Stock Options

1
CHAPTER 15
Stock Options
At a very exclusive party, a high-class,
finely-clad woman slinked up to the CEO of a
Fortune 500 company and said, I will do anything
anything you want. The CEO flatly responded,
Re-price my options.
Chapter Sections Options on Common Stocks The
Options Clearing Corporation Why Options Option
Moneyness Option Payoffs and Profits Option
Strategies Option Prices, Intrinsic Values, and
Arbitrage Employee Stock Options Put-Call
Parity Stock Index Options
2
What is an Option Contract?

• A security that gives the holder the right to buy
  or sell a certain amount of an underlying
  financial asset at a specified price for a
  specified period of time
• Financial asset examples Stocks, bonds, etc.
• Options contracts are not investments
• They are contracts between two investors
• Buyer of the option contract gets the right to
  buy (or sell) the financial asset at a given
  price for a given period of time
• Seller of the option contract must buy (or sell)
  the asset according to the terms of the contract

3
What is an Option Contract?
(continued)

• Options contracts are part of a class of
  securities called derivatives
• Derivatives are securities that derive their
  value from the price behavior of an underlying
  real or financial asset
• Options contracts have no voting rights, receive
  no dividends nor interest, and eventually expire
• Their value comes from the fact that they allow
  the holder of the option to participate in the
  price behavior of the underlying asset
• With a much lower capital outlay

By the way, options contracts are usually just
referred to as options.
4
What is an Option Contract?
(continued)

• Options allow an investor to leverage their
  outlay of capital
• Leverage the ability to obtain a given equity
  position at a reduced capital investment, thereby
  magnifying returns (review)
• With options, you can make the same amount of
  money from a stock or other security as if you
  bought it for full price
• But only come up 1/10th or less of the money

Sounds too good to be true, huh? Well, you are
right. It is too good to be true. Much of the
time, you lose the entire outlay. Options have
a time limit. Most options expire worthless.
5
What is the Rational for Options?

• Instead of buying a stock, buy an option to buy a
  stock (or an option to sell a stock)
• If the stock goes up, your option will go up
  (almost always much, much faster) and you can
  sell the option for a handsome profit
• There is only one catch The option expires in
  three, six or nine months
• If the stock does not go up, the option is
  worthless
• Most options expire worthless (Surprise!)
• There are some scenarios where options can be
  worthwhile but they are few and far between!

6
Option Contracts Example

• Stock currently selling for 20
• You buy a share of the stock for 20
• If it goes up to 30, you have earned 10 on a
  20 investment
• You buy an option to purchase a share of the
  stock at 20 currently selling at 20
• It might only cost you 1 for the option
• If the stock goes up to 30, your option price
  will probably go up to around 11
• You have earned 10 on a 1 investment
• That is leverage in action
• Congratulations! Pat yourself on the back!

7
Option Contracts Example
(continued)

• But what if the stock price stays at 20
• Your option expires worthless at the end of
  three, six, or nine months
• And, of course, after your option expires, the
  stock price zooms to 40
• You were so sure that this stock was going to hit
  the big time and you were absolutely right
• But because you bought an option that expired,
  you lost the ability to share in the success of
  the stock

My advice? Forget about the option and just buy
the stock! But since this is an Intro to
Investments class, we need to become proficient
in the concepts, terms, and techniques of
options. So
8
Two Main Types of Options

• Call Option Contract a.k.a. Call
• A negotiable instrument that gives the buyer of
  the option the right to buy the underlying
  security at a stated price within a certain
  period of time
• (The previous example was a call option)
• When people talk about options, they are usually
  talking about call options
• Put Option Contract a.k.a. Put
• A negotiable instrument that gives the buyer of
  the option the right to sell the underlying
  security at a stated price within a certain
  period of time
• Opposite of a call option

9
Two Main Types of Options
(continued)

• Where did the terms call and put come from
  and how will I remember which is which?
• The term call comes from the idea that when you
  buy a call option, you get the right to call the
  stock away from the seller of the option
• The term put comes from the idea that when you
  buy a put option, you get the right to put the
  stock to the seller of the option

