Understanding Equity Options - The Options Clearing Corporation

The Options IndustryCouncil (OIC) is a non-profitassociation created to educatethe investing public and brokersabout the benefits and risksof exchange-traded options.Options are a versatile but complex product and that is why OICconducts hundreds of seminars throughout the year, distributeseducational software and brochures, and maintains a web sitefocused on options education.All seminars are taught by experienced options instructors whoprovide valuable insight on the challenges and successes thatindividual investors encounter when trading options. In addition,the content in our software, brochures and web site has beencreated by options industry experts. All OIC-produced informationhas been reviewed by appropriate compliance and legal staff toensure that both the benefits and risks of options are covered.OIC was formed in 1992. Today, its sponsors include BATS OptionsExchange, BOX Options Exchange, Chicago Board OptionsExchange, C2 Options Exchange, International Securities Exchange,Miami International Securities Exchange, LLC, NASDAQ OMXPHLX, NASDAQ Options Market, NYSE Amex Options, NYSE ArcaOptions and OCC. These organizations have one goal in mind forthe options investing public: to provide a financially sound andefficient marketplace where investors can hedge investment riskand find new opportunities for profiting from market participation.Education is one of many areas that assist in accomplishing thatgoal. More and more individuals are understanding the versatilitythat options offer their investment portfolio, due in large part to theindustry’s ongoing educational efforts.

Table of ContentsIntroduction 3Benefits of Exchange-Traded Options 5■ Orderly, Efficient, and Liquid Markets■ Flexibility■ Leverage■ Limited Risk for Buyer■ Guaranteed Contract PerformanceOptions Compared to Common Stocks 8What is an Option? 9■ Underlying Security■ Strike Price■ Premium■ American-Style Expiration■ The Option Contract■ Exercising the Option■ The Expiration ProcessLEAPS ® /Long-Term Options 13The Pricing of Options 14■ Underlying Stock Price■ Time Remaining Until Expiration■ Volatility■ Dividends■ Interest Rates■ Finding Option Premium QuotesBasic Equity Options Strategies 17Buying Equity Calls 18■ to participate in upward price movements■ to lock in a stock purchase price■ to hedge short stock salesBuying Equity Puts 21■ to participate in downward price movements■ to protect a long stock position■ to protect an unrealized profit in long stockSelling Equity Calls 26■ covered call writing■ uncovered call writing1

Selling Equity Puts 30■ covered put writing■ uncovered put writingConclusion 33Glossary 34Appendix: Expiration Cycle Tables 38For More Information 40This publication discusses exchange-traded options issuedby The Options Clearing Corporation. No statement in thispublication is to be construed as a recommendation topurchase or sell a security, or to provide investment advice.Options involve risks and are not suitable for all investors.Prior to buying or selling an option, a person must receivea copy of Characteristics and Risks of StandardizedOptions. Copies of this document may be obtained fromyour broker or from any of the exchanges on which optionsare traded.20132

IntroductionOptions are financial instruments that can provideyou, the individual investor, with the flexibility youneed in almost any investment situation you mightencounter.Options give you options. You’re not just limitedto buying, selling or staying out of the market.With options, you can tailor your position to yourown situation and stock market outlook. Considerthe following potential benefits of options:■ You can protect stock holdings from a declinein market price■ You can increase income against currentstock holdings■ You can prepare to buy stock at a lower price■ You can position yourself for a big marketmove — even when you don’t know whichway prices will move■ You can benefit from a stock price’s rise or fallwithout incurring the cost of buying or sellingthe stock outrightAn equity option is a contract which conveysto its holder the right, but not the obligation, to buyor sell shares of the underlying security at a specifiedprice on or before a given date. After this givendate, the option ceases to exist. The seller of an optionis, in turn, obligated to sell (or buy) the sharesto (or from) the buyer of the option at the specifiedprice upon the buyer’s request. Like trading in stocks,option trading is regulated by the Securities and ExchangeCommission (SEC).3

The purpose of this booklet is to provide an introductoryunderstanding of equity options and how theycan be used. Options are also traded on a wide varietyof indexes, on U.S. Treasury rates, and on foreigncurrencies; information on these option products isnot included in this booklet but can be obtained bycontacting your broker or the exchanges on whichthese options are listed. U.S. option exchanges seekto provide competitive, liquid, and orderly marketsfor the purchase and sale of standardized options. Alloption contracts traded on U.S. securities exchangesare issued, guaranteed and cleared by OCC. OCCis a registered clearing corporation with the SECand plays a critical role in the U.S. capital markets asthe exclusive clearinghouse for exchange-traded options.OCC’s conservative financial and proceduralsafeguards, substantial and readily available financialresources, and its members’ mutual incentives protectthe organization from settlement losses.This introductory booklet should be read inconjunction with the option disclosure document,titled Characteristics and Risks of StandardizedOptions, which outlines the purposes and risks ofoption transactions. Despite their many benefits,options are not suitable for all investors. Individualsshould not enter into option transactions untilthey have read and understood the risk disclosuredocument which can be obtained from their broker,any of the options exchanges, or OCC. It must benoted that, despite the efforts of each exchange toprovide liquid markets, under certain conditions itmay be difficult or impossible to liquidate an optionposition. Please refer to the disclosure documentfor further discussion on this risk and other risks intrading equity options. In addition, margin requirements,transaction and commission costs, and taxramifications of buying or selling options should bediscussed thoroughly with a broker and/or tax advisorbefore engaging in option transactions.Note: For the sake of simplicity, the calculations of profit andloss amounts in this booklet do not account for the impact ofcommissions, transaction costs and taxes.4

