Stock Options

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
terms of the contract were customized or 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, which greatly increased the market
and liquidity of options. Options trading began on April 26, 1973, with 1.1 million
contracts traded that year. Trading volumes have increased substantially since then:

• 1981: 100 million

 • 2004: 1 billion
• 2006: 2 billion

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.

Example—The Profit Advantage of Options, and the Risk

On October 6, 2006, an April 2007 call to buy Microsoft stock 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 Microsoft stock would
cost $8.00. To buy 100 shares of Microsoft stock 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 Microsoft stock for $30, which could then be sold
for $40 in the market. 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.

The Option Contract

Option Contract

• Underlying Security
• Call or Put
• American or European Style
• Strike Price
• Expiration Date
• Number of Shares
(or other Multiplier
—usually 100)

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 number of
shares of the underlying security for each contract, which is almost always 100 shares for
equity options, the strike price, and the expiration date.

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 options allow the holder to exercise the option at any time before

expiration, whereas European options allow the holder to exercise only for a short
time before the expiration date. 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. 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.

January February March • Options expire the Saturday following the 3rd Friday of the month.

Sequential Sequential Sequential However, they must be exercised by Friday.

• The 2 near-term options are the nearest 2 months. The sequential
Cycle Cycle Cycle
cycle calendar determines the expiration month for the 2 long-term options.
January February March The longest term option is no more than 9 months.

April May June • LEAPS, if available, expire in the 2 January's following the long-term
options.
July August September

October November December

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 6¼% to 5¾% 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, style, 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, and that also has 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 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 they would trade around $25 per
share, because 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, or 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, merges, is dissolved, or is 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 x Price = New Number of Shares x 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 x 50 = 200 x 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, we find that each share price is now 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 New Share Number = 100 x 50/20 = 250. To verify: 100 x 50 = 250 x 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 of these can be found at the Options
Clearing Corporation. The search engine provided allows searches for year, month,
keywords, or memo number.

Options Trading

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, the transaction costs of these options are greater and the
liquidity is less.

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: American Stock Exchange

LLC, (AMEX), the Pacific Exchange, Inc. (PCX), and the Philadelphia Stock

Exchange, Inc. (PHLX).

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 any

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 with a base plus per contract.

Real World Example—Commission Schedules for Buying and Selling Options

Note that this is NOT a comparison of the different companies, but is simply a sample of how option
trading is priced, and its actual cost. As of 10/20/2006:

TD Ameritrade: $9.99 + $0.75 per contract for Internet options trades.

Schwab: Same price; phone trades are $5 more, and broker-assisted trades are $25 more.

OptionsXpress: $1.50 per contract with a minimum standard rate of $14.95. Also has numerous
discounts for active traders.

E*trade: Sliding commission scale which ranges from $6.99 + $0.75 per contract for traders making at
least 1500 trades per quarter to $12.99 + $1.25 per contract for investors with less than $50,000 in
assets, and making fewer than 30 trades per quarter. Charges $19.99 for exercise and assignments.

The price of the option is known as the premium. 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 the 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

Intrinsic Value of Call = Current Price of Security – Strike Price of Call,

if the Difference > 0; 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.

Intrinsic Value of Put = Strike Price of Put – Current Price of Security,

if the Difference > 0; 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 current price of Microsoft stock 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.

Calls

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

Microsoft stock 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

“writes” 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 to be 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 stocks must first borrow the stock to sell it. The short seller of stocks must eventually
buy back the stock to close his 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

Sell 10 call contracts for $3.20 per share.
at $0.35 per share.

$350.00 Total cost for 10 calls $3,200.00 With MSFT trading at $33, the call has risen to
with 100 shares per contract: $3.20. Intrinsic Value = $3 per share;
$0.35 x 10 x 100 = $350 time value = $0.20 per share. Multiply call price
 times the number of shares per contract times the
number of contracts. $3.20 x 10 x 100 = $3,200

+ $9.95 Commission per trade. - $9.95 Subtract commission per trade.

Commission per contract =

+ $7.50 - $7.50 Subtract commission per contract.
$0.75 x 10

Total cost = Premium + Subtract your original premium cost + buying

= $367.45 - $367.45
Commissions. 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.

The 2 graphs below show the profit-loss scenarios for call holders and call writers when the call is

exercised. Note how the profit of the call holder is the loss of the call writer, and vice versa. The

call holder has a long position, while the call writer has a short position. It is said to be a short

position, because the call writer has to buy back the call to close out his position, whereas the

long call holder sells his call to close out his position.
Puts

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 Microsoft stock 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 Exercise 10 put contracts to sell

at $2.20 per share. Microsoft for $30 per share.

