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# Options Basics Reports.doc

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### Options Basics Reports.doc

1. 1. Options Basics Reports Section 1: Options Overview An option is the right to buy or sell a given amount of stock at a set price on or before the date of expiration for that option. Similar to stocks, options are openly traded in markets; however, unlike stocks, options do expire and are not limited in quantity. There are two main types of options: call options and put options. Call options allow the owner of the option to purchase stock at a set price (the strike price) on or before the option’s expiration date. This is an option, however, and the owner of the option is not obligated to buy any stock; by not exercising the option, he merely loses the amount he paid for it. Similarly, put options allow their owners to sell an amount of stock at a set price on or before the expiration date. This means the seller of the option will buy that stock at the set price should the buyer of the option choose to exercise that right. Below is a picture of the listing for options: Image provided by CBOE: The Options Institute http://www.cboe.com/LearnCenter/cboeeducation/Course_01_01/mod_01_11.html The left column lists the prices for available call options. To determine the price of the option, you must multiply the higher of the two numbers in that row by one hundred (the minimum amount of shares that are purchased with an option). Similarly, you can perform the same multiplication on the higher price in the put option to determine its price. The middle column lists the strike price of the option and the month of expiration. For example, the row with the circled number is offering an option for stock in company XYZ that will expire on the third Friday in May. The call option costs two hundred dollars, the put option costs forty-five dollars, and the strike price for both options is thirty dollars per share. Those that sell options are known as writers, and those that purchase options are known as holders. When a holder thinks the value of a particular stock is going to go up, he may purchase a call option with a higher strike price than the anticipated ending price on the day of expiration. If the stock does indeed go above the strike price, the holder could exercise his option, buy shares of the stock at the lower price, and then sell them back into the market for a profit. If the holder feels that the stock may drop in value, he could purchase a put option as a sort of insurance policy on his stock. If the value decreases significantly, he may exercise the put option, sell the stock to someone at a higher cost than what the market price is, and reduce the amount of financial loss he incurs. Options
2. 2. are good alternatives to actual participation in the stock market because, while success is tied to market activity, the overall risk is much lower. The writer is the individual that bears the obligation and most of the risk in the transactions. Section 2: Introduction to Options Strategies From the previous section, it is easy to see the benefits of both sides, as well as the risk assumed by the writer. For the holder, there are two distinct advantages: making profit through the use of call options and minimizing financial loss through the use of put options. The writer risks having his customers exercise their options and losing money, but this risk is offset by the high return from the up-front payment for the option. The option that gives the right to exercise is the long option; on the other hand, an option that obligates to an assignment is the short option. Writers have short options; if they agree to purchase or sell stock at a strike price, they must follow through with the agreement if they are assigned to someone that holds that option. Buying a call or put makes you long to that option and selling either makes you short to that option. However once the option has been transacted, both parties still have options. The party short to the option can purchase it back from the holder; the holder can simply choose not to exercise the option or sell it back for a profit (if the writer looks at market trends and feels the option is going to cost him, he may try to buy back the option at a higher price than what the holder paid for it but for less than what he feels he will lose should the option be exercised). An investor can use the options market to make money even if he or she owns no actual stock. The put option, for example, increases in value as the price of the stock falls. Say you purchase a put option on a stock for forty dollars, and at the time of expiration the value of each share of stock is thirty. The value of the put option is now worth one thousand dollars less the cost of purchasing the actual option. Even if you don’t own the shares of stock that you could sell at the higher price, it is possible to sell the option back into the market as the expiration date gets closer because there is someone in the market that does own the stock and would like to sell it at a higher price than it is currently worth. There is no actual sale of stock shares, but rather the sale of the option to sell higher than market value. Both call and put options can be traded in this manner; it is the value of that option to those that do own stock that gives it extended value. Both of these investment options rely upon the fact that the market price will either increase or decrease and that there will be someone in the market who would like the option to exercise in order to subsequently amplify or dampen the price change. There are also options for investors that feel the market price will remain the same. If an investor owns shares of a stock and believes the stock price will remain relatively unchanged, he or she may offer a call option to potential holders. The holder that purchase the option will hope the stock price increases past the strike price; he or she will then be able to exercise and make a profit. If the price of the stock does increase, the writer will make a profit on the sale of the option and the shares of stock but lose the value in the difference between the strike and market price. If the value remains the same, the writer has made money off of the sale of the option. If the value of the stock
3. 3. decreases, the writer loses value on the stock but does keep the money from the option transaction. Section 3: Expiration, Exercise, and Assignment According to the CBOE website, only thirty percent of options expire worthless each month. Ten percent of available options are actually exercised. This means sixty percent of the options are either sold back into the marketplace by their holders or bought back by the writers that initially sold them. When the call option is exercised, the holder notifies the brokerage firm through which the option was sold that he is going to exercise his option. The firm notifies the OCC, and they find a writer that has issued an option in the same class and series. The writer is notified of the transaction; the firm delivers the stock to the holder and the money to the writer. The holder must have enough money to actually purchase the total amount of shares at the strike price, and the writer must own or obtain enough shares to sell when he is assigned to a holder. Section 4: Options Pricing 1