls, the market maker may not be so eager to be on the short side of the transaction. We found in Chapter Three that the call owner’s gains are the call seller’s losses. If you buy a call, you have the potential for unlimited gains, and that means the call seller is exposed to unlimited losses.

If the market maker is to be on the short side of 10 one-year calls, his risk is that the stock price rises. In order to protect himself from this risk, he can purchase 1,000 shares of ABC stock. Now, no matter how high the stock moves, he will always be able to deliver 1,000 shares of stock (represented by the 10 calls) at expiration.

However, because the market maker now owns the stock, there is now a new risk; the stock price may fall. To protect himself from this risk, he can buy 10 $50 puts with one year to expiration.

Our market maker is now long 1,000 shares of stock, long 10 $50 put options and short 10 $50 call options. By using these options, the market maker is now fully hedged (protected) against any stock price movement at expiration. This means he is guaranteed to receive $50 per share ($50,000 total) for his stock no matter what happens one year from now. How is this possible?

Think back to the first chapter when we talked about rights and obligations. The market maker paid $50 for the stock and has the right to sell it for $50 by exercising the put. The market maker will exercise the put if the stock price is below $50 at expiration and receive $50 per share. By selling the call, he has the obligation to sell the stock for $50 at expiration. Of course, the only time someone would exercise the call is if the stock’s price is above $50 at that time. If the stock is above $50 at expiration, the market maker will be assigned (“called away”) on the short call and receive $50 per share. What happens if the stock is exactly $50 at expiration? In this case, both options expire worthless and the market maker can sell the stock in the open market for $50. So no matter what happens to the price of the stock at expiration, the market maker is guaranteed to receive $50 per share in one year. It is kind of ironic that, using these speculative derivatives of puts and calls, we can actually create a risk-free portfolio. This is perfect proof of our statement in the first chapter that options are not necessarily risky; it all depends on how they’re used.

The market maker can now sell you the 10 calls with confidence knowing that all stock price risk has been removed. But what price should he charge you for the 10 calls?

We stated the market maker is guaranteed to receive $50,000 in one year regardless of the stock price. Because this is guaranteed, we can easily figure out what the value of this package is worth today. Let’s assume that the risk-free interest rate is 2%. Chapter Two showed us that the present value of $50,000 in one year is $50,000 / (1.02) = $49,020 today. The market maker should therefore pay $49,020 today for the package containing long stock, long put and short call positions. If he pays $49,020 and receives $50,000 in one year, his return on investment will be 2%, which is exactly the interest rate he should receive for a risk-free investment.

The market maker will spend $50,000 for the 1,000 shares of stock trading at $50. Let’s also assume he pays $3 for the put. Now he will spend an additional $3,000 for the put for a total cash outlay of $53,000. We already figured that the fair price for this package of three assets should be worth $49,020 yet he’s paying $53,000 for it.

The market maker has overpaid by $53,000 – $49,020 = $3,980, so he will need to bring in a credit for this amount. How can the market maker receive a credit of $3,980? Easy, he will fill your order on the 10 $50 calls for roughly $3.98. Doing so, he will receive the necessary credit to make his $53,000 cash outlay equal to $49,020. Of course, the market maker will try to make a little profit and quote a price of $4.00 or $4.10 on the $50 calls (remember, options above $3 must quote in ten-cent increments so $3.98 or $4.05 would not be allowed but $3.98 would be the theoretical price). Why won’t he scalp you and charge a much higher price, say $10? The reason is competition. If the market maker quotes too high of a price, somebody else will step in and offer a lower price. Market makers get very competitive with risk-free packages. The reason is they can, in this example, borrow at 2% and loan it risk-free at a higher percent. The reason their rate of return is higher than 2% is because of the additional few cents they tack on for profit, which is reflected in the bid-ask spread. In effect, they end up buying the put for less than the theoretically fair price and sell the call for a little more than the theoretically fair price, thus paying less for the package than the present value would suggest it is worth. However, if they are able to borrow at 2% and are earning a much larger risk-free return, market makers will want to create more of these packages and put buying pressure on the puts and selling pressure on the calls until the rate of return is much closer to the risk-free rate.

To summarize, the market maker’s initial position looks like this:

Buy 1000 shares at $50 = -$50,000
Buy 10 $50 puts at $3 = -$ 3,000
Sells 10 $50 calls at $3.98 = +$3,980
Equals -$49,020 cash outlay by market maker.