With MSFT trading at $25, exercising the put will

Total cost for 10 puts
$2,200.00 with 100 shares per contract:
$2.20 x 10 x 100 = $2,200
net you $5 per share. You buy 1,000 shares of
$5,000.00
Microsoft for $25,000 and sell it to a put writer for
$30,000. $30,000 - $25,000 = $5,000

Subtract commission to buy 1,000 shares of

+ $9.95 Commission per trade. - $12.95
Microsoft.

Commission per contract =

+ $7.50 - $19.95 Subtract exercise commission.
$0.75 x 10

= Total cost = Premium + Subtract your original premium cost + buying

- $2,217.45
$2,217.45 Commissions. 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
Microsoft stock was just $3 higher, then this investment would have netted a loss.

The 2 graphs below show the profit-loss scenarios for put holders and put writers when the put is

exercised. Note how the profit of the put holder is the loss of the put writer, and vice versa. A put

holder has a long position, while the put writer has a short position. It is said to be a short

position, because the put writer has to buy back the put to close out his position, whereas the

long put holder sells his put to close out his position.
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 to be wasting assets.

 For any given time until expiration, the time value is

greatest when the option is at the money, and diminishes as

it moves farther either out of the money or in the money.

Example—the Relationship of Premiums to Time Remaining until Expiration

The following list of expiration dates and the corresponding option premiums per share are for Microsoft

calls with a strike price of $30, and with the stock price at $27.87 on October 6, 2006.

• October, 2006: $0.05

• January, 2007: $0.35
• January, 2008: $1.95
• January, 2009: $3.30

Because the price of Microsoft is far more likely to rise above $30 by January, 2009 than it is by the 3rd
Friday of October, 2006, the call premium per share is much higher, but it is still much less than buying
the stock itself.

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,

Put Premiums
Call Premiums

Historically, higher interest rates generally result in higher call premiums and lower

put premiums, and interest rates are a factor in option pricing models. Rho is the
amount of change in premiums due to a 1% change in the prevailing risk-free interest
rate. Thus, a rho of 0.05 means that 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.

Reading Option Tables

The options prices for Microsoft on 10/6/2006 (10/6/2006 Stock Price: 27.87, Source:
MarketWatch.com) is shown below.

Microsoft Option Prices for 10/6/2006, Stock Price: $27.87, Source: MarketWatch.com

October, 2006 Options

CALLS Strik PUTS

Chang e Symbo
Symbol Last Vol Bid Ask Open Int. Last Change Vol Bid Ask Open Int.
e Price l

MQFJU 20.40 501.00 20.30 20.50 902.00 7.50 MQFVU 0.05

MQFJB 17.80 +0.20 98.00 17.80 18.00 451.00 10.00 MQFVB 0.05

MQFJV 15.10 +0.90 450.00 15.30 15.50 811.00 12.50 MQFVV 0.05

50.0
MQFJC 12.60 +0.30 2.00 12.90 13.00 1,307.00 15.00 MQFVC 0.05 0.05 0.05 4,947.00
0

25.0
MQFJW 10.50 +0.70 7.00 10.40 10.50 3,068.00 17.50 MQFVW 0.05 0.05 0.05 2,416.00
0

10.0
MQFJD 7.70 -0.10 5.00 7.90 8.00 8,637.00 20.00 MQFVD 0.05 0.05 0.05 15,744.00
0

20.0
MSQJX 5.30 698.00 5.40 5.50 56,176.00 22.50 MSQVX 0.05 0.05 0.05 116,763.00
0
 10.0
MSQJJ 2.90 -0.10 3,111.00 2.90 3.00 170,134.00 25.00 MSQVJ 0.05 +0.01 0.05 0.05 69,588.00
0

15,3
MSQJY 0.60 5,536.00 0.55 0.60 113,590.00 27.50 MSQVY 0.15 -0.05 00.0 0.15 0.20 49,523.00
0

Price of Microsoft stock on 10/6/2006 -> 27.87

162.
MSQJK 0.05 +0.03 24.00 0.05 0.05 191,924.00 30.00 MSQVK 2.15 +0.05 2.05 2.15 399.00
00

150.
MSQJZ 0.05 1.00 0.05 0.05 4,028.00 32.50 MSQVZ 5.30 -0.40 4.50 4.70 350.00
00

88.0
MSQJL 0.05 170.00 0.05 467.00 35.00 MSQVL 13.20 7.00 7.20 35.00
0

150.
MSQJU 0.05 4.00 0.05 4.00 37.50 MSQVU 10.30 -1.70 9.50 9.70 250.00
00

MSQJH 0.05 10.00 0.05 10.00 40.00 MSQVH 13.20 2.00 12.00 12.20

604.
MSQJV 0.05 10.00 0.05 10.00 42.50 MSQVV 17.90 14.50 14.70 300.00
00

400.
MSQJI 0.05 45.00 MSQVI 19.50 17.00 17.20 250.00
00

November, 2006 Options

CALLS Strik PUTS

Chang e Symbo
Symbol Last Vol Bid Ask Open Int. Last Change Vol Bid Ask Open Int.
e Price l

