The Language of Options

Download: The Language of Options Many investors find that learning about options is akin to learning a new language. There is an element of truth in this, to the extent that to fully understand what options are and how they can be used, one must become comfortable with a number of options related terms. By the end of this module you should be able to talk options somewhat more fluently. Class, Series, Type Lets start with a stock, say Google (GOOG). There are options traded on GOOG and all of the options on this one stock make up an option class . Other examples of classes are all of the options on IBM, GM or MSFT, all of the options on the Standard & Poors 500 Index (SPX) and all of the options on the Spyders (SPY). Within a class, there are two types of options: puts and calls. And, more specifically, a series refers to an option with a given strike price and a given expiration date, such as the GOOG September 400 calls. If you want to know which series make up a class, the easiest way to find out is to call up an options chain . A chain lists all of the different series that make up a class. You can find chains on various web-sites, including the CBOEs, and most probably, on the site of your brokerage firm. Not all chains present the information in the same format; some will list all calls, then all puts, some will list the series by expiration month and other chains can be customized by their users. You should familiarize yourself with the chains you will be using to obtain quotes. Click here for an example of a chain from the CBOE web-site. Long and Short The words long and short both have two different meanings, which can easily lead to confusion. Lets start with long and short as they are used to describe a security position. You purchase 200 shares of IBM; you have established a long position in this stock. You also buy some call options on Intel; you are now long Intel calls. And to complete your portfolio, you purchase puts on Pfizer; you are long Pfizer puts. Easy enough: long simply means that you have purchased some security, stock or option. Short is slightly trickier. Shorting a stock is an investment technique where an investor borrows shares of stock (in most cases from his/her brokerage house), and sells these shares. This is know as shorting a stock . The reason this is done is that the price of the stock in question is expected to fall. Think of shorting a stock at $50. One month later these shares have dropped to $40 and you decide to cover your short position. To do this you purchase the same number of shares you have shorted and deliver these shares to your brokerage house to replace the shares you borrowed. You will notice that your profit is $10 per share, since you bought the stock at $40, sold it at $50, but chronologically, you sold the shares before buying them. Most of us are more used to doing things the other way around: buying the stock first, then selling it. The risk of a short stock position is rising prices. At some point, you will have to return the borrowed shares and if the price is $60 or $70 you will find yourself in the position of buying a stock at $60 or $70 and selling it (or more precisely, having already sold it) at $50. Shorting options is most often referred to as selling or writing . Unlike stocks you can short an option that you do not own without having to borrow it from anyone. Shorting an option creates an obligation but not necessarily the obligation to buy back the option. This will be covered in more detail. For now, simply remember that if someone tells you Im short GM it means that they sold shares they did not own and are more than likely expecting the price of this stock to drop. They will have to buy

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back these shares at some point in the future. If you hear Im short the Exxon March 75 calls or Im short the MMM November 110 puts this means that these investors have sold options they did not own, now have some type of obligation which may or may not require them to buy back these options. Long and short can also be synonymous with bullish and bearish . Someone who is long the market has a position that will benefit from a rising market; this investor may have gone long the market by buying stocks, but may also have taken an option position. Being short the market means that a position will be profitable in a down (bearish) market. Once again, this can be accomplished by shorting stocks, or taking a position in options. It is possible to go long the market by shorting some options! The bias of this position is bullish but this bias was created by shorting some options. Expiration Cycles, Strike Price Intervals Take a specific option series, say the AIG April 55 calls. You will note that this option has an expiration month, April, and an exercise price, 55. If you pull up the option chain for different stocks you may notice that they have different expiration months, and you may wonder if there is any logic as to which month is trading for any given stock. Every stock is assigned to one of three expiration cycles: the January, the February or the March cycle. The months in each of these 3 cycles are as follows: January cycle: February cycle: March cycle: January, April, July, October February, May, August, November March, June, September, December

There are four expiration months listed for all optionable stocks (some have more, see below). These four months are determined as follows: the next two calendar months, plus the next two months from the stocks relevant cycle. Heres what this means. Assume it is early November and a given stock is in the March cycle. The four expiration months that will be listed for trading are: November and December (these are the next two calendar months), plus March and June (the next two months from the March cycle). Heres a second example: its late February and a stock is in the February cycle. By late February we mean that its after the February expiration date. The next two months are therefore March and April, and the next two months from the February cycle are May and August. The first expiration month is referred to as the front month and the longer-dated expiration months as the back months . How can you determine to which cycle a stock has been assigned? The easiest way may be to pull up the stocks option chain and see which months are listed. Remember, the first two months will always be listed, so pay attention to the two longer-dated expirations. For more thorough cycle chart, please refer to our Cycles and Strike/Month Codes .

