Options have many uses and investors need to be aware of their ramifications in order to be able to use them.
In order to do so, investors need to familiarize themselves with knowledge about options.
Learning the Vocabulary
Options: They are stock derivative investments.
Derivative security: A financial security that derives its value from another security.
Options and futures: These are stock derivatives that offer investors some of the benefits of stocks without having to own them.
Options contract: This gives the holder the right to buy or sell shares of a particular common stock at a predetermined price (strike price) on or before a specified date (expiration date).
Option: An option is a right, not an obligation, to buy or to sell stock at a specified price before or on an expiration date.
Strike price: The price at which the holder of the option can buy or sell the stock.
Expiration date: An option expires on its expiration date.
Stock Option: This is a derivative security because its value depends on the underlying security, which is the common stock of the company.
Options market: Chicago Board Options Exchange (CBOE), New York Stock Exchange (NYSE), the American Options Exchange (AOE), the Philadelphia Exchange (PHO), and the Pacific Exchange (PSE). Options can also be traded in the over-the-counter market.
Options websites: www.cboe.com, www.nyse.com/futuresoptions/nyseamex, www.amex.com, www.phlx.com. Click on all exchanges and list all options and LEAPS. Click on Submit, and a list of options for the stock you requested will appear.
Options contracts: Calls and Puts
Call option: A call option gives the option owner the right to buy shares of the underlying company at a predetermined price (strike price) before expiration.
Put option: A put option contract gives the option owner the right to sell shares of the underlying company at the strike price before expiration.
Option holder: Option holder has the right to convert the contract at his/her discretion. It is not an obligation. Holders of the option can exercise the option when it is to their advantage and let the options contract expire if it is not advantageous.
Options contract: SIX items of note in an options contract. 1. Name of the company whose shares can be bought or sold. 2. The number of shares that can be bought or sold, generally 100 shares per contract. 3. The exercise or strike price, which is the stated purchase or sale price of the shares in the contract. 4. The expiration date, which is the date when the option to buy or sell expires. 5. The settlement procedure. 6. The options exercise style.
Option buyer: The option buyer is also referred to as the option holder.
Option seller: The seller of the original contract is referred to as the option writer. In any contract, there are at least two parties: buyers and sellers.
Settlement procedure: This is stipulated for stock options, which indicates when delivery of the underlying common stock takes place after the holder exercises the option.
Options exercise style: There are two basic exercise styles that determine when the option can be exercised, namely, American style and European style.
American style: Options on individual stocks can be exercised ANY time before the expiration date.
European style: Stock index options can be exercised ONLY on expiration date.
Life of the option: The expiration date is also important, as it specifies the life of the option.
Standardized expiration dates: The expiration dates are standardized for options contracts listed on the exchanges. There are three cycles for listed option expirations, and each option is assigned to one of these cycles: January cycle: January-April-July-October; February:cycle: February-May-August-November; and March cycle: March-June-September-December.
Options Clearing Corporation (OCC): The trading of options is greatly facilitated by the Options Clearing Corporation, which, besides maintaining a liquid marketplace, also keeps track of the options and the positions of each investor. Buyers and writers of options do not deal directly with one another but instead with the OCC.
Contract period for stock options: The contract period for stock options is standardized with three-, six-, and nine-month expiration dates. Generally, two options on a stock are introduced to the market at the same time with identical terms except for the strike (exercise) price.
LEAPS (long-term equity anticipation securities): Longer-term options contracts, called LEAPS have life spans of up to three years before expiry. They have similar characteristics to the short-term options contracts but, because of their longer expiration periods, have higher premium prices.
Time value of an option: An option is a wasting asset. There is a time value to the price of an option. The more time before the option expires, the greater is the time value of the option. As the option moves closer to its expiration, so the time value of the option decreases in value. Generally, options are not normally exercised until they are close to expiry because an earlier exercise means throwing away the remaining time value. Another generalization with options (both calls and puts) is that most options are not bought with the intention of exercising them. Instead, they are bought with the intention of selling them.
Intrinsic value of the call option: The intrinsic value of a call option is the difference between the market price of the stock and the strike price. Intrinsic Value of Call Option = Market Price of the Stock - Strike Price.
In the money call option: When the market price is greater than the strike price, the call option is said to be in the money.
Out of the money call option: A call option is said to be out of the money when the market price of the stock is less than the strike price.
At the money call option: The market price of the option equals the strike price.
Time value of put option: Puts are wasting assets and have no value at expiration.
Intrinsic value of put option: The intrinsic value of the put option is determined by subtracting the market price of the stock from the strike price. Intrinsic Value of a Put Option = Strike Price - Market Price of the Stock.
Out of the money put option: If the put option has no intrinsic value, it is out of the money.
In the money put option: If the put option has intrinsic value, it is in the money; and it is profitable to exercise the put option.
At the money put option: If the strike price equals the market price of the stock, the option is at the money.
Writing options: Investors can also write or sell options, which provide additional income from the premiums received from the buyers of the option contracts. The upside potential to this strategy for option writers is limited, however, because the most money the writer can make is the amount of the option premium.