MQFKA 22.70 +0.10 2.00 22.80 23.00 101.00 5.00 MQFWA 0.05
MQFKU 20.60 +0.70 50.00 20.40 20.50 614.00 7.50 MQFWU 0.05 1.00 0.05 1.00

MQFKB 17.90 +0.60 53.00 17.90 18.00 704.00 10.00 MQFWB 0.05 1.00 0.05 1.00

MQFKV 14.80 +0.10 11.00 15.40 15.50 49.00 12.50 MQFWV 0.05 4.00 0.05 4.00

MQFKC 13.00 398.00 12.90 13.00 398.00 15.00 MQFWC 0.05 8.00 0.05 8.00

MQFKW 10.38 +0.38 1.00 10.40 10.50 57.00 17.50 MQFWW 0.05

MQFKD 7.40 349.00 7.90 8.10 1,230.00 20.00 MQFWD 0.05

20.0
MSQKX 5.60 +0.20 2.00 5.50 5.60 1,777.00 22.50 MSQWX 0.05 0.05 0.05 41.00
0

35.0
MSQKJ 2.95 -0.15 197.00 3.00 3.10 9,614.00 25.00 MSQWJ 0.10 -0.02 0.05 0.10 7,461.00
0

388.
MSQKY 0.95 -0.05 2,966.00 0.95 1.00 74,823.00 27.50 MSQWY 0.50 0.45 0.50 18,459.00
00

27.87 Last as of 10/6/2006

110.
MSQKK 0.12 -0.03 4,539.00 0.10 0.15 20,846.00 30.00 MSQWK 2.10 2.10 2.20 1,106.00
00

MSQKZ 0.05 32.50 MSQWZ 4.70 -0.47 2.00 4.50 4.70 2.00

MSQKL 0.05 35.00 MSQWL 7.00 7.20

MSQKU 0.05 37.50 MSQWU 9.50 9.70

MSQKH 0.05 40.00 MSQWH 12.00 12.20

MSQKV 0.05 42.50 MSQWV 14.50 14.70

MSQKI 0.05 45.00 MSQWI 17.00 17.20

January, 2007 Options

CALLS Strike PUTS

 Chang Symbo
Symbol Last Vol Bid Ask Open Int. Price Last Change Vol Bid Ask Open Int.
e l

