Option Theory Basics

Option Basics What is an Option? Option Theory Basics An option is a traded security that is a derivative product. By derivative product we mean that it is a product whose value is based upon, or derived from, the price of something else. Since we are talking about stocks, a stock option is based upon, among other things, the price of the underlying stock. There are also options on other traded securities such as currencies, indexes and interest rates, but here we will limit our discussion to stock options, or options based on stock. An option is a depreciating asset in the sense that it has a limited life, and has to be used before the date on which it expires. As time goes by and the option moves closer to its expiration date, it loses value. When we speak of options in terms of volume, we refer to contracts. Each stock option contract is equivalent to 100 shares of stock. When we talk about two contracts, we are talking about 200 shares, 10 contracts; we are talking about 1,000 shares, 75 contracts 7500 shares and so on. Amount of Shares Equivalent Amount of Option Contracts 100 1 200 2 1000 10 7500 75 15000 150 50000 500 100000 1000 NOTE: It is important to understand the dollar cost of options before actually trading them. When an option is quoted at $1.00 per contract, the investor must realize that the $1.00 represents a price of $1.00 per share, not per contract. Remember that each contract is worth 100 shares. This means that if you were to buy one option contract at a quoted price of $1.00, your total cost will be $100.00 (1 contract x $1.00 per share x 100 shares per contract). If you were to buy 10 contracts for $1.50 per contract, your total cost will be $1500.00. Use the formula below when calculating total dollar cost of the option. Total Dollar Cost of Trade = Number of Contracts x Price per Contract x 100 1

Option contracts are literally a sales agreement between two parties. The two parties are the buyer (or holder) and the seller (or writer). When you buy an option contract you are considered to be long the option. When you sell an option contract, you are considered to be short the option. This, of course, is assuming you have no previous position in the said option. In an option contract, although it seems as though the buyer and seller must be tied together, they are not. You see, the buyer doesn t really buy from the seller and the seller doesn t really sell to the buyer. In reality, an organization called the OCC or Options Clearing Corporation steps in between the two sides. The OCC buys from the seller and sells to the buyer. This makes the OCC neutral, and it allows both the buyer and the seller to trade out of the position without involving the other party. The two kinds of options are Calls and Puts. A call option gives the buyer the right but not the obligation to buy a specific security at a specific price by a specific date. It s a way of locking in the purchase price of the stock for a period of time. A put option gives the buyer the right but not the obligation to sell a specific security at a specific price by a specific date. It s a way of locking in the sales price of a stock for a period of time. The specific date is known as the contract s expiration date. On or prior to the expiration date the holder of the option contract has the right to exercise the option. The term exercise means the process by which the buyer of an option converts the option into a long stock position in the case of a call or a short stock position in the case of a put. The term assign or assignment means the process by which the seller of an option is notified of the buyer s intention to exercise. Buyers of options exercise. Sellers of options are assigned. The strike price or exercise price is defined as the price at which the holder has the right to buy (for a call) or sell (for a put), the underlying security. Strike prices are quoted in dollars, i.e. May 50 calls means May $50.00 strike calls. These terms are discussed in more detail in Important Options Terms & Definitions 2

There are several other important terms in an option contract: A long position is defined as any position which will theoretically increase in value should the price of the underlying security increase. Vice versa, the position will theoretically decrease in value should the underlying security decrease. The buying of stock, the buying of a call, or the sale of a put all constitute a long position. 3

A short position is defined as any position which will theoretically increase in value should the price of the underlying security decrease. Vice versa, the position will theoretically decrease in value should the underlying security increase. The selling of stock, the selling of a call, or the buying of a put all constitute a short position. 4

An option can be described by its strike price s proximity to the stock s price. An option can either be in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM). An at-the-money option is described as an option whose exercise or strike price is approximately equal to the present price of the underlying stock. For instance, if Microsoft (MSFT) is trading at $65.00, then the January $65.00 call would be an example of an at-the-money call option. Similarly, the January $65.00 put would be an example of an at-the-money put option. Please view charts below for at-the-money option examples. MSFT CALLS Stock = $65.00 Strike Price Option Price Status Intrinsic Extrinsic 50 15.10 ITM 15.00.10 55 10.30 ITM 10.00.30 60 5.70 ITM 5.00.70 70.75 OTM 0.75 75.35 OTM 0.35 80.15 OTM 0.15 MSFT PUTS Stock = $65.00 Strike Price Option Price Status Intrinsic Extrinsic 50.10 OTM 0.10 55.30 OTM 0.30 60.70 OTM 0.70 70 5.70 ITM 5.00.70 75 10.30 ITM 10.00.30 80 15.10 ITM 15.00.10 5

