Stock options give the option holder the right, but not the obligation, to buy or sell particular stocks for a particular price, called the strike price, within a specified time. Options (also called contingent claims) are derivatives, so called because their value derives from other securities (called the underlying security, or just underlying or underlier), which in the case of stock options are particular stocks. They are used extensively for hedging because options allow an investor to protect a position for a small cost, and speculators like them because their profit potential is much greater than the underlying securities. Besides common stock, there are also options for stock indexes, foreign exchange, agricultural commodities, precious metals, and interest rate futures.
Although options were originally traded in the over-the-counter (OTC) market, where the contract terms were negotiated, option trading really took off when the first option exchange, the Chicago Board Options Exchange (CBOE), was organized in 1973 to trade standardized contracts, increasing the market and liquidity of options. Options trading began on April 26, 1973, with 1.1 million contracts traded that year. Since then, trading volumes have increased substantially, with billions of contracts traded in 2017.
Leverage is the Fundamental Advantage of Options
Leverage is the fundamental advantage of options. A small investment can benefit from the price movements of securities that would either cost much more to own outright, or would require a much greater risk. For instance, to buy 100 shares of a $50 stock would require a $5,000 investment, but to buy 1 call contract for 100 shares of that same stock at $5 per share would require a $500 investment. It is because of leverage that options are excellent financial instruments for hedging a long or short position, or for pure speculation.
Of course, options have a downside; otherwise, why would anyone bother buying the underlying security. Although the risk is limited to the premium for the option holder, the disadvantage of buying options is that they can expire completely worthless, and often will. If the stock price does not move sufficiently in the right direction before the expiration date, then the investor loses the entire investment.
Important Note: I review my articles periodically to make sure that they are up-to-date. Some of the examples are dated, but if the examples continue to illustrate the basic principles, which they usually do, then I continue to use those examples, since it takes a lot of work to redo, while redoing them using more recent dates offers no pedagogical advantage.
Example—The Profit Advantage of Options, and the Risk
On October 6, 2006, an April 2007 call to buy MSFT (MSFT) for the price of $30 (October 6, 2006 stock price: $27.87) was selling for .80 per share. Thus, 1 call contract to buy 100 shares of MSFT would cost $8.00. To buy 100 shares of MSFT would cost $2,787.00! Since Microsoft is coming out with Office 2007 and Windows Vista, let's say the price rises to $40 per share by April, 2007. The call contract would allow the holder to buy 100 shares of MSFT for $30, which could then be sold for $40 in the market (or the stock could be sold short, then covering the short by exercising the call). That's a profit of $10 per share, or $1,000 per call contract, which equals 12,500% ($1,000/$8), over the original investment of $8 for the call contract, in the span of about 6 months. It would be virtually impossible to even approach getting the same return on investment buying the stock itself! An investor who bought the stock instead of the call would have a profit of only 144% ($40/$27.87) in the same time period. Of course, if Microsoft's stock price didn't increase above $30 per share by the expiration date in April, 2007, then the call contract would expire completely worthless, while the stock holder would still have the stock, and could receive dividends on it. In fact, according to the Options Clearing Corporation, about 30% of all options expire worthless every month.
Update: The high for MSFT on April 20, 2007, which was the expiration date for this option, was $29.10, so this option expired worthless. During the October 2006 to April 2007 period, MSFT was briefly above $30, with a high slightly above $31. So even if the option was closed out at the market top, profits would have been minimal after subtracting the call premium and transaction costs.
The Option Contract
- Underlying Security
- Call or Put
- American or European Style
- Strike Price
- Expiration Date
- Number of Shares
(or other Multiplier
The elements of a standardized option contract specifies whether it is a put or call, its style as to when the option can be exercised, the underlying security, the strike price, the expiration date, and the number of shares of the underlying security for each contract, which is almost always 100 shares for equity options. (However, different countries may have different standards. For instance, option contracts traded in the UK on the London International Financial Futures and Options Exchange (LIFFE) is for 1000 shares.)