MQFAM 16.00 +0.50 200.00 15.90 16.00 8,454.00 12.00 MQFMM 0.05 1,528.00

315.
MQFAC 12.70 -0.30 1.00 13.00 13.10 934.00 15.00 MQFMC 0.05 0.05 0.05 461.00
00

20.0
MQFAO 11.00 -0.03 210.00 11.00 11.10 12,278.00 17.00 MQFMO 0.05 0.05 0.05 8,173.00
0

15.0
MQFAP 8.70 +0.30 20.00 8.50 8.70 18,718.00 19.50 MQFMP 0.05 0.05 0.05 60,815.00
0

MQFAD 7.90 -0.20 10.00 8.00 8.20 37,408.00 20.00 MQFMD 0.05 5.00 0.05 0.05 54,156.00

MQFAQ 6.04 -0.06 44.00 6.10 6.20 24,912.00 22.00 MQFMQ 0.10 -0.05 7.00 0.05 0.10 192,184.00

250.
MSQAQ 2.50 2.65 22.00 MSQMQ 1.00 0.80 0.85
00

27.0
MSQAX 5.70 +0.10 74.00 5.60 5.80 39,206.00 22.50 MSQMX 0.10 +0.05 0.05 0.10 124,529.00
0

23.0
MSQAR 3.80 341.00 3.80 3.90 103,746.00 24.50 MSQMR 0.20 -0.05 0.15 0.20 120,586.00
0

1,05
MSQAJ 3.40 1,495.00 3.30 3.40 149,959.00 25.00 MSQMJ 0.25 +0.05 0.20 0.25 90,231.00
7.00

86.0
MSQAS 1.80 +0.05 537.00 1.75 1.80 224,125.00 27.00 MSQMS 0.65 +0.05 0.55 0.60 121,031.00
0

543.
MSQAY 1.40 -0.05 917.00 1.40 1.45 133,362.00 27.50 MSQMY 0.80 +0.05 0.70 0.80 54,303.00
00

27.87 Last as of 10/6/2006

 12.0
MSQAT 0.50 -0.05 1,918.00 0.45 0.55 135,973.00 29.50 MSQMT 1.85 1.80 1.90 27,744.00
0

59.0
MSQAK 0.35 1,210.00 0.30 0.35 391,895.00 30.00 MSQMK 2.20 +0.05 2.20 2.30 10,117.00
0

20.0
MSQAA 0.10 23.00 0.05 0.10 95,835.00 32.00 MSQMA 6.20 4.00 4.20 13.00
0

27.0
MSQAZ 0.07 +0.02 58.00 0.05 0.10 47,094.00 32.50 MSQMZ 4.70 +0.20 4.50 4.70 62.00
0

50.0
MSQAB 0.05 20.00 0.05 117,013.00 34.50 MSQMB 9.80 6.50 6.70 100.00
0

28.0
MSQAC 0.05 100.00 0.05 26,032.00 37.00 MSQMC 11.00 9.00 9.20 3.00
0

14.0
MSQAU 0.05 37.50 MSQMU 11.70 9.50 9.70 69.00
0

April, 2007 Options

CALLS PUTS
Strike
Chang Symbo
Symbol Last Vol Bid Ask Open Int. Price Last Change Vol Bid Ask Open Int.
e l

MQFDA 22.30 +0.10 50.00 22.80 23.00 337.00 5.00 MQFPA 0.05 1.00 0.05 1.00

MQFDU 18.50 339.00 20.40 20.50 339.00 7.50 MQFPU 0.05

MQFDB 16.20 300.00 17.90 18.00 157.00 10.00 MQFPB 0.05

MQFDV 15.60 +0.50 1.00 15.50 15.60 491.00 12.50 MQFPV 0.05

MQFDC 12.60 -0.10 121.00 13.10 13.20 1,514.00 15.00 MQFPC 0.05
 760.
MQFDW 10.90 +0.70 110.00 10.60 10.80 2,199.00 17.50 MQFPW 0.05 0.05 0.05 870.00
00

1,00
MQFDD 8.40 +0.20 25.00 8.20 8.40 990.00 20.00 MQFPD 0.10 -0.05 0.05 0.15 1,591.00
0.00

MSQDX 6.00 +0.40 30.00 5.90 6.10 2,472.00 22.50 MSQPX 0.20 -0.05 6.00 0.15 0.25 4,887.00

MSQDJ 3.70 -0.10 174.00 3.80 3.90 64,832.00 25.00 MSQPJ 0.50 +0.05 5.00 0.40 0.45 6,061.00

275.
MSQDY 2.00 289.00 2.00 2.05 27,623.00 27.50 MSQPY 1.10 1.05 1.15 7,642.00
00

27.87 Last as of 10/6/2006

193.
MSQDK 0.80 -0.02 632.00 0.80 0.85 18,703.00 30.00 MSQPK 2.50 2.40 2.50 1,415.00
00

MSQDZ 0.25 -0.05 22.00 0.20 0.30 6,271.00 32.50 MSQPZ 5.30 +0.20 3.00 4.50 4.70 5.00

28.0
MSQDL 0.05 -0.05 42.00 0.05 0.10 1,709.00 35.00 MSQPL 8.60 7.00 7.20 3.00
0

300.
MSQDU 0.05 40.00 0.05 130.00 37.50 MSQPU 10.90 9.50 9.70
00

MSQDH 0.05 40.00 MSQPH 12.00 12.20

MSQDV 0.05 42.50 MSQPV 14.50 14.70

MSQDI 0.05 45.00 MSQPI 17.00 17.20

January, 2008 Options

CALLS PUTS
Strike
Chang Symbo
Symbol Last Vol Bid Ask Open Int. Price Last Change Vol Bid Ask Open Int.
e l
 10.0
WMFAC 13.43 -0.13 112.00 13.40 13.50 28,912.00 15.00 WMFMC 0.10 0.05 0.10 6,971.00
0

