Basics of Option from Volatile Markets

OPTION BASICS

To understand and implement option strategies effectively, you need to understand not only how stocks and the equity markets work, but what options are, how they function, and what affects their value. The strategy discussions in this book assume you are already familiar with stocks and options, so to refresh you on the basics, we have constructed Chapters 1 and 2 as a review of listed equity options. If you are already familiar with options, you can begin reading about call writing in Chapter 3.

What Are Options?

An option is a contract representing the right, for a specified term, to buy or sell a specified security at a specified price. Like stock, they are also standardized so they can trade on formal securities exchanges and are regulated by the Securities and Exchange Commission (SEC).

There are two types of options: puts and calls.

• Call option: A contract representing the right for a specified term to buy a specified security at a specified price.
• Put option: A contract representing the right for a specified time to sell a specified security at a specified price.

The specified price is known as the strike, or exercise, price; the specified term is determined by the option’s expiration date; and the specified security is referred to as the underlying security. There are exchange-listed options on a number of securities and even non-securities (such as indexes), but this book is devoted entirely to those on stocks and exchange-traded funds (ETFs).We may refer to both of these in aggregate as equity options. A standard equity option represents 100 shares of the underlying stock or ETF Thus a call option on Disney with a strike price of $35 that expires in two months gives the buyer the right, anytime during the next two months, to buy 100 shares of Disney at $35 each.

• Strike price: The price at which the underlying security of an option can be purchased or sold by the contract buyer.
• Expiration: The date when the terms of an option contract terminate.
• Underlying security: The security that an option gives its buyer the right to buy or sell.

An option contract is not issued until a buyer and seller come together in the marketplace. When an exchange initiates trading on a particular option, no contract exists until the first transaction takes place. The option is issued when party A agrees to buy one or more contracts from party B, and additional contracts are issued as other buyers and sellers make deals.

Standardization

Although options contracts are legally binding, you need not call your attorney to draw one up when you want either to buy or to sell. Option contracts are originated and standardized by an independent entity called the Options Clearing Corporation (OCC). To comply with SEC regulations, the OCC files a prospectus for all options on behalf of all the buyers and sellers. It also sets, guarantees, and enforces all contract terms and keeps the master versions of all contracts. You see only a trade confirmation, as you most often do with stocks. (If you are curious, you can see the OCC prospectus on the Internet at www.optionsclearing.com under Publications.)

OCC: The Options Clearing Corp., an independent entity that acts as the issuer and guarantor for all listed option contracts.

By standardizing contracts, the OCC enables options to be traded in the secondary market (on an exchange), just like a listed stock or bond. In other words, they are interchangeable, or fungible. When you buy 100 shares of Disney common stock for your account, you know that those shares are exactly the same as any other Disney common shares. Similarly, the OCC guarantees that when you buy a particular Disney call option, your contract has the same terms—that is, it is for the same type of option, on the same underlying stock, with the same strike price and expiration—as all others referred to with the same designation. All options having identical terms are said to be part of the same series and are interchangeable.

• Class: All the options of the same type that have the same underlying security. For example, all the call options that exist for Microsoft stock are part of the same option class.
• Series: All the options in the same class that also have the same strike price and expiration date. For example, all IBM calls in January with a strike price of 150 are part of the same option series.

Listed options are those that are formally traded on a recognized exchange. Non-listed, or over-the-counter (OTC), options also exist, but they are not standardized and are used infrequently. For the most part OTC options are only used by institutions. All the options reported through quote services are listed, and options may be listed on more than one exchange. This does not affect the option’s interchangeability. Option exchanges generally trade during the same hours as the underlying stocks plus a few extra minutes at the end of the day (4:02 P.M. Eastern time), except on the Friday before expiration, when they stop trading right at 4 P.M.

The OCC plays another important role: as intermediary between option buyers and sellers. When you buy or sell an option, you are actually dealing directly with the OCC (through your broker), rather than with a particular individual. That means you do not need to worry about the integrity of the transaction or about the other party’s ability to pay. Their broker worries about that.

