Bid and Ask Prices

Let’s take a brief detour here to learn more about what the bid and

ask represent since they can be confusing to new traders. Notice that

the $32.50 call shows a

bid price of $4.70 and an ask price of $4.90.

You have to remember that the options market, just like the stock

market, is a live auction. There are traders continuously placing bids to buy and

offers to sell. The bid price is the highest price that someone is willing to pay at

that moment. The asking price is the lowest price at which someone will sell at that

moment. If these terms are confusing, think of the terms you use when buying or

selling a home. If you wish to buy a home, you submit a bid. Buyers place bids.

If you were selling your home, you’d say I am “asking” such-and such a price for

it. Sellers create asking prices. Sometimes you will hear the word “offer” instead of

“ask” but they mean the same thing. If the bid represents the highest price someone

is willing to pay that means you can receive that price if you are selling your option.

You are selling to a buyer and the trade can get executed. Notice that you cannot

sell at the $4.90 asking price because that is a seller too and you cannot execute a

trade by matching a seller with a seller.

Likewise, if you are buying this option, you should refer to the asking price to

see how much it will cost you. Since the asking price shows the lowest price that

someone will sell, we know you can buy the option for that price. In this case,

you are buying from a seller and the trade can get executed. This is important to

remember since the price you pay or receive depends on the bid and ask. This trade

may appear to be a good deal if you can sell for $4.90 but you will be disappointed

if you find that you only receive $4.70. You need to be aware of which price applies

to your intended action.

In summary, if you are selling then you should reference the

bid price. If you are buying, you should look at the asking price.

This is especially

critical for options traders since the volume on options is not as high as it is for the

stock and, consequently, options will have larger spreads between the bid and ask.

For example, in the upper right corner of Table 1-1, you can see that the stock is

bidding $37.10 and asking $37.11, which represents a one-cent spread between

the buyers and sellers. However, the $32.50 call option is bidding $4.70 and asking

$4.90, which is a 20-cent spread. The bigger that spread, the more critical it is to

understand what these numbers mean, otherwise you could be in for an unpleasant

surprise when trading. We’ll learn more about the bid and ask in Chapter Four

when we examine the Limit Order Display Rule and how you can use it to your

advantage to lessen the effect of the spread.

The “bid” price represents the highest price that a BUYER is willing to

pay. It is consequently the price at which you can sell the option.

The “ask” price represents the lowest price that a SELLER is willing to

receive. It is consequently the price at which you can buy the option

Okay, let’s try the next call on the list in Table 1-1, which is the

05 Jul 35 call

(notice that the strikes are in $2.50 increments since eBay is below $50, which is

in agreement with what we stated earlier). If you buy this call option, you have the

right, not the obligation, to buy 100 shares of eBay for $35 per share through the

third Friday in July ‘05. Since eBay is trading for $37.11, we know that anybody

holding this option has an immediate advantage of $37.11 - $35 = $2.11 by buying

this call and we now know that this advantage must be reflected in the price. You

can verify that the asking price is $2.70, which shows the apparently free $2.11

benefit is not free. Again, the reason traders will pay more than the $2.11 benefit

is because there is time remaining on the option and it certainly could end up with

more value. If you want to buy this contract, it will cost you $2.70 * 100 shares =

$270 per contract + commissions. If you buy two contracts, you will control 200

shares and that will cost $540 and so on.

While we’re talking about the prices in Table 1-1, let’s explain what the rest of

the columns mean. The

LAST SALE column records the price of the last trade of

the option. Option traders rarely look at this, since that price could have occurred

during the last minute but it also could have been last week. We don’t know when

that trade took place. We just know that was the price when it last traded. For stock

traders, the last sale will generally be very close to the bid and ask of the stock,

because optionable stocks generally have high volume – but that is not necessarily

true for their options. In Table 1-1, you can see that the last trade on eBay was

$37.11 with the bid at $37.10 and the asking price at $37.11. The last sale for

the stock is very close to the current bid and ask, which will usually be the case.

But notice that the last trade for the $32.50 call was $4.40 with the bid and ask at

$4.70 to $4.90. This shows that the last trade is somewhat stale; that’s why option

traders generally do not look at the last trade. If you were buying this option, the

last sale would lead you to believe that it would cost $4.40 when it would really

cost $4.90. If you were selling the option, the last sale may make you decide against

it since it appears you would only receive $4.40 when, in actuality, you get $4.70.

The

NET column shows the difference, or the “net change,” between the last

trade and the last closing price just as it does for stocks. For the July $32.50 call, the

last trade was $4.40 and that price was down $1.20 from its previous price, which

means the previous trade was $4.40 + $1.20 = $5.60. If this option traded at $5.60

and the next trade was at $4.40 then that represents a $1.20 drop in price, which is

what the

NET column shows. Again, the reason for the apparent big drop in price

is because there was a big time delay between those two trades.

