OPTIONS are securities that are under the general classification of Derivative
Products. Derivatives are securities that derive their value from the movement
in the price of another asset (the underlying asset). In the case of Options,
the underlying asset is usually common stock.
An option comes in two forms: CALLS and PUTS.
A CALL option gives the holder the right, but not the obligation, to BUY 100
shares of the underlying stock for a predetermined price for a specific period
of time. Each call option controls one "round lot" of stock which is 100 shares.
A PUT option gives the holder the right, but not the obligation, to SELL 100
shares of the underlying stock for a predetermined price for a specific period
of time. Each put option controls one "round lot" of stock which is 100 shares.
Before 1973, option contracts were not standardized but specific to the
individuals that wanted to engage in a transaction. This lack of standardization
made the contracts ill-liquid.
In 1973, the Chicago Board Options Exchange was established for call options.
The market response was huge. Within three years, the American, Pacific
and Philadelphia exchanges were trading calls.
WHY OPTIONS? Options are used for both Insurance and Speculation. In the
mid-1980's derivative instruments were given a "once-over" by the press when
some firms that used these products found themselves in deep financial trouble
when the derivatives that
they purchased caused serious losses.
From a speculation standpoint, people and companies can and do lose money on
derivative instruments. They also can and do lose money on stocks, bonds, real
estate, mutual funds, art, etc. Derivative instruments can and do have a place
in many portfolios.
FOUR PRIMARY OPTION TRANSACTIONS
BUY A CALL OPTION
Let's say that AOL stock is trading on
the New York Stock Exchange with a price of 100 per share. To own a round
lot of AOL, an investor would need $10,000 (100x100).
If the investor felt that AOL was about to move up in the very near future,
the investor could buy a call option. The call gives the investor the right,
but not the obligation to buy AOL at a predetermined price, say 95. If the
call buyer is correct and AOL rises to 105, she can buy 100 shares at the
predetermined 95 price. [Called the STRIKE PRICE].
BUY A PUT OPTION
Say that AOL stock is trading on the New
York Stock Exchange with a price of 100 per share. To own a round lot of
AOL, an investor would need $10,000 (100x100). If the investor felt that
AOLs price was about FALL in the very near future, the investor could buy a
put option. The put gives the investor the right, but not the obligation to
SELL AOL at a predetermined price, say 105. If the put buyer is correct
and AOL falls to 90, she can sell 100 shares at the predetermined 105 price.
SELL A CALL OPTION
The seller or "writer" of an option HAS
an obligation to SELL or DELIVER shares of the underlying security for the
strike price. If an investor sells or writes the MAY 100 Call on AOL, the
call seller would be obliged to deliver 100 shares to the call buyer if the
call buyer chose to exercise his call option. The call seller has all of the
obligation, the call buyer has the rights [but NOT the obligation]. The call
seller enters into this transaction for the benefit of receiving the premium
from the buyer as income. Confused? You betcha!
SELL A PUT OPTION
Remember the discussion on buying puts.
The put buyer wants the price of the stock to fall. Put buyers are in the
same camp as short sellers, they believe that stocks will fall in price,
speculating on that move OR purchasing insurance on a long portfolio.
Put sellers want the price of the stock to RISE. The put
writer or seller has an obligation to BUY 100 shares of stock per contract
at the strike price by the exercise month.
Put sellers are in the same camp as CALL BUYERS. Except that the put seller
will earn the premium and no more. Let's use another example.
If QCOM is trading for 140 and I think that the stock is going to rise, I
could buy a call to capitalize on the increase in price. I could also SELL
the 130 Put. As usual, two things could happen: (1) the stock could rise. In
this case, I would keep the premium. (2) the stock could fall, to say, 125.
In that case, I would be forced to BUY 100 shares at 130.
Put selling has brought me several $ in premiums over the years. Only on a
couple of very memorable occasions did the stock go below the strike price.
If you don't get greedy, these can work well.
The other way to look at put selling is that it is, in essence, a limit
order to buy the stock that pays you money to wait!
Check out:
www.cboe.com. For options information, seminars, free literature,
free CD's on options and much more. It is the Chicago Board Options
Exchange.
OPTION POSITIONS
BUY A CALL
Call Buyer wants stock price to INCREASE
Call Buyer is exposed to UNLIMITED Gains, LIMITED
losses
Speculative reason for buying the call: Call buyer
would be speculating on the rise of the stock by buying the call.
Insurance reason for buying the call: You could
hedge a SHORT POSITION by buying the call.
BUY A PUT
Put Buyer wants stock price to DECREASE
Put Buyer is exposed to LIMITED Gains, LIMITED losses
Speculative reason for buying the put: Put buyer
would be speculating on the decrease of the stock price by buying the put.
Insurance reason for buying the put: You could hedge
a LONG POSITION by buying the put.
SELL A CALL
Call Sellers (Writers) want the stock price to FALL
Call Sellers are exposed to LIMITED Gains (the option premium is all they would gain)
Call Sellers are exposed to UNLIMITED Losses (unlimited if writing naked options)
Speculative reason for selling the call: Call Seller
would be speculating that the stock price would decrease.
Insurance reason for selling the call: You could
hedge a LONG POSITION by selling the call.
SELL A PUT
Put Seller (writers) want the stock price to INCREASE
Put Seller is exposed to LIMITED Gains (the option premium is all they would gain)
Put Seller is exposed to LIMITED Losses
Speculative reason for selling the put: Put Seller would be
speculating on the increase of the stock price.
Insurance reason for selling the put: You could hedge a
SHORT POSITION by selling the Put.