Calls and puts are the 2 types of options. A call gives the holder the right, but not the obligation, to buy a specific security for a set price, called the strike or exercise price. A put gives the holder the right, but not the obligation, to sell a particular security for the strike price.
Depending on the price of the underlying security, option strike prices are set at $2.50, $5 or $10 intervals, and most options are created and traded with price increments a little above and a little below the current market price of the underlying security.
If the price of the underlying security moves substantially before expiration dates, then new options are created with strike prices closer to the new market price of the underlying security. The older contracts are then exercised, closed out, or left to expire.
There are 3 styles of options that differ as to when the option can be exercised. American-style options allow the holder to exercise the option at any time before expiration, whereas European-style options allow the holder to exercise only for a short time before the expiration date. The option style is not related to geography — most options traded in Europe are American-style options. All equity options are American-style options, but most foreign currency options and CBOE stock index options are European-style options. Note that, although European-style options can only be exercised during a brief time right before expiration, the options can be sold before then. Most options that require a cash settlement instead of the delivery of securities are European-style options, because it makes no sense to exercise an option for cash when it can simply be sold for cash. The capped-style option can only be exercised for a specific time before expiration, unless the underlying security reaches the cap price, in which case, the capped-style option is exercised automatically. This cap limits the profit potential of the option for the holder and the risk for the option writer.
A standardized option contract is always for 100 shares of the underlying security, unless it is adjusted for a stock split, or some other event that would affect the relationship of the option to the underlying security.
Options always expire on the Saturday following the 3rd Friday of the expiration month, although they must be exercised by the Friday before expiration since that is the last trading day. The Saturday following expiration is used so that brokers can confirm customer option positions and related paperwork incurred by expiration and exercise. There are at least 2 near-term options which expire in the nearest 2 months, and there are 2 long-term options. When the current month's options expire, then more are created that expire in the month after the next. Example: when January options expire, then more options are created that expire in March, so that the 2 near-term options will expire in February and March.
The expiration dates of long-term options are based on specific sequences. The exact months of expiration are based on 3 different sequential cycles: the January Sequential Cycle, the February Sequential Cycle, and the March Sequential Cycle. For larger companies and major indexes for which there is a significant market demand, there are also LEAPS (Long-Term Equity AnticiPation Securities), which are special options that initially have expiration dates several years into the future, and always expire in January. Generally, there are 2 series of LEAPS that expire in the 2 January's following the long-term options.
Example—Option Expiration Cycles
Microsoft is on the January cycle, so before the 3rd Saturday in November, 2006, the 2 near-term options are for November and December, the 2 far-term options are for January and April, and the 2 LEAPS expire in January 2008 and 2009. On the Monday following option expiration in November, the 2 near-term options will be for December and January and the 2 far-term options will be for April and July.
The Expiration—and Risk—of S & P 500 Index Options
Some option contracts differ slightly from most others. For instance, the S & P 500 Index Option contracts differ because they expire Thursday night before the 3rd Friday, and the settlement value of the contract depends on the opening stock prices of the S & P 500 on the Friday following expiration. On August 17, 2007, Ben Bernanke, Chairman of the U.S. Federal Reserve, lowered the Fed discount rate from 6% to 5% before the stock market opened on Friday morning. This raised the opening stock prices, causing many S & P 500 puts, that would have otherwise been in the money based on Thursday's closing prices, to become worthless.
An option class consists of all contracts that have the same type (call or put), style (American or European), and underlying security. Thus, all Microsoft calls compose an option class, while all Microsoft puts compose another. An option series is composed of the set of all options of the same option class that also have the same strike price and expiration date. Thus, all Microsoft calls with a strike price of $30 that expire in January, 2007 composes an option series; a strike price of $35 would be another series.
Option Contract Adjustments and the Adjustment Panel
When an investor buys an option contract, that contract is based on what is known about the contract terms at the time; however, events can occur that would change the basic relationship between the option contract and the right that it confers. For instance, if the company declares a 2-for-1 stock split, then each share of stock will be doubled, but the stock price will be half of what it was prior to the split. Thus, if XYZ stock, selling for $50 per share, splits 2-for-1, then there would be twice as many shares, but their value would decrease to around $25 per share, since the value of the company has not increased because of the split, and, therefore, the total market capitalization would remain about the same.
