Wednesday, April 29, 2015

Option Basics

You now have enough information to understand some hypothetical call and
put options. These two assets – calls and puts – are the building blocks for every
option strategy you will ever encounter. This is why it is crucial that you understand
the rights and obligations that they convey. Most confusion with option strategies
stem from not understanding (or simply forgetting) who has the right and who has
the obligation.
Because options are binding contracts, they are traded in units called contracts.
Stocks are traded in shares; options are traded in contracts. An option contract, just
like a pizza coupon, will always be designated by the underlying stock it controls
along with the expiration month and strike price. For example, let’s assume we are
looking at a Microsoft June $30 call.
We’ll soon show you where you can look up actual option quotes and symbols for
options, but for now let’s make sure you understand what this option represents.
Using your understanding of pizza coupons, what do you suppose the buyer of
one contract is allowed to do? The buyer of this call has the right (not the obligation)
to purchase 100 shares of the underlying stock – Microsoft – for $30 per share at
any time through the third Friday in June. (Remember that the expiration date
for stock options is always the third Friday of the expiration month.) The buyer of
this coupon is “locked in” to the $30 price no matter how high Microsoft shares
may be trading. Obviously, the higher Microsoft trades, the more valuable the call
option becomes.
To understand this concept a little better, assume that you have found a piece
of property valued at $300,000 and wish to buy it. But you’d first like spend a few
days researching the area before buying it. If you do, you’ll run the risk of losing
it to another investor. What can you do? You can go to the broker and put down
some money to hold the property for you. For instance, you may pay $500 for
several days worth of time. If you decide against the property, you lose the $500.
These arrangements are done all the time in real estate and are called “options” on
real estate. Assume that you pay the $500 for five days worth of time and are now
locked into a binding agreement to buy the property for $300,000 over the next
five days. Now suppose that some news is spreading that the area is about to be
commercially zoned and some big businesses are interested in it. Property in the
area goes up dramatically overnight. But even if you decide to not buy the property,
don’t you think that somebody else would love to be in possession of the contract
that you have giving them the right to pay $300,000? Of course they would. And
these people will start offering you large amounts of money to persuade you to sign
over the contract to them. You could just sell it to them and they could sell it to
others. This is exactly what most traders do with the equity options market.
Now let’s go back to our option example. How much will it cost you to
use (exercise) your call option? Because you are buying 100 shares of stock, the
strike price must be multiplied by 100 as well. (The number “100” is called the
“multiplier” of the option for this reason.) If you were to exercise this Microsoft
$30 call option, you would pay the $30 strike * 100 shares = $3,000 cash. This is
called the total contract value or the exercise value. In exchange for that payment,
you’d receive 100 shares of Microsoft. It works just like a pizza coupon. You pay
a fixed amount of cash and receive some type of underlying asset. Most brokers
charge a standard stock commission to exercise your options. If you exercised this
call, your broker would probably charge you his regular commission for buying
100 shares of stock. After all, the long call option is simply a means for buying
regular shares of stock.
To restate a previous point, it is important to understand that if you buy call
or put options, you are not required to ever buy or sell shares of stock. Further,
you do not ever need the shares of stock in your account at any time. Most option
contracts are opened and closed in the open market without a single share of stock
changing hands. Even though you're allowed to purchase or sell stock with your
options, most traders never do. Instead, they just buy and sell the contracts in the
open market amongst other traders.
Now let’s assume we are looking at a Microsoft June $30 put option. Think
about your auto insurance policy and try to figure out what this option allows
you to do. If you buy this put option, you have the right to sell 100 shares of
Microsoft for $30 per share at any time through the third Friday in June. Because
you are locking in a selling price, put options become more valuable as the stock
price falls. If you exercise this put option, you are selling 100 shares of Microsoft,
which means you will have 100 shares of Microsoft taken from your account and
delivered to someone else. In exchange, you will receive the $30 strike * 100 shares
= $3,000 cash. If you exercise this put, your broker will probably charge the regular
stock commission for selling 100 shares of stock since the put option is simply a
