By definition, If the exercise price of a call option is less than the present market (or spot) price of the underlying stock (or index), then the call option is said to be in-the-money option. 2) Moneyness is always looked at from the point of view of the Buyer of the option contract. 3) Moneyness, atleast definition-wise, does not have any relation to the expiry date of the option. Now as mentioned in points 3 and 4 above, the price or premium paid for buying the option and the expiry date of the option has nothing to do to determine the "moneyness" of this option. In this case the buyer has the right to buy the options at $60 per share (which is the strike price of the option), although the market price of IBM stock is higher ($65). Another way to look at the moneyness is the profitability in the pay off function for this position. Another way to gauge the moneyness of a Put option is to see whether the current postion is profitable for the buyer or not. Please note that moneyness of options keep changing as the time passes by, and as the spot price of underlying keeps changing. When buying or selling an option, you must choose from a set of predetermined price levels at which you will enter the futures market if the option is exercised.
If you have already purchased an option, you can offset this position by selling another option with the same strike price and delivery month.
If you have written (sell) an option, you can offset this position by buying an option with the same strike price and delivery month. The buyer of a call option will make money if the futures price rises above the strike price. The seller of a call option loses money if the futures price rises above the strike price. If the futures price drops below the strike price, the option buyer will not exercise the option because exercising will create a loss for the buyer.
The buyer of a put option will make money if the futures price falls below the strike price.
The seller of a call option loses money if the futures price falls below the strike price. If the futures price rises above the strike price, the option buyer will not exercise the option because exercising will create a loss for the buyer. The intrinsic value is the amount of gain that can be realized if the option is exercised and the resulting futures position closed out. Extrinsic (extra) value is the amount by which the option premium exceeds the intrinsic (exercise) value. Market volatility - As the futures market becomes more volatile, the extrinsic value increases.
Below are examples of call and put options that are in-the-money, at-the-money, and out-of-the-money. Below are actual examples of soybean option premiums for various strike prices and delivery months. The options with strike prices at-the-money and out of-the-money have premiums containing no intrinsic value (exercise value.) Only those options that are in-the-money have premiums with intrinsic value. This occurs because the August option will be traded for a longer period of time than the July option.
An option trader who is writing a call option for $6.50 will be liable for exercise value if the futures price increases by only one cent.
We're often asked to explain what determines the price of crude oil (as well as bunker fuel, diesel fuel, gasoil, gasoline and jet fuel) options. The variable which has the most influence on the price of an option is the relationship between the price of the underlying crude oil futures or swap and the strike price of the option. An option is at-the-money when the strike price equals or is very close to the price of the underlying futures or swap.
Traders who implement an ITM covered call strategy writes (sells) a call option for leverage against potential losses on owned shares. There are three ways to define the relationship between an option's strike price and the market price of its underlying asset. ITM - In The Money: The underlying asset's market price is more than option's strike price. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. The call buyer exercises his or her right to buy 100 shares at $45, paying $4500 for the seller's assets. Pluses: The upside to this type of strategy is that the investor will always make a profit when the price of the underlying asset rises. Minuses: The downside in using covered call strategy is that the method limits an investor's profits.
Share Share this post on Digg Del.icio.us Technorati Twitter Igor View Public Profile Send a private message to Igor Find all posts by Igor View Igor's Videos Arcade Challenge Igor in the Arcade! If you come from a directional trading background (meaning long or short), then you probably only focus on where a stock or market is going.
If you’re in the dark about the true mechanics of options expiration, make sure you read this before you trade another option. On the third Saturday of the month, if you have any options that are in the money, you will be assigned. The transaction in these options is handled between you, your broker, and the Options Clearing Corporation.
If you are long options that are in the money, you will automatically begin the settlement process.
Each option has a price that the buyer can buy or sell the stock– this is known as the strike price. With the introduction of weekly options into the mix, we now have options that expire every single Friday.
For monthly SPX options, they stop trading on Thursday, and the settlement value is based on an opening print Friday morning. It’s very similar comparing traditional particle physics with what happens at the quantum level. We know that if the option is out of the money, it will have no directional exposure (0 delta), and if the option is in the money it will behave like stock (100 delta). If you have an option that switches from OTM to ITM very quickly, your risks change drastically.