Now, consider 2 option holders. One holder has a call to buy XYZ stock for $50; the other holder has a put to sell XYZ stock for $50 per share. If there were no contract adjustments, the call would almost certainly expire worthless, because the stock, now trading at $25 per share is not likely to double before expiration, while the put would be instantly profitable, with a rate of return that any investor would envy! Now consider the writers of these 2 options. The call writer would get to keep his premium, but the put writer would now have to buy stock for $50 that she could have purchased on the open market for half that price.
To prevent these scenarios, adjustments are made to the option contracts (sometimes called adjusted options), when the relationship to the underlying security is significantly altered. These alterations can include stock splits, reverse stock splits, stock dividends or distributions, rights offerings, a reorganization or recapitalization of the company, or a reclassification of the underlying security. It can also occur if the issuer of the underlying security is acquired or merges, or is dissolved or liquidated.
There are standard ways to adjusting the contracts in common events, such as stock splits, but, when the event is peculiar, and creates an uncertainty as to how the adjustment should be made, an adjustment panel will decide on the contract adjustments. All contract adjustments are published by the Options Clearing Corporation. The adjustments are listed in reverse chronological order, but the page includes a search box for looking for particular options. The effective date is the ex-date established by the primary market in the underlying security.
Generally, option contracts are adjusted to maintain the same basic relationship between the option and the underlying security. The necessary adjustments in most of these cases can be found by the following equation:
Number of Shares × Price = New Number of Shares × New Price
Note that the share number and price are inversely related. If the number of shares is adjusted upward, then the price of each share must be adjusted downward, and vice versa. No adjustments are made for cash distributions of 10% or less.
Example—Adjusting Option Contracts for Stock Splits
In a 2-for-1 stock split, contracts are usually adjusted by doubling the number of option contracts, and halving their price. Thus, a call for 100 shares of XYZ stock for $50 per share would become 2 calls for $25 per share. Using the equation above to verify: 100 × 50 = 200 × 25.
In cases where the divisor is greater than 1, then each contract is adjusted by altering the number of shares for each contract and their price, to accommodate anyone holding just 1 contract. So, in a 5-for-2 split, each share is priced at 2/5 of the old price, which is $20 (in other words, if you have 2 shares of stock worth $100 total, then after the split, you will have 5 shares of stock worth $100 total, so each share must now be worth $20), so the number of shares for each contract must be adjusted upward so that, by transposing the above equation, we see that the new Share Number = 100 × 50/20 = 250. To verify: 100 × 50 = 250 × 20. Thus, each option contract will be for 250 shares with a strike price of 2/5 of whatever it was before the split.
Other kinds of adjustments are more rare, and all these can be found at the Options Clearing Corporation. The search engine provided allows searches for year, month, keywords, or memo number.
Options were originally traded over the counter (OTC), and still are. The advantages of the OTC market over the exchanges is that the option contracts can be tailored: strike prices, expiration dates, and the number of shares can be specified to meet the needs of the option buyer. However, OTC options have greater transaction costs and less liquidity.
Organized exchanges offer standardized contracts that are cheaper and easier to sell. The CBOE was the original exchange for options, but, by 2003, it has been superseded in size by the electronic International Securities Exchange (ISE), based in New York. Most options sold in Europe are traded through electronic exchanges. Other exchanges for options in the United States include: NYSE Euronext (NYX), and the NASDAQtrader.com.
Options are traded just like stocks; however, the option holder, unlike the holder of the underlying stock, has no voting rights in the corporation, and is not entitled to dividends. Brokerage commissions must also be paid to buy, sell, or exercise options, and generally these commissions are a little higher than for stocks. Prices are usually quoted as a minimum amount plus per contract, but phone orders cost more, and broker-assisted trades are the most expensive. Many brokerages also offer a sliding commission scale for active traders, yielding lower commissions for certain minimum number of trades.