Writing covered option: A covered option is an option that is written against an underlying stock that is owned, or sold short, by the writer. The writer of the option owns the stock against which the options are written.
Writing naked option: This is the second method of writing an option. A naked option, is an option written on an underlying stock that is not owned or sold short by the writer.
Writing covered calls: A covered call limits the appreciation the writer can realize. Therefore, it is a good idea to write covered calls on the stocks you think won't rise or fall very much in price.
Writing naked call: Writing a naked call on a stock is more risky than writing a covered call because of the potential for unlimited losses. A naked call is when the writer does not own the underlying stock, which would limit the losses if the stock rocketed up in the price. Investors can profit from writing naked calls on stocks whose prices either decline or remain relatively flat below the strike price for calls.
Writing covered puts: The writer of a covered put sells short the underlying stock and receives a premium for the covered put. If the option is exercised, the writer would buy back the stock at the strike price and use the shares to close out his short position.
Writing naked puts: The writer of a put option expects the stock to rise or at best not fall in price. If the put writer does not own the underlying stock, the contract is a naked or uncovered put, which necessitates that the writer deposits an amount of money with the brokerage firm for the required margin.Without owning the underlying stocks, the potential loss is not cushioned if the price of the stock falls rapidly.
Combination of Puts and Calls: Straddle and Spread
Straddle: A straddle is the purchase (or sale) of a put and a call with the same strike price and the same expiration date.
Spread: A spread is the purchase or sale of a combination of put and call options contracts with different strike prices.
Stock Index Options: Stock index options allow investors to take long and short positions on the market without having to buy or sell short the stocks that make up the index. A stock index option is a put or call written on a market index. With stock index options you can track the markets without having to buy or sell the stocks. Options on stock indices are valued and trade in the same way as options on individual stocks with the notable exceptions that settlement is made in cash for the former.
Rights: A right, also known as a preemptive right, is an option allowing a shareholder to by additional shares of new stock of the company at a specified price within a specified time period before the shares are offered to the public. A right allows a current shareholder to buy more common stock of the company in advance of the public at a discounted price (subscription price). Stock rights are issued to existing shareholders on a stated date. These rights give existing shareholders the opportunity to maintain their same proportionate ownership in the company after the new issue of common stock. Rights, like options, can be bought for one of two reasons: either to exercise the rights or to speculate on the rights.
Trading cum rights: To be eligible to buy these additional shares at the subscription price, the common stock of the company must be owned as of the record date set by the board of directors. Most rights offering have a short period of time (between two and six weeks) for existing shareholders to either subscribe to the new shares or sell the rights. It is during this period that the stock is said to be trading cum rights, where the value of the right is included in the market price of the stock.
Trading ex-rights date: After a specified date, known as the ex-rights date, stock transactions do not include the rights. Theoretically, the stock price goes down after this date, when the rights trade separately.
Value of a right: The value of a right depends on the market price of the stock, the subscription price of the right, and the number of rights necessary to buy each new share.
Cum Rights Value: The formula to determine the value of the rights before they trade independently of the stock is as follows: Cum Rights Value = (Market Price of Stock - Subscription Price) / (Number of Rights to Buy a Share + 1)
Ex-rights Value: After the stock trades ex-rights, its price declines by the value of the right, because rights trade separately from the stock. Investors who want to buy the rights can purchase them on the market in the same way they can purchase the stock. The ex-rights value is calculated as follows; Ex-rights Value = (Market Price of Stock - Subscription Price) / (Number of Rights Needed to Buy a Share)
Warrants: A warrant is a security that allows its owner to purchase a stated number of shares of common stock at a specified price within a specified time period. A warrant is similar to a long-term option in that it gives the owner the right to by a stated number of shares of the underlying company's stock at a specific price within a specific period of time. The differences between warrants and options are that with warrants the specified price can be fixed or it can rise at certain intervals, such as every five years, and the company can extend the expiration date. Warrants have longer lives than options. An option can have a life of nine months or less; warrants extend for years, and some companies have issued perpetual warrants. Generally, there is a waiting period before warrants can be exercised. Corporations issue warrants as sweeteners with other securities issued by the company. Warrants can be attached to bonds or preferred stocks. In some cases, warrants have been distributed to shareholders in place of stock or cash dividends. The major advantage of warrants over options is that warrants have longer lives. Warrants do well when stock prices are rising, but investors should still be selective about the warrants they buy. If the stock never goes up in price, there is little to no opportunity to profit from buying the warrants. Generally, as with options, warrants should be bought to trade and not to exercise.
Value of a warrant: When a company issues warrants, the purchase price of the stock is generally fixed at a higher price than the market price of the stock at issue. Value of a warrant = (Market price of stock - Exercise price ) x (Number of shares purchased with the warrant).
Premium of a warrant: Premium = Market price of the warrant - Value of the warrant. If the market price of the stock never rises to the strike price of the warrant during its life, the warrant is not exercised and expires.
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