This is guaranteed to grow to a value of $50,000 in one year since $49,020 * 1.02 = $50,000 because of the full hedge provided by the long put and short call.

This three-sided position (long stock + long put + short call) established by the market maker is called a conversion. If he had done the reverse (short stock + short puts + long calls) then it would be called a reverse conversion or reversal. Reversals are one of many “locked” trades. A locked trade simply means that it cannot lose. In this case, the market maker buys the three assets at a discount from the exercise price and receives the full exercise price at expiration.

To be continued…..

Dec

18

Options 101 #55 Chapter Four Answers

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Chapter Four Answers

1) You have Dell Computer options in your account with the symbol DLQDE. Which month and strike do they represent?
a) April $25
Notice that you do not even need to know the root symbol for the underlying stock if you are only trying to determine the month and strike. The month and strike are always determined by the last two letters of the option symbol, which are D (April) and E ($25 strike) in this example.

2) For any option symbol, the last two letters always designate (in order):
b) Month and strike
As stated in the answer to the previous question, the last two letters always represent the month and strike in that order. Train your eye to separate the last two letters from the option symbol as those are the month and strike. The remaining letters make up the root symbol.

3) The “month code” for an option identifies it as a call by using which set of letters?
a) A through L
The first 12 letters of the alphabet (A through L) designate the 12 months of the year for call options.

4) When a stock if first assigned an option trading cycle, it is assigned to one of which three cycles?
d) January, February, March
These cycles are also known as Cycle 1, Cycle 2, and Cycle 3 respectively. Once a stock is assigned a cycle it never changes.

5) It is now April and you find that ABC stock has April, May, August, and November options. Which cycle is ABC on?
d) February cycle
Because it is April, we know that April and May options must be traded for all contracts regardless of which cycle it may be on. So those two months tell us no information about the cycle that this stock is on. To determine that we need to look to the following month for the answer and that is August. August is the middle month or “February” position for that quarter so this is a February-cycle stock.

6) It is now April and ABC has April, May, August, and November options. When will February options start trading?
c) When June expires
Start with April, May, August, and November contracts. When May expires June will be added as the near-term contract. When May expires, July will be added as the near-term contract. When June expires, the near-term contract (July) is already trading. The exchange will roll out the next quarterly month, which will be February.

7) When equity options are first issued, they control how many shares of stock?
b) 100

8) You own 10 ABC $50 calls. ABC goes through a 2:1 split tomorrow. How many contracts will you have and which strike price after the split?
d) 20 contracts, $25 strike
As with shares of stock, a 2:1 split will double the number of shares that you own and cut the market price in half. The same is true for options. You will end up with double the number of contracts and the strike will be cut in half. Another way to check this is to understand that the total contract value must remain the same. If you have 10 contracts of the $50 calls, you have a total exercise value of 1,000 shares * $50 = $50,000. If the strike is cut in half to $25, the total contract value must still remain the same and that means that there must be $50,000/$25 = 2,000 shares, or 20 contracts.

9) The open interest for a particular option is 3,000. Today you notice that 50 contracts traded but tomorrow the open interest is still 3,000. How could this happen?
d) 50 were opening and 50 were closing
Open interest only increases if both parties – the buyer and seller – are entering into opening transactions. The reason this open interest remained the same is because one trader was opening while the other trader was closing, so the net result was unchanged.

10) You bought one $40 call when the underlying stock was $40. The stock has quickly risen to $45 with two months remaining before your option expires. If you wish to own the stock, you should:
b) Wait until expiration and only exercise if it is advantageous
It is never advantageous to exercise your call option early to simply gain the stock. The reason is that you are “throwing away” the time premium of the option when you exercise and then you are exposed to the total risk of the stock. You should wait until expiration before you exercise. If the stock’s price is still above the strike price then go ahead and exercise the option. However, if the stock’s price is below the strike price then just purchase the shares in the open market and let the call option expire worthless.

11) You own a call option and the underlying stock is about to pay a large surprise dividend. You wish to exercise the call so that you can collect the dividend. When should you exercise the call?
c) Exercise the day before the ex-date

12) You own 300 shares of Dell Computer and have placed a stop order at $25. How will this order be handled? The order:
d) Becomes a market order if Dell trades at or below $25

13) You own 300 shares of Dell Computer and have placed a stop order at $25 with a stop limit of $24.50. How will this order be handled? The order:
c) Becomes a limit order at $24.50 if Dell trades at or below $25

14) Stop and stop limit orders:
b) Are never guaranteed to prevent losses

15) XYX stock is trading for $37 and pays a $1 dividend tomorrow. What will happen to the stock tomorrow assuming all else being constant?
b) The price of XYZ will be reduced by $1
The stock’s price is always reduced by the amount of the dividend. XYZ would open at $36 “unchanged” assuming that no other factors created buying or selling pressure.

