understanding options

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Bartholomew Reed
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1 Investment Planning understanding options Get acquainted with this versatile investment tool.

2 Understanding Options This brochure discusses the basic concepts of options: what they are, common investment terms and how they work. Options can be used in a variety of ways to help you reach your investment goals and objectives, although they are not for everyone. Work with your financial advisor to determine if options may be suitable for your portfolio and to create a customized solution to fit your needs. Investor Objectives Income Generation Risk Reduction Targeted Selling Stock Acquisition Raymond James Financial Advisor Customized Solution

Work with your financial advisor to determine if options may be suitable for your portfolio and to create a customized solution to fit

3 Options: a Portfolio Tool An option is a contract that provides an investor with certain rights or obligations related to an underlying security, such as stock, depending on the type of contract involved and whether it is bought or sold. Options strategies can provide the flexibility to help meet different investor objectives. Your financial advisor will help you carefully weigh the benefits and risks associated with options to determine if they may be suitable for your portfolio. Common Terms to all Options Strike price The strike price is the specified price per unit at which the underlying stock will change hands after the option is exercised by its owner. Stock option contracts typically have strike prices in increments of $1, $2.50 or $5, depending on the stock associated with the option contract. Income Generation Options can be used as an income-generation strategy via premiums received by selling options. Risk Reduction Investors who currently own a stock can reduce their exposure to downside price risk. Premium The premium is the market price of the option contract, which is paid by option buyers and received by option sellers. Targeted Selling Investors who currently own a stock can seek sale prices by the selection of an option strike price. Investor Objectives Stock Acquisition Investors who want to purchase a stock can utilize options to target specific acquisition prices via the option strike price. Expiration date The expiration date is the predefined date that marks the last time at which the option can be exercised. Stock options have various expirations available in the listed market, typically including one in each of the current month and the next month, and two additional within the following six months. Some stocks have option contracts with expiration dates greater than one year. 1

Your financial advisor will help you carefully weigh the benefits and risks associated with options to determine if they may be suitable for your portfolio.

4 Types of Options Call Options A buyer of a call option purchases the right, but not the obligation, to buy stock at a predetermined strike price no later than a predefined expiration date. A seller (often called a writer) of a call option has the obligation to sell stock at a predetermined strike price if assigned an exercise notice at any time before the expiration of the contract. Put Options A buyer of a put option purchases the right, but not the obligation, to sell stock at a predetermined strike price no later than a predefined expiration date. A seller (often called a writer) of a put option has the obligation to buy stock at a predetermined strike price if assigned an exercise notice at any time before the expiration of the contract. Comparing calls versus puts Buy Call Sell Call Buy Put Sell Put Contract Provisions Right to Buy Obligation to Sell Right to Sell Obligation to Buy Control of Exercise Decision Yes No Yes No Potential Profit Unlimited Limited to Premium Substantial Limited to Premium Potential Loss Limited to Cost Unlimited Limited to Cost Substantial Premium Paid Received Paid Received Options are described as being in-the-money, at-the-money or out-of-the-money based on the relationship of the stock price to option strike price. Option Type In-the-Money At-the-Money Out-of-the-Money Call Market Price > Strike Price Market Price = Strike Price Market Price < Strike Price Put Market Price < Strike Price Market Price = Strike Price Market Price > Strike Price 2

Put Options A buyer of a put option purchases the right, but not the obligation, to sell stock at a predetermined strike price no later than a predefined expiration date.

5 OptionS Markets Understanding Option Quotes Listed equity option contracts typically cover 100 underlying shares. Listed equity option premiums are typically quoted on a per-share basis. Thus, an investor targeting 100 underlying shares would use one option contract and pay the quoted premium (buying the option) or receive the quoted premium (selling the option) and multiply the premium price by 100. Opening and Closing Trades Since options are contracts between the buyer and the seller, a new transaction creates a right for the buyer and an obligation for the seller. When an investor initiates an option position, by either buying or selling, it is called an opening trade, since a new contractual agreement is established. For example, if an investor were to sell a call or a put option to initiate a position, the transaction would be considered a sale to open. Conversely, when an investor wishes to exit an existing option position, it is called a closing trade since the contractual agreement is ended. Options Exchanges Options are traded on exchanges similar to stock exchanges. U.S. option exchanges seek to provide competitive, liquid and orderly markets for the purchase and sale of standardized options. Transactions involving standardized U.S. option contracts are executed on one of many options exchanges. The Options Clearing Corporation Options traded on any of the exchanges are cleared through the Options Clearing Corporation (OCC). The OCC issues and guarantees every option contract traded on a U.S. options exchange. Investors do not face the credit risk of the counterparty associated with their specific transactions. Option Pricing Option prices consist of two components: intrinsic value and time value. Intrinsic Value The intrinsic value is the portion, if any, of the option premium that represents the value realizable through exercise (or the in-the-money value). At expiration, an option is worth only its intrinsic value as determined by the closing price of the stock. Time Value The time value is the portion of the option premium that is not intrinsic value. The premium of an option with no intrinsic value is comprised exclusively of time value. As expiration approaches, the time value decreases, reaching zero at expiration. The time remaining until an option expires has value because, with more time, there is continuing opportunity for profit but also risk of loss. Example: Assume a call option has a strike price of $50. The underlying stock is currently trading at $55. The call premium is currently $7. Intrinsic Value: The call has $5 of intrinsic value ($55 market price - $50 strike price) Time Value: The call has $2 of time value ($7 option premium - $5 intrinsic value) 3

premium price by 100. Opening and Closing Trades Since options are contracts between the buyer and the seller, a new transaction creates a right for the buyer and an obligation for the seller.

6 Factors Affecting Options Premiums There are many variables that affect option prices. The volatility of the underlying asset is a key factor in calculating the option premium. Volatility is the measure of fluctuation, not direction, of stock price movement. Since volatility reflects both upside and downside price potential, an increase in volatility will typically increase both call and put premiums. The underlying stock price may also have a major influence on the price of an option. Typically, as the underderlying stock price increases, the value of calls also increases, while the value of puts decreases. As the stock price decreases, the opposite usually occurs. Other factors, such as interest rates, the dividend paid by the underlying stock and general market conditions, may also influence the price of an option. Which strategies should you consider? Since your goals and objectives are unique to your situation, your financial advisor can best assist you in evaluating which, if any, option strategy is right for you. Options involve risk and are not suitable for all investors. When appropriate, options should comprise a modest portion of an investor s portfolio. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your financial advisor, from cboedirect.com/resources/intro.aspx or by contacting Raymond James at 880 Carillon Parkway, St. Petersburg, FL The information in this document is provided solely for general education and information purposes and, therefore, should not be considered a complete description of listed options. No statement within this document should be construed as a recommendation to buy or sell a security or to provide investment advice. Please consult a tax advisor for the tax implications involved in the use of options. 4

Since volatility reflects both upside and downside price potential, an increase in volatility will typically increase both call and put premiums.

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Buying Equity Call Options

Buying Equity Call Options Presented by The Options Industry Council 1-888-OPTIONS Equity Call Options Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor