Options are often referred to as contracts: you can buy 10 contracts, sell 5 contracts, etc.

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1 1 of 6 Options Mechanics In this module we cover some of the nuts and bolts issues related to options trading. Here are some of the boring but necessary things you need to know! BTO, STC, STO, BTC You have a securities account in which there is some cash, no stocks and no options. You decide to purchase 5 of the HPQ Feb. 40 calls at $2.00. You place the order and you identify it as BTO: buy to open. Download: Options' Mechanics The Buy part of BTO should be self-explanatory. The Open simply means that this is a new position, one that you are opening. Two weeks go by, HPQ rises and you decide to take your profits, placing on order to sell 5 HPQ Feb. 40 calls at $4.00. Nice trade. You identify this trade as STC: sell to close. Once again, the Sell part is obvious. The Close indicates that you are selling options that you already own and that this will close out a long position. Note that you could have decided to take your profit on only part of your position and sold 2 of your HPQ calls. This trade would also have been labeled STC even though you would be closing only a fraction of your holdings. There are no longer any securities in your account, just cash. You decide to short some puts, selling 3 of the IP March 50 puts at $3.00. You identify this order as STO: sell to open. You are selling (shorting) options that you do not own, creating a new position and assuming an obligation. It s a Sell, but it s also an opening trade as it creates a new position. A few weeks later, you decide to cover your IP puts by placing an order to buy 3 IP March 50 puts at $1.00. This order is identified as BTC: buy to close. You are buying options that you previously shorted, so the purchase results in canceling your obligation, not in creating a long position. If you initially sold 3 and then buy 3 to close, your ending position is flat, a fancy way of saying you no longer have a position in a security. It may not be necessary for you to identify an options trade as BTO or BTC. Your broker s computer system may automatically do this for you, especially if you are trading on the internet. But when placing an order by phone, you may want to identify your buys and sells as open or close. Volume, Open Interest Options are often referred to as contracts: you can buy 10 contracts, sell 5 contracts, etc. Trading volume is simply all of the trades in one option series, or the all of the trades in one class. This is quite straightforward. The trading volume in the CHK June 25 calls yesterday was 450 contracts. Or the trading volume in the CHK option class was 3,232 contracts yesterday. Let s now assume that a new option is created. These options have never traded before, so previous trading volume is by definition zero. Let s concentrate on just one series, the August 55 calls. During the first day s trading session the following trades take place: 10 contracts at $ contracts at $ contracts at $ contracts at $3.70 What is the trading volume for the day? Easy: = 32. What is the open interest at the end of the day? We don t know. First, we haven t defined open interest, and second, we do not have the information necessary to calculate the day s end open interest. To do this we need more data on

2 the trades that took place, as follows: Paul BTO 10 at $4.00 / STO 10 at $4.00 Peter Mary BTO 7 at $3.90 / STO 7 at $3.90 Jane Peter BTC 5 at $3.80 / STO 5 at $3.80 David Linda BTO 10 at $3.70 / STO 10 at $3.70 Martha We have expanded the information to indicate if the transactions were opening or closing. We have also included the names of the traders purely to make the example easier to explain. On the trading floor no names are used or known. The first line shows Paul buying 10 contracts from Peter, both on an opening basis. Since this is the first trade in this option, it would have been difficult for anyone to place a closing trade! After this first trade, the open interest is 10: that is, the number of contracts that are open, not yet closed out. Paul is long 10 contracts and Peter is short 10 contracts. The number of long and short contracts must always be equal. The second trade has Mary buying 7 contracts from Jane; both traders are opening positions, so after the second trade the open interest totals 17 contracts. (Paul is long 10, Mary is long 7 for a total of 17 long contracts; Peter is short 10, Jane is short 7 for a total of 17 short contracts). The third trade shows Peter buying 5 contracts to close (remember, he was short 10 contracts before this trade), and David selling 5 contracts to open. What is happening here? Peter has had a change of mind and decided to close out part of his position. What does this do to the open interest? In fact, it has no impact on the open interest. After the third trade Paul is still long 10 contracts, Mary is long 7, for a total of 17 long; Peter is now short 5 contracts (was short 10, but closed out 5), Jane is short 7 and David is short 5 for 17 total shorts. Finally, the fourth and last trade shows Linda buying 10 to open and Martha selling 10 also to open; this will raise the total open interest to 27. Longs: Paul 10, Mary 7 and Linda 10. Total: 27. Shorts: Peter 5, Jane 7, David 5 and Martha 10. Total: 27. When does open interest go down? When both the buyer and seller are closing positions. To verify this, assume that another trade takes place where Martha buys 3 to close and Paul sells 3 to close. Recalculate the open interest; it should now be 24. Open interest is calculated by the exchanges at the end of the trading day for all series in a class and for the class in total. Some investors view this number as a liquidity indicator: high open interest indicates many investors with positions in a given option series or class. Bid Ask If you pull up an option chain, you will notice three columns of prices: last, bid and ask. Here s an example from the CBOE web-site: Click here for sample option chain. The Last column records the last price at which this option traded. This may appear important, but a lot of traders look at this as old or past information. The last trade could have been 2 seconds ago, but it also could have taken place 2 hours ago. Traders are usually more interested in the other two columns, bid and ask. Bid : this indicates the price that some investor or market maker is willing to pay for the option. This is most important if you are looking to sell an option. You must remember that if you are a seller, you must find a buyer, and the bid shown is the highest amount one buyer is willing to pay.

3 Ask (also known as offer ): this indicates the price at which someone is willing to sell this option. This is most important to you if you are looking to buy this option as the ask shown is that of the seller willing to accept the lowest price. Types of Orders You decide to purchase 10 of the IBM April 100 calls. The only variable left to negotiate, once you have chosen this option, is the price. All other variables, strike price, expiration date, shares per contract, are fixed. You may want to start by determining what is the current bid-ask on this option. You look on the IBM option chain and find it is quoted at 3.40 (bid) 3.50 (ask). The two most common types of orders are market orders and limit orders. A market order is one that will be executed immediately at the best price possible. In our example, the April 100 calls are offered at 3.50, so this is the price you are most likely to pay if you place a market order (there is the possibility that by the time your order gets to the exchange the market will have changed and you could get a different price, possibly paying more, possibly paying less.) A market order is usually used when speed is a more important consideration than specific price. You are willing to risk paying a slightly higher premium in order to get immediate execution. In a limit buy order you specify the maximum price you are willing to pay for a given option. If you place a 3.50 limit on your purchase of the April 100 calls you will more than likely get filled immediately. Only if the offered price of the option is raised would you not purchase these options. You could also opt to place an order to purchase the April 100 calls at In this case, you are now bidding 3.40 along with other traders and investors and you will buy your options only if the offered price falls to 3.40 or if other investors sell some options at A limit order is usually used when price is more important than speed of execution. Note that you could also place a limit order to buy below the current bid-ask, for example placing on order to buy 10 contracts at In this case you are hopping that the option s price will fall to 3.20 and that you will be able to buy your calls at the specified price. In placing sell orders, a market order will also be executed immediately while a limit orders specifies the lowest price you are willing to accept. If the GE June 90 puts are , a market order to sell 5 contracts would probably be filled at A limit order will guarantee that the options will not be sold at a price lower than the limit price although there is no guarantee that the options will be sold. There are also a number of different contingent orders. A contingent order is one triggered by a specified condition. Market on open (MOO) orders will be filled at the opening price, Market on close (MOC) will be transacted at the closing price. A Stop order becomes a market order if a trigger price is reached. But remember that the vast majority of orders are simple market or limit orders. Option Quotes: Nickels, Dimes and maybe Pennies The difference between an option s bid and its ask is known as the bid-ask spread. Investors prefer narrow bid-ask spreads. Currently, for options trading under $3.00, the narrowest bid-ask spread is $0.05; for options trading above $3.00 it is $0.10. But wait! You ve probably seen stocks trading in pennies where the bid-ask spread can be as low as $0.01. Pennies trading has arrived and some options now trade in pennies. Option Symbols In early 2010, the major exchanges moved to simplify the process of assigning option symbols. The result is a still lengthy but far cleaner set of letters and numbers that can be decoded even by option novices. Anatomy of an Option Symbol For example, let's take a look at the following option symbol:

4 AAPL C Let's break it down one step at a time. We begin by putting each piece that we explain in bold-type. Step 1: The Stock Symbol AAPL C AAPL is simply the option symbol. In this case, it refers to Apple Computer. Under the old systi, NYSE stocks would get their three-letter symbol, but NASDAQ stocks would get an adjusted three-letter acronym instead of their standard symbol (i.e. AAPL would have been assigned the symbol AAQ). Under the current systi, regardless of where a stock trades, option symbols will use the standard stock symbol. Therefore, Apple Computer uses its NASDAQ-appointed symbol? AAPL. Step 2: The Expiration Date AAPL C The expiration date format is yymmdd. In this case, the first two digits represent the year, which is The next two digits represent the month, which is Deciber. The last two digits represent the actual expiration date, in this case, the 18th of the month. Step 3: The Option Type AAPL C The letter immediately after the expiration date tells us what kind of option we are trading. C stands for call and P stands for put. Hence, in this particular symbol, it is clear that we are looking at a call option. Step 4: The Strike Price AAPL C The entire set of numbers after the letter tells us the option strike. In this case, the option strike is 175. The three zeroes at the end show that we take each strike out to three decimal places. Hence, we may read this as the strike. Putting it all together! AAPL C As we analyze the above symbol, we see that we have the AAPL Deciber 175 Call. In addition, we know that this is an option on a NASDAQ stock (4-letter symbol) and that the option specifically expires on Deciber 18, Quiz Time! Q: Taking the information above, can you tell what option this symbol represents? GE P2500 A: Let's break it down one step at a time. Step 1: The Option Symbol We can see that the symbol is GE, or General Electric.

5 5 of 6 Step 2: The Expiration Date The ensuing six numbers, represent the expiration date in yymmdd format. This means that the option expires on January 22, Step 3: The Option Type The letter after the expiration date is P, meaning that this is a put option. Step 4: The Strike Price Remember that option strike portion of the symbol goes out to three decimal places. Therefore, 2500 represents the 2?-strike, not the 25-strike. Hence, the symbol GE P2500 represents the GE January 2? Put, specifically expiring on January 22, Impact of Stock Splits on Options Every once in a while, a stock splits. What impact, if any, does this have on the underlying options? First, let s review the basics of stock splits. GGG is trading at $120 and the corporation decides to split its shares 2-for-1. Assume you hold 100 shares of GGG pre-split. On the day the split becomes effective you will receive an additional 100 shares, bringing your total holdings to 200 shares. But this is not manna from heaven. GGG will most probably be trading, on a post-split basis, somewhere around $60. The total value of your shares has not changed: pre-split you had 100 valued at $120 (total value $12,000) and post-split you own 200 shares valued at $60 (total value $12,000). What if you didn t own the stock but a June 120 call? A June 120 call gives you the right to purchase 100 shares of GGG at $120 per share. Post-split you will have very little interest in paying $120 for GGG as its price will be in the $60 range. Has your call become worthless overnight? No, because options are adjusted for splits. Your GGG June 120 call will be replaced by 2 GGG June 60 calls. Notice that your right to buy 100 shares at $120 has been replaced by the right to purchase 200 shares at $60. The aggregate exercise value of your calls (the amount you will have to pay if you exercise them) remains unchanged at $12,000. For splits that are of the type n -for-1 (2:1, 3:1, 4:1, etc) the following adjustments are made: the number of contracts is multiplied by n (that is: by 2 for a 2:1, by 3 for a 3:1, etc) and the option s strike price is divided by n (that is: by 2 for a 2:1, by 3 for a 3:1, etc). Here are a couple of examples: Pre-split Series Split Ratio Post-split Series July 150 put 3 for 1 July 50 put June 60 call 4 for 1 June 15 call December 55 put 5 for 1 December 11 put What do you think will happen to your options post-split? Go back to your long GGG June 120 call. If this call was trading at $5 pre-split, then post-split you can expect that the June 60 calls will be trading at about $2.50 each. The total value of your options will not be affected by the stock split (although it could change due to other factors).

6 This only leaves the odd ball splits, the 3-for-2, 5-for-4, otherwise known as the m -for- n splits. First let s look at a stock splitting 3-for-2. You own 100 shares of TTT, trading at $140 and the company decides to split the stock 3-for-2. Post-split, you will own 150 shares (you now have 3 shares for every 2 you had pre-split) and TTT will be trading around $93.33, about two thirds of its pre-split price. But what if you didn t own the stock but a put option? If you owned 1 put pre-split and use the same mathematical logic as we been using so far, you will conclude that you will own 1.5 puts post-split. But there is no such thing as a fractional option. You may own 1, 2, but not 1.5 options. How do we get around this problem? Simply, by not adjusting the number of contracts and by adjusting the number of shares per contract. Here s what happens: pre-split you owned 1 TTT March 140 put; this put gave you the right to sell 100 shares of TTT at $140. Post-split you will still own 1 put on TTT, but your put option will now give you the right to sell 150 shares of TTT. What will happen to the price of your put? If it was trading at $3.00 pre-split it should be trading around $2.00 post-split. But wait a minute! If you held one contract pre-split and it was trading at $3.00, its value was $300. Now, post-split, you still hold one contract and its trading at $2.00. Have you just lost one third of your option value? No. Remember that the price of options is quoted on a per share basis. Pre-split, this means that the value of your put is $3.00 per share for 100 shares, for a total value of $300. Post-split, the value of your put is $2.00 per shares for 150 shares, for the same total value of $300. The following table gives some examples of m-for-n type stock splits. You can review it to make sure you understand all of the adjustments made. Pre-split Series June 60 call March 50 put April 110 put Pre-split Premium Pre-split Value Split Ratio Post-split Series $4.00 $400 3 for 2 June 40 call (150 shares per option) $7.00 $700 5 for 4 March 40 put (125 shares per option) $9.00 $ for 10 April 100 put (110 shares per option) Post-split Premium Post-split Value $2.67 $ $5.60 $700 $8.18 $ You will notice small differences between the pre-split and post-split values due to rounding. If you remember only one thing about how splits affect options then remember this: options are adjusted in such a way as to be fair to both the option buyers and option sellers and in a way that should not create or destroy value simply as a result of the split.