16) When a stock splits, the exchanges adjust option strikes and possibly the contract sizes. What is the purpose of these adjustments?
a) They keep the total value of the contract the same
Option contracts are always adjusted so that the total value of the contract (exercise value) remains unchanged. You will find examples of this in Question 5 and Question 15.

17) No matter which cycle a stock may be trading, there will always be which two contracts traded?
b) The current month plus the following month

18) You own a $50 call option. If the underlying stock undergoes a 5:4 split tomorrow, which adjustments will be made to the contract?
a) The strike will be adjusted to $40 and the contract will control 125 shares
A 5:4 split increases the number of shares by a factor of 5/4 = 1.25. If you own 100 shares, you will have 125 shares after the split. The strike must also be reduced to $50/1.25 = $40. Notice that the total contract value remains the same. Prior to the split, the contract controls 100 shares at $50, or $5,000 total contract value. If the strike is reduced to $40, it must control $5,000/$40 = 125 shares. The point to remember is that any adjustment made to an options contract leaves you no better or worse off. It is simply an adjustment made to reflect the current prices without adversely affecting your option contract.

19) Large bid ask spreads are the result of:
d) Low volume

20) An option is currently bidding $5 and asking $5.30. You place an order to sell 20 contracts at $5.10 and find that the bid immediately jumps to $5.20. This is most likely due to the market maker:
b) Leaning against the book

Dec

17

Test Options 101 # 54 Chapter Four Questions

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1) You have 5 Dell Computer options in your account with the symbol DLQDE. Which month and strike do they represent?
a) April $25
b) May $20
c) May $25
d) April $27.50

2) For any option symbol, the last two letters always designate (in order):
a) Month and style
b) Month and strike
c) Strike and month
d) Strike and type

3) The “month code” for an option identifies it as a call by using which set of letters?
a) A through L
b) M through X
c) U through Z
d) A through T

4) When a stock if first assigned an option trading cycle, it is assigned to one of which three cycles?
a) January, February, May
b) January, June, December
c) January, June, September
d) January, February, March

5) It is now April and you find that ABC stock has April, May, August, and November options. Which cycle is ABC on?
a) March cycle
b) December cycle
c) January cycle
d) February cycle

6) It is now April and ABC has April, May, August, and November options. When will February options start trading?
a) When April expires
b) When May expires
c) When June expires
d) February options will never trade for this cycle

7) When equity options are first issued, they control how many shares of stock?
a) 50
b) 100
c) 150
d) 1,000

8) You own 10 ABC $50 calls. ABC goes through a 2:1 split tomorrow. How many contracts will you have and which strike price after the split?
a) 20 contracts, $50 strike
b) 10 contracts, $50 strike
c) 10 contracts, $25 strike
d) 20 contracts, $25 strike

9) The open interest for a particular option is 3,000. Today you notice that 50 contracts traded but tomorrow the open interest is still 3,000. How could this happen?
a) This is a mistake and the open interest should be 3,050
b) All were closing trades
c) All were opening trades
d) 50 were opening and 50 were closing

10) You bought one $40 call when the underlying stock was $40. The stock has quickly risen to $45 with two months remaining before your option expires. If you wish to own the stock, you should:
a) Exercise the call immediately to take advantage of the $40 purchase price
b) Wait until expiration and only exercise if it is advantageous
c) Exercise immediately if there is sufficient open interest
d) Wait until expiration and exercise the call regardless of the stock’s price

11) You own a call option and the underlying stock is about to pay a large surprise dividend. You wish to exercise the call so that you can collect the dividend. When should you exercise the call?
a) Exercise on the payable date
b) Exercise the day after the ex-date
c) Exercise the day before the ex-date
d) Exercise on the ex-date

12) You own 300 shares of Dell Computer and have placed a stop order at $25. How will this order be handled? The order:
a) Becomes a market order if Dell trades at $25 or higher
b) Is filled at $25 if Dell trades at $25 or below
c) Becomes a limit order at $25 if Dell trades at $25 or below
d) Becomes a market order if Dell trades at or below $25