Benefits ofExchange-Traded OptionsOrderly, Efficient, and Liquid Markets ... Flexibility... Leverage ... Guaranteed Contract Performance.These are the major benefits of options traded onsecurities exchanges today.Although the history of options extends severalcenturies, it was not until 1973 that standardized,exchange-listed and government-regulated optionsbecame available. In only a few years, these optionsvirtually displaced the limited trading in over-thecounteroptions and became an indispensable tool forthe securities industry.Orderly, Efficient, and Liquid MarketsStandardized option contracts provide orderly,efficient, and liquid option markets. Except underspecial circumstances, all equity option contracts typicallyare for 100 shares of the underlying stock. Thestrike price of an equity option is the specified shareprice at which the shares of stock will be bought orsold if the buyer of an option, or the holder, exerciseshis option. A range of strike prices are listed,and only strike prices a few levels above and belowthe current market price are traded. Other than forLEAPS®, which are discussed below, Weeklys SMand Quarterlys, at any given time a particular equityoption can generally be bought with one of four expirationdates (see tables in Appendix). As a result ofthis standardization, option prices may be obtainedquickly and easily at any time. Both intra-day andclosing option prices (premiums) for exchange-tradedoptions may be found on the web sites of many brokeragefirms and option exchanges, as well as throughThe Options Industry Council (OIC) by visitingwww.OptionsEducation.org.Note: An options contract may be for 100 shares of an underlyingstock or exchange traded fund (ETF). For educationalpurposes, however, this booklet will refer to underlyingshares simply as stock.5

FlexibilityOptions are an extremely versatile investment tool.Because of their unique risk/reward structure, optionscan be used in many combinations with otheroption contracts and/or other financial instrumentsto create either a hedged or speculative position.Some basic strategies are described in a later sectionof this booklet.LeverageAn equity option allows you to fix the price, for aspecific period of time, at which you can purchase orsell 100 shares of stock for a premium (price) whichis only a percentage of what you would pay to ownthe stock outright. That leverage means that by usingoptions, you may be able to increase your potentialbenefit from a stock’s price movements.For example, to own 100 shares of a stock tradingat $50 per share would cost $5,000. On the otherhand, owning a $5 call option with a strike price of$50 would give you the right to buy 100 shares of thesame stock at any time during the life of the optionand would cost only $500. Remember that premiumsare quoted on a per share basis; thus a $5 premiumrepresents a premium payment of $5 x 100, or $500,per option contract. Let’s assume that one monthafter the option was purchased, the stock price hasrisen to $55. The gain on the stock investment is$500, or 10%. However, for the same $5 increase inthe stock price, the call option premium might increaseto $7, for a return of $200, or 40%.Although the dollar amount gained on thestock investment is greater than the option investment,the percentage return is much greater with optionsthan with stock.Leverage also has downside implications. If thestock does not rise as anticipated or falls during thelife of the option, leverage will magnify the investment’spercentage loss. For instance, if in the aboveexample the stock had instead fallen to $40, the losson the stock investment would be $1,000 (or 20%).For this $10 decrease in stock price, the call optionpremium might decrease to $2 resulting in a loss of$300 (or 60%). You should take note, however, thatas an options buyer the most you can lose is the premiumamount you paid for the option.6

Limited Risk for BuyerUnlike other investments where the risks may haveno limit, options offer a known risk to buyers. An optionbuyer absolutely cannot lose more than the priceof the option, the premium. Because the right tobuy or sell the underlying security at a specific priceexpires on a given date, the option will expire worthlessif the conditions for profitable exercise or sale ofthe contract are not met by the expiration date. Anuncovered option seller (sometimes referred to as theuncovered writer of an option), on the other hand,may face unlimited risk.Guaranteed Contract PerformanceAn option holder is able to look to the system createdby OCC’s By-Laws and Rules rather than to anyparticular option writer for performance. Throughthat system, OCC guarantees performance to sellingand purchasing clearing members, eliminating counterpartycredit risk. Prior to the existence of optionexchanges and OCC, an option holder who wantedto exercise an option depended on the ethical andfinancial integrity of the writer or his brokerage firmfor performance. Furthermore, there was no convenientmeans of closing out one’s position prior to theexpiration of the contract.OCC, as the common clearing entity for allexchange-traded option transactions, resolves thesedifficulties. Once OCC is satisfied that there arematching trades from a buyer and a seller, it seversthe link between the parties. In effect, OCC becomesthe buyer to the seller and the seller to the buyer. Asa result, the seller can ordinarily buy back the sameoption he has written, closing out the initial transactionand terminating his obligation to deliver theunderlying stock or exercise value of the option toOCC, and this will in no way affect the right of theoriginal buyer to sell, hold or exercise his option. Allpremium and settlement payments are made betweenOCC and its clearing members. In turn, OCC clearingmembers settle independently with their customers(or brokers representing customers).7

