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Options
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

The privileges of buying and/or selling specified securities or commodities in specified amounts, at specified prices, and for a specified duration of time.  Since consideration passes for such options, they are legally binding contracts for their duration.  Most customary options are those to buy or sell securities, commodities, or real estate, but option contracts may be made for almost any good or service.  Rights under options are sometimes sufficiently valuable to command substantial premiums.

Methods of trading on the New York Stock Exchange include seller's options calling for delivery times longer than the regular way basis of fourth full business day after date of transaction.  On the stock exchanges, also, it is customary for the exchange's rules to specify that neither a member acting as specialist, nor a member organization in which such member is a participant, nor any other participant in such member firms shall directly or indirectly acquire or grant any option to buy or sell or to receive or deliver shares of the stock in which such member is a participant, nor any other participant in such member firms shall directly or indirectly acquire or grant any option to buy or sell or to receive or deliver shares of the stock in which such member is a specialist.  Such a rule is Rule 105 of the New York Stock Exchange.  No member while on the floor shall initiate the purchase or sale on the exchange for his own account, or for any account in which he, his member firm, or any participant therein is directly or indirectly interested, of any stock in which he holds or has granted any put, call, straddle or option, or in which he has knowledge that his member organization or any participant therein holds or has granted any such options (Rule 96).  Such rules reflect the concern that interests in options might lead to manipulation, as options were a favorite device of POOL operators.

Standardized Options Trading.  

Options are traded on 14 exchanges in the United States .  Daily volume often exceeds a million contracts.  Many options are also traded in the over-the-counter market.

These options give a holder the right to buy from the OPTIONS CLEARING CORPORATION, in the case of a call, or sell to the Options Clearing Corporation, in the case of a put, the number of shares (typically 100 shares) of the underlying security covered by the option at the stated exercise price by the proper filing of an exercise notice with the Options Clearing Corporation prior to the fixed expiration time of the option.  The designation of a stock option includes the name of the underlying stock, the expiration month, the exercise price, and whether the option is a call or a put.

The settlement procedures of the Options Clearing Corporation are designed so that for every outstanding option there is a writer- and a clearing member who is or who represents the writer-of an option of the same series who has undertaken to perform the obligations of the clearing corporation in the event an exercise notice for the option is assigned to him.  As a result, no matter how many options of a given series may be outstanding at any time, there will always be a group of writers of options of the same series who, in the aggregate, have undertaken to perform the clearing corporation's obligations with respect to such options.

Once an exercise notice for an option is assigned to a particular writer, that writer is contractually obligated to his broker to deliver the underlying security, in the case of a call, or to pay the aggregate exercise price, in the case of a put, in accordance with the terms of the option.  This contractual obligation of the writer is secured by the securities or other margin which the writer is required to deposit with his broker with respect to the writing of all options.

The clearing member representing the writer is also contractually obligated, whether or not his customer performs, to perform the clearing corporation's obligations on an assigned option.  Standing behind a clearing member's obligations are (1) the clearing member's net capital, (2) the clearing member's margin deposits with the clearing corporation, (3) the clearing corporation's lien on certain of the clearing member's assets, and (4) the clearing fund.  The clearing fund is the minimum initial deposit of each clearing member, upon admission to membership, of $10,000 plus such additional amount as may be fixed by the clearing corporation, re-determined on a monthly basis pursuant to a formula prescribed in the rules of the clearing corporation.  All clearing fund deposits must be made in cash or by the deposit of securities issued or guaranteed by the U.S. government and having a maturity of ten years or less.

Each clearing member is required, with respect to each stock option for which it represents the writer (such positions in options are referred to as short positions), either to deposit the underlying stock (in the case of a cal) or U.S. Treasury bills in an amount of at least equal to the exercise price (in the case of a put) or in the alternative to deposit and maintain specific margin with the clearing corporation amounting to 100% or such greater percentage as the clearing corporation prescribes (as of June 30, 1981, 130%) of the closing asked quotation for the option on the exchanges on the preceding business day.