13) You own 300 shares of Dell Computer and have placed a stop order at $25 with a stop limit of $24.50. How will this order be handled? The order:
a) Is filled for $24.50 if Dell trades at $25 or higher
b) Is filled for $24.50 is Dell trades at $25 or lower
c) Becomes a limit order at $24.50 if Dell trades at or below $25
d) Becomes a market order if Dell trades at or below $24.50

14) Stop and stop limit orders:
a) Are guaranteed to fill within 5% of your stop price
b) Are never guaranteed to prevent losses
c) Are guaranteed to prevent losses
d) Are guaranteed to fill within 10% of your stop price

15) XYX stock is trading for $37 and pays a $1 dividend tomorrow. What will happen to the stock tomorrow assuming all else being constant?
a) The price of XYZ will remain the same
b) The price of XYZ will be reduced by $1
c) The price of XYZ will be increased by $1
d) The stock will halt trading until all options are exercised

16) When a stock splits, the exchanges adjust option strikes and possibly the contract sizes. What is the purpose of these adjustments?
a) They keep the total value of the contract the same
b) They increase the value of the contract to reflect the higher demand for the stock
c) They decrease the value of the contract to reflect the decreased demand for the stock
d) They are strictly a way for the exchanges to make money

17) No matter which cycle a stock may be trading, there will always be which two contracts traded?
a) The current month plus the first cycle month
b) The current month plus the following month
c) The current month plus the second cycle month
d) The first months of the following quarterly cycles

18) You own a $50 call option. If the underlying stock undergoes a 5:4 split tomorrow, which adjustments will be made to the contract?
a) The strike will be adjusted to $40 and the contract will control 125 shares
b) The strike will remain at $50 and the contract will control 125 shares
c) The strike will be adjusted to $40 and the contract size remains at 100 shares
d) The strike will be adjusted to $62.50 and the contract will control 125 shares

19) Large bid-ask spreads are the result of:
a) Fraudulent market maker activity
b) Leaning against the book
c) High volume
d) Low volume

20) An option is currently bidding $5 and asking $5.30. You place an order to sell 20 contracts at $5.10 and find that the bid immediately jumps to $5.20. This is most likely due to the market maker:
a) Not receiving your order
b) Leaning against the book
c) Filling your order
d) Dishonestly jumping in front of your order

Dec

16

Options 101 #53

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Leaning Against the Book
We just learned how to gain an advantage against the market makers when trading small numbers of contracts. However, there is a tactic used by market makers that can hurt you if you are trading larger numbers of contracts, say 20 or more. Let’s use the above example and assume the quote is bid $2.00 and ask is $2.25. You place an order to buy 20 contracts for $2.15. If your order is not filled, you would expect the quote to move to bid $2.15 and ask $2.25. But the very second you send the order you see the quote move to bid $2.20 and ask $2.25. What happened? How did someone manage to jump in front of your $2.15 bid so quickly? While it could have happened by chance, the more likely answer is that it was the market maker placing a new higher bid in response to yours. Why would he do this? The reason is that you now have enough contracts to cover the 20-contract minimum required by the exchange.

If the market maker is filled at $2.20, he has effectively purchased a call option for only five cents rather than the $2.00 price he was previously willing to pay. Here’s why: If he is filled at $2.20 and the market rallies, then all is well and the market maker will make money from the long call options. But if the market falls, he can always get rid of his contracts by selling them to you for $2.15, which leaves him with a five cent loss. In effect, the market maker is using you as his stop order! He has “leaned” against his “book” of business for support. So if you’re placing larger quantities of contracts (20 or more) it’s best to do one of two things: First, you can feed your contracts into the market in smaller lots, perhaps placing four trades of five contracts each. Many brokers, though, will charge four separate commissions to do this, so it may not be advantageous. But if your broker aggregates all orders by symbol and side (buy or sell) at the end of the day, this may be a viable choice for you. The second thing you can do is mark your order with a “not held” qualifier. If you trade online, you should be able to check off a box that says “not held” or “NH,” which means you are not holding the floor broker accountable to “time and sales.” Time and sales is just a running record of all transactions, which shows the execution prices and the time it was filled. Time and sales is the modern version of the “ticker tape” or just “tape.”

