49. The Options Market

The trading of stock options--"puts and calls"--has become an important investment tool, due to a unique set of forces coming together in the securities marketplace. Several years ago, the Chicago Board of Trade was casting about for new ways to apply its special expertise in commodity futures contracts. At the same time, securities investors, locked into a dreary stock market and dissatisfied with what they felt was inadequate performance of common stocks, were also looking about for new ways to increase the yield on their portfolios. As a result, in April 1973, a new exchange--the Chicago Board Options Exchange--initiated trading in call options contracts for a limited number of NYSE-listed stocks. The exchange standardized option expiration dates, terms of contracts, and scale of premiums. It structured options that satisfy the broadest possible spectrum of participants: from "hedgers", protecting their "inventory" of securities, to "speculators", risking their capital in quest of substantial capital gains.

The new market for options has overshadowed the traditional, over-the-counter puts and calls market, which, while it still exists, lacks the liquidity of exchange auction trading and clearinghouse facilities. The CBOE's success quickly prompted other exchanges to follow suit: Options on listed securities are now traded on the American Stock Exchange, the Philadelphia Stock Exchange, the Pacific Stock Exchange, and the Midwest Stock Exchange. All of the exchanges use one clearing operation to facilitate bookkeeping and settlement arrangements. Some of the nation's leading brokerage firms now have specially trained registered brokers who handle options trading exclusively, and they are probably the best source of information on the intricacies of options trading.

WHAT ARE PUTS AND CALLS? A "call" is a contract offering the buyer of the call the right to buy shares of a certain issue of stock at any time prior to the call's expiration date for a specified price (called the
"striking price"). The buyer of the call pays a premium to the call's seller or writer for the privilege of having the purchase opportunity. The writer must deliver the underlying stock issue whenever called. A "put"
offers its buyer the right to sell shares of given stock issue anytime before the expiration date at the given striking price. The put writer receives his or her premium in return for being required to purchase the
put buyer's stock at the striking price whenever the latter chooses to excersise his or her option.

Here are definitions of some basic terms used in discussing the option market.

UNDERLYING SECURITY: The security subject to being purchased or sold upon the exercise of an option.

SERIES OF OPTIONS: Options of the same class having the same exercise price and expiration time and the same unit of trading.

UNIT OF TRADING: The number of units of the underlying security designated by the clearing corporation as the subject of a single option. In the absence of any other designation, the unit of trading for a common stock is 100 shares, subject to adjustment in certain events.

EXERCISE PRICE: The price per unit at which the holder of an option may purchase the underlying security upon exercise. The exercise price is sometimes called the "striking price".

EXPIRATION TIME: The latest time in the expiration month when an option may be exercised at the clearing corporation.

PREMIUM: The aggregate price of an option agreed upon between the buyer and writer or their agents in a transaction on the floor of an exchange.

COVERED CALL WRITER: A writer of a call who, so long a as he or she remains obligated as a writer, owns the shares or other units of underlying security covered by the call, or holds on a share-for-share basis a call of the same class as the call written if the exercise price of the call held is equal to or less than the exercise price of the call written.

UNCOVERED WRITER: A writer of an option who is not a covered writer (sometimes called a naked call option).

WHY WRITE OPTIONS? Writing covered call options can be a conservative approach to investing, since it offers a hedge against market declines and
a way of maximizing portfolio yields. Writing naked options, on the other hand, is more of a gamble than an investment.

As an example of a covered call option, assume Mr. E owns 1,000 shares of Handy-Dandy stock quoted at $40 a share. The stock has not moved much in the past couple of years, so E decides to try to earn some income by selling call options on it. Handy-Dandy is listed on one of the exchanges that trade options, so Mr. E has no problem finding a buyer; he just calls his broker, who puts in an order to sell 10 options on Handy-Dandy at $40 a share with a premium of $4,000 ($4 a share) to run approximately six months. As the expiration date approaches, the following market conditions might result in Mr. E taking these courses of action.

(1) MARKET STABLE: Handy-Dandy shares neither increase nor decrease in value. The price of the option comes down. The options are not exercised. After the expiration date Mr. E pockets his profit and can sell another 10 options at a similar premium.

(2) MARKET ADVANCES: Let's say the price of Handy-Dandy shares moves up to 45. The buyer is now going to exercise his right to purchase the actual shares at 40 and Mr. E must put them up for delivery. Chances are, however, the buyer will close out his position by selling the contract in the open market for, say, $6,000. Mr. E can repurchase the contract at that price, taking a loss of $2,000. But he still has the stock, now worth $45,000. He can sell a new options contract at the higher base of 45, sell the stock, or stand pat, depending on his inclination or his tax position.

(3) MARKET DECLINES: If the price of Handy-Dandy shares has slipped to 35, the options contract cannot be exercised and expires worthless. Mr. E keeps the $4,000, but his shares have declined in value by $5,000. If he sells the stock, he has a real loss of $1,000, just one-fifth of what it would have been without the "hedge" of the options contract. If he believes the underlying value of the shares is sound, he can choose instead to keep his stock and sell a new options contract at the lower base.

WHY BUY OPTIONS? The aim of option buying is to leverage surplus income in the hopes of hitting a big payoff. Relatively little investment in an option premium can produce a potential speculative gain far in excess of the gain possible by investing in the underlying security.

TO ILLUSTRATE: Mr. A is a 44-year-old, unmarried executive with a sizable salary (this is, according to a recent poll, the typical options buyer). He is a "nothing ventured, nothing gained" high-risk taker and buys the 10 options on Handy-Dandy shares at $40 a share sold by E for a $4,000 premium. Here's what can happen.

(1) MARKET ADVANCES: Handy-Dandy shares move up along with the market and hit 50. The options rise right along with the stock, from 4 to 6-1/2 a share. Mr. A can liquidate his position by selling the contract, in which case he realizes a profit of $2,500, an increase of 62% on the $4,000 he risked. If, instead, he exercises his call on the stock at the expiration date, he would have to come up with $40,000 to buy 1,000 shares of Handy-Dandy at 40, but his total investment of $44,000 would give him stock worth $50,000.

(2) MARKET DECLINES: If the stock slips along with the market and hovers near 35, Mr. A's options are worthless. He has lost all of his $4,000 investment. Should the stock stay at 40, he has still lost his money; and if the stock moves up fewer than 4 points, he loses part of his investment.

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