Option Listings

The option exchanges determine what options they will list—in other words, which underlying stocks they will allow options to trade on. Thus IBM, for instance, has no say as to whether options are listed on its shares. Currently, options are available on approximately 2,600 stocks and ETFs, with new listings added every month. The reason that figure is so small compared with the total universe of listed stocks is that only certain stocks meet the exchanges’ requirements. Because of the close relationship between options and their underlying securities, primary among the exchanges’ criteria are that the underlying stocks be listed and actively traded on a national market. Other requirements concern the number of shares outstanding, the stock’s price history, its daily trading volume, the company’s assets, and so on. As an example, new options listings are not approved for stocks trading below $7.50.

TABLE 1.1 Option Examples

Since 100 shares is the standard contract size for a single option, you only need to identify any option by the four items that make it unique: underlying stock; expiration month; strike price; and type. Table 1.1, for example, shows that IBM Jan 150 call designates a call option on IBM shares, expiring in January, with a strike price of 150.

Strike Price

Options on a particular stock are always available for at least several different strike prices above and below the current price of the stock. The number of strikes, which can sometimes rise to 50 or more on a single underlying, depend on the stock’s price and volatility (how much the share price has moved historically). A volatile stock such as Research in Motion (RIMM), for example, currently has more than 50 strike prices for the January 2011 expiration month. The option exchanges offer strikes in increments of $2.50, $5, or $10, depending on the price of the underlying stock. Thus, if XYZ is selling for around $50 a share when options trading on the stock begins, the exchange would typically allow trading (for both puts and calls) on a range of strike prices including, say, $40, $45, $50, $55, and $60. On the other hand, if the share price is $16, you would probably see strike prices of $15, $17.50, and $20. As stocks move, new strike prices are added, although the exchanges generally do not add new strikes during the last few weeks before an expiration.        

Depending on the price of the underlying stock at the time, options at various strike prices are said to be in the money or out of the money. These terms are important to the covered writer (option seller) and will be referred to frequently in the text.

• In the money (ITM): Describes a call option whose strike price is below the current price of the underlying stock or a put with a strike above the current price. Example: When ABC stock is trading at $43, call options with strike prices of $40, $35, and $30 are all in the money.
• Out of the money (OTM): Describes a call option whose strike price is above the current price of the underlying stock or a put with a strike below the current price. Example: When ABC stock is trading at $43, call options with strike prices of $45, $50, and $55 are all out of the money.
• At the money (ATM): Describes an option that has a strike price equal to (or close to) the current price of the underlying stock. Example: A GHI call option with a strike of $30 is at the money when the stock is trading at or very close to $30.

Expiration

The most distinctive characteristic of options is their limited life, determined by the expiration date. On that date, they cease to exist, and any value they may have contained up to that point becomes moot. In contrast, when bonds mature, they can no longer be traded but they do make their last interest payment and repay their principal. When options expire, if they are in the money (ITM) by any amount (even $.01), they are automatically exercised by the Option Clearing Corp. It is important to remember whether you are a buyer or a seller of options.

To keep things standardized, all the options expiring in a particular month do so on the same day: the Saturday following that month’s third Friday. Saturday was chosen to give brokers one last morning following the last trading day to reconcile their clients’ positions and make sure there are no errors going into expiration. The third Friday of each month is therefore the last day expiring options can be traded. Expiring options can be bought or sold as usual on this Friday, but trading is frequently heavier than average, as people close out positions before they expire.

There are now options on some stocks and ETFs that expire at the end of each quarter or even each week.

One glance at an option table in the Wall Street Journal or on a computer shows that options on different stocks have expirations in different months. It may appear strange to have options on one stock expire in January, February, April, and July while options on the next one expire in January, February, May, and August. Actually, there is logic to this, although it may seem a bit obscure. When options first began trading on formal exchanges in the 1970s, expirations were quarterly. Thus, for every stock, only three-month, six-month, and nine-month options were initially made available. Then, when three months passed and the first option expired, a new nine-month option would be added on to the end. It was done that way because there was not enough volume (liquidity) in the beginning to justify having options expiring every month for individual stocks, and because the quarterly cycle enabled the exchanges to offer option expirations that corresponded to the quarterly earnings calendar of the underlying companies.