The

VOL column shows us the volume, which is simply the number of

contracts traded that day. For the stock market, volume refers to the number of

shares traded; for the options market, it refers to the number of contracts but the

idea is the same.

The

OPEN INT column shows how many contracts are currently in existence,

which is called the “open interest.” We’ll find out more about open interest in

Chapter Four.

A brief explanation, however, is worth mentioning here. When you buy or sell

a contract, you must specify whether you are entering or exiting the contract. If

you are entering into the contract (or increasing the size of an existing position)

then you are “opening” the contract. However, if you are exiting the contract (or

decreasing the size of an existing position) then you are “closing” the contract.

Most brokerage firms require that you specify whether you are opening or

closing the position. For instance, if you wish to buy 10 Microsoft July $30 calls

you would enter the order as “buy to open” 10 Microsoft July $30 calls. You would

not say “buy” 10 Microsoft July $30 calls. The reason is that the word “buy” alone

doesn’t tell the broker if you are buying the calls to own them (opening transaction)

or if you are buying the calls to close a short position (closing transaction). Using

the words “to open” or “to close” clarifies your intentions.

Some of the newer firms do not require the use of the words “opening” or

“closing.” Instead, they account for it based on the existing positions in your

account. For instance, if you have no Microsoft July $30 calls then the above order

is recognized as an opening transaction. On the other hand, if you were short 10

Microsoft July $30 calls then the order is recognized as a closing transaction.

Every time the buyer and seller are entering an “opening” order it adds to the

open interest. For instance, if you are buying 10 contracts to open and the seller is

selling 10 contracts to open, then open interest is increased by 10.

If the buyer and seller were, instead, both entering “closing” transactions, then

open interest would decrease by 10 contracts. Finally, if one is “opening” while the

other is “closing,” then that order has no effect on the open interest.

Open interest provides a measure of how many contracts are currently in

existence and therefore provides a measure of liquidity. That’s what the open

interest column shows.

Understanding a Real Call Option

Now that you know how call and put options work, let’s take a look at some

real call and put options. Let’s pull up some quotes and see if we can make some

sense of what we’re looking at.

You can obtain option quotes for any optionable stock by going to www.cboe.

com. That’s the homepage for the Chicago Board Options Exchange (CBOE),

which is one of the largest option exchanges in the world. Bear in mind that the

options market is open from 9:30am to 4:02pm ET (it is open until 4:15pm ET for

index options). If you are pulling up quotes after 4:02pm, you’re looking at closing

prices rather than live quotes. Also, options go through what is called an

opening

rotation

every morning. This is simply an open outcry system that establishes option

prices based on the current stock price openings. For this reason, you may not see

live option quotes until 9:35 or 9:40 even though the options market is technically

open at 9:30.

If you click on “Quotes” and then “Delayed Quotes” you will find a box where

you can type your stock ticker symbol. If you are looking for options on eBay,

for example, just type the ticker symbol “EBAY” and hit enter. At this time, the

shortest-term options on eBay were July ’05 (26 days until expiration) and the

longest term was January ’08 (943 days to expiration). The lowest strike is $22.50

and the highest is $80. So even though option contracts are standardized, there are

many to choose from. Table 1-1 shows some of the shorter-term options available

at the time of this writing:

Before we continue, we need to introduce some more terminology that has

been deliberately withheld until now for the fact that it will be easier to understand

at this point. There are three main classifications for options. First, there are two

types

of options: calls and puts. Second, all options of the same type and same

underlying represent a

class of options. Therefore, all eBay calls or all eBay puts

(regardless of expiration) make up a class. Third, all options of the same class, strike

price, and expiration date make up a

series. For instance, all July $32.50 calls form

a series

At the time these quotes were taken, eBay stock was trading for $37.11, which

you can see in the upper right corner of Table 1-1. The first column is labeled

“calls” and several columns to the right you will find one labeled “puts.” The first

call option on the list is

05 Jul 32.50. The “05 Jul” tells us that the contract expires

in July ‘05 and the “32.50” designates that it is a $32.50 strike price. The last

trading day for this option will be the third Friday in July ‘05. All you have to do

is look at a calendar and count the third Friday for July ‘05 and that is the last day

you can trade the option (which happens to be July 15 for this particular year).

Remember, you can buy, sell, or exercise this option on

any day, but the last day to

do so is July 15. All 05 July options will expire on the same date regardless of the

strike price or whether they are calls or puts.

The “

XBAGZ-E” notation is the symbol for that option. Just as every stock

has a unique trading symbol, each option carries a unique symbol. However, you

can forget about the “dash E,” as the letter E is a unique identifier for the CBOE,

which just tells us these quotes are coming from that exchange. If you wanted to

buy or sell this option online, you’d enter the symbol “XBAGZ.” Your broker,

however, may require you to follow this symbol with “.O” to show that it is an

option (for example, XBAGZ.O). Your broker will make it very clear if he has these

requirements, but the actual symbol (XBAGZ in this example) will always remain

the same regardless of which brokerage firm you use.