WMFAW 11.20 +0.10 264.00 11.10 11.20 2,047.00 17.50 WMFMW 0.20 2.00 0.15 0.20 25,134.00

WMFAD 8.90 61.00 8.90 9.00 71,653.00 20.00 WMFMD 0.35 +0.05 1.00 0.30 0.35 227,800.00

20.0
WMFAX 6.90 +0.05 167.00 6.80 6.90 52,716.00 22.50 WMFMX 0.55 -0.05 0.50 0.55 60,497.00
0

45.0
WMFAE 4.90 -0.10 247.00 4.80 5.00 198,059.00 25.00 WMFME 0.95 0.95 1.00 135,890.00
0

2,14
WMFAY 3.30 +0.10 567.00 3.20 3.30 124,167.00 27.50 WMFMY 1.75 1.70 1.80 92,797.00
5.00

27.87 Last as of 10/6/2006

23.0
WMFAF 1.95 1,062.00 1.90 1.95 305,372.00 30.00 WMFMF 3.00 +0.05 2.90 3.00 28,398.00
0

300.
WMFAG 0.55 +0.05 136.00 0.50 0.55 90,401.00 35.00 WMFMG 7.20 +0.10 7.00 7.20 367.00
00

WMFAH 0.15 489.00 0.10 0.15 53,174.00 40.00 WMFMH 12.10 -0.38 2.00 12.00 12.20 257.00

January, 2009 Options

CALLS PUTS
Strike
Chang Symbo
Symbol Last Vol Bid Ask Open Int. Price Last Change Vol Bid Ask Open Int.
e l

VMFAC 13.70 +0.40 16.00 13.70 13.80 6,389.00 15.00 VMFMC 0.20 -0.05 5.00 0.15 0.20 490.00

50.0
VMFAD 9.60 -0.20 2,764.00 9.60 9.80 20,651.00 20.00 VMFMD 0.60 +0.05 0.55 0.60 25,572.00
0
 10.0
VMFAX 7.80 +0.40 27.00 7.70 7.90 5,001.00 22.50 VMFMX 1.00 +0.05 0.90 1.00 14,412.00
0

15.0
VMFAE 6.10 +0.10 45.00 6.00 6.20 21,472.00 25.00 VMFME 1.60 1.50 1.60 20,197.00
0

533.
VMFAY 4.52 +0.02 544.00 4.50 4.70 7,102.00 27.50 VMFMY 2.40 -0.05 2.30 2.45 5,224.00
00

27.87 Last as of 10/6/2006

VMFAF 3.30 -0.10 54.00 3.30 3.40 51,798.00 30.00 VMFMF 3.50 -0.30 6.00 3.40 3.60 8,361.00

616.
VMFAG 1.55 -0.04 105.00 1.50 1.60 4,050.00 35.00 VMFMG 7.20 -0.10 7.10 7.20 2,179.00
00

VMFAH 0.65 -0.05 12.00 0.60 0.70 5,970.00 40.00 VMFMH 12.10 -0.43 2.00 12.00 12.20 308.00

Most of the column headings are the same as they would be for stocks: 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), volume, and bid and ask prices. Each option has a

unique symbol that corresponds to a specific strike price and expiration date. The

last column is 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 even before expiration. At expiration, the number of contracts drops to zero. 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.
 Another obvious relationship is that for any given strike price, the call and put values
have an inverse relationship—when one is high, the other is low. This results because
when one is in the money, the other option, for the same strike price, must be
necessarily out of the money.

If the price of Microsoft 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.

Another trend that can be gleaned from the table is that the greater the intrinsic value
(the more in the money), the lesser the time value for any given amount of time left on
the contract.

The Options Clearing Corporation (OCC)

The Options Clearing Corporation (OCC) is jointly owned by the exchanges that

trade options, and is registered with the Securities and Exchange Commission

as a clearing corporation. As a registered Derivatives Clearing Organization

(DCO) under the Commodities Futures Trading Commission (CFTC)

jurisdiction, the OCC also offers clearing and settlement services for transactions in
futures and options on futures. Its website, optionsclearing.com, hosts statistics and
news on options, and publishes any notifications about changes in the trading rules, or
the adjustment of certain option contracts that were subjected to unusual circumstances,
such as a merger of companies whose stock was the underlying security to the option
contracts.

The OCC, like other clearing companies, is the direct participant in every purchase and
sale of an option contract. When an option writer or holder sells his contracts to someone
else, the OCC serves as an intermediary in the transaction. The option writer sells his
contract to the OCC and the option buyer buys it from the OCC.

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 follow all of
the rules, and that the contract writer will perform.
The Exercise of Options by Option Holders and the Assignment to Fulfill the Contract
to Option Writers

When an option holder wants to exercise his option, he must notify his broker of the
exercise, and if it is the last trading day for the option, the broker must be notified 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 be different for different option classes or for
index options. Although policies differ among brokerages, it is the duty of the option
holder to notify his broker to exercise the option before the cut-off time.