LEAPS

Expirations

In addition to the 4 short-term expiration months, selected stocks have an additional two longer-dated expirations. These longer-dated options are know as LEAPS. All LEAPS expire in January. So, in early 2009, a stock would have 4 short-term expirations, plus a January of 2010 expiration and a January of 2011 expiration. On Monday of expiration week in September, October, and November (depending on

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the stocks expiration cycle) the January 2012 LEAPS will be added as the January 2010 will now be considered a short-term option. Strike Price Intervals If you pull up an option chain you will notice that there may be a June 40 call, a June 45 call and a June 50 call listed on a particular stock. The interval between the options exercise prices is set at $5. This rule applies to stocks trading between $25 and $200. Below $25 the interval between strikes is $2.50, and above $200 it is $10. But there are exceptions! Some less volatile stocks may have $2.50 intervals above the normal $25 cutoff, and some low-priced stocks may even have $1.00 intervals. The best way to know whats available is to pull up an option chain. Paying for Options, Margining Short Positions As a general rule, if you purchase an option, you must pay its full price on the following business day. This is different from stocks where you may borrow funds from your brokerage house to partially finance your purchase. If you establish a short option position you may be required to margin this position. This means that you must provide funds or securities as a guarantee since a short option position usually entails your assuming an obligation and you must show that you are financially able to do so. Some short options will be considered covered and will not require any margin. Margin requirements for the more complex option strategies can be difficult to calculate. Fortunately this task has been automated at most brokerage houses. Exercise and Assignment Option buyers obtain rights: the purchaser of a call obtains the right to buy the stock under option, the buyer of a put obtains the right to sell the underlying stock. At some point in time an investor who is long an option (i.e., has purchased an option) may decide to invoke this right. He/she does so by exercising the call or the put. To exercise an option an investor either instructs his/her broker (usually by phone) or, if this feature is available, may exercise on the brokerage houses web-site. Once an exercise notice has been submitted, it is deemed irrevocable, a fancy way of saying You cant change your mind. From your perspective what is important is the exercise cut-off time set by your brokerage firm. This is simply the time by which you must inform your broker that you want to exercise an option on a given day. There is also an exchange cut-off time, but this is for your brokerage firm to worry about, not you. An option exercise triggers a stock trade: if you exercise a call you are effectively buying the underlying stock. You must pay for the stock against which payment you will receive the shares. Settlement of an option exercise is 3 business days after the day when it was exercised. If an option is exercised on a Monday, the settlement will occur on the Thursday. If an option is exercised on a Thursday, the settlement will be on the following Tuesday. If an investor has a short position in an option (i.e., has sold an option), he/she has assumed an obligation: the obligation to sell a stock if short a call, or to buy a stock if short a put. Whenever an investor (with a long position) exercises an option, another investor who is short the same option series will be assigned . If exercising an option is something an investor does, being assigned is something that happens to an investor. An investor knows he/she is being assigned when they receive, from their brokerage house, an assignment notice. This notification may be done by phone or by e-mail. Assignment notices are

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usually sent out in the morning, before the markets open. Please note that if an option is exercised by Peter on Monday, Paul will receive an assignment notice on Tuesday morning. Settlement will be 3 business days after the option was exercised, on Thursday. This is only 2 days after Paul receives the assignment notice. American and European Style Options As far as exercise/assignment goes, there are two option styles: American and European style options. An American style option may be exercised on any business day, including the day on which it is purchased. For example, if Mary buys a November call option on June 14 she has the right to exercise this option on June 14 and on every business day up to and including the third Friday in November. American style options can be exercised early and this leads to early assignment. If Mary exercises a November option during the month of June, someone (an investor with a short position in that same option series) will be assigned in June. Any short position in an American style option includes the risk of being assigned early. By the way, this may or may not be a bad thing, depending on the option, the strategy involved and the traders position in other securities. Heres an easy one: all equity options are American style. A European style option is one which may be exercised on only one date, the day immediately preceding the options expiration. So if Jane purchases a European July put in March, she will not have to right to exercise it until immediately prior to the options expiration date in July. Heres a not so easy one: most index options are European style, but a few are American style. If you are going to trade index options you should verify (before trading!) if they are American or European exercise style. And as you probably noticed, the terms American and European have nothing to do with geography.

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