The price of the option is known as the premium. When the option is first sold, the option buyer pays the premium to the option writer. Thereafter, it trades in the secondary market. Option premiums can be divided into 2 components: time value and intrinsic value. All options have time value (sometimes called extrinsic value) because an option, as long as it exists, gives the holder the right to buy or sell the underlying security for the strike price. The greater the time until expiration, the greater the chance that the option can become profitable, and thus, the greater the time value. As the remaining time for the option declines, so does its time value, until at expiration it becomes completely worthless, and ceases to exist. Standardized option contracts expire the 3rd Saturday of the month of expiration; however, the last trading day is the Friday before expiration.
If the security is currently trading above the exercise price of a call, or if the security is currently trading below the strike price of a put, then the option also has intrinsic value, which, in the case of a call, is the difference between the current price of the security and the strike price. If this difference is zero or negative, then the call has no intrinsic value, but only time value.
Option Premium = Intrinsic Value + Time Value
- If Current Price of Security – Strike Price of Call > 0
- Intrinsic Value of Call = Current Price of Security – Strike Price of Call
- Else: Intrinsic Value = 0.
The intrinsic value of a put is the difference between the strike price of the put and the current price of the security.
- If Strike Price of Put – Current Price of Security > 0
- Intrinsic Value of Put = Strike Price of Put – Current Price of Security
- Else: Intrinsic Value = 0.
As the intrinsic value of an option increases, the time value of the option decreases.
When an option has intrinsic value, it is said to be in the money, if the strike price of the option and the price of the underlying security are equal, then the option is said to be at the money, and if the intrinsic value is negative, then the option is said to be out of the money.
Example—Intrinsic Values of Calls and Puts
If the price of MSFT is $28, then:
- the intrinsic value of a Microsoft call with a $25 strike price is $3 per share, and a put with the same strike has no intrinsic value, and is, therefore, out of the money.
- a call with a strike price of $30 has no intrinsic value, but a put would have an intrinsic value of $2 per share.
A call is created when an investor accepts the legal obligation for a specified time to sell a particular security for a particular strike price. For instance, he might write a call to sell MSFT for $25 until the 3rd Saturday in January. The investor is called the call writer because, by accepting the legal obligation for the option premium, he creates or â€œwritesâ€ the option contract. The call writer is said to have a short position. If the call writer already owns the security on which the call is written, then the call is a covered call; otherwise, it is a uncovered call or a naked call, in which case, if the option is exercised, the call writer will have to buy the stock on the open market for whatever the current price is, which is the risk that a naked call writer bears. A call writer has the duty to deliver the security for the strike price when the call is exercised.
Option Writer or Seller?
Sometimes, an option seller is considered an option writer—and in many contexts, these 2 words are used as synonyms—but this is not necessarily so, or even likely. Anyone who already owns an option has a long position in it and would most likely close his position by selling it rather than exercising it, because options always have some time value before expiration, so selling an option is usually more profitable than exercising it. But the option holder has no legal obligation, since he only bought the contract, not write it. However, an option writer sells an option that she created by agreeing to the legal obligation imposed by the contract that she sold for the premium. She is said to have a short position because, to close out her obligation before expiration, she would have to buy back a contract with the same terms that she wrote. To have a short position in options is similar to having a short position in stocks, except that the option writer creates the option to sell, whereas the short seller of stock must first borrow the stock to sell it, which must eventually be bought back to close out the position. The option writer must also buy back the contract to close out her position before expiration, which she would do if she thought that the option will move more into the money before expiration, but she could also just let the option expire if she thought that the option will not be in the money at expiration, thereby saving the commission of buying the option back, or she could fulfill her obligation when assigned an exercise, because, at expiration, there is no time value left to the option, so it might be cheaper than buying back the option earlier.
The most that the call writer can make is the amount of the premium; his potential loss is much greater, because the stock can rise by a much larger amount than the premium.
Writing a call is a bearish strategy, because the call writer obviously doesn't expect the stock to rise above the strike price.
