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Stock Option Concepts / Strategies




What are Options?
 
An option is a formal contract which grants the holder or buyer of a call or put option the right to buy (in the case of a call) or sell (in the case of a put) a certain quantity of a specific underlying interest at a stipulated price within a specific period of time. The seller or writer of an option contract assumes the obligation to sell (in the case of a call) or buy (in the case of a put) a certain quantity of a specific underlying interest at a stipulated price within a specific period of time.

For Example:

10 XYZ June 20 Calls

This means that the holder of the option contract has acquired the right to purchase 1,000 shares (10 contracts x 100 shares per contract = 1,000 shares) of XYZ stock at $20 per share on or before the expiration date in June.
 
 
Basic Option Terminologies
 
Calls An option where the seller has an obligation to SELL and the buyer has the right to BUY a specific quantity of the underlying interest at a stipulated price on or before the expiry date. For this right, the buyer pays the seller a premium when the transaction occurs (option bought).
 
Puts An option where the seller has an obligation to BUY and the buyer has the right to SELL a specific quantity of the underlying interest at a stipulated price on or before the expiry date. For this right, the buyer pays the seller a premium when the transaction occurs (option bought).
 
Holder or Buyer The person who buys the option contract and pays the premium to have the right to exercise the option.
 
Seller or Writer The person who grants or sells the option contract and receives the premium, obligating him/her to have the option exercised at the buyers discretion.
 
Underlying Interest The specific security involved in the contract. Normally, 100 shares of the underlying interest are covered under each option contract. That is to say that every option contract covers 100 shares of the associated stock. Example: 3 Call options refers to 300 shares of the associated stock.
 
Expiration or Expiry Date The date on which the contract expires. The stipulated future date by which the buyer must exercise his/her right or the option expires worthless to him/her. The Expiry dates are always the 3rd Friday of the specified month. Generally, there are option contracts for each month of the year, but there are times when specific option contracts are not available for given months.
 
Exercise or Strike Price The price at which the underlying interest may be bought or sold according to the terms of the contract. For Puts, the buyer will exercise his/her right if the price is below the strike price. For Calls, the buyer will exercise his/her right if the price is above the strike price. The strike price is generally specified in 2.5, 5, and 10 dollar increments. Not all values will be available for a number of reasons, of which the most common is that the underlying interest has recently had a drastic fluctuation in price and there are no option contracts designated for its new relative price range.
 
Exercise The action of the buyer acting on his/her right to have the seller buy (in the case of Puts) or sell (in the case of Calls) the underlying interest according to the terms of the contract.
 
Expire The case where the expiry date passes and the buyer has not acted on his/her right to have the seller buy or sell the underlying interest. In this case, the option contract is deemed worthless, the buyer has no more rights, the seller has no more obligations, and the seller gets to keep the premium he/she was paid at the time the transaction occurred (option bought).
 
Premium The price the buyer of an option contract pays the seller of the contract for the right to exercise the option. This amount is paid to the seller at the time the transaction occurs (option bought). There are a number of factors which affect the premium amount:
  • Duration till the expiry date (the longer the duration the higher the premium amount)

  • Difference in strike price from the current price of the underlying interest (the smaller the difference, not "in the money", the higher the premium amount)

  • Recent rise or decline in price of the underlying interest (rises increase Call premium amounts and declines increase Put premium amounts)

  • Volatility of the underlying interest (the higher the volatility the higher the premium amount)
 
In The Money A strike price for an option contract which at the time the transaction occurs (option bought), the option is exerciseable. For Puts, a strike price above the current underlying interest's price. For Calls, a strike price below the current underlying interest's price.
 
Covered Calls An option where the seller of Call option contracts owns the underlying interests. If the contract is exercised then the seller gives up the underlying interest he/she already owns (limited risk since he/she does not have to purchase it at the market value to cover his/her obligation).
 
Naked Calls An option where the seller of Call option contracts does not own the underlying interests. If the contract is exercised then the seller must buy the underlying interest at the market price to cover his/her obligations and give them to the buyer (unlimited risk since he/she has to purchase it at the market value to cover his/her obligation - the purchase price could be significantly higher than the obligated strike price).
 
 
Basic Characteristics of the Option Contract
 
The option holder (buyer) is not obligated to exercise the option and will not normally do so unless it is to his/her advantage. If the option is not exercised by the option holder by the expiration date, the option privilege expires and the contract becomes void and expires. The person who sells the option (writer) must be prepared to honour the terms of the contract if the contract is exercised during the lifetime of the option.
 