means for selling regular shares of stock.
What if you only wish to buy or sell fewer than 100 shares of stock? You can
do that but in a roundabout way. Using the call example above, let’s say you only
wanted to buy 60 shares of Microsoft for $30. You would still exercise the call
option for 100 shares and then immediately submit an order to sell 40 shares
(which would carry a separate commission). Each contract is good for 100 shares
and you must buy and sell in that amount. But there’s nothing stopping you from
immediately entering another order to customize those amounts to suit your needs.
Likewise, if you exercised a put option but only wanted to sell 60 shares of stock,
you would have to exercise the put and sell 100 shares and then immediately place
an order to buy 40 shares.
Options Are Standardized Contracts
The reason that options are inflexible as to the number of shares is because
options are standardized contracts. A standardized contract means there is a uniform
process that determines the terms, which are designed to meet the needs of most
traders and investors. By using standardized contracts, we lose some flexibility in
terms (such as the number of shares, strike prices, and expiration dates) but increase
the ease, speed, and security in which we can create the contracts.
In fact, if the exchanges find there is not sufficient demand for options on a
stock, they will not even list those options. Most of the well-known companies
have options available. If a stock has listed options, it is an optionable stock.
Microsoft and Intel, for example, are optionable. There are currently more than
2,300 optionable stocks, so the list is quite large.
Another limitation of standardized contracts is the fixed strike price
increments. If the stock price is below $50, you will find options available in
$2.50 increments. If the stock price is between $50 and $200, options will be in
$5 increments. And if the stock price is over $200, you will find option strikes in
$10 increments. Notice that the strike price increments have nothing to do with
the current price of the stock. The increments are based on the stock’s price at the
time the options start trading. If a stock’s price has been greatly fluctuating, you
might find different increments for different months. For instance, you may find
$2.50 increments for the first two expiration months and $5 increments in later
expiration months. This just tells you that the stock’s price was above $25 when
the later months started trading.
By having standardized strikes, we can quickly bring new contracts to market
that meet the needs of the vast majority of people. Imagine how overwhelming
the task would be if the exchanges tried to meet everybody’s needs by creating
strike prices at every possible price such as $30, $30.01, $30.02, etc. and then
matched those with every possible expiration date such as June 1, June 2, June 3,
etc. It would be a near impossibility. To solve these problems, the exchanges created
standardized contracts so that we can have some flexibility while still keeping the
list manageable.
What if you really want a customized contract? Is it possible to get one?
Technically, there is nothing illegal about two people having a contract drawn up
by an attorney that specifies the terms on which they agree to buy and sell stock.
You could therefore have an attorney write a contract for you and another trader,
thus creating your own call or put option. A contract drawn in this manner is
completely flexible -- but it is also very time consuming and costly. In addition,
even though you may have a legally binding contract, it is possible that the seller
decides to not fulfill his obligation if the buyer wishes to exercise his option. If
that happens, now you’ve got your hands tied up in court trying to get the seller
to conform to the terms of the contract. In other words, customized contracts are
subject to performance risk. That is, will the seller perform his part of the agreement
if the buyer decides to exercise?
Standardized options solve the performance risk problem too since the OCC
acts as the buyer to every seller and the seller to every buyer. If you exercise an
option, the OCC uses a random process to decide who will be assigned. When you
enter an options contract, you do not know who is on the other side of the trade.
Nobody knows. It is strictly the person who ends up with the random assignment.
Standardization increases confidence and influences the progress toward a smoothly
running, liquid market.
Besides having an attorney draw up a contract, there is another way to get
flexible contracts. You can buy FLEX contracts through the Chicago Board Options
Exchange (CBOE) that are totally customizable, but they also require an extremely
large contract size – usually more than one million dollars. Because FLEX options
are traded through the OCC they are not exposed to performance risk despite their
large contract sizes. Because of the size requirements though, FLEX options are
mostly used by institutions such as banks, mutual funds, and pension funds. The
standardized market is the solution for the rest of us.

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