In the rest of this chapter, we will focus on exchange-traded stock options. The contract specifications and trading of index options, currency options, and futures options are discussed further in Chapter 11.
As already mentioned, a stock option contract is an American-style option contract to buy or sell 100 shares of the stock. Details of the contract, such as the expiration date, the strike price, what happens when dividends are declared, how large a position investors can hold, and so on, are specified by the exchange.
One of the items used to describe a stock option is the month in which the expiration date occurs. Thus, a January call on IBM is a call option on IBM with an expiration date in January. The precise expiration date is 10:59 p.m. Central Time on the Saturday immediately following the third .Friday ofJhg-£xpirat'nn mnnfo The last day on which options trade is the third Friday of the expiration month. An investor with a long position in an option normally has until 4:30 p.m. Central Time on that Friday to instruct his or her broker to exercise the option. The broker then has until 10:59 p.m. the next day to complete the paperwork notifying the exchange that exercise is to take place.
Stock options are on a Jajiuai^, Febnaary, or March cycle. The January cycle consists of the months of January, April, July, and October. The February cycle consists of the months of February, May, August, and November. The March cycle consists of the months of March, June, September, and December. If the expiration date for the current month has not yet been reached, options trade with expiration dates in the current month, the following month, and the next two months in its cycle. If the expiration date of the current month has passed, options trade with expiration dates in the next month, the next-but-one month, and the next two months of the expiration cycle. For example, IBM is on a January cycle. At the beginning of January, options are traded with expiration dates in January, February, April, and July; at the end of January, they are traded with expiration dates in February, March, April, and July; at the beginning of May, they are traded with expiration dates in May, June, July, and October; and so on. When one option reaches expiration, trading in another is started. Longer dated stock options known as LEAPS also trade on exchanges. They will be discussed in more detail in Chapter 11.
The exchange chooses the strike prices at which options can be written. For stock options, strike prices are normally spaced $2^, $5, or $10 apart. (An exception occurs when there has been a stock split or a stock dividend, as will be described shortly.) The usual rule followed by exchanges is to use a $2| spacing for strike prices when the stock price is less than $25, a $5 spacing when it is between $25 and $200, and a $10 spacing when it is greater than $200. For example, at the time of writing, Citicorp has a stock price of 12 and the options traded have strike prices of 10, 12A, 15, \l\, and 20. IBM has a stock price of 99 \ and the options traded have strike prices of 90, 95, 100, 105, 110, and 115.
When a new expiration date is introduced, the two strike prices closest to the current stock price are usually selected by the exchange. If one of these is very close to the existing stock price, the third strike price closest to the current stock price may also be selected. If the stock price moves outside the range defined by the highest and lowest strike price, trading is usually introduced in an option with a new strike price. To illustrate these rules, suppose that the stock price is $53 when trading in the October options start. Call and put options would first be offered with strike prices of 50 and 55. If the stock price rose above $55, a strike price of 60 would be offered; if it fell below $50, a strike price of 45 would be offered; and so on.
For any given asset at any given time, there may be many different option contracts trading. Consider a stock where there are four expiration dates and five strike prices. If call and put options trade with every expiration date and every strike price, there are a total of 40 different contracts. All options of the same type (calls or puts) are referred to as an option class. For example, IBM calls are one class while IBM puts are another class. An option series consists of all the options of a given class with the same expiration dateand strike price. In other words, an option series refers to a particular contract that is traded. The IBM 110 January calls are an option series.
Options are referred to as in the money, at the money, or out of the money. An in-the-money option is one that would lead to a positive cash flow to the holder if it were exercised immediately. Similarly, an at-the-money option would lead to zero cash flow if it were exercised immediately, and an out-of-the-money option would lead to a negative cash flow if it were exercised immediately. If S is the stock price and X is the strike price, a call option is in the money when S > X, at the money when S = X, and out of the money when S < X. A put option is in the money when 5 < X, at the money when S — X, and out of the money when S > X. Clearly, an option will only be exercised if it is in the money. In the absence of transaction costs, an in-the-money option will always be exercised on the expiration date if it has not been exercised previously.
The intrinsic value of an option is defined as the maximum of zero and the value it would have if it were exercised immediately. For a call option, the intrinsic value is therefore max(S — X, 0). For a put option, it is max(X — S, 0). An in-the-money American option must be worth at leasLas much as its intrinsic value since the holder can realize the intrinsic value by exercising immediately. Often it is optimal for the holder of an in-the-money American option to wait rather than exercise immediately. The option is then said to have time value. The total value of an option can be thought of as the sum of its intrinsic value and its time value.
The early over-the-counter options were dividend protected. If a company declared a cash dividend, the strike price for options on the company's stock was reduced on the ex-dividend day by the amount of the dividend. Exchange-traded options are not generally adjusted for cash dividends. As we will see in Chapter 10, this has significant implications for the way in which options are valued.
Exchange-traded options are adjusted for stock splits. A stock split occurs when the existing shares are "split" into more shares. For example, in a 3-for-l stock split, 3 new shares are issued to replace each existing share. Since a stock split does not change the assets or the earning ability of a company, we should not expect it to have any effect on the wealth of the company's shareholders. All else being equal, the 3-for-l stock split just referred to should cause the stock price to go down to one-third of its previous value. In general, an n-fox-m stock split should cause the stock price to go down to m¡n of its previous value. The terms of option contracts are adjusted to reflect expected changes in a stock price arising from a stock split. After an n-for-m stock split, the exercise price is reduced to m/n of its previous value and the number of shares covered by one contract is increased to n /m of its previous value. If the stock price reduces in the way expected, the positions of both the writer and the purchaser of a contract remain unchanged.
Consider a call option to buy 100 shares of a company for $30 per share. Suppose that the company makes a 2-for-l stock split. The terms of the option contract are then changed so that it gives the holder the right to purchase 200 shares for $15 per share.
Stock options are adjusted for stock dividends. A stock dividend involves a company issuing more shares to its existing shareholders. For example, a 20 percent stock dividend means that investors receive 1 new share for each 5 already owned. A stock dividend, like a stock split, has no effect on either the assets or the earning power of a company. The stock price can be expected to go down as a result of a stock dividend. The 20 percent stock dividend referred to is essentially the same as a 6-for-5 stock split. All else being equal, it should cause the stock price to decline to 5/6 of its previous value. The terms of an option are adjusted to reflect the expected price decline arising from a stock dividend in the same way as they are for that arising from a stock split.
Consider a put option to sell 100 shares of a company for $15 per share. Suppose that the company declares a 25% stock dividend. This is equivalent to a 5-for-4 stock split. The terms of the option contract are changed so that it gives the holder the right to sell 125 shares for $12.
The exchange specifies a position limit for each stock upon which options are traded. This defines the maximum number of option contracts that an investor can hold on one side of the market. For this purpose, long calls and short puts are considered to be on the same side of the market. Also, short calls and long puts are considered to be on the same side of the market. The exercise limit equals the position limit. It defines the maximum number of contracts that can be exercised by any individual (or group of individuals acting together) in any period of 5 consecutive business days. For Digital Equipment, the position limit/exercise limit is at the time of writing 8,000 contracts.
Position limits and exercise limits are designed to prevent the market from being unduly influenced by the activities of an individual investor or group of investors. However, whether they are really necessary is a controversial issue.
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