Options Compared toCommon StocksListed options share many similarities with commonstocks:■ Both options and stocks are listed securities. Ordersto buy and sell options are handled throughbrokers in the same way as orders to buy and sellstocks. Listed option orders are executed on nationalSEC-regulated exchanges where trading isconducted in a competitive auction market.■ Like stocks, options trade with buyers makingbids and sellers making offers. In stocks, those bidsand offers are for shares of stock. With options, thebids and offers are for the right to buy or sell 100shares (per option contract) of the underlying stockat a given price per share for a given period of time.■ Option investors, like stock investors, have theability to follow price movements, trading volumeand other pertinent information day by day or evenminute by minute. The buyer or seller of an optioncan quickly learn the price at which his order hasbeen executed.Despite being quite similar, there are also someimportant differences between options and commonstocks which should be noted:■ Unlike common stock, an option has a limited life.Common stock can be held indefinitely in the hopethat its value may increase, while every option hasan expiration date. If an option is not closed out orexercised prior to its expiration date, it ceases toexist as a financial instrument. For this reason, anoption is considered a “wasting asset.”■ There is not a fixed number of options, as there iswith common stock shares available. An option issimply a contract involving a buyer willing to paya price to obtain certain rights and a seller willingto grant these rights in return for the price. Thus,unlike shares of common stock, the number of outstandingoptions (commonly referred to as “openinterest”) depends solely on the number of buyers8

and sellers interested in receiving and conferringthese rights.■ Finally, while stock ownership provides the holderwith a share of the company, certain voting rightsand rights to dividends (if any), option holders participateonly in the potential benefit of the stock’sprice movement.What Is an Option?An equity option* is a contract which conveys to itsholder the right, but not the obligation, to buy or sellshares of the underlying security at a specified priceon or before a given date. This right is granted by theseller of the option.There are two types of options, calls and puts.A call option gives its holder the right to buy an underlyingsecurity, whereas a put option conveys theright to sell an underlying security. For example, anAmerican-style XYZ May 60 call entitles the buyerto purchase 100 shares of XYZ Corp. common stockat $60 per share at any time prior to the option’s expirationdate in May. Likewise, an American-styleXYZ May 60 put entitles the buyer to sell 100 sharesof XYZ Corp. common stock at $60 per share at anytime prior to the option’s expiration date in May.Underlying SecurityThe specific stock on which an option contract isbased is commonly referred to as the underlying security.Options are categorized as derivative securitiesbecause their value is derived in part from the valueand characteristics of the underlying security. Anequity option contract’s unit of trade is the number ofshares of underlying stock which are represented bythat option. Generally speaking, equity options havea unit of trade of 100 shares. This means that oneoption contract represents the right to buy or sell 100shares of the underlying security.*Definitions for italicized words in bold can be found in theglossary section of this booklet.9

Strike PriceThe strike price, or exercise price, of an option is thespecified share price at which the shares of stock canbe bought or sold by the holder, or buyer, of the optioncontract if he exercises his right against a writer,or seller, of the option. To exercise your option isto exercise your right to buy (in the case of a call) orsell (in the case of a put) the underlying shares at thespecified strike price of the option.The strike price for an option is initially set ata price which is reasonably close to the current shareprice of the underlying security. Additional or subsequentstrike prices are added as needed. New strikeprices are introduced when the price of the underlyingsecurity rises to the highest, or falls to the lowest,strike price currently available. The strike price, afixed specification of an option contract, should notbe confused with the premium, the price at which thecontract trades, which fluctuates daily.If the strike price of a call option is less thanthe current market price of the underlying security,the call is said to be in-the-money because the holderof this call has the right to buy the stock at a pricewhich is less than the price he would have to pay tobuy the stock in the stock market. Likewise, if a putoption has a strike price that is greater than the currentmarket price of the underlying security, it is alsosaid to be in-the-money because the holder of thisput has the right to sell the stock at a price which isgreater than the price he would receive selling thestock in the stock market. The converse of in-themoneyis, not surprisingly, out-of-the-money. If thestrike price equals the current market price, the optionis said to be at-the-money.PremiumOption buyers pay a price for the right to buy or sellthe underlying security. This price is called the optionpremium. The premium is paid to the writer,or seller, of the option. In return, the writer of a calloption is obligated to deliver the underlying security(in return for the strike price per share) to a call optionbuyer if the call is exercised. Likewise, the writerof a put option is obligated to take delivery of the10

