central Options By Joseph Frey Are you looking for an alternative to stocks and bonds? Although

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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 : O P T I O N S A S A N A L T E R N A T I V E T O F I X E D I N C O M E A N D CASH O I C S E M I N A R O F F E R I N G S U P C O M I N G S E M I N A R S C H E D U L E 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 C O M M O N O P T I O N S T E R M S I N V E S T O R C O N F E R E N C E S Options as an Alternative to Fixed Income and Cash By Joseph Frey Are you looking for an alternative to stocks and bonds? Although potential returns are high, the stock market has been volatile over the last three years, while the ten year bond is only yielding around 3.36% 1. When interest rates rise again, bond prices will typically fall. The money market is an alternative: less volatile than stocks or bonds, there's relatively low risk. Because of this, money market rates of return are lower too 2. Here are some questions to ask yourself while examining your investment alternatives: Do you want lower risk than owning stocks or bonds outright? Do you want a higher return than the money market? What is your risk versus reward profile? O P T I O N S continued inside

2 PAGE 2 JOSEPH FREY is a marketing representative at the Philadelphia Stock Exchange. He is responsible for marketing equities, equity options and sector index options to investors, brokerage firms and institutional clients in the United States and Canada. Frey's responsibilities also include strategic marketing initiatives and business development. As a staff instructor for The Options Industry Council, Frey leads educational workshops for investors at sites throughout North America. Frey received a Bachelor of Science Degree in marketing from West Chester University. continued from front Depending on your investment strategy, you may want to consider options. Some options strategies may be less risky than stocks or bonds and can provide higher returns in flat to down markets than the money market. SELECTING A STRATEGY Let's look at an investment strategy that provides both downside protection as well as a return above the current money market or bond rates. Consider selling deep in-the-money call options, one-for-one against stock. Simply put, it's a variation on the covered call or buy-write replicating a fixed income investment return. With this strategy, we want the option to be called before or on the options expiration date, preferably sooner than later. Here's an example (see graph below): You purchase 1,000 shares of XYZ Corporation at $37.20 and simultaneously sell 10 contracts of the July 25 call options at $ The calls are deep in-the-money (strike price is substantially below the stock price). Most deep in-the-money options will have more intrinsic value and relatively little or no time value. Since we are taking on some risk, you must select a stock and strike price that will yield more than the money market or ten-year bond (our goal). You are now long 1,000 XYZ shares at a cost of $37,200, but it is offset by the $12,900 you ve received for selling the short calls. With the stock trading at $37.20, your adjusted cost basis is $24.30 per share. In order for losses to incur in this position, the price of XYZ Corporation must drop by more than 35% (below $24.30) in 67 days (July expiration). What is the likelihood of this? Would you buy the 25 strike puts with 67 days until expiration while the stock is at $37.20? Selling deep in-the-money calls against stock has considerably lower risk than simply purchasing stock or using ator out-of-the-money covered calls. But there is a tradeoff. When you lower risk, you lower potential returns. Since we wanted to replicate a fixed income investment with higher returns than the ten-year bond or the money market rate, the strategy we selected is acceptable. The profit potential per contract is calculated as shown on the next page. To simplify the computations, the examples in this article do not include commissions or transaction costs. Commission and transaction 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. Profit BEP Covered Call Strike Price Stock GRAPH: Profit and Loss Diagram for XYZ Corporation Loss Stock Price Lower Higher

3 PAGE 3 (Price of the call + Dividends) + (Strike price - Stock price) or ($ ) + ($25-$37.20) = $.70 profit per share x 100 shares x 10 contracts = $700 (maximum profit) IF-CALLED RATE OF RETURN Our objective is to have our stock called away, so let's use the if-called rate of return. The if-called rate of return assumes that the stock price remains or rises above the strike price and the calls are assigned at expiration. This means the stock is sold at the $25 strike price. When using the if-called rate of return, we assume the same period of profit can be earned repeatedly throughout the year. This may not always be possible. Using the formula shown below, let's calculate our potential return. After calculating the if-called rate of return, we see that the annualized rate is 15.69% - far exceeding the current ten-year bond and money market rates. But remember, this assumes that you will perform this scenario repeatedly throughout the year. Transaction costs can significantly reduce the rate of return if not managed carefully. The if-called rate is based on being assigned at expiration. It's possible that you could be assigned on the short calls and forced to deliver XYZ stock prior to expiration. We would prefer to be assigned earlier, which would revise our annualized rate of return upward. To see how the annualized rate changes if you are assigned prior to expiration, simply lower the number of days to expiration. IS IT RIGHT FOR YOU? Who should consider using this type of strategy? An investor who is slightly bearish to slightly bullish on the stock of choice? An investor who is looking to generate additional cash flow above a predetermined benchmark, such as the ten-year bond or money market rate? An investor who is willing to limit gains in return for downside protection? The answer is all the above, and then some. Although deep in-the-money covered calls may not be suitable for everyone, when used properly, they can help investors outperform market segments, the overall market, fixed income investments and cash. Deep in-the-money covered calls are just one of the many options strategies that can be used as an alternative to other investment vehicles to increase returns in the market, while providing lower risk. In fact, they can be done in a variety of asset accounts (depending on your specific plan or brokerage firm) including IRA accounts, 401k plans and other retirement accounts. Using options requires doing your homework, planning ahead, setting realistic expectations, and monitoring your investment. Not all trades work out the way we anticipate. In the example given, 15.69% was our annualized rate of return, but you can find both higher and lower returns. Just remember to be disciplined, stick to your plan unless something materially changes, and always trade smart. 1 Data as of June 24, % as of June 21 per Calculating the If-Called Rate of Return Strike Price - Initial Outlay + Dividends Initial Outlay X Time Factor Required Information Initial Outlay = Stock Price - Call Price Days in Year Days to Expiration Stock Price = $37.20 Strike Price = $25.00 Call Price = $12.90 Days to Exp. = 67 Dividend = ( ) + 0 $ X = 15.69% Note: Commissions and transaction costs not included.

