Wednesday, April 29, 2015

Option Terminology

We’re almost ready to talk about real call and put options but we first must
go over some other market terminology that you’ll need to understand. We just
covered the terms “long” and “short,” which are critical for understanding who has
the right and who has the obligation with any particular strategy. But we have a lot
more ground to cover before learning about strategies. Next, we must venture into
the remaining terms we will be using throughout the book.
Underlying Asset
In the pizza coupon example, we would say the underlying asset is a pizza.
Notice that the coupon limited us to how many pizzas we can purchase; we cannot
purchase all we want. In addition, the coupon is not good for any brand of pizza
but only the one advertised on the coupon. Call and put options work in similar
ways. The underlying asset for a call or put option is generally 100 shares of stock.
There are exceptions  to this rule such

as certain stock splits or mergers. But when options are first issued, they always
represent 100 shares of the underlying stock.
The “brand” of shares we can buy is determined by the call or put option. For
example, if we have a Microsoft call option, we have the right to buy 100 shares
of Microsoft. In this case, Microsoft would be the underlying stock. The price of an
option is tied to or derived by the underlying stock. Because of this, options are
one of many types of derivative instruments. A derivative instrument is one whose
value is derived by the value of another asset.
Strike Price (Exercise Price)
In our example, the pizza coupon states a specific purchase price of $10.00. No
matter what the price of pizzas may be when you get to the store, you are locked in
to the price of $10.00. If this were an option, we’d call this “lock in” price the strike
price, which is really a slang term that comes from the fact that we have “struck” a
deal at that price.
Another name for the strike price is the exercise price. The reason for this is
that if you choose to use your option, you must submit exercise instructions to your
broker, which is handled with a simple phone call. With a pizza coupon you just
“hand in” the coupon, but in the world of options you must “exercise” the option
through your broker.
If you exercise a call option, you must pay the strike price (since you’re buying
stock) and that’s why the strike price is also called the exercise price. It’s the price
you will pay for exercising the option to purchase shares of stock. If you are short
a call option, you’ll receive the strike price (because you’re selling stock). The
exercise price is the price that will be paid by the long position and received by
the short position.
The opposite is true for put options. If you exercise a put, you’ll receive the
strike price since you are selling shares of stock. The short put will pay the strike
price since he is the required to buy the stock. The exercise price is the price that
will be received by the long put and paid by the short put.
We’ll talk more about exercising options later but, for now, just understand
that the strike price and exercise price are two terms meaning the same thing. They
both represent the fixed purchase or selling price.