Buying a call is a bullish strategy, because obviously the call buyer thinks there is a good chance that the stock will rise above the strike price. The call holder is said to have a long position. Obverse to the call writer's potential profit and loss, the most that a call holder can lose is the cost of the premium, but his potential profits are much greater because the stock can rise by a much larger amount than the option premium.
Example—Profits and Losses on a Call Option
- Call Value at Expiration =
- Stock Price
- – Strike Price
- Net Profit of Exercised Call =
- Stock Price
- – Strike Price
- – Premium
- – Buy Commission
- – Exercise Commission
- Net Profit of Sold Call =
- Sell Premium
- – Buy Premium
- – Buy and Sell Commissions
On October 6, 2006, you bought 10 call contracts for Microsoft, with strike price of $30, expiring in January, 2007, at $0.35 per share, paying a typical commission of $9.95 per trade plus $0.75 per contract. Microsoft rises to $33 by December, so you decide to sell your calls to lock in your profits, with the calls trading at $3.20 per share, with $.20 being the remaining time value.
|To buy 10 call contracts |
at $0.35 per share.
|Sell 10 call contracts for $3.20 per share.|
|$350.00||Total cost for 10 calls |
with 100 shares per contract:
$0.35 × 10 × 100 = $350
With MSFT trading at $33, the call has risen to $3.20:
|+ $9.95||Commission per trade.||- $9.95||Subtract commission per trade.|
|+ $7.50||Commission per contract = $0.75 × 10||- $7.50||Subtract commission per contract.|
|= $367.45||Total cost = Premium + Commissions.||- $367.45||Subtract your original premium cost + buying commissions.|
|= $2,815.10||Net profit|
|= 766%||Rate of return for 2 months: 2,815.10/367.45.|
Even though an option might have value at expiration, it still may be an unprofitable transaction if it doesn't cover the original investment plus commissions, but, nonetheless, the option will still be exercised to get whatever value that it has.
A put is created when an investor accepts the legal obligation for a specified time to buy a particular security for a particular strike price. For instance, the put writer might accept the obligation to buy MSFT at $25 per share at any time before the 3rd Saturday of January. A put option on a given security gives the holder the right, but not the obligation, to sell the security at the strike price before the expiration date. The put writer is obligated to buy the security for the strike price from the put holder if the put is exercised. Thus, puts increase in price as the security falls in price. The put writer is said to have a short position, while the put holder has a long position. The most that a put writer can make is the premium, while the potential loss is the price of the security, if it should become worthless, because of bankruptcy, for instance. The most that a put holder can lose is the premium, and the most that he can make is the price of the security, because, although the price might, in exceptional circumstances, drop to zero, it can never be less than zero.
If the put writer has a short position in the underlying security, or if he has the cash in his account to buy the security if it is exercised, then it is a covered put; otherwise, it is an uncovered put or a naked put.
Any option writer with a short position can close out that position by buying an offsetting contract. A call writer can close out his position by buying a call with the same strike price and expiration date as the one he wrote; likewise for the put writer.
Example—Profits and Losses on a Put Option
- Put Value at Expiration =
- Strike Price
- – Stock Price
- Net Profit of Exercised Put =
- Strike Price
- – Stock Price
- – Premium
- – Buy Commission
- – Exercise Commission
- – Stock Buy Commission
- Net Profit of Sold Put =
- Sell Premium
- – Buy Premium
- – Buy and Sell Commissions
On October 6, 2006, you bought 10 put contracts for Microsoft, with strike price of $30, expiring in January, 2007, at $2.20 per share, paying a typical commission of $9.95 per trade plus $0.75 per contract. Microsoft drops to $25 per share by expiration day in January, 2007, so you exercise your put, allowing you to buy 1,000 shares of Microsoft in the open market for $25 per share, and selling it for $30 per share to a put writer.
|To buy 10 put contracts |
at $2.20 per share.
|Exercise 10 put contracts to sell |
MSFT for $30 per share.