Until June 1985 each class of options was assigned to one of three expiration month cycles:  the January-April-July-October cycle, the February-May-August-November cycle, or the March-June-September-December cycle.  Trading in options of a particular expiration month normally began approximately nine months earlier, so that at any given time there were generally three different expiration months open for trading, at 3-month intervals, in each class of options.  For example, on the day following the expiration of January options, trading in options expiring in the following October would normally be opened (and trading in options expiring in April and July had been previously opened).  From time to time exchanges changed the expiration month cycles to which particular classes of options were assigned.

In June 1985 CBOE piloted sequential expiration of stock options in 20 option classes.  This pilot met the needs of market participants trading primarily in near-term series, while enhancing volume and liquidity in those classes.  CBOE and other options exchanges expanded the sequential expiration pilot floor-wide in August 1987.

The SEC, as of October 22, 1989 , approved the options exchanges subsequently implemented the fixing of exercise prices at 5-point intervals for stocks trading at up to 100; and at 10-point intervals for stocks trading above 100.  When trading is introduced in a new expiration month, an exchange ordinarily selects the two or three standard exercise prices surrounding the current market price of the underlying stock.  For example, if the underlying stocks trades at 37 during the period when exercise prices are being selected for a new expiration month, two new series of options would ordinarily be introduced with exercise prices at 35 and 40.

However, as of April 1985, CBOE offered 2 point strike price intervals for options on stocks trading below $25, to enhance depth and liquidity in lower-priced options by giving investors more near-the-money strikes for hedging purposes.

 In May 1987 CBOE applied to the SEC for approval of long-term two-year options in SPX (The Standard and Poor's 500 index option) with strike price intervals of 25-points, compared with SPX's current (as of August 1987) 5-point strike prices.  Long-term options were designed to protect institutional portfolios from long-term market moves.

The appended table shows the volume of various options traded on the exchanges and in the over-the-counter market.

Uses of Options.  

Options may be purchased or sold through securities brokers, many of whom are members of one or more of the exchanges.  The price (premium) of an option, which is paid by the purchaser and is received by the writer (seller) of the option, is determined in the exchange's auction market.  Both purchasers and writers pay the transaction costs, which may include commissions charged or incurred in connection with the options transactions and may be significant.  Once an option has been issued by the clearing corporation, the contractual ties between the holder and the writer of the option are severed.  Instead, the holder of an option looks to the clearing corporation and not to any particular writer for performance in the event of exercise.  Since each time an option is issued to a holder there is a writer of an option of the same series contractually obligated to the clearing corporation (through a clearing member), the aggregate obligations of the clearing corporation to holders of options are backed up by the aggregate obligations that writers owe to the clearing corporation.  Upon exercise of an option, the clearing corporation assigns an exercise notice to a clearing member's account with the clearing corporation selected at random from among all clearing member accounts reflecting the writing of options of the same series as the exercised option.

The Option Clearing Corporation's prospectus lists the following possible uses for exchange-traded options.

1.   Using calls for leverage potential.  Because the premium of a call is considerably less than the cost of the underlying security covered by the call, a given amount of funds may purchase calls covering a much larger quantity of such security than could be purchased directly.  By so leveraging his funds, the purchaser of calls has the opportunity to benefit from any significant increase in the price of the security to a greater extent than had he purchased the security outright.  However, if the call is not sold while it has remaining value and if the security does not appreciate during the life of the call, the call purchaser may lose his entire investment in the call; whereas had he purchased the security directly, he might have had no loss or only a paper loss.  Moreover, if the underlying stock pays dividends, they would have been received by the investor as a stockholder, but not as the holder of calls.  In addition, except where the time value of the remaining life of a call may be realized in the secondary market afforded by the exchange-trading of the options, for a call purchase to be profitable the market price of the underlying security must exceed the exercise price by more than the premium and transaction costs paid in connection with the purchase of the call and its sale or exercise.

2.   Using calls as an alternative to investing in the underlying stock.  This use of calls assumes that an investor who anticipates a rise in the price of the underlying stock, but does not think it prudent to subject himself to the risk of a severe price decline by buying the underlying stock outright, will invest the entire difference between the cost of the call and the cost of the underlying stock in a relatively risk-free manner (such as a savings account or Treasury bills), the income from which helps to offset the cost of the call.  To the extent this is not done, the call investment becomes more of a leverage device, supra.  Moreover, a call investor does not have the choice of waiting out an unexpected downturn in the security price beyond the expiration date of the call.  In addition, the very security that might be considered more conservative from a direct purchase standpoint could be more risky as a call investment, because its high stability may also mean that its price is less likely to rise significantly during the relatively short duration of a call.