underlying security (at a cost of the strike price pershare) from a put option buyer if the put is exercised.Whether or not an option is ever exercised, the writerkeeps the premium. Premiums are quoted on a pershare basis. Thus, a premium of $0.80 representsa premium payment of $80.00 per option contract($0.80 x 100 shares).American-Style ExpirationThere are three styles of options: American,European and Capped. In the case of an Americanstyleoption, the holder of an option has the right toexercise his option at any time prior to its expirationdate; otherwise, the option will expire worthless andcease to exist as a financial instrument. At the presenttime, all exchange-traded equity options are American-style.The holder or writer of any style of optionmay close out his position simply by making anoffsetting, or closing, transaction. A closing transactionis a transaction in which, at some point prior toexpiration, the buyer of an option makes an offsettingsale of an identical option, or the writer of an optionmakes an offsetting purchase of an identical option.A closing transaction cancels out an investor’s previousposition as the holder or writer of the option.The Option ContractAn equity option contract is defined by thefollowing elements: type (put or call), style (American),underlying security, unit of trade (number ofshares), strike price, and expiration date. All optioncontracts that are of the same type and style and coverthe same underlying security are referred to as a classof options. All options of the same class that have thesame strike price and expiration date are referred to asan option series.If a person’s interest in a particular series of optionsis as a net holder (that is, if the number of contractsbought exceeds the number of contracts sold),then this person is said to have a long position inthe series. Likewise, if a person’s interest in aparticular series of options is as a net writer (if thenumber of contracts sold exceeds the number of contractsbought), he is said to have a short position inthe series.11

Exercising the OptionIf the holder of an equity option decides to exercisehis right to buy (in the case of a call) or to sell (inthe case of a put) the underlying shares of stock,the holder must direct his broker (if an OCC clearingmember) to submit an exercise notice to OCC.In order to ensure that an option is exercised on aparticular day, the holder must notify his broker beforethe broker’s cut-off time for accepting exerciseinstructions on that day. Different firms may havedifferent cut-off times for accepting exercise instructionsfrom customers, and those cut-off times may bedifferent for different classes of options.OCC will then assign this exercise notice toone or more clearing members with short positionsin the same series in accordance with its establishedprocedures. If the exercise is assigned to a clearingmember’s customers’ account, the clearing memberwill, in turn, allocate the exercise to one or more ofits customers (either randomly or on a first in firstout basis) who hold short positions in that series. Theassigned clearing member will then be obligated tosell (in the case of a call) or buy (in the case of a put)the underlying shares of stock at the specified strikeprice. Generally speaking, OCC clearing memberssettle the delivery and payment obligations arisingfrom the exercise of a physically-settled equity optionthrough the facilities of the correspondent stockclearing corporation.The Expiration ProcessAn equity option usually begins trading about eightmonths before its expiration date, and trades on oneof three expiration cycles. However, because of thesequential nature of these cycles, some options havea life of only one to two months. At any given time,an equity option can be bought or sold with one offour expiration dates as designated in the expirationcycle tables which can be found in the Appendix.Exceptions to these guidelines are LEAPS, discussedbelow, Weeklys and Quarterlys.The expiration date is the last day an optionexists. For listed equity options, except Weeklys andQuarterlys, this is the Saturday following the third12

Friday of the expiration month. Please note that thisis the deadline by which clearing members must submitexercise notices to OCC; however, the exchangesand brokerage firms have rules and procedures regardingdeadlines for an option holder to notify hisbrokerage firm of his intention to exercise. Pleasecontact your broker for specific deadlines.OCC has developed a procedure known asExercise by Exception to expedite its processing ofexercises of certain expiring options by clearingmembers of OCC. Ordinarily under this procedure,which is sometimes referred to as “Ex-by-Ex,” OCChas established in-the-money thresholds and everycontract for which Ex-by-Ex procedures apply thatis at or above its in-the-money threshold will beexercised unless OCC’s clearing member specificallyinstructs OCC to the contrary. Conversely, acontract under its in-the-money threshold will notbe exercised unless a clearing member specificallyinstructs OCC to do so. OCC does have discretionas to which options are subject to, and may excludeother options from, the Ex-by-Ex procedure.You should also note that Ex-by-Ex is not intendedto dictate which customer positions should or shouldnot be exercised and that Ex-by-Ex does not relievea holder of his obligation to tender an exercise noticeto his firm if the holder desires to exercise his option.Thus, most firms require their customers to notify thefirm of the customer’s intention to exercise even if anoption is in-the-money. You should ask your firm toexplain its exercise procedures including any deadlinethe firm may have for exercise instructions on the lasttrading day before expiration.LEAPS/Long-Term OptionsEquity LEAPS (Long-term Equity AnticiPationSecurities SM ) are long-term equity options and providethe holder the right to purchase or sell shares ofa stock at a specified price on or before a given dateup to three years in the future. As with other options,equity LEAPS are available in two types, calls and13