Your brokerage firm may list option symbols as “OPRA” codes. The committee

named for consolidating all of the option quotes and reporting them to the

various services is called the Options Price Reporting Authority or “OPRA.”

An OPRA code is the same thing as the option symbol. You can read more

about OPRA at www.OpraData.com.

The $32.50 strike means that the owner of this “coupon” has the right, not

the obligation, to buy 100 shares of eBay for $32.50 through the third Friday of

Jul ‘05. No matter how high a price eBay may be trading, the owner of this call

option is locked into a $32.50 purchase price. Now this seems like a pretty good

deal since the stock is trading much higher at $37.11. It appears that if you got the

$32.50 call, you could make an immediate profit of $37.11 - $32.50 = $4.31. In

other words, it appears that if we could get our hands on this coupon, we could

buy the stock for $32.50 and immediately sell it for the going price of $37.11

thus making an immediate profit of $4.31. However, you must remember that call

options, unlike pizza coupons, are not free. It will cost us some money to get our

hands on it.

How much will it cost to buy this coupon? We can find out by looking at the

“ask” column, which shows how much you will have to pay to buy the option. It

shows a price of $4.90 to buy this call. This means the apparently free $4.31 is no

longer free since you’re paying $4.90 for $4.31 worth of immediate benefit. In fact,

you will find that you must always pay for any immediate advantage that any call

or put option gives you. The main point is that you cannot use options to collect

“free money” in the market. When traders are first introduced to options, they

often think they can buy a call option that gives them an advantageous price and

then immediately exercise the call for a free profit. They overlook the fact that the

price of the option will more than reflect that benefit. Why would someone pay

$4.90 for $4.31 worth of immediate benefit? Because there is time remaining on

the option. It is certainly possible that the option will, at some point in time, have

more than $4.31 worth of benefit, and traders are willing to pay for that time.

The $4.90 price is also called the

premium. The premium really represents the

price per share. Since each contract controls 100 shares of stock, the total cost of

this option will be $4.90 * 100 = $490 plus commission to buy one contract. So if

you spend $490, you can control 100 shares of eBay through the expiration date

of the contract. That’s certainly a lot less than the $3,711 it would cost to buy 100

shares of stock. If you buy two contracts, you will control 200 shares and that will

cost $980 plus commissions, etc. Remember, we said that all options control 100

shares when they are first listed but it is possible for them to control more shares,

which is usually due to a stock split. If that happens, it is possible for the contract

size to change, which we will expand on more in Chapter Four. The main point

to understand is that you always multiply the option premium by the number of

shares that the contract controls in order to find the total price of the option. In

most cases, you will multiply by 100

Options Are Standardized Contracts

The reason that options are inflexible as to the number of shares is because

options are standardized contracts. A standardized contract means there is a uniform

process that determines the terms, which are designed to meet the needs of most

traders and investors. By using standardized contracts, we lose some flexibility in

terms (such as the number of shares, strike prices, and expiration dates) but increase

the ease, speed, and security in which we can create the contracts.

In fact, if the exchanges find there is not sufficient demand for options on a

stock, they will not even list those options. Most of the well-known companies

have options available. If a stock has listed options, it is an

optionable stock.

Microsoft and Intel, for example, are optionable. There are currently more than

2,300 optionable stocks, so the list is quite large.

Another limitation of standardized contracts is the fixed strike price

increments. If the stock price is below $50, you will find options available in

$2.50 increments. If the stock price is between $50 and $200, options will be in

$5 increments. And if the stock price is over $200, you will find option strikes in

$10 increments. Notice that the strike price increments have nothing to do with

the current price of the stock. The increments are based on the stock’s price at the

time the options start trading. If a stock’s price has been greatly fluctuating, you

might find different increments for different months. For instance, you may find

$2.50 increments for the first two expiration months and $5 increments in later

expiration months. This just tells you that the stock’s price was above $25 when

the later months started trading.

By having standardized strikes, we can quickly bring new contracts to market

that meet the needs of the vast majority of people. Imagine how overwhelming

the task would be if the exchanges tried to meet everybody’s needs by creating

strike prices at every possible price such as $30, $30.01, $30.02, etc. and then

matched those with every possible expiration date such as June 1, June 2, June 3,

etc. It would be a near impossibility. To solve these problems, the exchanges created

standardized contracts so that we can have some flexibility while still keeping the

list manageable.

What if you really want a customized contract? Is it possible to get one?

Technically, there is nothing illegal about two people having a contract drawn up

by an attorney that specifies the terms on which they agree to buy and sell stock.

You could therefore have an attorney write a contract for you and another trader,

thus creating your own call or put option. A contract drawn in this manner is

completely flexible -- but it is also very time consuming and costly. In addition,

even though you may have a legally binding contract, it is possible that the seller

decides to not fulfill his obligation if the buyer wishes to exercise his option. If

that happens, now you’ve got your hands tied up in court trying to get the seller

to conform to the terms of the contract. In other words, customized contracts are

subject to

performance risk. That is, will the seller perform his part of the agreement

if the buyer decides to exercise?