If you do not mark an order as “not held,” you can hold the broker accountable to time and sales. For example, say you have an order to buy at $2.15 and later see the asking price on time and sales moved below this price, say to $2.10. The only way for the asking price to fall to $2.10 is if all buyers at $2.15 were filled. If your order was not filled but you discovered this on time and sales, you could notify your broker and the order must be filled. This is a very rare occurrence but it does happen. However, if you mark an order as “not held,” that qualifier is stating that you will not hold the floor broker to the prices on time and sales. Still, a “not held” qualifier can be beneficial. When an order is marked this way, the floor traders do not have to show the order and can work it manually on the floor. In most cases, you will get a better fill than if you didn’t mark it “not held.”

Learn to use the Limit Order Display Rule and the 20-contract minimum exchange rules to your advantage. If you don’t, the market makers certainly will.
The Economics of Large Bid-Ask Spreads
We previously said that the difference between the bid and ask is called the bid-ask spread. Take a look at the bid-ask spreads from Table 4-1, which are reprinted below as Table 4-4:

Why do some option quotes have relatively small spreads, say 5 cents, while others have much wider spreads such as 20 cents? Many traders believe this is the market maker “playing games” or trying to “squeeze out” extra money from the more active options. The fact of the matter is that the market – people like you and me trading – create the spread. The spread is simply a reflection of the volume. Lower volume options have higher spreads, while higher volume options have narrow spreads.

In order to understand why this happens, you must understand some basic economics about prices. First, the higher that bid prices rise, the more that sellers are willing to come to the market. Figure 4-5 shows this relationship:


Figure 4-5 shows the volume (number of contracts) along the horizontal axis with the price on the vertical axis. The chart just shows that as the price rises, so does the volume.

This is another way of showing how the “supply” for an option is created. If you want more supply, you (or the market maker) must bid the contract higher. The higher the price, the more sellers will step in and unload contracts. Traders often have difficulty understanding how they can control the supply. Price is the answer. Rising prices act as a signal to the market that supply is needed. As prices rise, eventually someone will step in and sell. Figure 4-5 is a graphical representation of this process. Of course, we can never be sure of the number of contracts that will become available as the price continues to increase, but we just need to understand that it will increase.

Conversely, the lower the asking price falls, the more buyers will come to market as shown in Figure 4-6:

Figure 4-6 shows the “demand” side of the equation. As the asking price continues to fall, more and more buyers come to market in response to the lower price.

Figure 4-7 is an overlay of Figures 4-5 and 4-6. You can see there is a point where these two supply and demand lines intersect. We know from basic economics that they must intersect at the market clearing price, which is shown to be a volume of 50 contracts at a price of $4.00:

Figure 4-7: The Market Clearing Price is $4.00 with 50 Contracts Traded

A market clearing price is the price where all who want to buy and sell at that price can do so. In our example, a price of $4 means that 50 contracts will be purchased and sold. If the price were higher, we’d get more sellers than buyers. If the price were lower, we’d get more buyers than sellers. At a price of $4, there is an equal number of buyers and sellers and the market clears.

In the real world of options, we do not just have a single price. Instead, we have a bid-ask spread, which tends to reduce the volume. For instance, if we charge a higher price for those willing to buy, say $4.50, and are willing to pay a lower price to those wishing to sell, say $3.50, we will get fewer buyers and sellers. However, because of the two-price system, we can find an equilibrium point and the market can clear as shown by the shaded line in Figure 4-8:

Figure 4-8: Bid-Ask Spread Creates Lower Volume

Notice that the introduction of a spread shifted our market clearing volume of 50 down to 40. Bid-ask spreads create three major inefficiencies in the market:

• Buyers must pay more than the market clearing price ($4.50 in this example)
• Sellers must receive less than the market clearing price ($3.50 in this example)
• Less volume is created

It is for all these reasons why the market regulators create rules such as the Limit Order Display Rule to allow investors to compete in the market. The rules create smaller spreads, higher volumes, and a more efficient market.

The wider the spread, the lower the volume. Conversely, the lower the volume, the wider the spread must be to balance supply and demand. So the bid-ask spread is purely a function of the supply and demand for an option. If there is a heavy amount of supply and demand, say for at-the-money options, you’ll tend to find narrow bid-ask spreads. On the other hand, if you have deep-in-the-money or deep-out-of-the-money options then the spreads tend to widen, because there is very low volume in these contracts. The bid-ask spread is simply an economic reflection of the supply and demand for any particular strike. Remember, if you feel that a particular bid-ask spread is too wide, you are always free to tighten it up by either bidding higher or offering to sell for less. If your order is not filled, it must be posted due to the Limit Order Display Rule, which creates smaller bid-ask spreads. But if you’re not willing to bid higher or offer for less then you shouldn’t be too concerned that market makers are leaving the spreads wide. It’s not their job to determine the spread but rather to balance supply and demand.