If you have a short option that goes in the money into expiration, you must fulfill that transaction.
I found on Saturday that the short options had expired in the money, and that I now had a sizeable long position on in BIDU.
If you have a sold call, you will be given a short position if you don’t own the stock already. A good rule of thumb is if your option has no extrinsic value (time premium) left, then you need to adjust your position.
Option buying strategies attempt to make money if the underlying stock sees a faster move than what the options are pricing in.
Option selling strategies attempt to make money if the stock doesn’t move around that much. When an individual stock goes parabolic or sells off hard, we will look to fade the trade by either purchasing in-the-money puts or by selling OTM spreads.
With the market selling off hard in December and the VIX spiking up, premium in SPX weeklies were high enough to sell them.
These are high-risk, high-reward trades that speculate strictly on the direction of a stock. Since they can be no limit as to how high the stock price can be at expiration date, there is no limit to the maximum profit possible when implementing the long call option strategy. Risk for the long call options strategy is limited to the price paid for the call option no matter how low the stock price is trading on expiration date. Say you were proven right and the price of XYZ stock rallies to $50 on option expiration date.
However, if you were wrong in your assessement and the stock price had instead dived to $30, your call option will expire worthless and your total loss will be the $200 that you paid to purchase the option. Stock options give the option holder the right, but not the obligation, to buy or sell particular stocks for a particular price, called the strike price, within a specified time. Leverage is the Fundamental Advantage of OptionsLeverage is the fundamental advantage of options. Books about option trading have always presented the popular strategy known as the covered-call write as standard fare. At the time these prices were taken, RMBS was one of the best available stocks to write calls against, based on a screen for covered calls done after the close of trading. Figure 1 - RMBS May option prices with the May 25 in-the-money call option and downside protection highlighted. Alternative Covered Call Construction As you can see in Figure 1, we could move into the money for options to sell, if we can find time premium on the deep in-the-money options. Looking at another example, a May 30 in-the-money call would yield a higher potential profit than the May 25. As you can see in Figure 1, the most attractive feature of the writing approach is the downside protection of 38% (for the May 25 write). While there is less potential profit with this approach compared to the example of a traditional out-of-the-money call write given above, an in-the-money call write does offer a near delta neutral, pure time premium collection approach due to the high delta value on the in-the-money call option (very close to 100). The Bottom LineCovered-call writing has become a very popular strategy among option traders, but an alternative construction of this premium collection strategy exists in the form of an in-the-money covered write, which is possible when you find stocks with high implied volatility in their option prices. In this short instructional video Anton Theunissen explains what a married put is and how it works.
Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares.
However, the profit potential of covered call writing is limited as the investor had, in return for the premium, given up the chance to fully profit from a substantial rise in the price of the underlying asset. In addition to the premium received for writing the call, the OTM covered call strategy's profit also includes a paper gain if the underlying stock price rises, up to the strike price of the call option sold. Potential losses for this strategy can be very large and occurs when the price of the underlying security falls. An options trader purchases 100 shares of XYZ stock trading at $50 in June and writes a JUL 55 out-of-the-money call for $2.
It is interesting to note that the buyer of the call option in this case has a net profit of zero even though the stock had gone up by 7 points. Overall, writing out-of-the-money covered calls is an excellent strategy to use if you are mildly bullish toward the underlying stock as it allows you to earn a premium which also acts as a cushion should the stock price go down. As the covered call writer is exposed to substantial downside risk should the stock price of the underlying plunges, collars can be created to reduce this risk thru the use of put options. In-the-money covered call options are sold when the investor has a neutral to slightly bearish outlook towards the underlying security as their higher premiums provide greater downside protection. The reason for this is that the buyer of this call option has the right to buy the stock at a price which at present is smaller than the price he would have to pay to buy the stock in the stock market.