|$2,200.00||Total cost for 10 puts |
with 100 shares per contract:
$2.20 × 10 × 100 = $2,200
|$5,000.00||With MSFT trading at $25, exercising the put will net you $5 per share. You buy 1,000 shares of MSFT for $25,000 and sell it to a put writer for $30,000. $30,000 - $25,000 = $5,000|
|+ $9.95||Commission per trade.||- $12.95||Subtract commission to buy 1,000 shares of MSFT.|
|+ $7.50||Commission per contract = $0.75 × 10||- $19.95||Subtract exercise commission.|
|= $2,217.45||Total cost = Premium + Commissions.||- $2,217.45||Subtract your original premium cost + buying commissions.|
|= $2,782.55||Net profit|
|= 125%||Rate of return for 2 months: 2,782.55/2,217.45.|
Note that, to determine the value of a put, the stock price is subtracted from the strike price, whereas the value of a call is calculated by subtracting the strike price from the underlying stock price. Note, too, that, for both calls and puts, buy premiums and commissions are always subtracted. As you can see by comparing the 125% profit in this example to the 766% profit in the previous example, paying a higher premium greatly reduces the potential rate of return, and also increases the risk. For instance, if MSFT was just $3 higher, then this investment would have netted a loss.
The Determination of Option Premiums
Premiums are quoted for each share of a contract. Therefore, since most option contracts are for 100 shares of stock, the premium must be multiplied by the number of shares per contract—100. For instance, for an option that has a quote of $1, an investor would have to pay $100 for each option contract, plus sales commissions.
A number of factors determine the premium of an option. The most important factor is the relationship of the strike price to the current price of the underlying security. As the option goes into the money, the premium will increase by at least $1 for every $1 increase in the intrinsic value of the option. For a call, the premium increases by at least $1 for every $1 increase in the stock price. For a put, the premium increases by at least $1 for every $1 decrease in the stock price. Although there is still some time value for an option that is in the money, time value decreases as the intrinsic value increases.
For a particular strike price for a particular security, the time value is proportionate to the remaining time until expiration. This makes sense, since the more time that remains until expiration, the greater the chances that the option will go into the money. Because time value declines continually until expiration, options are considered wasting assets.
Volatility of the underlying security is an important factor in the time value of the premium. The greater the volatility of the underlying, the greater the chance that an option will go into the money, thus commanding a higher premium.
Dividends and interest rates have a minor impact on option premiums, but they are factors in theoretical models of option pricing, and in the put-call parity relationship that relates the put premium to the call premium of the same underlying security with the same strike price.
The payment of dividends of the underlying security may have a small effect on the premium, because the payment of dividends causes stock prices to decline (this results because the company, having paid out cash, has less value than before it paid the dividend). Thus, the call premium will decrease and the put premium will increase. Note, too, that as the ex-dividend date of the underlying security approaches, the greater the chance that an in-the-money call will be exercised, since it will allow the call holder to collect the dividend. (A more technical explanation of why dividends increase put premiums and decrease call premiums can be found in Put-Call Parity Relationship).
Prevailing Interest Rates,
According to option pricing models, call premiums increase or decrease with changes in interest rates, while put premiums vary inversely with interest rates. Rho measures this change with each 1% change in the prevailing risk-free interest rate. Thus, a rho of 0.05 means that, for a 1% increase in interest rates, the theoretical value of call premiums will increase by 5%, whereas the theoretical value of put premiums will decrease by 5%, because put premiums move opposite to interest rates. The values are theoretical because it is market supply and demand that ultimately determines prices, but interest rates do have some effect.
Option Ticker Symbols and Listings
Options are uniquely identified with ticker symbols, just like stocks. Before 2010, the option symbols had only a vague relationship to the underlying stock. In 2010, the ticker symbology was replaced by the OCC with a more informative system, such that the basic information about the option can easily be read from the ticker symbol itself. The option ticker symbol ranges from 17 to 21 characters, depending on the ticker symbol of the underlying security, and consists of the following components:
- stock ticker symbol (up to 6 characters)
- expiration year (2 numbers)
- expiration month (2 numbers)
- expiration date (2 numbers)
- whether it is a call or put (1 character: C/P)
- dollar portion of the strike price (5 numbers)
- decimal portion of the strike price (3 numbers)
Example for an option on Google that expires 04/19/2014, call, strike price: $1205, no decimal portion:
However, many brokers use a simplified expression to represent the option, which can vary among brokers.