puts. Like other exchange-traded equity options, equityLEAPS are American-style options.Equity LEAPS calls provide an opportunity tobenefit from a stock price increase without makingan outright stock purchase for those investors witha longer term view of the stock. An initial equityLEAPS position does not require an investor to manageeach position daily. Purchase of equity LEAPSputs provides a hedge for stock owners against substantialdeclines in their stocks. Current options userswill also find equity LEAPS appealing if they desireto take a longer-term position of up to three years insome of the same options they currently trade.Like other equity options, the expiration datefor equity LEAPS is currently the Saturday followingthe third Friday of the expiration month. All equityLEAPS expire in January.The Pricing of OptionsThere are several factors which contribute valueto an equity option contract and thereby influence thepremium or price at which it is traded. The most importantof these factors are the price of the underlyingstock, time remaining until expiration, the volatilityof the underlying stock price, cash dividends, andinterest rates.Underlying Stock PriceThe value of an equity option depends heavily uponthe price of its underlying stock. As previouslyexplained, if the price of the stock is above a calloption’s strike price, the call option is said to be inthe-money.Likewise, if the stock price is below a putoption’s strike price, the put option is in-the-money.The difference between an in-the-money option’sstrike price and the current market price of a shareof its underlying security is referred to as the option’sintrinsic value. Only in-the-money options haveintrinsic value.14

For example, if a call option’s strike price is$45 and the underlying shares are trading at $60, theoption has intrinsic value of $15 because the holderof that option could exercise the option and buy theshares at $45. The buyer could then immediately sellthese shares on the stock market for $60, yielding aprofit of $15 per share, or $1,500 per option contract.When the underlying share price is equal to the strikeprice, the option (either call or put) is at-the-money.An option which is not in-the-money or at-themoneyis said to be out-of-the-money. An at-themoneyor out-of-the-money option has no intrinsicvalue, but this does not mean it can be obtained at nocost. There are other factors which give options valueand therefore affect the premium at which they aretraded. Together, these factors are termed time value.The primary components of time value are time remaininguntil expiration, volatility, dividends, andinterest rates. Time value is the amount by which theoption premium exceeds the intrinsic value.Option Premium = Intrinsic Value + Time ValueFor in-the-money options, the time value is the excessportion over intrinsic value. For at-the-moneyand out-of-the-money options, the time value is thetotal option premium.Time Remaining Until ExpirationGenerally, the longer the time remaining until an option’sexpiration date, the higher the option premiumbecause there is a greater possibility that the underlyingshare price might move to make the optionin-the-money. Time value drops rapidly in the lastseveral weeks of an option’s life.15

VolatilityVolatility is the propensity of the underlying security’smarket price to fluctuate either up or down.Therefore, volatility of the underlying share priceinfluences the option premium. The higher the volatilityof the stock, the higher the premium becausethere is, again, a greater possibility that the optionwill move in-the-money.DividendsCash dividends are paid to the stock owner. Therefore,cash dividends affect equity option premiumsthrough their effect on the underlying share price.Because the stock price is expected to fall by theamount of the cash dividend, higher cash dividendstend to imply lower call premiums and higher putpremiums. (Because the terms of equity options maybe subject to adjustment upon the occurrence of certainevents, you should be familiar with the generaladjustment rules applicable to such options. Generallyspeaking, however, no adjustment is made toequity options for ordinary cash dividends.)Options may also reflect the influences of certainstock dividends (e.g., additional shares of stock)and stock splits because the number of shares representedby each option is adjusted to take thesechanges into consideration.Interest RatesHistorically, higher interest rates have tended to resultin higher call premiums and lower put premiums.Finding Option Premium QuotesIntra-day premium quotes (i.e., bid/ask prices) forexchange-traded options may be found by viewing“option chains” on web sites of brokerage firms,option exchanges, or through OIC by visitingwww.OptionsEducation.org. An option chain generallydisplays a range of available calls and puts. Each calland put chain contains the option symbol, expirationyear, month and day, call/put symbol and strike price.An example of a typical option chain can be found onthe following page.16

In this example of an option chain, the out-of-the-moneyXYZ June 50 calls last traded at $0.30, or $30 per contract,while XYZ stock is currently trading at $48.83 pershare. The in-the-money June 50 puts last traded at$1.45, or $145 per contract.Basic Equity Option StrategiesThe versatility of options stems from the variety ofstrategies available to the investor. Some of the morebasic uses of equity options are explained in the followingexamples. For more detailed explanations,contact your broker.For purposes of illustration, commission andtransaction costs, tax considerations and the costsinvolved in margin accounts have been omitted fromthe examples in this booklet. These factors will affecta strategy’s potential outcome, so always check withyour broker and tax advisor before entering into any ofthese strategies. The following examples also assumethat all options are American-style and, therefore, canbe exercised at any time before expiration. In all of thefollowing examples, the premiums used are felt to bereasonable but, in reality, will not necessarily exist ator prior to expiration for a similar option.17