An in-the-money call option is described as a call whose strike (exercise) price is lower than the present price of the underlying. An in-the-money put has a strike (exercise) price higher than the present price of the underlying, i.e. an option which could be exercised immediately for a cash credit should the option buyer wish to exercise the option. In our Microsoft example above, an in-the-money call option would be any listed call option with a strike price below $65.00 (the price of the stock). So, the MSFT January 60 call option would be an example of an in-the-money call. The reason is that at any time prior to the expiration date, you could exercise the option and profit from the difference in value: in this case $5.00 ($65.00 stock price - $60.00 call option strike price = $5.00 of intrinsic value). In other words, the option is $5.00 in-the-money. Using our Microsoft example, an in-the-money put option would be any listed put option with a strike price above $65.00 (the price of the stock). The reason is that at any time prior to the expiration date, you could exercise the option and profit from the difference in value: in this case $5.00 ($70.00 put option strike price - $65.00 stock price = $5.00 of intrinsic value.) In other words, the option is $5.00 in-the-money. Please view charts below for more in-the-money option examples. MSFT CALLS Stock =$ 65.00 Strike Price Option Price Status Intrinsic Extrinsic 50 15.10 ITM 15.00.10 55 10.30 ITM 10.00.30 60 5.70 ITM 5.00.70 70.75 OTM 0.75 75.35 OTM 0.35 80.15 OTM 0.15 MSFT PUTS Stock = $65.00 Strike Price Option Price Status Intrinsic Extrinsic 50.10 OTM 0.10 55.30 OTM 0.30 60.70 OTM 0.70 70 5.70 ITM 5.00.70 75 10.30 ITM 10.00.30 80 15.10 ITM 15.00.10 6

An out-of-the-money call is described as a call whose exercise price (strike price) is higher than the present price of the underlying stock. Thus, an out-of-the-money call option s entire premium consists of only extrinsic value. There is no intrinsic value in an out-of-the-money call because the option s strike price is higher than the current stock price. For example, if you chose to exercise the MSFT January 70 call while the stock was trading at $65.00, you would essentially be choosing to buy the stock for $70.00 when the stock is trading at $65.00 on the open market. This action would result in a $5.00 loss. Obviously, you would not want to do that. An out-of-the-money put has an exercise price that is lower than the present price of the underlying. Thus, an out-of-the-money put option s entire premium consists of only extrinsic value. There is no intrinsic value in an out-of-the-money put because the option s strike price is lower than the current stock price. For example, if you chose to exercise the MSFT January 60 put while the stock was trading at$65.00, you would be choosing to sell the stock at $60.00 when the stock is trading at $65.00 in the open market. This action would result in a $5.00 loss. Obviously, you would not want to do that. Please view charts below for out-of-the-money option examples. MSFT CALLS Stock = $65.00 Strike Price Option Price Status Intrinsic Extrinsic 50 15.10 ITM 15.00.10 55 10.30 ITM 10.00.30 60 5.70 ITM 5.00.70 70.75 OTM 0.75 75.35 OTM 0.35 80.15 OTM 0.15 MSFT PUTS Stock = $65.00 Strike Price Option Price Status Intrinsic Extrinsic 50.10 OTM 0.10 55.30 OTM 0.30 60.70 OTM 0.70 70 5.70 ITM 5.00.70 75 10.30 ITM 10.00.30 80 15.10 ITM 15.00.10 7

Premium is the total amount of money (price) you pay for an option. So, if the Microsoft (MSFT) May 65 calls cost you $1.50 then the $1.50 is the amount of the premium of the option. The total price of an option (premium) consists of two components. Those two components are intrinsic value and extrinsic value. Please view charts below for option price (premium) examples. MSFT CALLS Stock = $ 65.00 Strike Price Option Price Status Intrinsic Extrinsic 50 15.10 ITM 15.00.10 55 10.30 ITM 10.00.30 60 5.70 ITM 5.00.70 70.75 OTM 0.75 75.35 OTM 0.35 80.15 OTM 0.15 MSFT PUTS Stock = $65.00 Strike Price Option Price Status Intrinsic Extrinsic 50.10 OTM 0.10 55.30 OTM 0.30 60.70 OTM 0.70 70 5.70 ITM 5.00.70 75 10.30 ITM 10.00.30 80 15.10 ITM 15.00.10 8