So, in the beginning, options were designated to expire in one of the following three quarterly cycles (just to spread them out evenly throughout the year):

1. January-April-July-October.
2. February-May-August-November.
3. March-June-September-December.

Only three of the cycle months would be available at any one time, and when the nearest expiration passed, the next one in the calendar cycle would be added. If ABC options were introduced in cycle #1, they might begin trading with expirations in January, April, and July. On the Monday after the January options expired, the exchange would allow trading in October options, so that there would once again be three expiration months available.

For stocks on the January cycle, the process worked as follows:

. . . and so on.

It became evident, however, that both option buyers and sellers were more interested in the near-month expirations (the current calendar month and the next one out) than in the expirations three to nine months away. Reacting to this, the exchanges permitted the addition of two near-month expirations while keeping intact the quarterly cycle structure for the months farther out. So, today, instead of only three available expiration months at any one time, there are four—the two nearest months and the next two months in the quarterly cycle.

The January cycle now works as follows:

. . . and so on.

Don’t feel that you need to memorize these rules. Just be aware that there will always be two near-month options available for each stock and two expiration months farther out that will vary from stock to stock.

Since their inception in 1990, options with greater than nine-month terms have also been available. They are called long-term equity anticipation securities (LEAPS) and are available on close to 800 stocks at the present time. LEAPS usually expire in either December or January and may be available as far out as three years. Otherwise, they work the same way as regular listed options. As time brings them into the normal option expiration cycle, LEAPS become the regular option for that month, whether December or January.

Adjustments

When certain events affecting an underlying security occur—such as a stock split, merger, or spin-off—the terms of the option contract need to be adjusted so that both holders and writers have essentially the same position after the event as they did before it. These adjustments may affect strike price and number of underlying shares, but never expiration date.

Say XYZ Corp. decides to split its stock two-for-one. The company is issuing an additional share for each one currently outstanding, and the share price is consequently cut in half. Stockholders thus retain the same percentage ownership in XYZ Corp. after the split as before. But the holder of an unadjusted call option on XYZ would have the right to buy 100 shares that represent only half as much ownership in the company as before. The terms of option need to change to reflect the change in the underlying stock.

TABLE 1.2 Effect of Stock Splits on Options

Adjustments are decided upon, and effected by, a joint panel of the option exchanges and the OCC. In the XYZ example, on the effective date of the split, both holders and writers of existing options on the stock would have the number of their contracts doubled and the strike prices of these contracts halved. The before-and-after scenario is illustrated in Table 1.2.

Odd splits, such as 3-for-2 or 5-for-4, can yield even stranger fractional strike prices, such as 16.7. There cannot, however be a fractional option, so in these odd splits, the number of shares represented by one contract may change—to 133 or 150, for example—to match the new strike price.

Regular cash dividends (those equal to less than 10 percent of the value of the stock) are not considered sufficient to adjust the terms of an option. The rationale is that these dividends are built into the price of the stock over time and do not materially change the value enough to warrant specific option adjustments. Besides, it would be impractical to do so every time a company issued a regular dividend.

When a company spins off a new entity, shares in the spin-off become part of the deliverable in outstanding option contracts. If company XYZ, for example, issues 10 shares of QRS for each 100 shares of XYZ common, a contract formerly calling for the delivery of 100 shares of XYZ will now call for 100 shares of XYZ and 10 shares of QRS.

Exercise and Assignment

While it is certainly possible, and in fact commonplace, to buy and sell options without ever exercising them, it is very important for all option investors to be aware of the process and implications of exercise and assignment.

The Basic Mechanics

When holders wish to invoke the right given them by their option to buy or sell the underlying stock, they are said to exercise their option. This is accomplished by informing their broker. Notice can be verbal, just like placing an order to buy or sell stock (which is essentially what an exercise is anyway). Thus, if you hold a call option for DEF stock and you decide to exercise, you are essentially entering a buy order for DEF at the strike price, except that your order would be routed to the OCC rather than directly to the exchange where the stock trades. Exercises take effect at night after the close of trading. Since the price is determined by the option strike, it does not matter what time of day an option is exercised.