Expiration Date
Notice that the pizza coupon also has an expiration
date. You can use this coupon at any time up to and
including the expiration date. Equity options (options on
stock) always expire on the third Friday of the expiration
month. Technically speaking, equity options expire on
Saturday following the third Friday but that is really for
clearing purposes. That extra day (Saturday) gives the
OCC (Options Clearing Corporation) time to match buyers and sellers while the
contract is still legally “alive.” From a practical standpoint though, the last day to
close or to exercise your option is the third Friday of the expiration month. After
that, it’s no longer valid. So just because you may read that options expire on
Saturday, don’t think you can get up Saturday morning and call your broker with
exercise instructions – it’s too late. The third Friday of the expiration month is your
last day (not the only day) to close or exercise the option. (If Friday is a holiday, the
last trading day will usually be the preceding Thursday.)
Although a pizza storeowner may allow you to turn in an expired coupon,
there’s no such thing with the options market. The second that option expires, it’s
gone for good. There are some index options, such as options covering the S&P
500 Index that expire on the third Thursday of the expiration month. However,
we will only be discussing equity options in this book, so whenever we talk about
the expiration date, we will always be referring to the third Friday of the expiration
month unless otherwise stated.
American Versus European Styles
As stated before, most option contracts are simply
bought and sold in the open market without a single
share of stock ever changing hands. However, if you wish
to physically trade shares of stock, you must exercise your
option. When can you exercise your option? The answer
to that depends on the style of option. There are two styles
of options: American and European. The style of option has nothing to do with
its origin as implied by the names “American” and “European.” Instead, the style
simply tells us when the option may be exercised. American-style options can be
exercised at any time through the third Friday of the expiration month. European
style options, on the other hand, can only be exercised on the third Friday of the
expiration month. You generally do not get to select which style of option you
want. All equity options (that is, options on stock) are American style and can
be exercised at any time. Most index options are European style. There are a few
indices that offer both such as the OEX (S&P 100 Index), which is American style
and the XEO (letters reversed), which is the European version of the same index.
It may sound like the American-style option has a big advantage over a
European style. After all, for example, if a stock is really flying high it would be
nice to exercise a call option and buy the shares at a cheaper price and immediately
sell the shares to capture a profit. We’re going to find out in Chapter Four that
exercising a call option early for this reason is a big mistake. You will find out that
most of the time you are better off just selling the call option in the open market
rather than exercising it.
This book is written from the perspective of equity options, so we will assume
that all options discussed are American style unless otherwise stated. We only
differentiate the terms “American” and “European” so you will know what it they
mean if you hear them later while continuing to learn about options. The bottom
line is that all equity options are American style, which means the long position
can exercise them at any time during the life of the option even though it is rarely
optimal to do so.
The last day to buy, sell, or exercise your options is the third Friday of the
expiration month.

Physical Versus Cash Delivery
If you exercise an equity option, you will either buy or sell the actual (physical)
shares of the underlying stock. This is called physical delivery or physical settlement.
On the other hand, most index options, such as SPX (S&P 500), are cash
settlement rather than physical delivery. In other words, if the long position
exercises an index option, he receives the cash value of the option rather than
taking actual delivery of all the stocks in that index. Just realize that not all options
settle in physical delivery. As you continue to learn more about options you will
hear the terms “physical settlement” and “cash settlement,” and it’s important you
understand what these terms mean.
Exercise Versus Assign
We said earlier that it is the long positions who get to exercise their options.
What do short positions get to do? Nothing. Remember, short positions have no
rights. The short position may get a phone call from his broker stating that he has
just purchased or sold shares of stock due to a call option he sold. If you are required
to buy or sell shares of stock due to a short option, it is called an assignment.
If you get assigned on an option, your broker will notify you the next business
day to inform you of the assignment. He may say something like, “I’m calling to
inform you that you’ve been assigned on your short call options and have sold 100
shares for the strike price of $50.”
The words exercise and assign should only be associated with long and short
positions respectively. However, in the real world, if you are assigned on a short
option, brokers may say things like “you got exercised” on an option even though
it is technically incorrect. Long positions exercise. Short positions get assigned. In
truth, it doesn’t really matter in practice if an incorrect phrase is used such as “you
got exercised” rather than “you got assigned” as long as you understand the message.
However, if these terms are used, you do need to understand the difference. Most
books and literature on options carefully choose between the words “exercise” and
“assign” and you need to understand the actions they are referring to.
Let’s work through some examples to be sure you understand. If you are long a
call option, you have the right to exercise it and buy shares of stock. If you are short
the call, you might get assigned and be required to sell shares. If you are long a put
option, you have the right to exercise it and sell shares. If you are short the put
option, you could get assigned and be required to buy shares. To continue further,
if a long call holder uses his call to buy shares of stock he would say, “I exercised my
call.” The short call holder would say, “I got assigned on my call.”
It is important to understand that once you submit exercise instructions to your
broker and the shares and cash have exchanged hands it is an irrevocable transaction.
Make sure you want to exercise before submitting instructions. Also, many firms
have cutoff times after which exercise instructions cannot be changed (even though
the shares or cash may not have yet been exchanged). Check with your broker as to
what these cutoff times are before you submit exercise instructions.

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