Listings for options include:
- ticker symbol
- last price change (which must be multiplied by the number of shares represented by each contract—usually 100, for the actual last price of the contract)
- bid and ask prices
- open interest, which is the number of outstanding option contracts which have not been exercised or closed out.
Because options contracts are continually created and destroyed, open interest, unlike the number of shares of stock, fluctuates widely. At expiration, all contracts of that class are extinguished. Note that, in general, the greater the strike price is from the stock price, the smaller the open interest and the fewer the trades. In fact, many of the volume values have no number because there were no trades for that day.
If the price of the underlying stock should change by a large amount, then more options with strike prices clustering around the new price will be written, and options that were clustered around the old price will either be closed out or exercised, thereby decreasing the open interest, or there will be fewer trades for those options.
The Options Clearing Corporation (OCC)
The Options Clearing Corporation (OCC) is registered with the Securities and Exchange Commission as a clearing corporation. In addition to options, the OCC also offers clearing and settlement for futures and options on futures. Its website publishes statistics and news on options, and publishes all changes in the trading rules and any adjustments of option contracts that requires changes, such as a merger of companies whose stock was the underlying security to the option contracts.
The OCC issues, guarantees, and clears all option trades involving its member firms, which includes all U.S. option exchanges, and ensures that sales transactions are completed according to rules, and that all contracts will be honored.
Exercise and Assignment
An option holder exercises his option by notifying his broker of his intention to exercise. Moreover, on the last trading day for the option, notification must be given before the exercise cut-off time, which will probably be earlier than on trading days before the last day, and the cut-off time may differ for different option classes or index options. Brokers generally require notification to exercise an option, even if it is in the money.
After notification, the broker sends the exercise instructions to the OCC, who then assigns the exercise to one of its Clearing Members who are short in the same option series as is being exercised. The Clearing Member then assigns the exercise to a customer who is short in the option. The customer is selected by a specific procedure, usually on a first-in, first-out basis. Thus, there is no direct connection between an option writer and a buyer.
To ensure contract performance, option writers are required to post margin, the amount depending on how much the option is in the money. If the margin is deemed insufficient, then the option writer will be subjected to a margin call. Option holders don't need to post margin since the option will only be exercised if it is in the money. Moreover, options, unlike stocks, cannot be margined.
Because the OCC is always a party to an option transaction, an option writer can close out his position by buying the same contract back, even while the contract buyer retains her position, because the OCC draws from a commingled pool of contracts that lack any connection to the original contract writer and buyer.
Example—No Direct Connection between Investors Who Write Options and those Who Buy Them
John Call-Writer writes an option that legally obligates him to provide 100 shares of XYZ for the price of $30 until April, 2017. The OCC buys the contract, adding it to the many other option contracts in its pool. Sarah Call-Buyer buys a contract that has the same terms that John Call-Writer wrote—in other words, it belongs to the same option series. However, option contracts have no name on them. Sarah buys from the OCC, just as John sold to the OCC, and she just gets a contract giving her the right to buy 100 shares of XYZ for $30 per share until April, 2017.
Scenario 1—Exercises of Options are Assigned According to Specific Procedures
In February, the price of XYZ rises to $35, and Sarah thinks it might go higher in the long run, but since she doesn't think the stock will go much higher before the expiration of the call, she decides to exercise her call to buy XYZ at $30 per share to be able to hold the stock indefinitely. She instructs her broker to exercise her call, who then forwards the instructions to the OCC, who assigns the exercise to one of its participating members who provided the call; the participating member, in turn, assigns it to an investor who wrote such a call; in this case, it happened to be John's brother, Sam Call-Writer. John got lucky this time. Sam, unfortunately, either must turn over his appreciated shares of Microsoft, or he'll have to buy them in the open market to provide them. This is the risk that an option writer must take — an option writer never knows when he'll be assigned an exercise during any time in which the option is in the money.