Standardized options solve the performance risk problem too since the OCC

acts as the buyer to every seller and the seller to every buyer. If you exercise an

option, the OCC uses a random process to decide who will be assigned. When you

enter an options contract, you do not know who is on the other side of the trade.

Nobody knows. It is strictly the person who ends up with the random assignment.

Standardization increases confidence and influences the progress toward a smoothly

running, liquid market.

Besides having an attorney draw up a contract, there is another way to get

flexible contracts. You can buy FLEX contracts through the Chicago Board Options

Exchange

(CBOE) that are totally customizable, but they also require an extremely

large contract size – usually more than one million dollars. Because FLEX options

are traded through the OCC they are not exposed to performance risk despite their

large contract sizes. Because of the size requirements though, FLEX options are

mostly used by institutions such as banks, mutual funds, and pension funds. The

standardized market is the solution for the rest of us.

Option Basics

You now have enough information to understand some hypothetical call and

put options. These two assets – calls and puts – are the building blocks for every

option strategy you will ever encounter. This is why it is crucial that you understand

the rights and obligations that they convey. Most confusion with option strategies

stem from not understanding (or simply forgetting) who has the right and who has

the obligation.

Because options are binding contracts, they are traded in units called

contracts.

Stocks are traded in shares; options are traded in contracts. An option contract, just

like a pizza coupon, will always be designated by the underlying stock it controls

along with the expiration month and strike price. For example, let’s assume we are

looking at a Microsoft June $30 call.

We’ll soon show you where you can look up actual option quotes and symbols for

options, but for now let’s make sure you understand what this option represents.

Using your understanding of pizza coupons, what do you suppose the buyer of

one contract is allowed to do? The buyer of this call has the right (not the obligation)

to purchase 100 shares of the underlying stock – Microsoft – for $30 per share at

any time through the third Friday in June. (Remember that the expiration date

for stock options is always the third Friday of the expiration month.) The buyer of

this coupon is “locked in” to the $30 price no matter how high Microsoft shares

may be trading. Obviously, the higher Microsoft trades, the more valuable the call

option becomes.

To understand this concept a little better, assume that you have found a piece

of property valued at $300,000 and wish to buy it. But you’d first like spend a few

days researching the area before buying it. If you do, you’ll run the risk of losing

it to another investor. What can you do? You can go to the broker and put down

some money to hold the property for you. For instance, you may pay $500 for

several days worth of time. If you decide against the property, you lose the $500.

These arrangements are done all the time in real estate and are called “options” on

real estate. Assume that you pay the $500 for five days worth of time and are now

locked into a binding agreement to buy the property for $300,000 over the next

five days. Now suppose that some news is spreading that the area is about to be

commercially zoned and some big businesses are interested in it. Property in the

area goes up dramatically overnight. But even if you decide to not buy the property,

don’t you think that somebody else would love to be in possession of the contract

that you have giving them the right to pay $300,000? Of course they would. And

these people will start offering you large amounts of money to persuade you to sign

over the contract to them. You could just sell it to them and they could sell it to

others. This is exactly what most traders do with the equity options market.

Now let’s go back to our option example. How much will it cost you to

use (exercise) your call option? Because you are buying 100 shares of stock, the

strike price must be multiplied by 100 as well. (The number “100” is called the

“multiplier” of the option for this reason.) If you were to exercise this Microsoft

$30 call option, you would pay the $30 strike * 100 shares = $3,000 cash. This is

called the

total contract value or the exercise value. In exchange for that payment,

you’d receive 100 shares of Microsoft. It works just like a pizza coupon. You pay

a fixed amount of cash and receive some type of underlying asset. Most brokers

charge a standard stock commission to exercise your options. If you exercised this

call, your broker would probably charge you his regular commission for buying

100 shares of stock. After all, the long call option is simply a means for buying

regular shares of stock.

To restate a previous point, it is important to understand that if you buy call

or put options, you are not required to ever buy or sell shares of stock. Further,

you do not ever need the shares of stock in your account at any time. Most option

contracts are opened and closed in the open market without a single share of stock

changing hands. Even though you're allowed to purchase or sell stock with your

options, most traders never do. Instead, they just buy and sell the contracts in the

open market amongst other traders.

Now let’s assume we are looking at a Microsoft June $30 put option. Think

about your auto insurance policy and try to figure out what this option allows

you to do. If you buy this put option, you have the right to sell 100 shares of

Microsoft for $30 per share at any time through the third Friday in June. Because

you are locking in a selling price, put options become more valuable as the stock

price falls. If you exercise this put option, you are selling 100 shares of Microsoft,

which means you will have 100 shares of Microsoft taken from your account and

delivered to someone else. In exchange, you will receive the $30 strike * 100 shares

= $3,000 cash. If you exercise this put, your broker will probably charge the regular

stock commission for selling 100 shares of stock since the put option is simply a

means for selling regular shares of stock.