However, as explained in the article Time Decay in Options, it has severe impact on moneyness as it determines the price of the option. Hence, this situation is profitable to the Buyer, so it is called In the Money Call Option. As displayed in the payoff graph for the put option, the underlying price is lower than the strike price, so the put option is showing prift to the buyer. Although the stike price of option usually remains contant during the lifetime (unless there is some corporate action), but something which is in the money today, may be out of money tomorrow. If the rise is more than the cost of the premium and transaction, the buyer has a net gain. If the rise is more than the income from the premium less the cost of the transaction, the seller has a net loss.
In this situation the option buyer will let the option expire worthless on the expiration day.
If the decline is more than the cost of the premium and transaction, the buyer has a net gain. If the decline is more than the income from the premium less the cost of the transaction, the seller has a net loss. In this situation, the option buyer will let the option expire worthless on the expiration day. The option buyer pays the premium to the option writer (seller) at the time of the option transaction. A call option has intrinsic (exercise) value if the futures price is above the strike price.
Extrinsic value is the return that option writers (sellers) demand in return for bearing the risk of loss from an adverse price movement. These option terms pertain to the relationship between the current futures price and the strike price. In other words, a call option is in-the-money if the current futures price is above the strike price because it can be exercised at the strike price and sold at the current futures price for a gain. A one cent change in the future price will put the option either in-the-money or out-of-the-money. The time period from March 1 to mid July, when the August option expires, is four and one-half months.
They demand a higher return (premium) for bearing this risk for a longer time period, especially considering that June and July are usually periods of price volatility due to the crop growing season. It is only 14 cents for the 50 cents out of-the-money option ($7 strike price option) and 8 cents for the 50 cents in-the-money option ($6 strike price option). However, by writing a $7 option, the futures price will have to rise by over 50 cents before the writer will be liable for exercise value. Depending upon the price of the underlying swap relative to a given strike price, an option is said to be at-the-money, in-the-money, or out-of-the-money.
An option is considered in-the-money when the price of the underlying future or swap is above the strike price of a call option or when the price of the underlying swap is below the strike price of a put option. Understanding the differences between the terms is important when considering the returns involved in implementing a covered call strategy.
After adding the $200 in premiums received, the trader's covered call strategy results in a $200 profit [$4500 (received) - $4300 (Paid)]. The shares held by the writer loses $500 in paper value [$5000 (paid) -$4500 (worth on strike date)], but since the writer received $700 in premiums, he or she still makes a profit of $200.
The shares held by the writer loses $1000 in paper value [$5000 (paid) -$4000 (worth on strike date)], but since the writer received $700 in premiums, his or her loss reduces to $300.
Another advantage in using a covered call strategy is that the investor can also profit from a drop in price of the underlying asset. If the underlying asset's market value takes off, the trader cannot take advantage of the gain because he or she must sell assets at a fixed price after assignment. Make sure your books are cleared out of all in the money options if you don’t want to get assigned. This may be difficult into options expiration as the liquidity will dry up and you will be forced to take a worse price.
These kinds of rolls, as detailed in my options trading course, will move your position into a different contract that has more time value, or is out of the money. The profit technically comes from the delta (directional exposure), but since it is a long gamma trade, your directional exposure can change quickly leading to massive profits in the very short term.
If we think the options market is cheap enough and the stock is ready to move, we will buy weekly straddles. Generally a stock will develop a short term technical setup that looks to resolve itself over the course of hours instead of days. If the underlying stock price does not move above the strike price before the option expiration date, the call option will expire worthless. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. With underlying stock price at $50, if you were to exercise your call option, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. Options (also called contingent claims) are derivatives, so called because their value derives from other securities (called the underlying security, or just underlying or underlier), which in the case of stock options are particular stocks. A small investment can benefit from the price movements of securities that would either cost much more to own outright, or would require a much greater risk. We can begin by looking at the prices of May call options for RMBS, which were taken after the close of trading on April 21, 2006. As you can see in Figure 1, it would be possible to sell a May 55 call for $2.45 ($245) against 100 shares of stock.
But there is very little downside protection, and a strategy constructed this way really operates more like a long stock position than a premium collection strategy.