Buying Equity CallsA call option contract gives its holder the right to buya specified number of shares of the underlying stockat the given strike price on or before the expirationdate of the contract.I. Buying calls to participate in upward pricemovementsBuying an XYZ July 50 call option gives you theright to purchase 100 shares of XYZ common stockat a cost of $50 per share at any time before the optionexpires in July. The right to buy stock at a fixedprice becomes more valuable as the price of the underlyingstock increases.Assume that the price of the underlying shareswas $50 at the time you bought your option and thepremium you paid was $3.50 (or $350). If the priceof XYZ stock climbs to $55 before your option expiresand the premium rises to $5.50, you have twochoices in disposing of your in-the-money option:1) You can exercise your option and buy the underlyingXYZ stock for $50 a share for a total costof $5,350 (including the option premium) andsimultaneously sell the shares on the stock marketfor $5,500 yielding a net profit of $150.2) You can close out your position by selling the optioncontract for $550, collecting the differencebetween the premium received and paid, $200. Inthis case, you make a profit of 57% ($200/$350),whereas your profit on an outright stock purchase,given the same price movement, would beonly 10%.The profitability of similar examples will depend onhow the time remaining until expiration affects thepremium. Remember, time value declines sharply asan option nears its expiration date. Also influencingyour decision will be your desire to own the stock.If the price of XYZ instead fell to $45 and theoption premium fell to $0.90, you could sell youroption to partially offset the premium you paid. Otherwise,the option might expire worthless and your18

loss would be the total amount of the premium paidor $350. In most cases, the loss on the option wouldbe less than what you would have lost had you boughtthe underlying shares out-right, $260 on the optionversus $500 on the stock in this example.Buy XYZ 50 Call at $3.50 –$350Underlying Stock Risesto $55 & Premium Risesto $5.501) Exercise &buy stock –$5000Sell stock +$5500Cost of option –$350Profit +$150OR2) Sell option +$550Cost of option –$350Profit +$200Underlying Stock Fallsto $45 & Premium Fallsto $0.90Sell option +$90Cost of option –$350Loss –$260This strategy allows you to benefit from an upwardprice movement (by either selling the option at a profitor buying the stock at a discount relative to its currentmarket value) while limiting losses to the premium paidif the price declines or remains constant.II. Buying calls to lock in a stock purchasepriceAn investor who sees an attractive stock price butdoes not have sufficient cash flow to buy at the presenttime can use call options to lock in the purchaseprice for as far as eight months into the future.Assume that XYZ is currently trading at $55per share and that you would like to purchase 100shares of XYZ at this price; however, you do nothave the funds available at this time. You know thatyou will have the necessary funds in six months butyou fear that the stock price will increase during thisperiod of time. One solution is to purchase a sixmonthXYZ 55 call option, thereby establishing themaximum price ($55 per share) you will have to payfor the stock. Assume the premium you pay for thisoption is $4.25 (total).If in six months the stock price has risen to $70and you have sufficient funds available, the call can19

e exercised and you will own 100 shares of XYZ atthe option’s strike price of $55. For a cost of $425in option premium, you are able to buy your stockat $5,500 rather than $7,000. Your total cost is thus$5,925 ($5,500 plus $425 premium), a savings of$1,075 ($7,000 minus $5,925) when compared towhat you would have paid to buy the stock withoutyour call option.If in six months the stock price has insteaddeclined to $50, you may not want to exercise yourcall to buy at $55 because you can buy XYZ stock onthe stock market at $50. Your out-of-the-money callwill either expire worthless or can be sold for whatevertime value it has remaining to recoup a portionof its cost. Your maximum loss with this strategy isthe cost of the call option you bought or $425.III. Buying calls to hedge short stock salesAn investor who has sold stock short in anticipation ofa price decline can limit a possible loss by purchasingcall options. Remember that shorting stock requiresa margin account and margin calls may force you toliquidate your position prematurely. Although a calloption may be used to offset a short stock position’supside risk, it does not protect the option holderagainst additional margin calls or premature liquidationof the short stock position.Assume you sold short 100 shares of XYZ stockat $40 per share. If you buy an XYZ 40 call at a premiumof $3.50, you establish a maximum share priceof $40 that you will have to pay if the stock price risesand you are forced to cover the short stock position.For instance, if the stock price increases to $50 pershare, you can exercise your option to buy XYZ at $40per share and cover your short stock position at a netcost of $350 ($4,000 proceeds from short stock saleless $4,000 to exercise the option and $350 cost of theoption) assuming you can affect settlement of your exercisein time. This is significantly less than the $1,000($4,000 proceeds from short stock sale less $5,000to cover short) that you would have lost had you nothedged your short stock position.20