 
Why Investors Buy and Sell Options
 
a) For Buyers of Calls
  • Leverage

  • Diversification

  • Buying calls and investing the difference in interest bearing instruments

  • To fix a future purchase price

 
b) For Buyers of Puts
  • Leverage

  • As insurance against a drop in the price of the underlying interest

  • In anticipation of a market decline

 
c) For Sellers of Calls
  • Additional income

  • Protection against price decline

  • Modest profit if option is exercised

 
d) For Sellers of Puts
  • Additional income

  • To acquire stocks at a fixed price
 
 
Illustration of Puts
 
The following graph illustrates the underlying principles behind Puts.
 
 
The red dots identify the 2 significant points in time for Put contracts: current time and stock price (when option transaction occurs), and future expiry date and strike price.
 
The green shaded area represents the timeframe and stock price range when the buyer of Put contracts can force the seller to buy his/her underlying interests (exercising the right when the underlying interest's price is in this area). Generally, the buyer does not exercise his/her right in the middle of the timeframe, but rather he/she generally waits until the last day of the timeframe (on the expiry date if at all).
 
The yellow shaded area represents the timeframe after the expiry date, when Put contracts have expired and have no value.
 
The orange arrows represent two of the factors which have an affect on increasing premium amounts for Puts (ie. more likelyhood that the Put will be exercised):
  • Lengthening the timeframe (providing more time for the underlying interest's price to reach the strike price)

  • Raising the strike price (reducing the distance the underlying interest's price has to travel to reach the strike price)
 
The purple/pink arrows represent two of the factors which have an affect on decreasing premium amounts for Puts (ie. less likelyhood that the Put will be exercised):
  • Reducing the timeframe (providing less time for the underlying interest's price to reach the strike price)

  • Lowering the strike price (increasing the distance the underlying interest's price has to travel to reach the strike price)
 
The brown arrow identifies a strike price which is above the underlying interest's price at the time the Put transaction occurred (option bought). In this case, the Put option's strike price is considered to be in the money, which is an extension to raising the strike price concept illustrated by the verticle orange arrow. The higher the strike price the higher the Put premium (ie. more likelyhood that the Put will be exercised).
 
 
Illustration of Calls
 
The following graph illustrates the underlying principles behind Calls.
 
 
The red dots identify the 2 significant points in time for Call contracts: current time and stock price (when option transaction occurs), and future expiry date and strike price.
 
The green shaded area represents the timeframe and stock price range when the buyer of Call contracts can force the seller to sell his/her underlying interests (exercising the right when the underlying interest's price is in this area). Generally, the buyer does not exercise his/her right in the middle of the timeframe, but rather he/she generally waits until the last day of the timeframe (on the expiry date if at all).
 
The yellow shaded area represents the timeframe after the expiry date, when Call contracts have expired and have no value.
 
The orange arrows represent two of the factors which have an affect on increasing premium amounts for Calls (ie. more likelyhood that the Call will be exercised):
  • Lengthening the timeframe (providing more time for the underlying interest's price to reach the strike price)

  • Lowering the strike price (increasing the distance the underlying interest's price has to travel to reach the strike price)
 
The purple/pink arrows represent two of the factors which have an affect on decreasing premium amounts for Calls (ie. less likelyhood that the Call will be exercised):
  • Reducing the timeframe (providing less time for the underlying interest's price to reach the strike price)

  • Raising the strike price (reducing the distance the underlying interest's price has to travel to reach the strike price)
 
The brown arrow identifies a strike price which is below the underlying interest's price at the time the Call transaction occurred (option bought). In this case, the Call option's strike price is considered to be in the money, which is an extension to lowering the strike price concept illustrated by the verticle orange arrow. The lower the strike price the higher the Call premium (ie. more likelyhood that the Call will be exercised).
 
 
Peaks and Valleys Stock Option Methodology
 
For an overview of the Peaks and Valleys Investment Methodology, encompassing how and when we leverage stock options, refer to Investment Methodology which holds our Situational Stock Transaction Chart.
 
 
Reference to Other Writings on Stock Options
 
For further information on the many aspects of stock options, please visit the Chicago Board Options Exchange (CBOE) - they know their options. The above write-up on stock options just scratches the surface, highlighting the primary aspects needed to understand the main concepts.




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