Looking at the May 25 strike, which is in-the-money by $13.60 (intrinsic value), we see that there is some decent time premium available for selling. While there is no room to profit from the movement of the stock, it is possible to profit regardless of the direction of the stock, since it is only decay-of-time premium that is the source of potential profit. This is because the cost basis is much lower due to the collection of $1,480 in option premium with the sale of the May 25 in-the-money call option.Potential Return on in-the-Money Call Writes As you can see in Figure 2, with the May 25 in-the-money call write, the potential return on this strategy is +5% (maximum). The OTM covered call is a popular strategy as the investor gets to collect premium while being able to enjoy capital gains (albeit limited) if the underlying stock rallies. So he pays $5000 for the 100 shares of XYZ and receives $200 for writing the call option giving a total investment of $4800.
Since the striking price of $55 for the call option is lower than the current trading price, the call is assigned and the writer sells the shares for a $500 profit.
So if you are planning to hold on to the shares anyway and have a target selling price in mind that is not too far off, you should write a covered call. X has bought the IBM call option at $2 and the IBM call option has a strike price of 60 and expiry as 30-May-2010. X had bought a Put Option on IBM stock which has the strike price of $70, which gives him the right to sell the IBM stock at $70.
The content should NOT to be reproduced on any other website or through other medium, without the author's permission. The option seller (writer) must take the opposite side of the option buyer’s futures position. For example, if you choose a soybean option with a strike price of $7 per bushel, upon exercising the option you will buy or sell futures for $7. For example, corn options have December, March, May, July, and September delivery months, the same as corn futures. The amount of gain or loss from the transaction depends on the premium you paid when you purchased the option and the premium you received when you sold the option, less the transaction cost. The amount of gain or loss from the transaction depends on the premium you received when you sold the option and the premium you paid when you repurchased the option, less the transaction cost. The seller (writer) of the call option must sell futures (take the opposite side of the futures transaction) if the buyer exercises the option. The only money transfer will be the premium the option buyer originally paid to the writer. The writer (seller) of the put option must buy futures (take the opposite side of the futures transaction) if the buyer exercises the option. The only money transfer will be the premium the option buyer originally paid to the seller.
A put option has intrinsic (exercise) value if the future price is below the strike price. Conversely, a put option is out-of-the-money if the current futures price is above the strike price. In parentheses are the intrinsic (exercise) value and the extrinsic value for each option premium. Futures price would have to rise by over 50 cents before the option would contain any exercise value.
The time period from March 1 to mid June for the July option is only three and one-half months.
So the extrinsic value decreases as the option moves further out-of-the-money or in-the-money. So the writer will demand a higher return (extrinsic value) for writing an at-the-money option. The date on which the option quotes were taken (March 1) and the futures prices ($6.50) are also the same. Lastly, an option is considered out-of-the-money when the price of the underlying future or swap is below the strike price of a call option or when the price of the underlying futures or swap is below the strike price of a put option.
The strategy involves writing a call option ITM and buying the same number of regular shares of the underlying asset. Writing the call option leverages the investment against market downturns, and it gives the trader a cushion for reducing his or her losses. So if you are trading around OpEx with the SPX you need to check if it’s a weekly or monthly contract. And since option premium decays very fast into OpEx, the majority of your profits come from theta gains. You believe that XYZ stock will rise sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ call option covering 100 shares.
They are used extensively for hedging because options allow an investor to protect a position for a small cost, and speculators like them because their profit potential is much greater than the underlying securities. For instance, to buy 100 shares of a $50 stock would require a $5,000 investment, but to buy 1 call contract for 100 shares of that same stock at $5 per share would require a $500 investment. In 2010, the ticker symbology was replaced by the OCC with a more informative system, such that the basic information about the option can easily be read from the ticker symbol itself.
It involves writing (selling) in-the-money covered calls, and it offers traders two major advantages: much greater downside protection and a much larger potential profit range.
RMBS closed that day at 38.60, and there were 27 days left in the May options cycle (calendar days to expiration). This traditional write has upside profit potential up to the strike price, plus the premium collected by selling the option.
Downside protection from the sold call offers only 6% of cushion, after which the stock position can experience un-hedged losses from further declines. This is calculated based on taking the premium received ($120) and dividing it by the cost basis ($2,380), which yields +5%.
These conditions appear occasionally in the option markets, and finding them systematically requires screening. In fact, the covered call writer's loss is cushioned slightly by the premiums received for writing the calls. This brings his total profit to $700 after factoring in the $200 in premiums received for writing the call.