4 PAGE 4 OIC and Your Options Education Selecting the seminar that s right for you... Whether you re a beginner just learning about options, or a seasoned investor looking for more advanced information, OIC offers a seminar to meet your needs. Taught by exchange professionals, our FREE seminars cover a wide range of options topics. For a beginner with little or no options knowledge, our instructors suggest taking the seminars as listed below. Or, if you know the basics, pick up where you feel comfortable: Basic: Options Strategies for Stock Investors Offers an introduction to options as an investment tool. Requires no prior options knowledge. Explains fundamentals of options and how to use options as a way to participate in stock price movement. Demonstrates how to choose and use basic strategies in light of market expectations and volatility forecasts. Covered Calls, strategy-specific seminar Requires a working knowledge of options from either our basic seminar or beginner level online classes at Options University. Teaches how to create a disciplined approach to implementing the covered call strategy. Demonstrates how to calculate returns and how to manage covered call positions. Intermediate: Practical Strategy Applications Offers an in-depth look at options. Illustrates more complicated strategies for bullish, bearrish and neutral markets. Explains pricing concepts, time decay and volatility. Teaches how to manage an options portfolio using stock repair strategies. Builds on concepts taught in our basic seminar and in the intermediate level online classes at Options University. Directional Strategies, market-specific strategy seminar Explains how to choose strategies based on market condition and investor behavior, and how to plan options trades with realistic expectations. Demonstrates the difference between buying calls, selling puts and spreads. Teaches how to limit risk and take advantage of options time decay in slow moving markets. Complements content from intermediate and advanced level online classes at Options University. Options University at Allows you to take classes anywhere, anytime and at your own pace. Includes complete reference materials, recommended prerequisite reading, charts, graphs and quizzes. Offers a variety of classes with a wide range of topics and levels from beginner to advanced. UPCOMING OIC SEMINARS SEPTEMBER 9 Philadelphia, Directional Strategies 9 Providence, R.I., Basic 10 Boston, Basic 10 Philadelphia, Intermediate 11 Boston, Intermediate 16 Salt Lake City, Covered Calls 16 White Plains, N.Y., Basic 17 New York Midtown, Covered Calls 17 Seattle, Basic 18 New York Midtown, Intermediate 18 Seattle, Intermediate 30 Montreal, Basic 30 Washington, DC, Covered Calls OCTOBER 1 Toronto, Basic 1 Washington, DC, Intermediate 2 Toronto, Intermediate 7 Chicago, Directional Strategies 7 San Jose, Calif., Covered Calls 8 Chicago, Intermediate 8 San Jose, Calif., Intermediate 9 Hartford, Conn., Basic 14 Buffalo, N.Y., Basic 15 Parsippany, N.J., Basic 16 Parsippany, N.J., Intermediate 21 Sacramento, Calif., Basic 22 San Francisco, Covered Calls 23 San Francisco, Intermediate 28 Detroit, Basic 28 New York Downtown, Covered Calls 29 Detroit, Intermediate 29 Long Island, N.Y., Basic 30 Long Island, N.Y., Intermediate Registration is required. All seminars are FREE and held from 6 p.m. - 9 p.m. To register for a seminar or order a free CD or videotape, call OPTIONS or visit

