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
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.
are traded on 14 exchanges in the
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.
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.
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.
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
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.
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.
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.
SEC, as of
as of April 1985, CBOE offered 2½ 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.
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
appended table shows the volume of various options traded on the exchanges
and in the over-the-counter market.
Uses of 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.
Option Clearing Corporation's prospectus lists the following possible
uses for exchange-traded options.
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.
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.
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.
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).
following are possible uses for put options.
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.
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.
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
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
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.
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.
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.
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.
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 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.
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.
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.
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.
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.
the field of corporation finance, options granted to members of management
have become an increasingly widespread type of incentive compensation
in recent years.
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).
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.
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.
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.
brokerage firms have numerous publications explaining options and options