Intrinsic value, also called parity, is the amount by which an option is in the money. In the case of a call, the intrinsic value is equal to the present stock price minus the strike price. In the case of a put, the intrinsic value is equal to the strike price minus the present stock price. Only in-the-money options have intrinsic value. Out-of-themoney options have no intrinsic value. For example, with MSFT trading at $65.00, the MSFT January 60 calls will have $5.00 of intrinsic value. So, if the MSFT January 60 calls were trading at $5.70, then $5.00 of that premium would be intrinsic value. At the same time, the MSFT January 70 put will also have $5.00 of intrinsic value. So, if the MSFT January 70 puts were trading for $5.70, then $5.00 of that premium would be intrinsic value. Please view charts below for intrinsic value examples. MSFT CALLS Stock =$ 65.00 Strike Price Option Price Status Intrinsic Extrinsic 50 15.10 ITM 15.00.10 55 10.30 ITM 10.00.30 60 5.70 ITM 5.00.70 70.75 OTM 0.75 75.35 OTM 0.35 80.15 OTM 0.15 MSFT PUTS Stock = $65.00 Strike Price Option Price Status Intrinsic Extrinsic 50.10 OTM 0.10 55.30 OTM 0.30 60.70 OTM 0.70 70 5.70 ITM 5.00.70 75 10.30 ITM 10.00.30 80 15.10 ITM 15.00.10 9

Extrinsic value is defined as the price of an option less its intrinsic value. In the case of out-of-the-money options, the option s entire price consists only of extrinsic value. Extrinsic value is influenced by several factors, with the largest being volatility. In the examples above, if the MSFT January 60 calls were trading at $5.70 and $5.00 of that was intrinsic value, then the remainder ($.70) is extrinsic value. The same also holds true for the January 70 puts. If they were trading at $5.70 and $5.00 of that was intrinsic value, then the rest ($.70) is extrinsic value. Please view charts below for extrinsic value examples. MSFT CALLS Stock =$ 65.00 Strike Price Option Price Status Intrinsic Extrinsic 50 15.10 ITM 15.00.10 55 10.30 ITM 10.00.30 60 5.70 ITM 5.00.70 70.75 OTM 0.75 75.35 OTM 0.35 80.15 OTM 0.15 MSFT PUTS Stock = $65.00 Strike Price Option Price Status Intrinsic Extrinsic 50.10 OTM 0.10 55.30 OTM 0.30 60.70 OTM 0.70 70 5.70 ITM 5.00.70 75 10.30 ITM 10.00.30 80 15.10 ITM 15.00.10 10

The term time decay is defined as the rate by which an options extrinsic value decays over the life of the contract. This concept can be illustrated by the charts below. 11

Volatility is defined as the degree to which the price of a stock or other underlying instrument tends to move or fluctuate over a period of time. Implied volatility is a value derived from the option s price. It is backed out of the model from the extrinsic price of the option. It indicates what the market s perception of the volatility of the stock or underlying will be during the future life of the contract. A stock that has a wide trading range (moves around a lot) is said to have a high volatility. A stock that has a narrow trading range (does not move around much) is said to have a low volatility. The importance of volatility is that it has the single biggest effect on the amount of extrinsic value in an option s price. When volatility goes up (increases), the extrinsic value of both the calls and the puts increase. This makes all the option prices more expensive. When volatility goes down (decreases), the extrinsic value of both the calls and the puts decrease. This makes all the options prices less expensive. As stated earlier, a call option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right, but not the obligation, to purchase a specified stock or other underlying instrument, at a predetermined price on or prior to a specified date. The seller of a call option assumes the obligation of delivering the stock or other underlying instrument to the buyer should the buyer wish to exercise his option. The call is known as a long instrument which means the buyer profits from the stock going up, and the seller hopes the stock goes down or remains the same. For the buyer to profit, the stock must move above the strike price plus the amount of money spent to purchase the option. This point is known as the breakeven point and is calculated by adding the strike price of the call to its premium. While the buyer hopes the stock price exceeds this point, the seller hopes that the stock stays below the breakeven point. The buyer of the call has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the call. His unlimited potential gain comes from the stock s upside growth potential. The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the call. His unlimited risk comes from the stock price s ability to rise during the life of the contract. The seller is responsible for delivering the stock to the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale. It is compensation for taking on this risk. 12