To be continued…

Dec

15

Options 101 #52

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If any order matches a previous order it will be placed in line according to the time it arrived. For instance, if the next order is to sell 6 contracts at a limit of $2.25

This process continues until all the orders are on the books. Of course, the final list will be quite long, but the entire system is automated so it happens very quickly. Once all orders are in, only the highest bid and lowest offer are located at the center of the computer screen. When you access an option quote, you are looking at only the highest bid and lowest offer, which is called the inside quote. In this example, you would see the option quoted as bid $2.00 and asking $2.25 as shown in Table 4-3:
Table 4-3
2.35 (8)
2.30 (2)

2.25 (4)
Ask
2.00 2.25
Bid 10 x 4

2.00 (10)
1.95 (6)
1.90 (5)

The numbers 10 x 4 below the quote are called the size of the market. The size is always stated as two numbers; the first is the number of contracts available at the asking price and the second is the number available at the bid. Whenever you look at an option quote, you’re looking at the inside quote; you just see the highest bidder and the lowest offer at that point in time. The market maker’s book may contain hundreds or thousands of orders but you’ll only see the orders that are at the front of each respective line.

The difference between the bid and ask is called the bid-ask spread or, more simply, the spread. In this case, there is a 25-cent spread on the option quote.

Notice that all orders in our example were limit orders. That’s because we are assuming the market is not open yet but traders are placing orders. Any market orders placed prior to the open will get filled at the market price at the open but we don’t know what that price is until all limit orders are in. Any time you place a market order to buy (sell) you are really stating that you will take the current asking (bid) prices. In trading terminology, this is called “lifting” the offer or “hitting” the bid.

In our discussion on limit orders, we said it was possible to get a partial fill. Let’s now take a look at how that happens. Let’s say you place an order to buy 10 contracts “at market.” If there were no market makers to provide liquidity, you would buy the 4 contracts available at $2.25, buy the 2 available at $2.30, and buy the remaining 4 (of the 8 available) at $2.35. This is called a multiple fill since the order is filled at multiple prices.

The trader selling the 8 contracts at 2.35 would receive a confirmation saying that 4 contracts were sold at 2.35 and he has an open order to sell the remaining 4 at 2.35 (assuming he does not have an all-or-none restriction). This is called a partial fill. While multiple fills do occur, in most cases, market makers step in and take up some of the slack in size so your order is less likely to come back with multiple fills. In fact, as we will find out later, all option quotes must be good for at least 20 contracts on each side of the market. This just means that market makers must make sure that at least 20 contracts are available at the bid and 20 at the ask. So in the real world, your order for 10 contracts would not come back as a partial fill. But if the order was much larger than that (say 50 contracts) then it is certainly possible that you’d get multiple fills.

All option quotes must be good for at least 20 contracts on the bid and 20 contracts on the offer.

In Table 4-3, notice that the quote of bid $2.00 and asking $2.25 is not from the market maker, which is what a lot of traders think. The market makers must be ready to keep a liquid and orderly market when one is not available. If the market is quite liquid and competitive, it is possible that the inside quote is strictly due to retail traders. While the market makers usually have some presence at the bid and ask, it is possible that it is represented by only retail traders at certain times.

Now, it used to be the case that market makers did not have to allow you to compete with them. In our example, if you submitted a more competitive sell order, say $2.15, the market makers did not have to let you jump in front of the line and show that order. They could have let your order sit out in the wings and kept the asking price at $2.25. Obviously, this is not fair to the rest of the traders and it certainly hurts the efficiency of the market, since higher bids and lower offers will reduce the spread between the bid and ask. Higher bids attract sellers and lower offers attract buyers; both create more contracts traded in the marketplace. In order to ensure that higher bids and lower offers would be shown, the exchanges created the “Limit Order Display Rule,” which we can use to our advantage once you understand how it works.