What if you only wish to buy or sell fewer than 100 shares of stock? You can

do that but in a roundabout way. Using the call example above, let’s say you only

wanted to buy 60 shares of Microsoft for $30. You would still exercise the call

option for 100 shares and then immediately submit an order to sell 40 shares

(which would carry a separate commission). Each contract is good for 100 shares

and you must buy and sell in that amount. But there’s nothing stopping you from

immediately entering another order to customize those amounts to suit your needs.

Likewise, if you exercised a put option but only wanted to sell 60 shares of stock,

you would have to exercise the put and sell 100 shares and then immediately place

an order to buy 40 shares.

Physical Versus Cash Delivery

If you exercise an equity option, you will either buy or sell the actual (physical)

shares of the underlying stock. This is called

physical delivery or physical settlement.

On the other hand, most index options, such as SPX (S&P 500), are

cash

settlement

rather than physical delivery. In other words, if the long position

exercises an index option, he receives the cash value of the option rather than

taking actual delivery of all the stocks in that index. Just realize that not all options

settle in physical delivery. As you continue to learn more about options you will

hear the terms “physical settlement” and “cash settlement,” and it’s important you

understand what these terms mean.

Exercise Versus Assign

We said earlier that it is the long positions who get to exercise their options.

What do short positions get to do? Nothing. Remember, short positions have no

rights. The short position may get a phone call from his broker stating that he has

just purchased or sold shares of stock due to a call option he sold. If you are required

to buy or sell shares of stock due to a short option, it is called an

assignment.

If you get assigned on an option, your broker will notify you the next business

day to inform you of the assignment. He may say something like, “I’m calling to

inform you that you’ve been assigned on your short call options and have sold 100

shares for the strike price of $50.”

The words exercise and assign should only be associated with long and short

positions respectively. However, in the real world, if you are assigned on a short

option, brokers may say things like “you got exercised” on an option even though

it is technically incorrect. Long positions exercise. Short positions get assigned. In

truth, it doesn’t really matter in practice if an incorrect phrase is used such as “you

got exercised” rather than “you got assigned” as long as you understand the message.

However, if these terms are used, you do need to understand the difference. Most

books and literature on options carefully choose between the words “exercise” and

“assign” and you need to understand the actions they are referring to.

Let’s work through some examples to be sure you understand. If you are long a

call option, you have the right to exercise it and buy shares of stock. If you are short

the call, you might get assigned and be required to sell shares. If you are long a put

option, you have the right to exercise it and sell shares. If you are short the put

option, you could get assigned and be required to buy shares. To continue further,

if a long call holder uses his call to buy shares of stock he would say, “I exercised my

call.” The short call holder would say, “I got assigned on my call.”

It is important to understand that once you submit exercise instructions to your

broker and the shares and cash have exchanged hands it is an

irrevocable transaction.

Make sure you want to exercise before submitting instructions. Also, many firms

have cutoff times after which exercise instructions cannot be changed (even though

the shares or cash may not have yet been exchanged). Check with your broker as to

what these cutoff times are before you submit exercise instructions.

American Versus European Styles

As stated before, most option contracts are simply

bought and sold in the open market without a single

share of stock ever changing hands. However, if you wish

to physically trade shares of stock, you must exercise your

option. When can you exercise your option? The answer

to that depends on the

style of option. There are two styles

of options:

American and European. The style of option has nothing to do with

its origin as implied by the names “American” and “European.” Instead, the style

simply tells us when the option may be exercised. American-style options can be

exercised at any time through the third Friday of the expiration month. European

style options, on the other hand, can

only be exercised on the third Friday of the

expiration month. You generally do not get to select which style of option you

want. All equity options (that is, options on stock) are American style and can

be exercised at any time. Most index options are European style. There are a few

indices that offer both such as the OEX (S&P 100 Index), which is American style

and the XEO (letters reversed), which is the European version of the same index.

It may sound like the American-style option has a big advantage over a

European style. After all, for example, if a stock is really flying high it would be

nice to exercise a call option and buy the shares at a cheaper price and immediately

sell the shares to capture a profit. We’re going to find out in Chapter Four that

exercising a call option early for this reason is a big mistake. You will find out that

most of the time you are better off just selling the call option in the open market

rather than exercising it.

This book is written from the perspective of equity options, so we will assume

that all options discussed are American style unless otherwise stated. We only

differentiate the terms “American” and “European” so you will know what it they

mean if you hear them later while continuing to learn about options. The bottom

line is that all equity options are American style, which means the long position

can exercise them at any time during the life of the option even though it is rarely

optimal to do so.

The last day to buy, sell, or exercise your options is the third Friday of the

expiration month.