The moneyness of an option is determined by the "relative" values of strike price (Exercise price) and the underlying's spot price. For example, if you buy an option with the right to buy futures, the option seller (writer) must sell futures to you if you exercise the option. Option contracts are traded in a similar manner as their underlying futures contracts. However, you run the risk of having the option exercised by the buyer before you offset it. Because of extrinsic value, an option buyer can sell an option for as much or more than its exercise value.
The extrinsic value declines as the futures price moves away (above or below) from the strike price.
If this option is exercised, the option buyer will own a futures contract purchased at a strike price of $6. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000. Besides common stock, there are also options for stock indexes, foreign exchange, agricultural commodities, precious metals, and interest rate futures.Although options were originally traded in the over-the-counter (OTC) market, where the contract terms were negotiated, option trading really took off when the first option exchange, the Chicago Board Options Exchange (CBOE), was organized in 1973 to trade standardized contracts, increasing the market and liquidity of options. Option premiums were higher than normal due to uncertainty surrounding legal issues and a recent earnings announcement.
In other words, if we sold the May 25, we would collect $120 in time premium (our maximum potential profit).
When found, an in-the-money covered-call write provides an excellent, delta neutral, time premium collection approach - one that offers greater downside protection and, therefore, wider potential profit zone, than the traditional at- or out-of-the-money covered writes.
X, as a buyer, is in benefit, because he has the right to sell the IBM stock at a higher price of $70, rather than the current spot price of $65. All buying and selling occurs by open outcry of competitive bids and offers in the trading pit. The option writer (seller) takes the opposite side (sell) of the futures position at the strike price.
The premium is the maximum amount the option buyer can lose and the maximum amount the option seller can make. This occurs because exercising a put option places the option buyer in the futures markets selling (rather than buying) futures at the strike price. Because of market volatility, option writers demand a higher return to compensate them for the greater risk of loss due to a rapidly changing market.
Premiums received from writing the call cut losses, if the price of the underlying asset falls.
Since you had paid $200 to purchase the call option, your net profit for the entire trade is therefore $800. Although the risk is limited to the premium for the option holder, the disadvantage of buying options is that they can expire completely worthless, and often will. If we were going to do a traditional covered-call write on RMBS, we would buy 100 shares of the stock and pay $3,860, and then sell an at-the-money or out-of-the-money call option.
If used with margin to open a position of this type, returns have the potential to be much higher, but of course with additional risk. The $6.00 strike price option has extrinsic value of 8 cents, the difference between the premium and the exercise value.
The futures position can then be offset by buying a futures contract at the lower price for a gain. Note that, in general, the greater the strike price is from the stock price, the smaller the open interest and the fewer the trades.
The short call is covered by the long stock (100 shares is the required number of shares when one call is exercised).
If we were to annualize this strategy and do in-the-money call writes regularly on stocks screened from the total population of potential covered-call writes, the potential return comes in at +69%. If you can live with less downside risk and you sold the May 30 call instead, the potential return rises to +9.5% (or +131% annualized) - or higher if executed with a margined account. In addition to options, the OCC also offers clearing and settlement for futures and options on futures.
Since Microsoft is coming out with Office 2007 and Windows Vista, let's say the price rises to $40 per share by April, 2007.
Its website publishes statistics and news on options, and publishes all changes in the trading rules and any adjustments of option contracts that requires changes, such as a merger of companies whose stock was the underlying security to the option contracts.The OCC is the direct participant in every purchase and sale of an option contract. The call contract would allow the holder to buy 100 shares of MSFT for $30, which could then be sold for $40 in the market (or the stock could be sold short, then covering the short by exercising the call).
When an option writer or holder sells his contracts to someone else, the OCC serves as an intermediary in the transaction. It would be virtually impossible to even approach getting the same return on investment buying the stock itself! Moreover, on the last trading day for the option, notification must be given before the exercise cut-off time, which will probably be earlier than on trading days before the last day, and the cut-off time may differ for different option classes or index options.
