central Options By Marty Kearney

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1 YOUR RESOURCE FOR OPTIONS EDUCATION SM Options central IN THIS S U M M E R ISSUE: F E A T U R E : S E L L I N G P U T S O P T I O N S C E N T R A L M O V E S O N L I N E W H A T S N E W A T W W W O P T I O N S. C O M C O M M O N O P T I O N S T E R M S Y O U R O P T I O N S Q U E S T I O N S A N S W E R E D : B I D A N D A S K I N V E S T O R C O N F E R E N C E S Selling Puts: Risky or Conservative? By Marty Kearney Selling puts is a controversial strategy--some investors fear it, others embrace it. Why such opposing reactions? This article explains the risk versus profit potential of the strategy, how it works and when it might be used. It also discusses the nature of risk and identifies situations in which selling puts is viewed as either risky or conservative. STRATEGY MECHANICS The seller of an equity put option is described as having a short put position and assumes the obligation to purchase 100 shares of the underlying stock at the designated strike price. In return, the put seller receives a premium paid by the purchaser. Most brokerage firms require that selling puts be done in a margin account. Because the premium received is part of the total margin requirement, a put seller does not have use of the premium while a short put position is open.* O P T I O N S continued inside

2 PAGE 2 MARSHALL V. KEARNEY is senior staff instructor of The Options Institute at the Chicago Board Options Exchange. He began his association with CBOE as an independent market-maker in 1981, leaving the trading floor in 1992 to become a founding partner and registered options principal of PTI Securities L.P. Kearney has been a regular contributor to Reuters, WMAQ Radio, The CBS Radio Network, Barron s and others. He was previously a marketing director for NCR Corporation. *Before entering into this strategy, prior approval from a brokerage firm must be received. Typically, only individuals who meet minimum experience and net worth requirements receive approval. continued from front An example of a short put order is sell 1 XYZ September 50 put at $5.50. The seller of this put option would assume the obligation of purchasing 100 shares of XYZ stock at $50 per share--should the buyer elect to exercise. In return, the premium of $5.50 per share, or $550, is received. RISK AND PROFIT POTENTIAL The graph on page 3 shows the profit and loss of the put-selling strategy. If, at September expiration, the price of XYZ stock closes above $50, the put expires worthless, and the premium received will be kept. If XYZ closes below $50 at expiration, the put will have value, and its owner will likely exercise the right to sell XYZ stock at the $50 strike price. The put seller will then be obligated to purchase 100 shares of XYZ stock at $50 per share. The profit potential is limited to the premium received. Above a stock price of $50 at expiration, the line is flat at a profit of $5.50 per share. Below the $50 strike price, the risk of a short put position is equivalent to a long stock position at the effective purchase price, which is the strike price ($50) less the premium ($5.50), or $ AN INVESTMENT-ORIENTED USE OF A SHORT PUT Brigid, a conservative investor, finds XYZ stock to be an attractive investment, not at its current price of $52.10, not at $50, but at $ Assume also, that XYZ September 50 puts are trading for $5.50 and that Brigid is not in any hurry to acquire XYZ stock. If Brigid is forecasting that XYZ will trade in a range between $40 and $52.10 between now and September expiration, then Brigid has a couple of options. Option one would be to place a good- til-cancelled (GTC) order to buy 100 shares of XYZ at $ Option two would be to sell 1 September 50 put at $5.50. In both cases, it is assumed that Brigid deposits $44.50 per share in her brokerage account. Following is a comparison of the two strategies. While the GTC order to buy stock at $44.50 is being represented, Brigid is obligated to buy 100 shares at $ At expiration, either the price of XYZ stock would have stayed above $44.50, and Brigid would not have purchased any stock, or it would have traded below $44.50, and she would have bought 100 shares. If the stock stays above $44.50, then Brigid, in the case of the GTC order, would earn nothing except interest on funds in a money market account. If, however, Brigid sells 1 September 50 put at $5.50, she receives the premium ($550). At expiration, if XYZ is above $50, stock is not likely to be purchased. Brigid, however, keeps the premium. If XYZ is below $50 at expiration, Brigid is obligated to buy 100 shares at $50. Because she received $5.50 when she sold the put, her net cost is $44.50 per share. If the stock closes at $50 at expiration, a short 50 put may be assigned, or it could expire worthless. Assignment prior to expiration is also a possibility that Brigid should consider. A TRADING-ORIENTED USE Consider the case of Gerard, a