Get the idea? A call allows you to call away
the stock from someone (buy it from them). A
put allows you to put the stock to someone
(sell it to them). Let us look at each in
detail.
10
The Two Parties of a Call Option

• Buyer of the call option contract
• The Call Option Buyer of the contract is the
  person who will do the calling away
• They buy the right to call the stock away from
  (buy it from) the call seller
• They do not have to exercise the right
• In fact, often the options contract expires
  worthless
• Seller of the call option contract
• a.k.a. Option writer, Option maker
• The Call Option Seller of the contract is the
  person who must sell the stock (called away
  from)
• The call option seller is legally bound to sell
  the stock to the call buyer
• In return, they get the option price from the
  call option buyer

11
The Two Parties of a Call Option
(continued)

• What is the Call Option Buyer Hoping For?
• The call option buyer is hoping that the price of
  the stock will go up a call option buyer is
  bullish
• If an option buyer has a call option to buy at
  20 and the price goes to 30, the buyer can buy
  a 30 stock for only 20
• What is the Call Option Seller Hoping For?
• The call option seller is hoping that the price
  of the stock will go down or stay the same a
  call option seller is bearish (or at least not
  very bullish)
• If the stock stays around 20 or goes down, the
  call option buyer will not want to exercise the
  option and it will expire worthless
• And the call option seller gets to keep the price
  of the option

12
Call Option Example
Ed
Ted
20 call price
Pays 1
Gets 1
Call option buyer
Call option seller
Call Option Contract
The call option buyer wants the price of the
underlying stock to go up. He is bullish. No
matter what happens to the price of the stock, he
can buy it from (call it away from) the call
option seller for 20.
The call option seller wants the price of the
underlying stock to go down. He is bearish. No
matter what happens to the price of the stock, he
must sell it to (called away from) the call
option buyer for 20 if exercised.
The call option contract is tied to the
underlying stock. It will vary up down as the
stock varies.
13
The Two Parties of a Put Option

• Buyer of the put options contract
• The Put Option Buyer of the contract is the
  person who will do the putting to
• They buy the right to put the stock to (sell it
  to) the put option seller
• Again, they do not have to exercise this right
• Recall Often the options contract expires
  worthless
• Seller of the put options contract
• a.k.a. Option writer, Option maker
• The Put Option Seller of the contract is the
  person who must buy the stock (put to)
• The put option seller is legally bound to buy the
  stock from the put option buyer
• In return, they get the option price from the put
  option buyer

14
The Two Parties of a Put Option
(continued)

• What is the Put Option Buyer Hoping For?
• The put option buyer is hoping that the price of
  the stock will go down a put option buyer is
  bearish
• If an option buyer has a put option to sell at
  20 and the price goes to 10, the buyer can sell
  the 10 stock (put it to the option seller) for
  20
• What is the Put Option Seller Hoping For?
• The put option seller is hoping that the price of
  the stock will go up or stay the same a put
  option seller is bullish (or at least not very
  bearish)
• If the stock stays around 20 or goes up, the put
  option buyer will not want to exercise the option
  and it will expire worthless
• And the put option seller gets to keep the price
  of the option

15
Put Option Example
Ned
Fred
20 put price
Pays 1
Gets 1
Put option buyer
Put option seller
Put Option Contract
The put option buyer wants the price of the
underlying stock to go down. He is bearish. No
matter what happens to the price of the stock, he
can sell it to (put it to) the put option
seller for 20.
The put option seller wants the price of the
underlying stock to go up. He is bullish. No
matter what happens to the price of the stock, he
must buy it from (put to) the put option buyer
for 20 if the option is exercised.
The put option contract is tied to the underlying
stock. It will vary up down as the stock
varies.
16
Time for Questions on Options

• Options are confusing, arent they?
• In fact, the section on options is one of the
  hardest parts of the Series 7 Stockbroker exam
• Options sound like gambling. I am right?
• Yes. Options are a form of gambling. It is a
  zero-sum game. Someone wins, someone loses.
• A family acquaintance once called me. Hey,
  Frank. I hear you can make a lot of money
  investing in options!
• I said, Wait a minute. Yes, you can make a lot
  of money you can also lose a lot of money. But
  you cant invest in options. You can speculate
  in options. You can not invest in something that
  has a 60 chance of being worthless in three
  months! That is not investing.