Limit Order Display Rule
The Limit Order Display Rule, sometimes called the “Show or Fill Rule” (the official name is “Exchange Act Rule 11Ac1-4), is not a rule that the market makers make very well known for obvious reasons, as we shall soon see. However, knowing this rule can make a big difference in your option profits. Here’s how it works: Using our previous quote setup in Table 4-3, let’s assume you wish to place an order to buy 2 contracts. You don’t wish to pay the current asking price of $2.25 so you put in an order for something between the bid and ask, say $2.15. When the market maker receives the order, he now has one of two choices: He can either fill the order or show the order. If he chooses to not fill the order, he must show it by allowing you to jump in front of the line as shown in bold below:

2.35 (8)
2.30 (2)

2.25 (4)
Ask
2.15 2.25
Bid 2 x 4

2.15 (2)
2.00 (10)
1.95 (6)
1.90 (5)

Notice that by showing your order, the bid-ask spread has been reduced from a 25-cent spread (2.00 to 2.25) to a 10-cent spread (2.15 to 2.25). The narrower the spread, the more efficient the market. The Limit Order Display Rule was created for that very reason. Before the rule, market makers could hide your order from the public and just leave the quote at bid 2.00 and ask 2.25. Under the new rule, the market maker must either fill it or show it – even if your order is for just one contract.

Now you should have a clearer understanding why we said to be careful when using all-or-none (AON) restrictions, especially for less than 50 contracts. If you place an order with an all-or-none restriction, you’re telling the market maker that he can only fill the order in its entirety; he cannot come back with a partial fill. Because of this, many option traders believe that they should mark all orders with an all-or-none restriction to prevent partial fills. However, there is a big danger in using this restriction: The market maker is not required to show your order if it is marked all-or-none. And if your order is for 20 contracts or less, the quote size must be good for at least 20 so it’s redundant to mark it with an all-or-none restriction. You really hurt yourself by not allowing your order to be shown according to the Limit Order Display Rule. Again, use all-or-none restrictions sparingly. In most cases, they will only work against you.

To be continued…..

Dec

14

Options 101 #51

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Stop Limit Orders
A stop limit order is an extension of a stop order. The difference is that stop limit orders convert to a limit order, which means your shares will be sold only if the limit price or higher can be and guarantee a price. But as with any limit order, if you guarantee the price, you cannot guarantee the fill.

Key Differences Between Stops and Stop Limits

Stop Orders become a live “market” order if stop price is triggered. Guarantees that the order will be filled but cannot guarantee the price.

Stop Limit Orders become a live “limit” order if stop price is triggered. Guarantees the price but cannot guarantee that the order will be filled.

In order to place a stop limit order, you must specify two prices. The first price is the stop price. Once you specify the stop price, you must then specify a stop limit price (which must be less than or equal to your stop price).

Let’s use the previous example but now apply a stop limit. Assume you purchased 200 MSFT at $36 and have now placed the following order:

Sell 200 MSFT at a stop price of $35 with a stop limit of $34.50.

Notice that two prices must be entered. The first price ($35) is the stop price. This just tells the computer when to activate the order. If the stock trades at $35 or below, the order will become activated and becomes a live limit order to sell 200 shares of MSFT at the stop limit price ($34.50) or higher. The stop limit price you enter (second price) you enter must be less than or equal to the first price. Many traders like to reduce the second price a bit to allow for some market fluctuations if the order is triggered.

Now let’s go back to your stop limit order and assume that MSFT opens at $27. The order is activated because the stock traded at or below $35. You now have a live limit order to sell at $34.50. Obviously, the order cannot be executed since you are requiring a price of $34.50 or higher. This shows that stop limit orders do not prevent losses any more than stop orders. However, stop limit orders will keep you from selling at prices you consider unfavorable.

Which should you use, stop or stop limits? That depends on the situation; you may find that you use both at different times. The one question you need to answer is this: If MSFT opens below your stop price do you want to sell the shares at any price? Is your goal to simply get rid of the shares regardless of price? If the answer is yes, then use a stop order. However, if there is a price at which you’d rather hold onto the shares rather than sell then use a stop limit order.

Option Stop Orders
The key point you want to understand with stop and stop limits when applied to options is that the orders are “triggered” if the asking price equals the stop price or lower. Option stop orders and stop limits are not based on the last trade. The reason is that it is possible to not have any trades on the option even if the stock’s price is falling. In other words, there might not be any activity and therefore no last trades. However, the bid price and asking prices on the options will definitely change in response to the falling stock price. That’s why the exchanges trigger stop and stop limit orders on the asking price for options and execute the orders on the bid price.