3.   Hedging a short position against a price increase.  A call gives the holder the right to acquire the underlying security at a fixed price, so that an investor intending to sell a security short in anticipation of a decline in the price of the security may buy calls to hedge against a rise instead in the price of the security.  If the security's price remains the same for the life of the call, the transaction costs.  If it declines, any profit made in the short-selling transaction will be reduced by the amount of the premium and transaction costs.  However, should the price of the security rise, the short seller may be protected against a substantial loss he would otherwise have had to incur if he had to cover his short position at the increased market price.  Such hedged short selling, although less risky than un-hedged short selling, is considered suitable only for sophisticated investors.

4.   Fixing the price of a future security purchase.  If an investor anticipates the purchase of a security at some time in the future, such as when funds become available, and considers the present price of the security to be attractive, he may fix that price (plus the premium and transaction costs) as the purchase price of the security by buying a call that does not expire until after the time the purchase is anticipated.  At that time, he can merely exercise the call to acquire the security (unless the market price of the security has declined below the exercise price, in which event the security can be bought in the open market and the call allowed to lapse without exercise).

The following are possible uses for put options.

1.   Buying puts in anticipation of a price decline in the underlying security.  This use contemplates the purchase of puts by an investor who does not own the underlying security.  The put buyer, like the short seller, seeks to benefit from a decline in the market price of the underlying security.  Unlike the short seller, the put buyer does not become subject to margin and margin calls, nor to the theoretically unlimited risk of the short seller should the price of the underlying security rise instead of declining.  On the other hand, if the put is not sold when it has remaining value and if the market price of the underlying security remains equal to or greater than the exercise price during the life of the put, the put buyer will lose his entire investment in the put option.  Moreover, unless the put may be sold in a closing sale transaction, in order for the purchase of a put to be profitable the market price of the underlying security must decline sufficiently below the exercise price to cover the premium and transaction costs.  As the put buyer acquires puts covering a greater number of shares than he might have sold short directly, he is in a more highly leveraged position and is subject to the increased risks of that position.  Accordingly, the use of puts for leverage is extremely risky and is considered unsuitable for investors who do not have the financial capability to withstand large losses.

2.   Buying puts to hedge a long position in the underlying security against a price decline.  Puts may be purchased to protect the profits in an existing long position in an underlying security, or to protect a newly acquired position in an underlying security against a substantial decline in its market value.  In either case, the protection is provided only during the life of the put, when the holder of the put is able to sell the underlying security at the put exercise price regardless of any decline in the market price of the underlying security.  An investor using puts in this manner will have reduced any profit he might otherwise have realized in his long security position by the premium paid for the put and transaction costs.

Writing options.  

The writer of a call assumes an obligation to deliver the underlying security covered by the call against payment of the aggregate exercise price upon the assignment to him of an exercise notice by the Options Clearing Corporation.  This obligation continues until the writer closes out his position in the option; but once a writer has been assigned an exercise notice in respect of the option, he will thereafter be unable to effect a closing purchase transaction in that option and will be required to delivery the underlying security.

A principal reason for writing calls on a securities portfolio is to attempt to realize, through the receipt of premium income, a greater return than would be earned on the securities alone.  The covered call writer (who owns the underlying security) has in return for the premium given up the opportunity for profit from a price increase in the underlying security above the exercise price so long as his writer obligation continues, but has retained the risk of loss should the price of the security decline.  The call writer may be required to sell his securities at the exercise price at any time upon being assigned an exercise notice, and in such circumstances the net proceeds that he realizes from the sale of his securities at the exercise price may be substantially below the prevailing market price.