17
Option Attributes

• Strike Price a.k.a. Exercise Price
• The contract price between the buyer of an option
  and the seller of the option
• The stated price at which you can buy a security
  with a call option or sell a security with a put
  option
• Listed options traditionally sold in
• 2.50 increments for stocks selling for less than
  25
• 5.00 increments for stocks selling between 25
  200
• 10.00 increments for stocks selling for greater
  than 200
• But pricing is more flexible now
• There are some stock options that sell in 1
  increments

18
Option Attributes
(continued)

• Expiration Date
• The date at which an option expires
• Listed options always expire at the close of the
  market on the third Friday of the month of the
  options expiration
• The hour before close of the market on the third
  Friday is sometimes called the witching hour

As well as stock options, there are also stock
index options and stock index futures which we
will discuss later. When all three stock
options, stock index options, and stock futures
expire on the same day, then it is called the
triple-witching hour.
19
Option Attributes
(continued)

• Exercise Style
• American options
• Can be exercised at any time before the
  expiration
• European options
• Can only be exercised at expiration

Normally, if you wanted to take a profit from an
option that had done well and there was still
significant time until the expiration date, you
would simply resell the option instead of
actually exercising the option. However, with an
American-style option, if you really wanted the
stock, you could exercise the option and buy (or
sell) the stock before the expiration date. By
the way, there are several other types of options
with various provisions.
20
Quotations of Listed Options

• Go online to finance.yahoo.com
• Choose Investing Options
• (You could also just enter http//biz.yahoo.com/op
  t)
• Enter the symbol for the stock under Options
  Lookup
• (Not in the box next to the button labeled Get
  Quotes in the upper portion of the screen)
• Or, when you are viewing the quote of a stock,
  you could simply choose the Options link on the
  left hand side of the screen

The list of available options contracts and their
prices for a particular security is called an
option chain.
21
Options Contracts

• Buying Selling (writing, making) Options
  Contracts
• We have discussed options contracts as if they
  were traded just as stocks are traded
• In most ways, they are very similar
• But there is one major difference
• Options are sold as contracts
• Each contract represents one hundred shares of
  underlying security
• There are no odd-lots on the options exchanges

So if the listed price of the option is 5, then
one contract will cost 500 (5 100 shares).
Two contracts will cost 1,000, etc.
22
Options Contracts
(continued)

• Option Premium
• The quoted price the option buyer pays to buy a
  listed put or call option
• The seller (a.k.a. writer, maker) receives the
  premium immediately and gets to keep it whether
  or not the option is ever exercised
• (Did I mention that most options expire without
  being exercised? That most options expire
  worthless?)

To make it more confusing, the term premium is
also used in a more precise manner when valuing
options. For this reason, most people always
refer to the price of the option instead of the
premium of the option.
23
Valuations of Options

• In-the-money Call Option
• A call option with a strike price less than the
  market price of the underlying security
• Example Call Strike Price 50
• Market Price 54
• 4 In-the-money
• Out-of-the-money Call Option
• A call option with no real value because the
  strike price exceeds the market price of the
  stock
• Example Call Strike Price 50
• Market Price 47
• 4 Out-of-the-money

24
Valuations of Options
(continued)

• In-the-money Put Option
• A put option with a strike price greater than the
  market price of the underlying security
• Example Put Strike Price 50
• Market Price 46
• 4 In-the-money
• Out-of-the-money Put Option
• A put option with no real value because the
  market price exceeds the strike price of the
  stock
• Example Put Strike Price 50
• Market Price 52
• 2 Out-of-the-money

25
Valuations of Options Example
Call Option

• Call Option Example (Strike price 50, Option
  price 10)