Options that can be exercised at any time before expiration are said to be American style; those that can be exercised only at expiration are called European style or capped. This has nothing to do with where they trade. Equity options on individual stocks all trade American style. Index options trade European style.

As noted above, the standard contract size (or unit of trading) is 100 shares. That is the number of shares that the writer must deliver if a holder exercises the contract. These shares are sometimes referred to as the deliverable. There are listed options on common stocks as well as on some preferred stocks and American depositary receipts (ADRs) on foreign securities and on various other financial instruments, including futures and stock indexes. Index options may stipulate cash delivery instead of physical delivery, because of the practical considerations of buying every stock in an index. All equity options require physical delivery of the underlying shares. The process of actually delivering an underlying security as part of an option exercise is called settlement and is handled by your broker just like the settlement of a regular stock transaction.

When an option is exercised by one or more holders, the OCC must determine to whom in the writers’ pool to assign that exercise for fulfillment—in other words, which writer has to sell his or her stock. The notification process is referred to as an assignment. The OCC keeps the master record of which member brokerage firms are either short or long every option. It distributes assignments by passing them to member firms that have open short positions and letting them figure out which of their customer accounts receive assignments. The brokerage firms must have fair and reasonable ways to distribute assignments, but they do not all have to be the same. Some firms distribute assignments randomly, while others use a first-in/first-out policy.

Receiving an assignment notice from your broker is essentially the same as receiving a trade confirmation for buying or selling shares of stock, except that you did not have to enter an order—it was generated by the assignment notice. This should occur early in the morning following the exercise, but there is no guarantee on the exact time. The broker receives word during the night from the OCC and will want to let you know as soon as possible the next morning so that you do not unknowingly close your call position or sell your stock in the market that day. (Writers are not allowed to close a position once they have been assigned, even if the broker has not yet informed them of the assignment.) As soon as any of your short options are assigned, that, of course, eliminates those positions.

Say a holder of five Altria Group (MO) June 25 calls decides to exercise them. The OCC informs Charles Schwab that it is being handed an assignment for the calls. You are among the clients at Schwab who are short the MO June 25 calls. As it happens, you have 1,000 shares of the stock and are short 10 calls. Schwab informs you that “you have been assigned on 5 MO Jun 25 calls,” and you subsequently receive a trade confirmation that you sold 500 shares of MO at $25. You are left with 500 shares and five short calls—plus $12,500, less commission, added to your account.

• Exercise: The action that option holders take when they notify their brokers of their intent to invoke the right to buy (or sell) stock as stipulated in their option. When call holders exercise, they are purchasing the underlying stock at the designated strike price.
• Settlement: The process of delivering an underlying security (or other stipulated interest) as a result of an option exercise. Stock options always stipulate physical delivery of the underlying shares.
• Assignment: The action that the OCC and your broker take in selecting option sellers (writers) to fulfill the obligation stipulated by the option they sold. When call writers receive assignment notices from their brokers, they are selling the underlying stock at the designated strike price.

Since the OCC is the intermediary for all option transactions and assignments, it is able to keep track of how many contracts are outstanding at all times and determines at the end of each day how many are open (remain unclosed). The OCC publishes this number each day as the open interest.

• Open interest: The number of existing contracts that remain unclosed for a particular option. This figure is usually published each trading day by the OCC and is net of all trades that have occurred up to the close of the previous day. In conjunction with the daily volume of contracts traded, it provides an indication of the option’s liquidity (how easily it can be traded).

Expiration is the grand finale of the option opera. Once trading stops at the end of the Friday before an expiration Saturday, the only other actions that can take place are exercise and assignment. By Monday morning, that option is history. You won’t even see it among your account holdings anymore, although you will generally see the expiration on your activity screen. If you are short a particular option, however, you will receive notification from your broker confirming whether it expired or was assigned.