Expiration Date

Notice that the pizza coupon also has an

expiration

date

. You can use this coupon at any time up to and

including the expiration date. Equity options (options on

stock) always expire on the third Friday of the expiration

month. Technically speaking, equity options expire on

Saturday following the third Friday but that is really for

clearing purposes. That extra day (Saturday) gives the

OCC (Options Clearing Corporation) time to match buyers and sellers while the

contract is still legally “alive.” From a practical standpoint though, the last day to

close or to exercise your option is the third Friday of the expiration month. After

that, it’s no longer valid. So just because you may read that options expire on

Saturday, don’t think you can get up Saturday morning and call your broker with

exercise instructions – it’s too late. The third Friday of the expiration month is your

last

day (not the only day) to close or exercise the option. (If Friday is a holiday, the

last trading day will usually be the preceding Thursday.)

Although a pizza storeowner may allow you to turn in an expired coupon,

there’s no such thing with the options market. The second that option expires, it’s

gone for good. There are some index options, such as options covering the S&P

500 Index that expire on the third Thursday of the expiration month. However,

we will only be discussing equity options in this book, so whenever we talk about

the expiration date, we will always be referring to the third Friday of the expiration

month unless otherwise stated.

Strike Price (Exercise Price)

In our example, the pizza coupon states a specific purchase price of $10.00. No

matter what the price of pizzas may be when you get to the store, you are locked in

to the price of $10.00. If this were an option, we’d call this “lock in” price the

strike

price

, which is really a slang term that comes from the fact that we have “struck” a

deal at that price.

Another name for the strike price is the

exercise price. The reason for this is

that if you choose to use your option, you must submit

exercise instructions to your

broker, which is handled with a simple phone call. With a pizza coupon you just

“hand in” the coupon, but in the world of options you must “exercise” the option

through your broker.

If you exercise a call option, you must pay the strike price (since you’re buying

stock) and that’s why the strike price is also called the exercise price. It’s the price

you will pay for exercising the option to purchase shares of stock. If you are short

a call option, you’ll receive the strike price (because you’re selling stock). The

exercise price is the price that will be paid by the long position and received by

the short position.

The opposite is true for put options. If you exercise a put, you’ll receive the

strike price since you are selling shares of stock. The short put will pay the strike

price since he is the required to buy the stock. The exercise price is the price that

will be received by the long put and paid by the short put.

We’ll talk more about exercising options later but, for now, just understand

that the strike price and exercise price are two terms meaning the same thing. They

both represent the fixed purchase or selling price.

The Options Clearing Corporation (OCC)

Okay, this may sound good in theory but how do you know that the short

positions will actually follow through with their obligations if you decide to use

your call or put option?

The answer is that there is a clearing firm called the

Options Clearing Corporation,

or OCC. The OCC is a highly capitalized and regulated agency that acts as a

middleman to all transactions. When you buy an option, you are really buying

it from the OCC. And when you sell an option, you are really selling it to the

OCC. The OCC acts as the buyer to every seller and the seller to every buyer. It

is the OCC that guarantees the performance of all contracts. By performance we

obviously do not mean profits but rather that if you decide to use your option,

you are assured the transaction will go through. In fact, ever since the inception

of the options market and the OCC in 1973, not a single case of unfair or partial

performance has ever occurred. If you’d like to read more about the OCC, you can

find their website at www.OptionsClearing.com.

Before reading further, make sure you understand the following key concepts:

Key Concepts

1) Long call options give the buyer the right to BUY stock at a fixed price over a

given time period.

2) Short call options create the obligation to SELL stock at a fixed price over a

given time period.

3) Long put options give the buyer the right to SELL stock at a fixed price over a

given time period.

4) Short put options create the obligation to BUY stock at a fixed price over a

given time period.

5) Option sellers (calls or puts) keep the cash regardless of what happens in the

future.

6) The OCC acts as a middleman to all transactions.

More Option Terminology

We’re almost ready to talk about real call and put options but we first must

go over some other market terminology that you’ll need to understand. We just

covered the terms “long” and “short,” which are critical for understanding who has

the right and who has the obligation with any particular strategy. But we have a lot

more ground to cover before learning about strategies. Next, we must venture into

the remaining terms we will be using throughout the book.

Underlying Asset

In the pizza coupon example, we would say the

underlying asset is a pizza.

Notice that the coupon limited us to how many pizzas we can purchase; we cannot

purchase all we want. In addition, the coupon is not good for any brand of pizza

but only the one advertised on the coupon. Call and put options work in similar

ways. The underlying asset for a call or put option is generally 100 shares of stock.

There are exceptions (which we’ll explore later in Chapter Four) to this rule such

as certain stock splits or mergers. But when options are first issued, they always

represent 100 shares of the underlying stock.

The “brand” of shares we can buy is determined by the call or put option. For

example, if we have a Microsoft call option, we have the right to buy 100 shares

of Microsoft. In this case, Microsoft would be the

underlying stock. The price of an

option is tied to or

derived by the underlying stock. Because of this, options are

one of many types of

derivative instruments. A derivative instrument is one whose

value is derived by the value of another asset.