When the broker is notified, then the exercise instructions are sent to the OCC, which
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 will then assign the exercise to
one of its customers 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 because they will only exercise the option if it is in the money. Options,
unlike stocks, cannot be bought on margin.
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
his position, because the OCC draws from a pool of contracts that have no 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 Microsoft for the
price of $30 until April, 2007. The OCC buys the contract, adding it to the millions of 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 Microsoft for $30 per share until April, 2007.

Scenario 1—Exercises of Options are Assigned According to Specific Procedures

In February, the price of Microsoft rises to $35, and Sarah thinks it might go higher in the long run, but
since March and April generally are not good times for most stocks, she decides to exercise her call to
buy Microsoft stock at $30 per share to be able to hold the stock indefinitely. She instructs her broker to
exercise her call; her broker forwards the instructions to the OCC, which then assigns the exercise to one
of its participating members who provided the call for sale; 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 has to 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 has
to take—an option writer never knows when he'll be assigned an exercise, if the option is in the money.

Scenario 2—Closing Out an Option Position by Buying Back the Contract

John Call-Writer decides that Microsoft might climb higher in the coming months, and 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 there are no names on the option contracts. 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.

2005 Statistics for the Fate of Options

The Options Clearing Corporation reported the following statistics for 2005:
 All option writers who didn't close out their position earlier by buying an offsetting contract, made the
maximum profit—the premium—on those contracts that expired. Option writers have lost at least
something when the option is exercised, because the option holder wouldn't exercise it unless it was in
the money. The more the exercised option was in the money, the greater the loss is for the assigned
option writer and the greater the profits for the option holder. A closed out transaction could be at a
profit or a loss for both holders and writers of options. A closed out transaction always yields at least
some return of investment, because the investor would not close out his position unless he was getting
something back.

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
period of 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) x 100 = $2,500,
and the assigned call writer would have to pay that much.
Other Options

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.
 Bullish

[ buy call | sell put | bull spread | diagonal spread ]

Bearish

[ buy put | sell call | bear spread | diagonal spread | put hedge ]

Neutral

[ sell straddle | sell strangle | long butterfly | calendar spread | covered call ]

Volatile

[ buy straddle | buy strangle | short butterfly ]

1. BUY CALL
Strategy View
Investor thinks that the market will rise significantly in the short-term. .

Strategy Implementation
Call options are bought with a strike price of a. The more bullish the investor is, the higher the strike price should be.

Upside Potential
Profit potential is unlimited and rises as the market rises.

Breakeven Point at Expiry

Strike price plus premium.

Downside Risk
Limited to the premium paid - incurred if the market at expiry is at, or below, the strike a.

Margin
Not required

Comment
If the market does little then the value of the position will decrease as the option time value falls.

2. SELL PUT

Strategy View
Investor is certain that the market will not go down, but unsure/unconcerned about whether it will rise.

Strategy Implementation
Put options are sold with a strike price a. If an investor is very bullish, then in-the-money puts would be
sold.

Upside Potential
Profit potential is limited to the premium received. The more the option is in-the-money, the greater the premium received.

Breakeven Point at Expiry

Strike price less premium.

Downside Risk
Loss is almost unlimited ("almost" as the underlying price can not fall below zero!). High risk strategy. Potential huge losses
incurred if the market crashes. [If the strategy appeals, but not the downside risk, investors may prefer a bull spread].
 Margin
Always required

Comment
If the market does little, and time passes, this helps as the short position gains when the time value erodes.

3.BULL SPREAD

Strategy View
Investor thinks that the market will not fall, but wants to cap the risk. Conservative strategy for one who thinks that the market is more
likely to rise than fall.

Strategy Implementation
Call option is bought with a strike price of a and another call option sold with a strike of b, producing a net initial debit,
OR
Put option is bought with a stike of a and another put sold with a strike of b, producing a net initial credit.

Upside Potential
Limited in both cases -
Calls: difference between strikes minus initial debit
Puts: net initial credit
Maximum profit if market at expiry is above the higher strike.

Downside Risk
Limited in both cases -
Calls: net initial debit
Puts: difference between strikes minus initial credit
Maximum loss if at expiry market is below the lower strike.

Margin
Possibility for margin requirements to be off-set.

Comment
Time value erosion not too significant due to the balanced position. .

DIAGONAL SPREAD
Strategy View
Investor thinks that the market will be weak in the short-term, but then rally later.

Strategy Implementation
A near-dated call option is sold, and a longer-dated, further out-of-the-moneycall option is bought.