For example, if a seller sold the MSFT January 65 call for $2.00, he is giving the buyer the right to buy 100 shares (per contract) of MSFT from him for $65.00 per share at any time until the option expires. If MSFT rallies and trades up to $75.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00). Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00). If MSFT were to trade down to $55.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00). Parity is defined as the amount by which an option is in the money. Parity speaks of the option trading in unison with the stock. This also means that parity and intrinsic value are closely related. When we say that an option is trading at parity, we mean that the option s premium consists of only its intrinsic value.. For example, if Microsoft was trading at $53.00 and the January 50 calls were trading $3.00, then the January 50 calls are said to be trading at parity. Under the same guidelines, the January 45 call would be trading at parity if they were trading at $8.00. So, parity for the January 50 calls is $3.00 while parity for the January 45 calls is $8.00 Now if these calls were trading for more than parity, the amount (in dollars) over parity is called premium over parity. Thus, the term premium over parity is synonymous with extrinsic value, which was discussed above. If the stock is trading at $53.00 and the January 50 calls are trading at $3.50 then we would say that the calls are trading at $0.50 over parity. The $0.50 represents the premium over parity which is also the amount of extrinsic value. The $3.00 is the amount of intrinsic value or parity. The following graphs are called parity graphs. They are intended to show you your option s profit and loss at expiration (when they are trading at parity: i.e. when they are trading without intrinsic value). The first graph shows a call purchase and the second shows a call sale. The graphs show the amount of your expenditure (in the case of a purchase) or the amount you have received (in the case of a sale) and the dollar price of the stock where you would breakeven. In this example, we use the fictitious stock XYZ. Please make note of where the stock needs to be at expiration in order for you to be profitable, and how the premium paid (in the case of a purchase) or the premium received (in the case of a sale) affects your profitability. 13

Also notice the difference in the profit potential between a purchase of the option as opposed to a sale of the option. Lastly, it is important to note the unlimited potential risk inherent in the sale of an option, compared to the fixed risk of an option purchase. Please note the call parity graphs below. A put option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right but not the obligation to sell a specified stock or other underlying instrument at a specified price by a specified date. 14

The seller of a put option assumes the obligation of taking delivery of the stock or other underlying instrument from the buyer should the buyer wish to exercise his option. The put is known as a short instrument which means that the buyer profits from the stock going down. For the seller to profit, the stock must not move below the strike price plus the amount of money received for the sale of the option. This point is known as the breakeven point and is calculated by adding the calls strike price to the option s premium. Obviously, the buyer hopes that the stock price exceeds the breakeven point. For example, you buy the MSFT January 65 put for $2.00 because you think Microsoft is going to go down. This option gives you the right, but not the obligation to sell the stock at $65.00. In order to obtain this right, you had to spend $2.00. In order for you to make money, the stock would have to trade down below $63.00 by expiration. This is because the stock has to trade down below the strike plus the cost of the option. So if the stock traded down to $60.00, you would make $5.00 because you have the right to sell it at $65.00. However, because you paid $2.00 for the put, you must subtract that from your $5.00 profit for a total profit of $3.00. You have just made $3.00 on a $2.00 investment. Not a bad return. The buyer of the put has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the put. His unlimited potential gain comes from the stocks unlimited downside potential, at least all the way to zero. The seller, on the other hand, has limited potential gain and almost unlimited potential loss. The seller can only gain what he was paid for the put. The unlimited risk comes from the stock prices ability to decline during the life of the contract. For example, if a seller sold the MSFT January 65 put for $2.00, he is giving the buyer the right to sell 100 shares (per contract) of MSFT to him at $65.00 per share at any time until the option expires. If MSFT declines and trades down to $55.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00), for a net loss of $8.00. Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00), for a net gain of $8.00 per contract. If MSFT were to trade up to $75.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00). The seller is obligated to take delivery of the stock from the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale. 15

Please see the put parity graphs below. The definitions and concepts contained in the previous section are the building blocks of the option strategies we will discuss. It is of vital importance for you to go through these concepts and definitions several times to gain a clear understanding of them. 16