Option Concepts

The specifications of an option include, first, a clear description of what can be bought (for a call) or sold (for a put). For options on stock, each option is usually for 100 shares of a specified stock. Thus a call option on IBM is the option to buy 100 shares of IBM. Second, the exercise price, or strike price, must be specified. This is the price at which the asset can be purchased upon exercise of the option. For IBM stock the exercise price might be $70, which means that each share can be bought at $70. Third, the period of time for which the option is valid must be specified—defined by the expiration dale, Hence an option may be valid for a day, a week, or several months, There are two primary conventions regarding acceptable exercise dates before expiration An American option allows exercise at any time before and including the expiration date A European option allows exercise only on the expiration date The terms American and European refer to the different ways most stock options are structured in America and in Europe, but the words have become standard for the two different types of structures, no matter where they are issued. There are some European-style options in America. For example, if the option to buy a house in one year states that the sale must be made in exactly one year1 and not sooner, the house option can be referred to as a European option

These four features—the description of the asset, whether a call or a put, the exercise price, and the expiration date (including whether American or European in style)—specify the details of an option A final, but somewhat separate, feature is the price of the option itself—the premium If an option is individually tailored, this premium price is established as part of the original negotiation and is part of the contract If the option is traded on an exchange, the premium is established by the

Cal! Put

Option/strike Exp. Vol, Last Vol. Last






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FIGURE 12.1 Options quotations on General Motors stock (December 15, 1995K The firs! column shows the closing price of the stock The other columns give information about available options Source: The Wall Street Journal, December 15. 1994

371 45 Jan 104 J 49 7

maiket through supply and demand, and this premium will vary according to trading activity.

There are two sides to any option: the party that grants the option is said to write an option, whereas the party that obtains the option is said to purchase it The party purchasing an option faces no risk of loss other than the original purchase premium, However, the party that writes the option may face a large loss, since this party must buy or sell this asset at the specified terms if the option is exercised In the case of an exercised call option, if the writer does not already own the asset, he must purchase it in order to deliver it at the specified strike price, which may be much higher than the current market price. Likewise, in the case of an exercised put option, the writer must accept the asset for the strike price, which could be much lower than the current market price.

Options on many stocks are traded on an exchange In this case individual option trades are made through a broker who trades on the exchange. The exchange clearinghouse guarantees the performance of all parties Because of the risk associated with options, an option writer is required to post margin (a security deposit) guaranteeing performance,2

Exchange-traded options are listed in the financial press A listing of GM (General Motors) options is shown in Figure 12.1 There are several different options available for GM stock Some are calls and some are puts, and they have a variety of strike prices and expiration dates fn the figure, the first column shows the symbol for the underlying stock and the closing price of the stock itself The second column shows the exercise (or strike) price of the option. The third column shows the month in

-The initial margin level is often 50^ of the stock value of the option, with a maintenance level of 25%

which the option expires The exact expiration date during that month is the Saturday following the third Friday. The fourth and fifth columns give data on a call, showing the volume traded on the day reported and the last reported price for that option The final two columns give the analogous information for the put. All prices are quoted on a per-share basis, although a single option contract is for 100 shares.

As with futures contracts, options on financial securities are rarely exercised, with the underlying security being bought or sold Instead, if the price of the security moves in a favorable direction, the option price (the premium) will increase accordingly, and most option holders will elect to sell their options before maturity

There are many details with regard to options trading, governing special situations such as stock splits, dividends, position limits, and specific margin requirements, These must be checked before engaging in serious trading of options, However, the present overview is sufficient for understanding the basic mechanics of options.

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