The Long and Short of It

The financial markets are filled with colorful terminology.

And one of the biggest obstacles that new option investors face is

interpreting the jargon. Two common terms used by brokers and

traders are “long” and “short,” and it’s important to understand

these terms as applied to options.

If you buy any financial asset, you are “long” the position. For

example, if you buy 100 shares of IBM, using market terminology, you are long

100 shares of IBM. The term “long” just means you own it. Likewise, if you buy a

call option, you are “long” the call option.

If “long” means you bought it then “short” means you sold it, right? Not quite.

Some people will tell you that “short” just means you sold an asset, but that is an

incomplete definition. For example, if you are long 100 shares of IBM and then

sell 100 shares you are not short shares of IBM even though you sold 100 shares.

That’s because you bought the shares first and then sold them, which means you

have no shares left.

However, let’s say you bought 100 shares of IBM and then, by accident, entered

an order online to sell 150 shares of IBM. The computer will execute the order

since it has no way of knowing how many shares you actually own. (Maybe you

have shares in a safe deposit box or with another broker.) But if you really owned

only 100 shares then you would be “short” 50 shares of IBM. In other words, you

sold 50 shares you don’t own. And that’s exactly what it means to be short shares of

stock. It means you sold shares you do not own. However, when we short shares in

the financial market, it’s not meant to be by mistake – it is done intentionally. How

can you intentionally sell shares you don’t own? You must borrow them. In order

to further understand what it means to be “short” and how that applies to options,

let’s take a quick detour to understand the basics of short selling.

Traders use short sales as a way to profit from falling stock prices. Assume IBM

is trading for $70 and you think its price is going to fall. If you are correct, you

could profit from this outlook by entering an order to “short” or “sell short” shares

of IBM. Let’s assume you decide to short 100 shares. Your broker will find 100

shares from another client and let you borrow these shares. Although this sounds

like a lengthy, complicated transaction it takes only seconds to execute.

In terms of the mechanics, shorting shares is similar to making a purchase on

your credit card. Your bank finds loanable funds from somebody else’s account

to let you borrow and you then have an obligation to return those funds at some

time. How complicated is it to short shares of stock? About as complicated as it is

to swipe a credit card at a cash register.

Let’s assume you short 100 shares of IBM at $70. Once the order is executed,

you have $7,000 cash sitting in your account (sold 100 shares at $70 per share)

and your account shows that you are short 100 shares of IBM – you sold shares

that you do not own. Do you get to just take the $7,000 cash, close the account

and walk away? No, once you short the shares of stock, you incur an obligation to

replace those 100 shares at some time in the future. In other words, you must buy

100 shares at some time and return them to the broker. Obviously, your goal is to

purchase those 100 shares at a cheaper price.

Let’s assume that the price of IBM later drops by $5 to $65 and you decide to

buy back the shares. You could enter an order to buy 100 shares and spend $6,500

of the $7,000 cash you initially received from selling shares. Once you buy the 100

shares, your obligation to return the IBM shares is then satisfied and you are left

with an extra $500 in your account. In other words, you profited from a falling

stock price. This profit can also be found by multiplying the number of short

shares by the drop in price, or 100 shares * $5 fall in price = $500 profit. If you

have shorted 300 shares of IBM, you would have ended up with a 300 shares * $5

fall in price = $1,500 profit. Of course, if the price of IBM had risen at the time

you purchased them back, then you’d be left with a loss since you must spend more

than you received to return the shares. If short selling still sounds confusing, just

realize that the short seller generates profits in the same way as a stock buyer but by

entering transactions in the opposite order. For instance, when you buy stock, you

want to buy low and sell high. When you short stock, you want to sell high and

buy low. If you short a stock and then buy it back at a higher price, you’re left with

a loss because you really bought high and sold low.

Short selling works because traders are obligated to return a fixed number of

shares and not a fixed dollar amount. In our example, you shorted 100 shares with

a value of $7,000. Your obligation is to return 100 shares of IBM and not $7,000

worth of IBM. If you can purchase the shares for less money than you received,

you will make a profit.

This is not meant to be a course in shorting stocks but rather a way to understand

what the term “short” really means when applied to the stock or options market.

Shorting means you receive cash from selling an asset you don’t own and then incur some

type of obligation.

In the case of shorting stocks, your obligation is that you must

buy back the shares at some time.

If you short an option, you have sold something you don’t own. You get

cash up front and then incur some type of obligation depending on whether

you sold a call or put. If you short a call, you get cash up front and have the

obligation to sell shares of stock. If you short a put, you get cash up front and

have the obligation to buy shares of stock. The cash is credited to your account

immediately and is yours to keep regardless of what happens to the option. That

is your compensation for accepting an obligation, much like the premiums you

pay to an insurance company.