Scenario 2—Closing Out an Option Position by Buying Back the Contract
John Call-Writer decides that XYZ might climb higher in the coming months, so decides to close out his short position by buying a call contract with the same terms that he wrote—the same option series. Sarah, on the other hand, decides to maintain her long position by keeping her call contract until April. This can happen because option contracts are fungible. John closes his short position by buying the call back from the OCC at the current market price, which may be higher or lower than what he paid, resulting in either a profit or a loss. Sarah can keep her contract because when she sells or exercises her contract, it will be with the OCC, not with John.
Thus, the OCC allows each investor to act independently of the other.
Options Profits and Losses
Option writers whose contracts expire make the maximum profit possible for their position, which is the premium that they received, and option holders receive the maximum loss, which is the premium that they paid. Option writers whose contracts were assigned will have earned less than the premium or may well have suffered losses, since the option holder wouldn't exercise it unless it was in the money. A closed out transaction could be at a profit or a loss for both holders and writers of options. A closed out transaction will always yield at least some return of investment, because the investor would not close out his position unless he was getting or saving more than the transaction cost.
Stock Index Options
Stock index options are based on a stock index rather than on specific stocks. The value of index calls increase as the index increases, and the value of index puts increases as the underlying index decreases. These options are similar to stock options, but with some important differences.
Because these options are based on indexes, there is greater diversification, and usually less volatility than with specific stocks. An index is never going to drop to zero, and it will never increase as dramatically as some specific stocks can, especially within a short time. Therefore, the risk is more limited, but so is the profit potential. Also, contract adjustments are rarely needed for a stock index. For instance, stock splits of stocks within the index do not affect the index, and thus, no adjustments on the contracts are needed.
The strike price is based on an index value multiplied by the multiplier of the contract, which is usually $100 (USD). These options are settled by the exchange of cash, not securities, which, for obvious reasons, is called a cash settlement. The option writer who is assigned an exercise pays cash to the holder who exercised the option.
Many index options are European-style options that can be exercised for a short time right before expiration. However, this makes little difference for options that are settled in cash, because the option holder can always sell the option on the exchanges for cash at any time before expiration.
The cash that is paid upon exercise depends on the index, which depends on the component prices of the index. Some contracts have AM settlement and some have PM settlement. In AM settlement, the cash settlement value is calculated using the opening component prices on the day of expiration. In PM settlement, closing prices on the day of expiration are used to determine the cash settlement value of the contract.
The cash settlement amount is determined by multiplying the absolute difference between the index and the strike price of the option times $100. For instance, SXY KO-E (2006 Nov 1375.00 Call) is based on the S&P 500 index. If the index should close at 1400 on expiration day, then a call holder would receive (1400 - 1375) × 100 = $2,500, and the assigned call writer would have to pay that much.
There are options based on other assets besides stocks and stock indexes.
While futures confer the obligation to buy or sell something at a specific price, future options confer the right, but not the obligation, to buy or sell a specific futures contract at the strike price, and is settled in cash.
Foreign currency options confers the right to buy or sell a specific currency for a set amount in dollars, and is settled in U.S. dollars, which is equal to the absolute difference between the strike price of the in-the-money option and the foreign currency exchange rate at expiration. Thus, it is a way to freeze the foreign exchange rate for a given currency for the lifetime of the option. Foreign currency future options are options on futures contracts for currency rather than the currency itself. Options that are in the money pay the absolute difference between the price of the futures contract for currency and the strike price. The volume for currency futures options is much greater than for currency options.
Interest rate options gives the holder the right to buy or sell bonds at the strike price, which can include Treasury bills, notes, and bonds and GNMA pass-through certificates. Interest rate futures options gives the holder the right to buy or sell futures contracts on Treasuries, municipal bonds, and European government bond futures.