Limit Order Display Rule
In Chapter Two, we how the bid-ask spread near expiration can make a big difference on your profits, especially if the bid price falls below intrinsic value. In a similar fashion, the spreads at any time during the option’s life can have a dramatic negative impact on profitability even if the bid price represents the full intrinsic value. For example, assume a stock is trading for $51 and the $50 call is bidding $2 and asking $2.25. Both the bid and ask prices contain the $1 intrinsic value. However, if you were to buy at the asking price of $2.25 and immediately sell at the $2 bid price, you would instantly lose over 11% of your money just because of the spread. Many traders dream of making a quick 10% on their money but notice how the spread can quickly eat that away. The spread causes buyers to pay a higher price and sellers to receive a lower price than the theoretical fair value; it is a serious threat to profitability, especially when you consider the relatively low prices of options when compared to stocks.

But there is an effective way we can trade between the bid and ask to reduce this detrimental effect. The effectiveness of this technique hinges on an exchange rule called the Limit Order Display Rule. In order to understand how we can use this rule to our advantage, we must first understand how the quotation system works.

Understanding the Quote System
Let’s say you see an option with the following quote:

Bid: $2.00 Ask: $2.25

What exactly does this mean? We learned in the first chapter that the bid price represents the price at which you can sell while the asking price represents the price at which you can buy. In many ways, this is like the difference between retail and wholesale; you can buy this option for $2.25 but you can sell it for only $2.00.

While this is a correct interpretation of the bid and ask prices, it hides the source. Chapter One showed us that the bid price represents the highest bidder among a list of many bidders while the asking price (also called the offer price) is the lowest selling price among a list of many sellers. In order to understand this bid-ask interpretation better, it helps to see how option orders are accumulated by market makers. Whenever you submit an order to your broker, it is received by a market maker who will stack all orders according to price and time.

Here’s how the process works: Let’s assume the market is not open yet and the maker has no orders on the books. When orders are placed through the various brokerage firms, the market maker will accumulate them in a specific manner. Assume that the first order is an order to buy 5 contracts at a limit of $1.90. Because this is an order to buy, the market maker will list it under the “bid” column (remember, buyers place bids):

Bid Ask
1.90 (5)

The number in parenthesis shows the number of contracts at that price. Assume that the next order is an order to buy 10 contracts at a limit of $2.00. Because this is another buy order, the market maker will place it under the “bid” column as well. However, this trader is considered a “stronger” buyer since his buy price is higher than the person at $1.90. The markets are only concerned with the highest bidder and lowest offer. Because of this, the market maker will place the order above the $1.90 price as follows:

Bid Ask
2.00 (10)
1.90 (5)

Assume the next order is an order to sell 8 contracts at a limit of $2.35. Because this is a sell order, the computer will place it in the “ask” column (remember that sellers submit “asking” prices). As a matter of convention, asking prices are generally stacked on the top for reasons we will see shortly:

2.35 (8)
Bid Ask
2.00 (10)
1.90 (5)

The next order is an order to sell 4 contracts at a limit of $2.25. This trader is considered a “stronger” seller since the selling price is less than the previous order at $2.35. Because of this, the market maker will place this order below the previous order:

2.35 (8)
2.25 (4)
Bid Ask
2.00 (10)
1.90 (5)

Notice how the orders are being stacked. The bids are being stacked in descending order from strongest to weakest; that is, from highest to lowest. The sellers are stacked in ascending order from strongest to weakest; that is, from lowest to highest. Let’s say the next order is to buy 6 contracts at a limit of $1.95. This trader is the stronger than the buyer at $1.90 but not as strong as the one at $2.00, so that order will get placed between the two:

2.35 (8)
2.25 (4)
Bid Ask
2.00 (10)
1.95 (6)
1.90 (5)

To finish the example, assume that the next order is to sell 2 contracts at a limit of $2.30. This trader is a stronger seller than the one at $2.35 but not as strong as the one at $2.25, so that order will get placed between those two:

2.35 (8)
2.30 (2)
2.25 (4)
Bid Ask
2.00 (10)
1.95 (6)
1.90 (5)

To be continued…

Dec

11

Options 101 #50

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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……………..

Dec

10

Options 101 #49

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http://www.optionsuniversity.com/blog/images/booleanbrain.jpg 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….

Dec

9

Options 101 #48

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http://www.optionsuniversity.com/blog/images/booleanbrain.jpg 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 understand the 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……….

Dec

8

Options 101 #47

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http://www.optionsuniversity.com/blog/images/booleanbrain.jpg 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………..

Dec

7

Options 101 #46

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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………

Dec

4

Options 101 #45

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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!

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