Upside Potential
Unlimited, if the bought option is held after the short option expires (the position then becomes a straight-forward buy call). If the
position is closed at expiry of the near option, maximum profit will accrue if the market is at the level of the sold strike.

Downside Risk
Limited to the difference in strikes plus/minus the initial debit/credit when establishing the spread.

Margin
Yes, but off-set may apply.

Comment
There is a risk of the sold options being called (i.e. being exercised)

• bullish
o very bullish
o moderately bullish + certain that the market will not fall
o moderately bullish + fairly certain that the market will not fall
o bearish in immediate near-term (weeks) + bullish in longer term (months)

• bearish
o very bearish
o certain that the market will not rise
o moderately bearish + fairly certain that the market will not rise
o flat or mod. bullish in near-term (weeks) + bearish in longer term (months)
o hold stock and bearish

6. BUY PUT

Strategy View
Investor thinks that the market will fall significantly in the short-term. .
 Strategy Implementation
Put option is bought with a strike price of a. The more bearish the investor is, the lower the strike price should be.

Upside Potential
Profit potential is unlimited (well, not really unlimited of course as the market can not fall below zero).

Breakeven Point at Expiry

Strike price minus premium paid.

Downside Risk
Limited to the premium paid - incurred if at expiry the market is at or above the strike a.

Margin
Not required

Comment
If the market does little then the value of the position will decrease as the option time value falls.

7. SELL CALL

Strategy View
Investor is certain that the market will not rise and and is unsure/unconcerned whether it will
fall.

Strategy Implementation
Call option is sold with a strike price of a. If the investor is very certain of his view then
at-the-money options should be sold, if less certain, then out-of-the-money ones should be sold.

Upside Potential
Limited to the premium received - received if the market at expiry is at, or below, the option strike.

Downside Risk
Unlimited. Losses on the position will worsen as the market rises. [If the investor likes the idea of the strategy, but not the
downside risk, they might be interested in a bear spread].
Margin
Always required

Comment
If the market does little, and time passes, this helps as the short position gains when the time value erodes

8. BEAR SPREAD

Strategy View
Investor thinks that the market will not rise, but wants to cap the risk. Conservative strategy for one who
thinks that the market is more likely to fall than rise.

Strategy Implementation
Call option is sold with a strike price of a and another call option bought with a strike of b, producing a
net initial credit,
OR
Put option is sold with a stike of a and another put bought with a strike of b, producing a net initial debit.

Upside Potential
Limited in both cases -
Calls: net initial credit Puts: difference between strikes minus initial debit
Maximum profit if market at expiry is below the lower strike.

Downside Risk
Limited in both cases -
Calls: difference between strikes minus initial credit
Puts: net initial debit
Maximum loss if at expiry market is above the higher strike.

Margin
Possibility for margin requirements to be off-set.
 Comment
Time value erosion not too significant due to the balanced position. .

9. DIAGONAL SPREAD

Strategy View
Investor thinks that the market will be flat or rise only slightly in the short-term, but will then
fall later.

Strategy Implementation
Sell a near-dated put option and buy a longer dated out-of-the-money put.

Upside Potential
Large, if the bought option is held after the short option expires (the position then becomes a
straight-forward buy put). If the position is closed at expiry of the near option, maximum
profit will accrue if the market is at the level of the sold strike.

Downside Risk
Limited to the difference in strikes plus/minus the initial debit/credit when establishing the spread.

Margin
Yes, but limited.

Comment
There is a risk of the sold options being called (i.e. being exercised).

PUT HEDGE - hold stock, buy put

Strategy View
Investor holds stock and is worried about a market fall. Put options can be bought to protect the value
of the stock position, while not preventing the position to benefit in the event of a market rise.

Strategy Implementation
Put options are bought with a strike price of a.The number of put options bought will depend on the
bearishness of the investor and the size of the stock holding.
 Upside Potential
Profit potential is unlimited, being the ordinary return on the stock minus the fixed premium paid for the put option.

Downside Risk
Potentially limited, (depending on the hedge ratio initially applied). The gains on the put options - as the market falls - will off-set
the stock losses.

Margin
Not required

Comment
Strategy characteristics are similar to a buy call.

• neutral
o expect prices to fluctuate in very narrow range
o prices might flutuate in a broader range
o moderately certain that prices will not flutuate much
o short-term weakness but longer term rally
o hold stock but expect no movement

10. SELL STRADDLE

Strategy View
Investor is certain that the market will not be very volatile (will neither go up nor down very much).

Strategy Implementation
A call option and a put option are sold with the same strike price a.

Upside Potential
Limied to the two premiums received - will be realised if market at expiry is exactly at the strike price
level.