Of course, if Microsoft's stock price didn't increase above $30 per share by the expiration date in April, 2007, then the call contract would expire completely worthless, while the stock holder would still have the stock, and could receive dividends on it. Brokers generally require notification to exercise an option, even if it is in the money.After notification, the broker sends the exercise instructions to the OCC, who then assigns the exercise to one of its Clearing Members who are short in the same option series as is being exercised. During the October 2006 to April 2007 period, MSFT was briefly above $30, with a high slightly above $31. So even if the option was closed out at the market top, profits would have been minimal after subtracting the call premium and transaction costs.
Thus, there is no direct connection between an option writer and a buyer.To ensure contract performance, option writers are required to post margin, the amount depending on how much the option is in the money. If the margin is deemed insufficient, then the option writer will be subjected to a margin call.
Option holders don’t need to post margin since the option will only be exercised if it is in the money.
For instance, option contracts traded in the UK on the London International Financial Futures and Options Exchange (LIFFE) is for 1000 shares.)Calls and puts are the 2 types of options.
A call gives the holder the right, but not the obligation, to buy a specific security for a set price, called the strike or exercise price. Sarah Call-Buyer buys a contract that has the same terms that John Call-Writer wrote—in other words, it belongs to the same option series.
The older contracts are then exercised, closed out, or left to expire.There are 3 styles of options that differ as to when the option can be exercised. American-style options allow the holder to exercise the option at any time before expiration, whereas European-style options allow the holder to exercise only for a short time before the expiration date. Sarah buys from the OCC, just as John sold to the OCC, and she just gets a contract giving her the right to buy 100 shares of MSFT for $30 per share until April, 2007.Scenario 1—Exercises of Options are Assigned According to Specific ProceduresIn February, the price of MSFT rises to $35, and Sarah thinks it might go higher in the long run, but since she doesn't think the stock will go much higher before the expiration of the call, she decides to exercise her call to buy MSFT at $30 per share to be able to hold the stock indefinitely.
The option style is not related to geography — most options traded in Europe are American-style options. All equity options are American-style options, but most foreign currency options and CBOE stock index options are European-style options. Note that, although European-style options can only be exercised during a brief time right before expiration, the options can be sold before then.
Sam, unfortunately, either has to turn over his appreciated shares of Microsoft, or he'll have to buy them in the open market to provide them. Most options that require a cash settlement instead of the delivery of securities are European-style options, because it makes no sense to exercise an option for cash when it can simply be sold for cash. This is the risk that an option writer has to take—an option writer never knows when he'll be assigned an exercise during any time in which the option is in the money.Scenario 2—Closing Out an Option Position by Buying Back the ContractJohn Call-Writer decides that MSFT might climb higher in the coming months, so decides to close out his short position by buying a call contract with the same terms that he wrote—the same option series. The capped-style option can only be exercised for a specific time before expiration, unless the underlying security reaches the cap price, in which case, the capped-style option is exercised automatically. Sarah, on the other hand, decides to maintain her long position by keeping her call contract until April. The Saturday following expiration is used so that brokers can confirm customer option positions and related paperwork incurred by expiration and exercise. John closes his short position by buying the call back from the OCC at the current market price, which may be higher or lower than what he paid, resulting in either a profit or a loss. There are at least 2 near-term options which expire in the nearest 2 months, and there are 2 long-term options. When the current month's options expire, then more are created that expire in the month after the next. Option writers whose contracts were assigned will have earned less than the premium or may well have suffered losses, since the option holder wouldn't exercise it unless it was in the money. A closed out transaction could be at a profit or a loss for both holders and writers of options. The exact months of expiration are based on 3 different sequential cycles: the January Sequential Cycle, the February Sequential Cycle, and the March Sequential Cycle. A closed out transaction will always yield at least some return of investment, because the investor would not close out his position unless he was getting or saving more than the transaction cost.Stock Index OptionsStock index options are based on a stock index rather than on specific stocks. For larger companies and major indexes for which there is a significant market demand, there are also LEAPS (Long-Term Equity AnticiPation Securities), which are special options that initially have expiration dates several years into the future, and always expire in January. The value of index calls increase as the index increases, and the value of index puts increases as the underlying index decreases. These options are similar to stock options, but with some important differences.Because these options are based on indexes, there is greater diversification, and usually less volatility than with specific stocks.