Where the writer of a call owns neither the underlying security nor some other security (such as a warrant or option or convertible security for the underlying security) to acquire the underlying security, his naked option position is extremely risky and he may incur larger losses.  Such an uncovered call writer generally hopes to realize income from the writing transaction, but without the necessity of committing capital to the purchase of the underlying security.  However, he is required to maintain margin with his broker, and as distinguished from the covered call writer, he stands to incur an out-of-pocket loss if the price of the underlying security increases above the exercise price; the extent to which the current market value of the underlying security exceeds the aggregate exercise price (which theoretically can be without limit), reduced by the premium but increased by transaction costs, represents the uncovered call writer's loss.  Because of the potentially large (theoretically unlimited) losses which may be incurred, such transactions in uncovered calls are considered suitable only for sophisticated investors having the financial capacity to sustain such losses, including liquid assets available to meet margin calls and to cover by purchasing the underlying security, unless they are engaged in arbitrage or hedge transactions.

Like the writer of a call, a put writer hopes to realize premium income.  If the put writer does not have a short position in the underlying security or a long position in another put covering the same underlying securities (that expires no sooner than the put written and that has an exercise price not less than the exercise price of the put written), the put writer must either maintain margin with his broker on account of writing the put or else deposit with his broker or an approved bank or other depository an amount equal to the aggregate exercise price.  The risk position of a put writer who does not hold either a short position in the underlying security or another put of the same class is similar to that of a covered call writer who owns the underlying securities:  the put writer stands to incur a loss if and to the extent that the price of the underlying security falls below the exercise price, reduced by the premium received for writing the option but increased by the transaction costs.  If the put writer deposits an amount equal to the aggregate exercise price of the put with an approved bank or other depository in lieu of maintaining margin on his position and if the deposited funds are invested for the writer's account (or if the writer independently invests an amount equal to the aggregate exercise price), the put writer will receive the income earned on that investment in addition to premium income.

Puts may also be written by investors as a means of acquiring the underlying security at a net cost which is less than the current market price.  If the put is exercised, the put writer's cost of acquiring the underlying security will be the exercise price less the premium.  If the put is not exercised, the put writer will not have acquired the underlying security, but will nonetheless have earned the premium for writing the put.

If an investor writes a put covering an underlying security that he has sold short, the investor still hopes to realize premium income in the writing transaction, but his risk position is different from that of the put writer without such a short position.  In the former case, the investor may still incur a loss in his put writing transaction if the price of the underlying security falls below the exercise price, but this loss may be offset by a profit realized in the related short security position.  The put writer who is also a short seller of the underlying security bears the risk of his short security position.  Thus if the price of the underlying security should increase instead of decline, such an investor stands to incur a loss in covering his short security position, offset to the extent of the premium received in the put writing transaction.  Potential losses which may be incurred in short selling transactions are limited only by the extent of the increase in the price of the security sold short.  Accordingly, writing puts against short positions in the underlying security is risky, and is considered suitable only for sophisticated investors who have the means to meet margin calls and to sustain large losses.

A put writer may liquidate his position prior to the assignment of an exercise notice by purchasing a put of the same series as the put previously written.  To the extent that the cost of such a liquidating purchase plus transaction costs exceeds the premium initially received, the put writer will have incurred a loss in the put transaction.

Spread positions.  

A spread position is one in which an investor is the holder of one or more options of a given class and concurrently maintains a position as a writer of one or more options of different series within that same class, e.g., a spread position in which the investor is the holder of an XYZ April 35 call and the writer of an XYZ January 35 call.  Spread positions may involve holding an option with a different expiration date from that of the option written, as in the preceding example, or holding and writing options with different exercise prices but with the same expiration date, or holding and writing options in which both the expiration date and the exercise price differ.

Spread positions may be undertaken to fulfill a variety of investing strategies, and they are among the most complicated of all option transactions.  No investor should establish spread positions unless he thoroughly understands the mechanics and risks involved and is financially able to bear the risks.  In addition to the same risks that are involved in the purchase and writing of options, spreads are subject to certain special risks, including difficulty of execution, the risk of exercises, and the increased risk arising from closing out one side of the spread transaction.  An investor who writes a spread side is subject to being assigned at any time prior to the option's expiration an exercise notice to purchase or deliver the underlying security, so that he will no longer be in a spread position and instead will be subject to the risks of the other side of the original spread.

Straddles.  