3 PAGE 3 trader bullish on XYZ at $52.10, who wants to profit from a predicted short-term price rise. Gerard might consider selling 1 XYZ September 50 put at $5.50 with the hope of buying it back at a lower price if the price of XYZ stock rises as predicted. The risk, of course, is that the price of XYZ declines, the price of the put rises, and a loss is incurred. Because Gerard has no interest in actually purchasing XYZ stock, he may choose to deposit only the minimum required margin deposit. It is likely that his thinking goes something like this: If the stock price declines, then I will simply repurchase the put, take my loss and move on to the next trade COMPARING THE TWO PERSPECTIVES Although Brigid, the investor, and Gerard, the trader, entered into the same position--they both sold 1 XYZ September 50 put at $5.50--there are frequently different perceptions of the risk of what each has done. The investor is typically described as having sold a cash-secured put. This means that sufficient cash to purchase the stock has been placed on deposit with the brokerage firm. If the put is assigned, then paying for the stock is a simple matter; just use the funds on deposit. The maximum theoretical risk of a stock price decline is the same as for any other stock holding purchased for cash. The maximum risk is equal to the amount invested, and Brigid should monitor the XYZ shares as she would any other stock holding. The maximum percentage risk is 100 percent of the cash invested in the stock. Gerard s situation, however, is different. First, selling a put and depositing the minimum required amount is typically described as selling a naked put. This means that the margin deposit is not sufficient to purchase the underlying stock. Consequently, it is likely that a trader will receive a margin call if the put is assigned. A margin call is a demand made by a brokerage firm requiring an increase in account equity. If a client fails to meet a margin call, then the firm will typically close out one or more positions so that the account equity is adequate to meet the margin requirement for the remaining positions. Therefore, it is possible that the seller of a naked put could lose more than the initial margin deposit. This is where selling puts gets its reputation as a high-risk strategy. 4 2 P/L ! Stock price below $50 at expiration.! Put is assigned.! Put seller receives premium and must purchase stock for $50 per share. Stock Price! Stock price above $50 at expiration.! Put expires.! Premium is kept as income. SUMMARY Selling an equity put option creates an obligation to purchase the underlying stock. A margin deposit and prior approval from a brokerage firm are required to sell puts. The profit potential is limited to the premium received, but the risk is substantial. Below the break-even point (strike price less premium received), the maximum dollar risk of a short put position is equal to a long stock position. The term cash-secured put is used to describe a short put position that is backed with sufficient GRAPH: Short 50 Put at $5.50 continued

4 PAGE 4 Copy to come. options central moves online cash to purchase the underlying stock. Selling cash-secured puts can be viewed as a conservative investment-oriented strategy, when the goal is to purchase the underlying stock. The term naked put describes a short put position that is backed by a margin deposit, possibly the minimum requirement, that is insufficient to purchase the underlying stock. Selling naked puts involves risk that is greater than the margin deposit. It is a trading-oriented strategy suitable only for experienced traders who are capable of withstanding the associated risks. Selling puts can be risky or conservative--it depends on how you use them. To simplify the computations, the examples in this article do not include commissions. Commission costs will affect the outcome of all stock and options transactions and must be considered prior to entering into any transaction. Investors considering options should consult their tax advisors as to how taxes may affect the outcome of contemplated options transactions. Beginning in Fall 2002, OIC will offer Options Central exclusively online at Please visit us there to read the Fall 2002 newsletter, as well as subsequent issues featuring the latest information on options strategy and investor events. To be notified when a new issue of Options Central is posted, go to and select Register to sign up for an alert. what s new at OIC s Web site remains dedicated to informing investors about options. Whether you d like to register for a seminar near you, locate a resource or educate yourself online, visit Read below for news about the latest Web site additions. CHECK OUT TWO NEW ONLINE CLASSES: Covered Calls provides an in-depth review of the covered call strategy, one of the most common options strategies used. In Options Basics, you ll discover what it means to buy and sell options, and you ll gain the foundation you need for using options in your portfolio. COMING SOON: Buying Puts, where you ll learn how to use puts as insurance for stock holdings; Buying Calls, which covers the basics of purchasing equity call options; and Introduction to Spreading, which provides insight into the simultaneous purchase and writing of calls or puts with different strike prices. common options terms E Q U I T Y O P T I O N A contract that entitles the holder to buy or sell a specific number of shares (usually 100) of a particular underlying security at a predetermined price on or before a fixed expiration date. G O O D - ' T I L - C A N C E L L E D ( G T C ) O R D E R A type of limit order that remains in effect until it is either executed (filled) or cancelled by the originator, as opposed to a day order, which expires if not executed by the end of the trading day or cancelled by the originator. M A R G I N / M A R G I N R E Q U I R E M E N T The minimum collateral required to support an investment position. To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm. N A K E D / U N C O V E R E D O P T I O N An options position where the writer does not have the asset (in the case of a call) or the cash/short position (in the case of a put) to satisfy the holder in the event of exercise. O P E N I N T E R E S T The total number of outstanding options contracts in the exchange market in a particular options class or series. S E C U R E D P U T / C A S H - S E C U R E D P U T An option strategy in which a put option is written against a sufficient amount of cash (or T-bills) to pay for the stock purchase if the short option is assigned.