Sell Stock Shortat $40 +$4000Cover stock at $50 –$5000Proceeds fromshort sale +$4000Loss –$1000Cover stock at $30 –$3000Proceeds fromshort sale +$4000Profit +$1000Sell Stock Shortat $40 +$4000AND Buy 40 Callat $3.50 –$350If Stock Price Increases from $40 to $50:Exercise call tocover stock at $40 –$4000Cost of call –$350Proceeds fromshort sale +$4000Loss –$350If Stock Price Decreases from $40 to $30:Let call expire:cost of call –$350Cover stock at $30 –$3000Proceeds fromshort sale +$4000Profit +$650The maximum potential loss in this strategy is limitedto the cost of the call plus the difference, if any,between the call strike price and the short stock price.In this case, the maximum loss is equal to the cost ofthe call or $350. Profits will result if the decline inthe stock price exceeds the cost of the call.Buying Equity PutsOne put option contract gives its holder the right tosell 100 shares of the underlying stock at the givenstrike price on or before the expiration dateof the contract.I. Buying puts to participate in downwardprice movementsPut options may provide a more attractive methodthan shorting stock for profiting on stock price declines,in that, with purchased puts, you have a knownand predetermined risk. The most you can lose isthe cost of the option. If you short stock, the potentialloss, in the event of a price upturn, is unlimited.Another advantage of buying puts results fromyour paying the full purchase price in cash at the timethe put is bought. Shorting stock requires a marginaccount, and margin calls on a short sale might force21

you to cover your position prematurely, even thoughthe position still may have profit potential. As a putbuyer, you can hold your position until the option’sexpiration without incurring any additional risk.Buying an XYZ July 50 put gives you the rightto sell 100 shares of XYZ stock at $50 per share atany time before the option expires in July. This rightto sell stock at a fixed price becomes more valuable asthe stock price declines.Assume that the price of the underlying shareswas $50 at the time you bought your option and thepremium you paid was $4 (or $400). If the price ofXYZ falls to $45 before July and the premium rises to$6, you have two choices in disposing of your in-themoneyput option:1) You can buy 100 shares of XYZ stock at $45 pershare and simultaneously exercise your put optionto sell XYZ at $50 per share, netting a profit of$100 ($500 profit on the stock less the $400option premium paid).2) You can sell your put option contract, collectingthe difference between the premium paid and thepremium received, $200 in this case.If, however, you had chosen not to act, your maximumloss using this strategy would be the total costof the put option or $400. The profitability of similarexamples depends on how the time remaining untilexpiration affects the premium. Remember, timevalue declines sharply as an option nears itsexpiration date.If XYZ prices instead had climbed to $55 prior to expirationand the premium fell to $1.50, your put optionwould be out-of-the-money. You could still sellyour option for $150, partially offsetting its originalprice. In most cases, the cost of this strategy will beless than what you would have lost had you shortedXYZ stock instead of purchasing the put option,$250 versus $500 in this case.22

Buy XYZ 50 Put at $4 –$400Underlying Stock Fallsto $45 & Premium Risesto $61) Purchasestock –$4500Exercise option +$5000Cost of option –$400Profit +$100OR2) Sell option +$600Cost of option –$400Profit +$200Underlying Stock Risesto $55 & Premium Fallsto $1.50Sell option +$150Cost of option –$400Loss –$250This strategy allows you to benefit from downwardstock price movements while limiting losses to the premiumpaid if stock prices increase.II. Buying puts to protect a long stockpositionYou can limit the risk of stock ownership by simultaneouslybuying a put on that stock, a hedging strategycommonly referred to as a “married put.” This strategyestablishes a minimum selling price for the stockduring the life of the put and limits your loss to thecost of the put plus the difference, if any, betweenthe purchase price of the stock and the strike price ofthe put, no matter how far the stock price declines.This strategy will yield a profit if the stock appreciationis greater than the cost of the put option.Assume you buy 100 shares of XYZ stock at $40per share and, at the same time, buy an XYZ July 40put at a premium of $2. By purchasing this put optionfor the $200 in premium, you have ensured thatno matter what happens to the price of the stock,you will be able to sell 100 shares for $40 per share,or $4,000.If the price of XYZ stock increases to $50 pershare and the premium of your option drops to$0.90, your stock position is now worth $5,000 butyour put is out-of-the-money. Your profit, if you sellyour stock, is $800 ($1,000 profit on the stock lessthe amount you paid for the put option, $200). How-23

ever, if the price increase occurs before expiration,you may reduce the loss on the put by selling it forwhatever time value remains, $90 in this case if theJuly 40 put can be sold for $0.90.If the price of XYZ stock instead had fallen to$30 per share, your stock position would only beworth $3,000 (an unrealized loss of $1,000) but youcould exercise your put, selling your stock for $40per share to break even on your stock position at acost of $200 (the premium you paid for your put).Buy XYZ 40 Put at $2 –$200Buy 100 Shares at $40 –$4000Underlying Stock Fallsto $30 & Premium Risesto $111) Exercise optionto sell stock +$4000Cost of stock& option –$4200Loss –$200Underlying Stock Risesto $50 & Premium Fallsto $0.90Sell stock +$5000Sell option +$90Cost of stock& option –$4200Profit +$890OR2) Retain stockposition *Sell option +$1100Cost ofoption –$200Profit on option +$900*stock has unrealizedloss of $1000This strategy is significant as a method for hedging along stock position. While you are limiting your downsiderisk to the $200 in premium, you have not put aceiling on your upside profit potential.III. Buying puts to protect an unrealizedprofit in long stockIf you have an established profitable long stock position,you can buy puts to protect this position againstshort-term stock price declines. If the price of thestock declines by more than the cost of the put, theput can be sold or exercised to offset this decline. If24

