Option Trading & Future Trading

May.19, 2007 in Investment Opinions, U.S Hot Stocks

Basic Options Terminology and Education

An equity option is a contract that gives its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (in the case of a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer’s request. Equity option contracts usually represent 100 shares of the underlying stock.

Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. Equity option strike prices are listed in increments of 1, 2 ½, 5, or 10 points, depending on their price level. Adjustments to an equity option contract’s size and/or strike price may be made to account for stock splits, mergers, and stock dividends.

Equity option holders do not enjoy the rights due stockholders - e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights. Buyers and sellers in the exchange markets, where all trading is conducted in the competitive manner of an auction market, set option prices.

Types of Options - Calls & Puts
The two types of equity options are Calls and Puts. A call option gives its holder the right to buy 100 shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to sell the shares.

The opposite of a call option is a put option, which gives its holder the right to sell 100 shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to buy the shares.

An option’s price is called the “premium.” The potential loss for the holder of an option is limited to the initial premium paid for the contract. The writer, on the other hand, has unlimited potential loss that is somewhat offset by the initial premium received for the contract. Investors can use put and call option contracts to take a position in a market using limited capital. The initial investment would be limited to the price of the premium. Investors can also use put and call option contracts to actively hedge against market risk. A put may be purchased as insurance to protect a stock holding against an unfavorable market move while the investor still maintains stock ownership.

Here are some other terms relevant to options trading:

Underlying Security
The security - such as shares of General Motors (GM) - an option writer must deliver (in the case of call) or purchase (in the case of a put) upon assignment of an exercise notice by an option contract holder.
Expiration Friday
The Expiration day for equity options is the Saturday following the third Friday of the month. Therefore, the third Friday of the month is the last trading day for all expiring equity options. This day is called “Expiration Friday.” If the third Friday of the month is an exchange holiday, the last trading day is the Thursday immediately proceeding this exchange holiday. After the option’s expiration date, the contract will cease to exist. At that point the owner of the option who does not exercise the contract has no “right” and the seller has no “obligations” as previously conveyed by the contract.
Long
A long position in a stock or an option contract describes the fact that you have purchased and own that security in your brokerage account. For example, if you have purchased the right to buy 100 shares of a stock, and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock, and are holding that right in your brokerage account, you are long on a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock. When you are long on an equity option contract, you have the right to exercise that option at any time prior to its expiration. Your potential loss is limited to the amount you paid for the option contract.
Short
A short position in a stock or an option contract describes the fact that you have sold the stock short, or “written,” the options. For example, if you have sold the right to buy 100 shares of a stock to someone else, you are short a call contract. If you have sold the right to sell 100 shares of a stock to someone else, you are short a put contract. When you write an option contract you are, in a sense, creating it. No matter what happens to the price of the stock, the writer of an option collects and keeps the premium received from its initial sale. But you also now have the obligation to comply with the terms of that contract, meaning you will be forced to buy stock if you are short a put, or sell stock if you are short a call. The party who purchased the option from you can exercise his/her rights at any time before expiration. All option writers should be aware that assignment prior to expiration is a distinct possibility, and that your potential loss on a short call is theoretically unlimited. And for a put, although technically limited by the fact that stock prices cannot fall below $0, this potential loss could still be quite large if the underlying stock declines significantly in price.

The Trading Process
The trading process for options is very similar to that for stocks, although options trade on designated options exchanges such as the Chicago Board Options Exchange (CBOE) or the electronic International Securities Exchange (ISE). See the Educational Tab for The Trading Process for Individuals to get further information - include link here to Section F.2.

Index calls and puts
Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace.

Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the costs and complexities of doing so.

One significant difference between equity and index options is that index options are “cash-settled.” No physical delivery of shares occurs. Options are merely worth their intrinsic value at expiration, and the difference between the index’s level and exercise price of the option is paid or received in cash.
Intrinsic Value, Time Value, and “Moneyness”

When compared to a stock’s current market price, the strike price, or exercise price, of an option determines whether that contract is in-the- money, at-the-money, or out-of-the-money. If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the stock market. Similarly, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in-the-money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive selling the stock in the stock market. The converse of in-the-money is, not surprisingly, out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money.

The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value. The time value is the total option premium. This does not mean, however, that these options can be obtained at no cost. Any amount by which an option’s total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option’s premium that is affected by fluctuations in volatility, interest rates, dividend amounts, and the passage of time.

Equity call option:
In-the-money = strike price less than stock price
At-the-money = strike price same as stock price
Out-of-the-money = strike price greater than stock price
Equity put option:
In-the-money = strike price greater than stock price
At-the-money = strike price same as stock price
Out-of-the-money = strike price less than stock price
Option Premium:
Total price of an option, which consists of Intrinsic Value + Time Value

Expiration, Exercise and Assignment
The last day an option exists is known as the Expiration date. For listed stock options, this is the Saturday following the third Friday of the expiration month, when brokerage firms must submit exercise notices to Options Clearing Corporation. However, the exchanges and brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally on the third Friday of the month, before expiration Saturday, at some time after the close of the market (often 5:00 ET). The last day expiring equity options generally trade is also on the third Friday of the month, before expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day earlier, Thursday.

Basic Terminology & Characteristics
Futures are contracts between two parties regarding the price of an underlying commodity, financial instrument, or common stock. These agreements made between two parties through a regulated futures exchange. As opposed to securities, which represent an ownership stake in a company, these contracts specify that the parties agree to buy or sell an underlying asset – livestock, a foreign currency, or some other item – at a certain time in the future at a mutually agreed upon price. Each futures contract specifies the quantity and quality of the item, expiration month, the time of delivery and virtually all the details of the transaction except price, which the two parties negotiate based on current market conditions. Some futures contracts call for the actual, physical delivery of the underlying commodity or financial instrument at contract termination. Others simply call for a cash settlement at contract termination. Generally, however, market participants do not hold their futures contracts until termination but rather offset futures contracts they have bought (”gone long”) by a subsequent sale; or, offset futures contracts they have sold (”gone short”) by a subsequent purchase.

Types of Futures

Commodity Futures
The original and most widely know futures are traded based on the prices of agricultural products such as cattle, pork-bellies, and corn. Contracts based on industrial metals such as platinum and precious metals such as silver and gold also fall into this category.
Financial Futures
Although commodity futures were invented first, financial futures, such as contracts based on Treasury Bonds, Foreign Currencies, and Stock Indices now represent the vast majority of futures trading volume. These contracts allow large financial institutions to take sizable positions in the markets without dealing with the underlying assets. Most of these contracts are cash-settled.
Single Stock Futures
Single stock futures are futures contracts on individual stocks. These contracts have been in existence in Europe for some time, but they have only appeared in the U.S. since 2000, when Congress passed legislation lifting the ban on these products, which were already trading in Europe and elsewhere. A single stock futures contract is an contract to deliver shares of a specific stock at a specified expiration date. The size of these contracts is 100 shares, and about 200 of these contracts are traded at the OneChicago exchange. For more information, see www.onechicago.com.