A straddle is an equivalent number of puts and calls covering the same underlying security and having the same exercise price and expiration date.  An investor may buy a straddle or may write a straddle.  As with spreads, straddle orders are more difficult to execute than orders for puts or calls alone, because they require the execution of orders covering different options at or about the same time.  An investor who buys a straddle generally anticipates relatively large price fluctuations in the underlying security, but is unsure as to the direction in which the price may move.  Because the purchase of a straddle represents the purchase of two options, the premium for a straddle is greater than that for a put or a call alone.  This means that the price of the underlying security must rise of fall enough to permit the investor to recover the premium paid for the straddle plus transaction costs before a profit may be realized.

An investor who writes a straddle generally wishes to earn more premium income than he would earn from writing a put or a call alone.  It should be noted that if the price of the underlying security both rises and falls during the life of straddle, both the put and the call could be exercised, thus resulting in heavy losses.  These risks may be somewhat moderated if the investor buys the underlying security at the same time that he writes a straddle covering that security, which serves to cover his obligation as a writer of the call component of the straddle.  As in the case of other options transactions, writers of straddles are subject to the applicable margin requirements.

The intrinsic value of an option reflects the amount by which an option is in the money (the amount of the intrinsic value).  At a time when the current market price of ABC stock is $56 a share, an ABC $50 call would have intrinsic value of $6 a share.  If the price of the stock drops below $50, the call has no intrinsic value.  Time value refers to whatever value the option has in addition to its intrinsic value.  For example, when the market price of the ABC stock is $50 a share, an ABC $50 call may command a premium of $4 a share.  The $4 is time value and reflects the expectation that, prior to expiration, the price of ABC stock will increase by an amount that would enable an investor to sell or exercise the option at a profit.  An option may have both intrinsic value and time value, i.e., its premium may exceed its intrinsic value.  For example, with the market price of the ABC stock at $55, an ABC $50 call may command a premium of $6 a share - an intrinsic value of $5 a share and a time value of $1 a share.

Incentive Compensation Stock Options.  

In the field of corporation finance, options granted to members of management have become an increasingly widespread type of incentive compensation in recent years.

The incentive stock option (ISO) authorized by the 1981 Tax Act provides within its limits more attractive tax treatment for the recipient, similar to that which applied to the formerly authorized qualified stock option.  The recipient does not pay tax when he exercises the option, the tax being deferred until the stock is sold, which must be not earlier than one year after the date of exercise and two years after the date of granting the option.  At such time of sale, the difference between the exercise price and the sale price is taxable not at ordinary income tax rates, as in the case of nonqualified options whether or not the stock was sold, but at capital gains rates.  But the issuing corporation cannot take the difference between the exercise price and the sale price as a tax deductible form of compensation, as in the case of nonqualified options.  Moreover, the corporation is limited in ISOs to a maximum dollar amount of stock per recipient executive in a calendar year (although if the corporation does not grant an option in a given year, it may carry forward half of the unused amount for three years).

In the case of STOCK APPRECIATION RIGHTS (SARs), the recipient is paid the difference between the exercise price and the market price.  But there is an accounting disadvantage to the corporation in that the increase in value of the outstanding stock appreciation rights must be charged to current earnings of the corporation, which could prove to be an appreciable depressant to the corporation's earnings.

In investment banking, the investment banker underwriting new issues, particularly speculative issues of relatively new and untried firms, might specify, in addition to the usual underwriting spread (the difference between public offering price and net proceeds to the issuing corporation), additional underwriters' compensation in the form of options on additional stock at low prices as compared with the public offering price on current issue.  Thus if the new issue is successful and the public offering price is maintained or commands a premium, the underwriters are in position to exercise such options profitably within the option period.  The same principle would apply in the case of stock purchase warrants issued to the underwriters in such situations.

Summary.  

In addition to the market risks inherent in options transactions, there are special risks relating to the systems and procedures of the exchanges and the clearing corporation.  Because of the technicalities of the options and option combinations, as well as rules of the exchanges concerned and of the Options Clearing Corporation, and the necessity for keeping closely posted on market behaviour of the underlying stock and appurtenant positions of the investor in options, investors should become thoroughly familiar with the contents of the prospectus and the procedures of the Options Clearing Corporation.  Success in option operations also requires a close relationship between the investor and his account executive and knowledge by the latter of the investor's goals and objectives.

BIBLIOGRAPHY

Major brokerage firms have numerous publications explaining options and options trading.  


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