Theoretically, for every 1 above the strike
price, the call buyer earns a dollar and the call
seller (a.k.a. call writer) loses a 1.
26
Valuations of Options Example
Call Option
(continued)

• Call Option Example (Strike price 50, Option
  price 10)

But the previous graph ignored the price of the
option. The call buyer had to pay 10 and the
call seller received 10.
27
Valuations of Options Example
Put Option
(continued)

• Put Option Example (Strike price 50, Option
  price 10)

Again, theoretically, for every 1 below the
strike price, the put buyer earns a dollar and
the put seller (a.k.a. put writer) loses a 1.
28
Valuations of Options Example
Put Option
(continued)

• Put Option Example (Strike price 50, Option
  price 10)

But again, the previous graph ignored the fact
the put buyer had to pay 10 for the option and
the put seller (a.k.a. put writer) earned 10.
29
Valuations of Options
(continued)

• Time Premium
• The amount by which the option price exceeds the
  options in-the-money value
• In general, the longer the time to expiration,
  the greater the size of the time premium
• If an option is out-of-the-money, then the
  entire price of the option is due to the time
  premium

In other words, an option that is in-the-money
will sell for more than the amount it is
in-the-money because of the time remaining
until the expiration date. Often, an option that
is out- of-the-money will still have time
value. The option still has time to become worth
more (as the underlying stock price changes).
30
Commissions on Option Contracts

• And Do Not Forget Commissions!
• In the previous examples, we did not include the
  cost of the commissions
• A commission is charged whenever an option is
  bought or sold
• Both buyer and seller pay a commission
• And a commission is charged when and if the buyer
  exercises the option and buys or sells the stock
• Again, both buyer and seller pay a commission
• When you include the commissions, it makes it
  that much harder to make money in options

But if you are a broker, you would simply love to
have your clients get hooked on options. P.S.
None of my clients trade options. I would do my
best to talk them out of it if they asked to!
31
Option Strategies

• Speculating You will often hear
• If you feel the market price of a particular
  stock is going to move up
• If you anticipate a drop in price within the
  next six months
• It is a highly risky investment strategy, but it
  may be suited for the more speculatively
  inclined.

The flaw in these arguments is this There has
never been a successful method to predict stock
prices in the short term. You may feel or
anticipate that the price will go up or down,
but that does not mean that it will. It is not
investing, it is gambling. Plus, you may be
correct but your option may expire before you are
proven correct.
32
Option Strategies
(continued)

• Hedging
• A transaction or series of transactions made to
  reduce the risk of adverse price movements in an
  asset
• Hedging can be thought of as insurance
• And although insurance can be useful in some
  circumstances, it is not free
• You pay for the insurance via the price of the
  option and the commissions

Investors can use hedging strategies when they
are unsure of what the market will do. A perfect
hedge reduces your risk to nothing (except for
the cost of the option and the commissions).
33
Option Strategies
(continued)

• Hedging Example
• You own 100 shares of Butterfly.com and it is
  currently selling for 50
• You are afraid the price will plummet within the
  next 3 months to 10
• You purchase a put at 50
• No matter what happens, you can sell the stock
  for 50 but only until the option expires
• Then you must go out and buy more insurance
• This is called a protective put

Insurance is not free. Using options as
insurance is one way to keep your broker very
happy. If you are sure the stock will fall, why
not just sell the darned thing?
34
Option Strategies
(continued)

• Straddle
• The simultaneous purchase (or sale) of a put and
  a call on the same underlying financial asset
• If the price is volatile in either direction, up
  or down, you will make money (providing you pass
  the break-even point for both purchases plus the
  commissions)
• If the stock price is not volatile, you would
  sell (a.k.a. write, make) the straddle and hope
  that the price does not change greatly

Two commissions at the same time! Your broker is
gonna really love you!
35
Option Strategies
(continued)

• Straddle Example
• Butterfly.com is selling for 50 but its price is
  extremely volatile
• You purchase a call for 50 and a put for 50
• The price of the call option is 4 and the price
  of the put option is 5
• Now, no matter which way the price goes, one of
  your options will be in-the-money