However, the last trading day and the last day to notify the broker to exercise an option is the preceding Friday.The 2 near-term options are the nearest 2 months. For instance, stock splits of stocks within the index do not affect the index, and thus, no adjustments on the contracts are needed.The strike price is based on an index value multiplied by the multiplier of the contract, which is usually $100 (USD). These options are settled by the exchange of cash, not securities, which, for obvious reasons, is called a cash settlement. The option writer who is assigned an exercise pays cash to the holder who exercised the option.Many index options are European-style options that can be exercised for a short time right before expiration. Federal Reserve, lowered the Fed discount rate from 6?% to 5?% before the stock market opened on Friday morning. However, this makes little difference for options that are settled in cash, because the option holder can always sell the option on the exchanges for cash at any time before expiration.The cash that is paid upon exercise depends on the index, which depends on the component prices of the index. Thus, all Microsoft calls compose an option class, while all Microsoft puts compose another. In AM settlement, the cash settlement value is calculated using the opening component prices on the day of expiration. An option series is composed of the set of all options of the same option class that also have the same strike price and expiration date.
In PM settlement, closing prices on the day of expiration are used to determine the cash settlement value of the contract.The cash settlement amount is determined by multiplying the absolute difference between the index and the strike price of the option times $100.
For instance, if the company declares a 2-for-1 stock split, then each share of stock will be doubled, but the stock price will be half of what it was prior to the split. Thus, if XYZ stock, selling for $50 per share, splits 2-for-1, then there would be twice as many shares, but their value would decrease to around $25 per share, since the value of the company has not increased because of the split, and, therefore, the total market capitalization would remain about the same.Now, consider 2 option holders.
One holder has a call to buy XYZ stock for $50; the other holder has a put to sell XYZ stock for $50 per share. Thus, it is a way to freeze the foreign exchange rate for a given currency for the lifetime of the option.
If there were no contract adjustments, the call would almost certainly expire worthless, because the stock, now trading at $25 per share is not likely to double before expiration, while the put would be instantly profitable, with a rate of return that any investor would envy! Foreign currency future options are options on futures contracts for currency rather than the currency itself.
Options that are in the money pay the absolute difference between the price of the futures contract for currency and the strike price. The call writer would get to keep his premium, but the put writer would now have to buy stock for $50 that she could have purchased on the open market for half that price.To prevent these scenarios, adjustments are made to the option contracts (sometimes called adjusted options), when the relationship to the underlying security is significantly altered. The volume for currency futures options is much greater than for currency options.Interest rate options gives the holder the right to buy or sell bonds at the strike price, which can include Treasury bills, notes, and bonds and GNMA pass-through certificates. These alterations can include stock splits, reverse stock splits, stock dividends or distributions, rights offerings, a reorganization or recapitalization of the company, or a reclassification of the underlying security.
It can also occur if the issuer of the underlying security is acquired or merges, or is dissolved or liquidated.There are standard ways to adjusting the contracts in common events, such as stock splits, but, when the event is peculiar, and creates an uncertainty as to how the adjustment should be made, an adjustment panel will decide on the contract adjustments. The adjustments are listed in reverse chronological order, but the page includes a search box for looking for particular options. The effective date is the ex-date established by the primary market in the underlying security.Generally, option contracts are adjusted to maintain the same basic relationship between the option and the underlying security. The necessary adjustments in most of these cases can be found by the following equation:Number of Shares ? Price = New Number of Shares ? New PriceNote that the share number and price are inversely related.
If the number of shares is adjusted upward, then the price of each share must be adjusted downward, and vice versa. No adjustments are made for cash distributions of 10% or less.Example—Adjusting Option Contracts for Stock SplitsIn a 2-for-1 stock split, contracts are usually adjusted by doubling the number of option contracts, and halving their price. Thus, a call for 100 shares of XYZ stock for $50 per share would become 2 calls for $25 per share. The search engine provided allows searches for year, month, keywords, or memo number.Options TradingOptions were originally traded over the counter (OTC), and still are.