When you sell (short) an option you will receive cash, which is yours to keep

regardless of what happens in the future.

The following table may help you to visualize the rights-versus-obligations

relationships:

LONG SHORT

Call

Right to buy stock Obligation to sell stock

Put

Right to sell stock Obligation to buy stock

Notice that the long and short positions are taking opposite sides of the

transaction. For instance, the long call (call buyer) must be matched with a short

call (call seller). The long call has a

right while the short call has an obligation.

Rights and obligations are opposites. In addition, the long call gets to

buy while the

short call is required to

sell. Buying and selling are also opposites.

For put options, the long put (put buyer) must be matched with a short put

(put seller). As with call options, it is the long position that has the

right while the

short position has the

obligation (opposites). The long put, however, has the right

to sell while the short put is required to buy (opposites).

This arrangement is required to make the options market work. Both parties

(the buyer and seller) cannot have rights. They can neither both buy nor both sell.

One side has the right to buy (or the right to sell), while the opposite side has the

obligation to complete the transaction.

This arrangement is often a source of confusion for new traders. They wonder

how the option market can work if everybody has a right to buy or sell. The answer

is that it is only the

long position that has the rights. The short position has an

obligation. It is important to understand this relationship when going through this

book, especially when you get to strategies.

Long options have rights. Short options have obligations.

Getting Out of a Contract

We just learned that you can get into an option contract by either

buying or selling a call or put. But once you’re in the contract, is there a

way to get out of it at a later time? The answer is yes. All you have to do

is enter a

closing transaction (also called a reversing trade). In other words, you can

always “escape” your obligations by simply doing the reverse set of actions that got

you into the contract in the first place.

For example, if you are short an option and decide at a later time you don’t want

the corresponding obligation, you can get out of it by simply

buying the options

back. This is much like you do with shares of stock if you are short. However, just

because you can get out of the contract doesn’t mean that you can avoid any losses

that may have accrued. The price you pay to get out of the contract may be higher

and, in some cases, much higher than the price you originally received from selling

it – just as when shorting shares of stock. But the point is that you can get out of a

short option contract by simply buying it back.

If the idea of buying back a contract sounds confusing, think of the following

analogy. You probably have a cell phone are locked into some type of agreement such

as a one-year

contract. Cell companies do this to prevent people from continually

shopping around and jumping to the hot promotion of the month. However, your

cell provider will also have some type of “buy back” clause in the contract. That is,

if you wish to get out of the agreement, you must pay a fixed amount of money,

perhaps $200, and you can escape your remaining obligations. If you pay this fee,

the company cannot take you to court later and say that you didn’t fulfill your

obligations. The reason is that you bought the contract back – it no longer exists

between you and the company. That’s the fee they specified to end all obligations.

This is mathematically the same thing that happens when you buy back a

contract in the options market. Although it is not a fee to end the contract, what

you’re really doing is going long and short the same contract, thereby eliminating

all profits or losses beyond that point. If you’re long the contract and you’re short

the same contract, then you’ve effectively ended all obligations.

Likewise, you can get out of long call option by simply doing the reverse;

that is, selling the same contract that you own. Because of this possibility, most

option traders simply trade the contracts back and forth in the open market rather

than using them to buy or sell shares of stock. As we will later see, trading option

contracts is a big advantage because they cost a fraction of the stock price.

You can always get out of an option contract at any time by simply entering

a reversing trade.

Let’s make sure you understand the concepts of long and short calls and puts

by using our pizza coupon and car insurance analogies. If you are in possession of

a pizza coupon, you are “long” the coupon and have the right, not the obligation,

to buy one pizza for a fixed price over a given time period. In the real world, you

do not buy pizza coupons; they are handed out for free. But that doesn’t put an

end to our analogy because the basic idea is still there. Since you are holding the

coupon, that means you posess the right to use it, and that’s the role of the long

position. The pizza storeowner would be “short” the coupon and has an

obligation

to sell you the pizza if you choose to use your coupon. You have the right; he has

the obligation.

If you buy an auto insurance policy you are “long” the policy and have the

right to “put” your car back to the insurance company. The insurance company

is “short” the policy; it receives money in exchange for the potential obligation of

having to buy your car from you. Whether you make a claim or not, the insurance

company keeps your premium just as you will when selling options. That’s its

compensation for accepting the risk.

In the real world of car insurance, you cannot just force the insurance company

to buy the car back for any reason. There are certain conditions that must be

met; for example, the car must be damaged or stolen. You can’t just obligate the

insurance company because you don’t like it anymore or because it has depreciated.

However, in the real world of put options, you can sell your stock at a fixed price

for

any reason while your put option is still in effect. There are no restrictions. Of

course, you wouldn’t want to do that if the fixed price you’d receive is less than the

current market price. The main point is that if you are long a put option, you call

the shots. You have the rights. You have the “option” to decide. You have the right

to sell your stock for that fixed price at any time during the time your “policy” is

in effect.