5 PAGE 5 bid and ask Q: HOW ARE SETTLEMENT PRICES CALCULATED FOR INDEX OPTIONS? A: The settlement price for cash-settled index options is generally based on the day s opening or closing prices--as stipulated by the contract terms--hence the terminology, a.m.- or p.m.-settlement. For settlements based on the closing prices, the index normally is calculated using the last price from its primary market for each one of the component stocks (p.m.-settled). This most likely would be the very last posted dissemination of the underlying index. On the other hand, for index settlements based on the open, the exercisesettlement value is calculated using the opening (first) reported sales price in the primary market of each component stock on the last business day (usually a Friday) before the expiration date. A settlement value is not determined until each constituent in the index has opened for trading on the settlement calculation date.* Be careful to note the distinction between the settlement value and opening level of the index. On many days, the first tick of an index is identical to the previous business day s closing level. This can occur whenever the first tick is calculated, either before any stock has opened--with all stocks having opened unchanged--or from a combination of all stocks either having opened unchanged or not yet being open in the primary market. If any stock has opened prior to the first tick of the index, that price will be reflected in the level of that first tick, and the level may or may not change depending on: the weight of that stock in the index; any other concurrent opening component stock prices; and the effect of rounding to two decimal places in the index calculation. Q: WHEN DO THE 2005 LEAPS BEGIN TRADING? A: Here is a schedule: Cycle 1 - May 28; Cycle 2 - July 1; and Cycle 3 - July 29. To find out how the LEAPS listing process works, visit our Web site at: Click on FAQ s, and select cycles. Q: IF I EXERCISE AN IN-THE-MONEY CALL OPTION, HOW SOON CAN I SELL THE STOCK? A: As soon as you tell your broker you would like to exercise your right to buy the stock (strictly speaking, give him or her irrevocable instructions ), you are deemed a stock owner. Because of the irrevocable nature of the call exercise, you will be buying the stock at the strike price, and you can sell those shares immediately after giving instructions to exercise. Q. WHY DO OPTIONS PRICES RISE WHEN INTEREST RATES RISE? A. It sounds like you are asking why call option prices rise when interest rates rise. Options are priced on a riskneutral basis, that is, on a delta-neutral or fully hedged basis. So, a long call would be paired with a short stock, and a short stock position generates interest revenue that makes the call option worth more. If interest rates go up, the interest revenue from the short stock position increases, which makes the call worth still more. Note that for put options it works the opposite way, and dividends work in the opposite direction. A stock s value is equal (theoretically) to the present value of all its future dividends, so an increase in the interest rate used to discount the future dividends will reduce the value of the stock. When someone says higher interest rates make call options worth more, there is an implicit assumption of all other things being equal. Practically speaking, all other things are rarely equal, and the decline in a stock s price due to an interest rate increase will often overwhelm the effect of the higher interest rate on the option. *If a stock in the index does not open on the day the exercise and settlement value is determined, the last reported sales price in the primary market will be used in calculating the exercise-settlement value. your options question to The Options Industry Services Call Center at options@theocc.com. The most comprehensive interactive software on options Now Available! Order your copy today: OPTIONS Tailor it to your skill level... with audio, video and exploration by subject. Test your options knowledge before you invest. Navigate easily! Find quizzes, strategy analysis, definitions and more! Get software updates automatically!

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