But the call cost you 4 and the put cost you 5,
so the price has to move at least 9 either way
before you break-even. And we did not include
the cost of the commissions. You paid two
commissions for the straddle and possibly one
more for exercising the option. Brilliant
strategy, huh? Wait, it gets better.
36
Option Strategies
(continued)

• Spread
• The simultaneous purchase and/or sale of two or
  more options with different strike prices and/or
  expiration dates
• Example Stock selling for 50
• Buy a call at a strike price of 50
• Sell a call at a strike price of 55
• You paid for the call at 50, you got paid for
  the call at 55
• If the stock price rises, you make money

The possibilities are endless. And so are the
commissions.
37
Option Strategies
(continued)

• Selling Options a.k.a. Writing Options, Making
  Options
• Selling options allows the individual investor to
  play the part of the casino
• You become the Las Vegas casino and the option
  buyers are betting against you
• More often than not, the option writer is
  right.
• Most options expire worthless
• Have I mentioned this yet?
• No matter what happens, the option seller gets
  the buyers premium the price of the option

If and when I ever begin trading options, it will
be as an option writer. But that does not mean
you still can not lose big.
38
Option Strategies
(continued)

• Selling Options (continued)
• Covered Options
• Options written against stock owned (or sold
  short) by the writer
• Naked Options a.k.a. Uncovered Options
• Options written on securities not owned (or sold
  short) by the writer

The amount of return to the option writer is
always limited to the amount of option premium
received. But the loss can be substantial, even
unlimited in the case of a naked call, a.k.a.
uncovered call.
39
Option Strategies
(continued)

• Selling Options (continued)
• Covered Call
• You own a stock and you are considering selling
• You write a covered call and receive the premium
• If the stock price jumps substantially, the stock
  will be called away from you (You will be forced
  to sell)
• If the stock price stays the same or goes down,
  the option will expire worthless
• And you can then write another covered call
• In either case, you get to keep the premium

This strategy is only one of two option
strategies I personally would ever consider.
40
Option Strategies
(continued)

• Selling Options (continued)
• Covered Call Example
• You own Butterfly.com and it is currently selling
  for 50 a share You bought it at 40 and want
  to sell
• You write a covered call at 55 and receive 500
  since the premium for a 55 call is currently 5
• If the stock price jumps over 55, it will be
  called away from you at 55
• It is as if you actually sold it for 60 ( 55
  5 )
• If the stock prices stays below 55, you can
  write another covered call

This strategy allows you to make extra money from
a stock that you already own. Do you see any
disadvantages?
41
Option Strategies
(continued)

• Selling Options (continued)
• Naked Put
• You are considering purchasing a stock and you
  have the cash to make the transaction
• You write a naked put and receive the premium
• If the stock price falls substantially, the stock
  will be put to you (you will have to purchase it)
• If the stock price stays the same or goes up, the
  option will expire worthless
• And you can then write another naked put
• In either case, you get to keep the premium

This is the only other option strategy that I
would personally consider.
42
Option Strategies
(continued)

• Selling Options (continued)
• Naked Put Example
• You are considering purchasing Butterfly.com and
  it is currently selling for 50 and you have the
  cash
• You write a naked put at 45 and receive a 300
  premium since the cost of a 45 put is currently
  3
• If the stock price falls below 45, the stock
  will be put to you at 45
• It is as if you bought it at 42 ( 45 - 3 )
• If the stock price stays the same or goes up, you
  can write another naked put

This strategy allows you to make extra money from
a stock that you want to purchase. Do you see
any disadvantages?
43
Employee Stock Options

• Employee Stock Options (a.k.a. ESOs)
• An option granted to an employee by a company
  giving the employee the right to buy shares of
  stock in the company at a fixed price for a fixed
  time
• Usually have some significant differences from
  normal call options
• Cannot be sold
• Expire in many years (up to 10 years)
• Usually have a vesting period (typically 3 to 7
  years)
• If you leave before the vesting period is over,
  you lose your stock options

During the tech boom of the late 1990s, ESOs
were used extensively to attract employees to
start-up companies.
44
Employee Stock Options
(continued)

• Employee Stock Options (a.k.a. ESOs)
• During the 2000-2002 bear market, ESOs were the
  subject of much controversy
• There is still some fall-out and publicity as
  companies and the SEC continue to wrangle over
  how and even if they should be used
• Currently, companies can give ESOs to their
  employees and not have to pay anything
• They do not reduce the companys earnings
• Many companies have agreed to expense stock
  options
• Unfortunately, how do you come up with a price
  for something that is currently worthless?