5 PAGE 5 bid and ask Q: IF I BUY A EUROPEAN STYLE INDEX OPTION, IS IT TRUE THAT I CANNOT EXIT THE POSITION UNTIL EXPIRATION? A: The European style feature of an option refers to an option s exercise style and is not related to an investor s ability to exit a position at any time (up to expiration) through a closing transaction. So, while it is true that a European style option cannot be exercised until expiration, an investor can close the option position through the market at any time up to the last trading day for the option. If an investor 'buys to open' a European style index option, the investor can elect to either a) exit the position through a 'closing' sell transaction in the marketplace at any time up to expiration, or b) allow the option to expire. If the investor allows the option to expire, it will either expire out-of-themoney and essentially be worthless or it will expire in-the-money. If the option expires in the money, the option will generally be exercised. The cash value of that index option will be the difference between the option s strike price and the settlement value of the index. Q: HOW WILL MY STRIKE PRICE CHANGE IN A STOCK BUYOUT? A: In situations where an option is adjusted, it's often helpful to evaluate the contract as a whole rather than on a per share basis. An option contract defines an exchange of cash for securities, and the option holder can choose whether or not to enter into the exchange during a period of time also defined in the contract. The cash side of the transaction is always the strike price times the contract multiplier. The securities side is usually 100 shares of the underlying stock. For discussion purposes, here s an example: XYZ January call Strike price: $30 Contract multiplier: 100 Deliverable: 100 shares XYZ The holder of this option has the right to pay $3000, the strike price times the multiplier, for a block of 100 shares of XYZ, the deliverable, at any time through the third Friday of January. Now let's suppose XYZ is taken over by ABC, and that for each share of XYZ, investors will receive 2.5 shares of ABC. Since shares of XYZ will no longer exist once the merger is completed, a substitution will be made to the deliverable based on the following: 100 XYZ = 250 ABC So, after the option has been adjusted it will have the following characteristics: Strike price: $30 Contract multiplier: 100 Deliverable: 250 shares ABC The option holder still has the right to pay the same amount, $3000, for a block of shares, now 250 ABC. Notice that upon exercise, the option holder will be paying $12 per share for ABC ($3000 divided by 250), so the option s strike price does not correspond to a price per share of the underlying stock (originally XYZ, now ABC). That's because this option was written in terms of XYZ, and even though the deliverable was converted to an different number of shares of another stock, the option continues to trade in terms of XYZ. For purposes of analysis, the hypothetical price of XYZ is 2.5 times the market price of ABC. You may see your options questions answered in Options Central. Send them to OIC at: options@theocc.com or One North Wacker Drive, Suite 500, Chicago, IL common options terms AT-THE-MONEY A term that describes an option with a strike price that is equal to the current market price of the underlying stock. BUY-WRITE cuted simultaneously. Example: buying 500 shares XYZ stock, and writing 5 XYZ May 60 calls. IF-CALLED RATE OF RETURN The annualized percentage profit of a covered write, assuming the stock price rises to the price of the short call and is sold at that price on the option expiration date. IN-THE-MONEY An adjective used to describe an option with intrinsic value. A call option is in the money if the stock price is above the strike price. A put A covered call position in which stock is purchased and an equivalent number of calls written at the same time. This position may be transacted as a combined order, with both sides (buying stock and writing calls) being exeoption is in the money if the stock price is below the strike price. INTRINSIC VALUE The in-the-money portion of an option's price. OUT-OF-THE-MONEY An adjective used to describe an option that has no intrinsic value, i.e., all of its value consists of time value. A call option is out of the money if the stock price is below its strike price. A put option is out of the money if the stock price is above its strike price.

6 investor conferences OIC is participating in the following upcoming events. To register, call the telephone number listed. Chicago Online Trading Expo July Sheraton Chicago Hotel & Towers Call and mention OIC priority code # Traders Library 3rd Annual Options Trading Forum Oct Sheraton Chicago Hotel & Towers Call for information San Francisco Money Show Oct San Francisco Marriott Call and mention OIC priority code # One North Wacker Drive, Suite 500 Chicago, Illinois OPTIONS The American Stock Exchange THE-AMEX Chicago Board Options Exchange THE-CBOE International Securities Exchange Pacific Exchange PCX-PCX1 Atlantic City Money Show Aug. 7-9 The Atlantic City Convention Center Call and mention OIC priority code # AAII Investor Conference Nov. 5-7 Riviera Hotel and Casino, Las Vegas More information available soon. Options involve risk and are not suitable for everyone. Prior to buying or selling options, you must read the option disclosure document, Characteristics and Risks of Standardized Options, which can be obtained from your brokerage firm, from any Exchange on which options are traded, by calling OPTIONS, or by writing The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois Consult your tax advisor for tax considerations. Philadelphia Stock Exchange THE-PHLX The Options Clearing Corporation For More Information Call OPTIONS or write The Options Industry Council. If you have additional questions about options, call your financial advisor or one of the Exchanges listed here.