Breakeven Points
The lower point (b) will be the strike minus the value of two premiums received, the upper point (c) will be the strike plus the
two premiums received. [If the investor would like to broaden this band, a sell strangle might be interesting].
 Downside Risk
Unlimited - should the market fall or rise greatly.

Margin
Always required

Comment
If the market does little then the value of the position will benefit as the short positions gain when the option time value falls.

11. SELL STRANGLE

Strategy View
The investor thinks that the market will not be volatile within a broadish band.

Strategy Implementation
Put option is sold with a strike price of a and a call option is sold with the higher strike
price b

Upside Potential
Limited to the two premiums received.

Breakeven Point at Expiry

Lower point (c) will be the lower strike minus the two premiums received, the upper point (d) will be the higher strike plus the
two premiums recieved.

Downside Risk
Unlimited - should the market fall or rise greatly. [If the investor likes the strategy, but not the downside risk, a long butterfly
might be interesting].

Margin
Always required
 Comment
If the market does little then the value of the position will benefit as the short positions gain when the option time value falls.

12. LONG BUTTERFLY

Strategy View
Investor thinks that the market will not be volatile, but wants to cap the downside risk. .

Strategy Implementation
Call option with low strike b bought and 2 call options with medium strike a sold and call option
with high strike c bought. (The same position can be created with puts, but is less common).

Upside Potential
Limited - to the difference between the lower and middle strikes minus the net debit of establishing
the spread.

Downside Risk
Limited to the initial net debit of establishing the spread.

Margin
Margin should be possible.

Comment
Can be difficult to execute such strategies quickly.

13. CALENDAR SPREAD

Strategy View
Investor thinks that the market will be weak in the short-term, but rally in the longer-term.

Strategy Implementation
Near dated call option is sold, and a longer-dated call option with the same strike is bought. [If
the investor holds the opposite view, then a comparable strategy can be construced with puts].

Upside Potential
Large, if the bought option is held after the short option expires (the position then becomes a
straight-forward buy call). If the position is closed at expiry of the near option, maximum profit will accrue if the market is at the
level of the sold strike.
 Breakeven Point at Expiry
Strike price plus premium

Downside Risk
Limited to the initial debit incurred for establishing the spread. .

Margin
Off-set may be available.

Comment
There is a risk of the sold options being called (i.e. being exercised).
Sometimes called a horizontal or time spread.

14. COVERED CALL - long stock, sell call

Strategy View
An investor holds stock but does not think the stock will rise in the short term, or that the stock will be neutral, income can be gained
by selling call options against the stock holding.

Strategy Implementation
Call options are sold. The number of call options sold will be determined by the investor's market view and the size of the stock
holding.

Upside Potential
Limited - by selling calls, the investor is writing off the potential prfit of the stock position. Maximum profit is the strike minus
the market price plus the premium received.

Downside Risk
Large: Similar to that incurred with ordinary stock ownership, only off-set partially by the (fixed) option premium received. Main
loss could be the opportunity loss if the market rises strongly.

Margin
Always required

• volatile
 o expect prices to be very volatile
o expect prices to be volatile
o moderately expect prices to be volatile

BUY STRADDLE

Strategy View
Investor thinks that the market will be very volatile in the short-term.

Strategy Implementation
Call option and put option are bought with the same strike price a - usually at-the-money.

Upside Potential
Unlimited Breakeven Point at Expiry
Lower point is the strike minus the two premiums paid, and the upper is the strike plus the two
premiums.

Downside Risk
Limited to the two premiums paid. [If the investor would like to decrease the premium paid, a buy strangle might be interesting]

Margin
Not required

Comment
Position loses value with passage of time as time value decreases on options

BUY STRANGLE

Strategy View
Investor thinks that the market will be very volatile in the short-term [this is similar to the buy straddle but
the premium paid here is less]

Strategy Implementation
Put option is bought with a strike a and a call option is bought with a strike b.
 Upside Potential
Unlimited - should the market fall or rise greatly.

Downside Risk
Limited to the two premiums paid. [If the investor would like to reduce the premiums paid still further, a short butterfly might be
interesting].

Margin
Not required

Comment
Position loses value with passage of time as time value decreases on options

SHORT BUTTERFLY

Strategy View
Investor mildly thinks that the market will be volatile.

Strategy Implementation
Call option is sold with strike b, two call options are bought with strike a and a call option
is sold with strike c.[A similar position can be created with puts].

Upside Potential
Limited to initial credit received.

Downside Risk
Limited to the difference between the lower and middle strikes minus the initial spread credit.

Margin
Off-set may be available.

Comment
May be difficult to execute this strategy quickly.