45
Employee Stock Options
(continued)

• Employee Stock Options (a.k.a. ESOs)
• To make matters worse, while some people became
  fabulously wealthy through ESOs during the
  Internet mania,
• Example John Moores of Padres Peregrine fame
• Many other people were socked with crippling tax
  burdens on worthless pieces of paper when their
  companies collapsed!
• How can that be, you ask?
• The AMT (Alternative Minimum Tax) does not care
  if you never exercise the options
• You still owe the tax on the paper gain
• Even if you never were able to realize the gain
  Bizarre!

46
Valuations of Options Revisited

• Wait a minute. Did you ask, How do you come up
  with a price for something that is currently
  worthless?
• Yes, that is correct. Since many ESOs are
  out-of-the-money, often by a large amount, or
  can not be exercised for a long time, or both,
  how does the company put a price on it?
• The financial world currently uses a system
  called the Black-Shoales Option Pricing Model
• It may sound impressive, but it is really very
  silly
• In my humble opinion

Chapter 16 is devoted to the Black-Shoales model.
We are going to ignore it, if you do not mind.
47
Valuations of Options Revisited

• Example The Black-Shoales Option Pricing Model
• Stock currently selling for 7.50 per share
• Employee stock option has an exercise price of
  10
• It is currently out-of-the-money
• Plus the option can not be exercised for 3 years
• The Black-Shoales model might say that the
  employee stock option is worth 2.50

Huh? You can not sell it. You can not exercise
it for 3 years. It is out-of-the-money. How
is it worth 2.50? The stock price might never
go over 10. And if you are unfortunate enough
to be affected by the AMT, you might have to pay
taxes on it!
48
Stock-Index Options

• A put or call option written on a specific stock
  market index, such as the SP 500
• A stock-index option allows an investor to
  purchase or sell an option that responds to a
  stock market index
• Can hedge a portfolio by purchasing a put on a
  stock-index option that represents the portfolio
• Acts as insurance against a large loss (until it
  expires)
• Over 75 indices represented
• Large, mid, small cap stocks
• Domestic, international, regional,
  country-specific

Whether speculating or hedging, it is still risky
and expensive.
49
Other Types of Options

• Interest Rate Options
• Put and call options written on fixed-income
  securities such as bonds
• Currency Options
• Put and call options written on foreign
  currencies
• Can be an important tool for foreign investors
  and multi-national corporations who must
  periodically convert U. S. Dollars to and from
  other currencies
• LEAPS
• Long-term Equity Anticipation Securities
• Long-term options 9 months to 3 years (?)

50
Warrants

• A long-lived option that gives the holder the
  right to buy stock in a company at a price
  specified on the warrant
• Warrants are usually issued by the same company
  that issues the underlying stock
• Often as accompanying securities to bonds
• Or as compensation to employees (like ESOs)
• Unlike options where each contract represents 100
  shares of stock, one warrant represents the right
  to buy one share of stock
• Warrants are always call options
• There are no put warrants

51
Final Comments on Options?

• STAY AWAY FROM THEM!

The possibilities are endless, and so are the
commissions. (Wait! Lets hear what Optionetics
has to say about options!)
52
CHAPTER 15 REVIEW
Stock Options
Chapter Sections Options on Common Stocks The
Options Clearing Corporation Why Options Option
Moneyness Option Payoffs and Profits Option
Strategies Option Prices, Intrinsic Values, and
Arbitrage Employee Stock Options Put-Call
Parity Stock Index Options
Next week Chapter 14, Futures Contracts