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Derivatives
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Stock Options
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Stock Warrants
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Interest Rate Swaps
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Interest Rate Caps, Floors
and Collars
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Swaptions
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Futures and Forward
Contracts
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Managed Futures
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Stock Options
A stock option is a
contract that gives the holder the right to purchase or sell shares of a
security at a specified price (strike price) on or before a given date
(expiration date). This is a risky instrument! Forget the rhetoric for a
minute; options are a gamble. The option marketplace is very orderly and
efficient, making trading these instruments easy. There are classes, books,
seminars, TV shows, websites and companies that can help train someone in
the option markets. Nevertheless, options are highly leveraged financial
instruments that carry extreme risk. You can lose all of your investment
overnight. The fact that the cost basis of options is less then the
underlying securities does not limit your risk. A lot of small losses can
add up to a significant loss. Once the time elapses, when the exercise date
passes, the option is worthless and the premium spent for the option is gone
forever. Options are classified as derivatives because the price of options
is dependent on the value of the underlying securities. They are also called
wasting assets. With stocks, you are buying an ownership position in a
company. If your initial decision is not great, which happens often, time
may be able to cure your mistake. With options, you don’t have room for
timing mistakes.
"Fair is Fair" that is why the back dating of employee
stock options by corporations should be prevented.
On a more positive note, there are many other valuable uses
and benefits of options.
Calls
versus Puts
A call option gives the
holder the right to buy the underlying security at the strike price, on or
before the expiration date. The holder of a call option is betting that the
security will increase in value and exceed its strike price. The holder can
then call in the security for a profit. A put option is the reverse of a
call option; it gives the holder the right to sell the security at the
strike price, up to the expiration date. The holder of a put option is
betting that the security will decline below the strike price. This way, he
can “put” the stock to the counterparty.
Option Styles
Exchange traded options
are usually “American-style,” where the holder can exercise his option any
time before the expiration date of the option. However, there are also
“European-style” options, where the holder is limited to exercising
his option to a specified period of time. A “capped-style” option is where
the holder of the option is limited in potential profit by a price cap. If
the stock price reaches the cap, the option is automatically exercised. In
the case of a call option, the cap price is equal to the strike price plus
the cap interval. With a put option, the cap price is equal to the strike
price less the cap interval.
Strike Price
This is the exercise
price for which the underlying security can be purchased, as with a call
option, or the selling price in the case of a put option. When the
underlying security is at the strike price it is considered to be
“at-the-money”. An “in-the-money” option is one that has intrinsic value. An
“out-of-the-money” option is one with no intrinsic value.
Intrinsic Value and
Time Value
Intrinsic value is the
dollar amount of the option that is in-the-money. In the case of a call
option that is in-the-money, it is the difference between the strike price
of the option and the higher market value of the underlying security. It
excludes any premium for the time value of the option. With a put option, it
is the difference between the strike price and the lower market value of the
underlying security.
Time value is the
difference between the premium on the option and the option’s intrinsic
value. It’s the portion of the premium that is attributed to the time value
of the option.
Example
What makes options and
puts so appealing is leverage. Let’s use Pfizer as an example: on 7/6/05 the
stock was selling at $26.85 and their August 27 ½ calls traded at 75 cents.
Thus a 100 share contract cost $75 plus commission. Options expire on the
third Friday of the month, in this case August the 19th. (They
actually expire on the third Saturday of the month, but the markets are
closed.) If you were to buy 100 shares of the stock, it would cost $2,685.
If the price increased to $30 one would have a profit of $315 or an 11.7%
increase. Now, if you purchased the $27 ½ (strike price) calls for 75 cents,
and Pfizer increased to the same $30 per share, prior to August 20th
your profit would be $175 or a 233% increase. The profit (or loss) is
based on the strike price plus the premiums paid, compared to the market
value ($27 ½ +.75 = $28 ¼ - $30) or $1.75 profit per share, times 100
(number of shares in one option contract) = $175. Options are written on
blocks of 100 shares. That’s a lot of leverage! Look at the difference in
your return: if you purchased the stock the return was 11.7%, but by using
options the return was 233%. That’s the benefit of leverage; for $75 you
controlled $2,685 worth of stock. Pfizer’s January 06, $27 ½ options costs
$1.50 and their January 07, $27 ½ Leaps cost $2.80. LEAPS are long-term
options with an expiration date up to three years in the future. The longer
out one goes, the more expensive the option. The risk is that if Pfizer
stays flat until the option’s expiration date, the option holder loses 100%
of his investment, while the stock holder maintained his investment. Options
are all about timing. As a postscript, the January 06 options expired
worthless as the stock closed at $24.28 on 1/17/06.
The Underlying
Securities
Options are available on
individual stocks, stock indexes, currencies, futures contracts, treasury
security interest rates and recently, exchange-traded funds.
Selling Calls and
Puts
Selling a call option is
where one is paid a premium to sell the underlying shares at the strike
price, on or before the expiration date. Selling a put is the reverse of a
call; one is paid a premium to be ready and able to buy the underlying
security at the strike price, any time prior to the expiration date. As a
seller, you have no control over whether or not the option is exercised. If
investors need to close out their positions early, they need to purchase
offsetting contracts.
In writing a covered
call, one owns the underlying security and writes a call against it. It’s a
nice way to increase the cash return on a stock in a flat or declining
market. However, in a bull market there’s a bigger risk of losing your
shares at the strike price. Using the same example as discussed above, if
one owned Pfizer and sold an option by writing a covered call, the seller
would receive a premium of 70 cents. There is always a 5 to 10 cent
difference between buying and selling a call.
In writing a covered put
one, has a short position in the underlying security and writes a put
against it.
A “naked option” is an
uncovered option where the writer does not own the underlying security. The
issue with naked options is that the writer has an unlimited loss potential
if the value of the security substantially changes. This is not a smart
move, because for a relatively small premium, one is taking a huge risk.
Quadruple Watching
Days
The third Fridays of
March, June, September and December are when stock options, stock index
options, stock index futures and single stock futures all expire. Trading
volume is usually high, as investors close out positions.
Interested in more
information on options? Look at Yahoo Finance, at
http://finance.yahoo.com. It tracks options
by company, and is a good resource for the research of options. Other good
sources are the Chicago Board of Options at
www.cboe.com, Option Industry Council at
www.888options.com and Options Clearing Corporation at
www.optionsclearing.com.
Option trading is for
the more experienced investor. There are many successful option strategies;
just be careful, because the risks can be high. Options are a form of
derivative, and fortunes have been lost on derivatives.
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