The advantages of the OTC market over the exchanges is that the option contracts can be tailored: strike prices, expiration dates, and the number of shares can be specified to meet the needs of the option buyer.
However, OTC options have greater transaction costs and less liquidity.Organized exchanges offer standardized contracts that are cheaper and easier to sell. The CBOE was the original exchange for options, but, by 2003, it has been superseded in size by the electronic International Securities Exchange (ISE), based in New York. Brokerage commissions must also be paid to buy, sell, or exercise options, and generally these commissions are a little higher than for stocks. Prices are usually quoted as a base plus per contract.Real World Example—Commission Schedules for Buying and Selling OptionsNote that this is NOT a comparison of the different companies, but is simply a sample of how option trading is priced, and its actual cost. All options have time value (sometimes called extrinsic value) because an option, as long as it exists, gives the holder the right to buy or sell the underlying security for the strike price. The greater the time until expiration, the greater the chance that the option can become profitable, and thus, the greater the time value. As the remaining time for the option declines, so does its time value, until at expiration it becomes completely worthless, and ceases to exist.
For instance, he might write a call to sell MSFT for $25 until the 3rd Saturday in January. The investor is called the call writer because, by accepting the legal obligation for the option premium, he creates or “writes” the option contract. If the call writer already owns the security on which the call is written, then the call is a covered call; otherwise, it is a uncovered call or a naked call, in which case, if the option is exercised, the call writer will have to buy the stock on the open market for whatever the current price is, which is the risk that a naked call writer bears. Anyone who already owns an option has a long position in it and would most likely close his position by selling it rather than exercising it, because options always have some time value before expiration, so selling an option is usually more profitable than exercising it.
But the option holder has no legal obligation, since he only bought the contract, not write it. However, an option writer sells an option that she created by agreeing to the legal obligation imposed by the contract that she sold for the premium. She is said to have a short position because, to close out her obligation before expiration, she would have to buy back a contract with the same terms that she wrote.
To have a short position in options is similar to having a short position in stocks, except that the option writer creates the option to sell, whereas the short seller of stock must first borrow the stock to sell it, which must eventually be bought back to close out the position. It is said to be a short position, because the call writer has to buy back the call to close out his position, whereas the long call holder sells his call to close out his position.PutsA put is created when an investor accepts the legal obligation for a specified time to buy a particular security for a particular strike price. For instance, the put writer might accept the obligation to buy MSFT at $25 per share at any time before the 3rd Saturday of January.
A put option on a given security gives the holder the right, but not the obligation, to sell the security at the strike price before the expiration date. The put writer is obligated to buy the security for the strike price from the put holder if the put is exercised.
The most that a put writer can make is the premium, while the potential loss is the price of the security, if it should become worthless, because of bankruptcy, for instance.
Note, too, that, for both calls and puts, buy premiums and commissions are always subtracted. As you can see by comparing the 125% profit in this example to the 766% profit in the previous example, paying a higher premium greatly reduces the potential rate of return, and also increases the risk.
For instance, if MSFT was just $3 higher, then this investment would have netted a loss.The 2 graphs below show the profit-loss scenarios for put holders and put writers when the put is exercised. It is said to be a short position, because the put writer has to buy back the put to close out his position, whereas the long put holder sells his put to close out his position.The Determination of Option PremiumsPremiums are quoted for each share of a contract. Therefore, since most option contracts are for 100 shares of stock, the premium must be multiplied by the number of shares per contract—100. For instance, for an option that has a quote of $1, an investor would have to pay $100 for each option contract, plus sales commissions.A number of factors determine the premium of an option.
The most important factor is the relationship of the strike price to the current price of the underlying security. As the option goes into the money, the premium will increase by at least $1 for every $1 increase in the intrinsic value of the option. This makes sense, since the more time that remains until expiration, the greater the chances that the option will go into the money.
Note, too, that as the ex-dividend date of the underlying security approaches, the greater the chance that an in-the-money call will be exercised, since it will allow the call holder to collect the dividend. Thus, a rho of 0.05 means that, for a 1% increase in interest rates, the theoretical value of call premiums will increase by 5%, whereas the theoretical value of put premiums will decrease by 5%, because put premiums move opposite to interest rates.
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