By the time expiring options stop trading on Friday afternoon, the ones that are in the money will generally be in the hands of market makers and other professionals, who will exercise them. Most speculators will have traded out and closed their positions. Regardless of who owns the options, however, you can expect them to be exercised. If they are in the money by more than $0.01, they will be exercised automatically (by OCC rules).

By the way, you do pay commissions on exercises and assignments, since they are essentially the equivalent of buy and sell orders.

Positions

The buyers of an option are considered holders. This is a virtual term only; there is nothing physical to hold. In fact, there are no certificates with options—everything is done by book entry. But since the buyers pay money, they are considered owners of the options. As with stock, when you buy an option, you create a long position in your account.

The option seller is also called the writer. Again, this is just a label, a holdover from the old days, when put and call contracts were actually written by people who owned stock and offered these options for sale. Writers receive money, and their position is considered short. The terms buying and selling are actions. The terms long and short describe positions, indicating whether you actually have possession of the asset or not.

As with stocks, you can initiate an option position by buying (going long) or selling (selling short) as your opening transaction. With covered writing, your opening transaction is to sell one or more call options short. Once you have become either a holder or a writer of an option, you can close your position anytime before expiration, as long as the option is trading, simply by executing an offsetting, or closing, transaction at the prevailing market price. The only catch is that you must accept the market price for the option in effect at the time. To close a short position in a call option on XYZ stock, for example, you would simply buy a call on XYZ with the same strike and expiration. When you close your option position, you wipe the slate clean, completely eliminating any further rights or obligations from prior contracts.

Since you can initiate an option position by either buying or selling, four scenarios are possible when you enter any option order. You may:

1. Buy to open (if you are simply buying a put or call).
2. Buy to close (if you are already short an option and are closing out).
3. Sell to open (if you are initiating a covered write).

• Sell to close (if you had previously bought an option and are now closing). 

It is standard practice throughout the industry to require you to indicate on every option order whether you are opening or closing. (You will also usually be asked whether an opening sale is covered or naked; for a discussion of these terms, see the next section.) This information does not affect your trade or the price in any way.

• Holders: Those who initiate a position by buying an option. They do not actually hold anything physical. What they hold is the right to buy or sell stock.
• Writers: Those who initiate a position by selling an option. Writers are obligated to fulfill the buyers’ right to buy or sell stock. They do not actually write anything, though in the very early days of option contracts, it would generally have been the seller who would have written a contract and offered it for sale.
• Long: Term used to describe the position of an option holder.
• Short: Term used to describe the position of an option writer.

Covered versus Naked

When you write a call option, you are contractually obligated to deliver (sell) the underlying stock if assigned. If you own enough of the underlying stock to make good on this obligation, then your option is considered covered. It’s like saying it is secured in the banking world. Since you own the underlying stock, writing a covered call option entails no additional risk: You can deliver the stock upon being assigned, regardless of the share price at the time. If, on the other hand, the stock is not in your account when you write the call, your option position is considered uncovered, or naked. An uncovered call option exposes you to a theoretically unlimited loss if the stock goes way up, because you will have to buy it to fulfill your obligation to the OCC and the option holder when the contract is exercised.

TABLE 1.3 Covered versus Naked Examples

The fact that one option contract represents 100 shares of stock means that you must remember this multiplier (100) when figuring how many contracts to buy or sell. To sell (write) options on more than 100 shares, you would simply sell multiple option contracts. For 300 shares, you could sell up to three contracts. For 1,000 shares, you could sell up to 10 contracts, and so on. There are no fractional option contracts, and thus no way to buy or sell a listed option for fewer than 100 shares. (Occasionally, however, some options that have been adjusted for splits may be for 150 shares, and that will be made known to you.) So if you happen to have an odd number of shares, such as 458, you will only be able to write covered calls against 400 shares.

You can certainly have more than the required amount of shares in your account than you need to deliver if your calls are assigned. Say you own 1,000 shares of DEF and sell six DEF calls. You would at most have to deliver 600 shares if assigned, so you’re completely covered. But if you have 1,000 shares and sell 12 calls, then two of those calls are naked. See Table 1.3 for examples.