you decide to exercise, you may sell your stock at theput option’s strike price, no matter how far the stockprice has declined.Assume you bought XYZ stock at $60 per shareand the stock price is currently $75 per share. By buyingan XYZ put option with a strike price of $70 for apremium of $1.50, you are assured of being able to sellyour stock at $70 per share during the life of the option.Your profit, of course, would be reduced by the$150 you paid for the put.For example, if the stock price were to dropto $65 and the premium increased to $6, you couldexercise your put and sell your XYZ stock for $70 pershare. Your $1,000 profit on your stock position wouldbe offset by the cost of your put option resulting in aprofit of $850 ($1,000 - $150). Alternatively, if youwished to maintain your position in XYZ stock, youcould sell your in-the-money put for $600 and collectthe difference between the premiums received andpaid, $450 ($600 - $150) in this case, which mightoffset some or all of the lost stock value.If the stock price were to climb, there would beno limit to the potential profit from the stock’s increasein price. This gain on the stock, however, wouldbe reduced by the cost of the put or $150.Buy XYZ 70 Put at $1.50 –$150Own 100 Shares Bought at $60Which Are Trading at $75at the Time You Buy Your Put –$6000Underlying Stock Fallsto $65 & Premium Risesto $61) Exercise optionto sell stock +$7000Cost of stock –$6000Cost of option –$150Profit +$850OR2) Retain stock position *Sell option +$600Cost of option –$150Profit on option +$450*stock has unrealizedgain of $500Underlying Stock Risesto $90 & Premium Fallsto $0.151) Sell stock +$9000Sell option +$15Cost of stock –$6000Cost of option –$150Profit +$2865OR2) Retain stock position *Sell option +$15Cost of option –$150Loss on option –$135*stock has unrealizedgain of $300025

Selling Equity CallsAs a call writer, you obligate yourself to sell, at thestrike price, the underlying shares of stock uponbeing assigned an exercise notice. For assuming thisobligation, you are paid a premium at the time you sellthe call.I. Covered Call WritingThe most common strategy is selling or writing callsagainst a long position in the underlying stock, referredto as covered call writing. Investors write covered callsprimarily for the following two reasons:1) to realize additional returns on their underlyingstock by earning premium income; and2) to gain some protection (limited to the amountof the premium) from a decline in the stockprice.Covered call writing is considered to be a more conservativestrategy than outright stock ownership becausethe investor’s downside risk is slightly offset by thepremium he receives for selling the call.As a covered call writer, you own the underlyingstock but are willing to forgo price increases in excessof the option strike price in return for the premium.You should be prepared to deliver the necessary sharesof the underlying stock (if assigned) at any time duringthe life of the option. Of course, provided that yourposition has not been assigned, you may cancel yourobligation by executing a closing transaction, that is,buying a call in the same series.A covered call writer’s potential profits andlosses are influenced by the strike price of the call hechooses to sell. In all cases, the writer’s maximum netgain (i.e., including the gain or loss on the long stockfrom the date the option was written) will be realizedif the stock price is at or above the strike price of theoption at expiration or at assignment. Assuming thestock purchase price is equal to the stock’s currentprice: 1) If he writes an at-the-money call (strike priceequal to the current price of the long stock), his maxi-26

mum net gain is the premium he receives for sellingthe option; 2) If he writes an in-the-money call (strikeprice less than the current price of the long stock), hismaximum net gain is the premium minus the differencebetween the stock purchase price and the strikeprice; 3) If he writes an out-of-the-money call (strikeprice greater than the current price of the stock), hismaximum net gain is the premium plus the differencebetween the strike price and the stock purchase priceshould the stock price increase above the strike price.If the writer is assigned, his profit or loss isdetermined by the amount of the premium plus thedifference, if any, between the strike price and theoriginal stock price. If the stock price rises above thestrike price of the option and the writer has his stockcalled away from him (i.e., is assigned), he forgoesthe opportunity to profit from further increases in thestock price. If, however, the stock price decreases, hispotential for loss on the stock position may be substantial;the hedging benefit is limited only to the amountof the premium income received.Assume you write an XYZ July 50 call at a premiumof $4 covered by 100 shares of XYZ stock whichyou bought at $50 per share. The premium you receivehelps to fulfill one of your objectives as a call writer:additional income from your investments. In this example,a $4 per share premium represents an 8% yieldon your $50 per share stock investment. This coveredcall (long stock/short call) position will begin to showa loss if the stock price declines by an amount greaterthan the call premium received or $4 per share.If the stock price subsequently declines to $40,your long stock position will decrease in value by$1,000. This unrealized loss will be partially offset bythe $400 in premium you received for writing the call.In other words, if you actually sell the stock at $40,your loss will be only $600.On the other hand, if the stock price rises to $60and you are assigned, you must sell your 100 shares ofstock at $50, netting $5,000. By writing a call option,you have forgone the opportunity to profit from anincrease in value of your stock position in excess of thestrike price of your option. The $400 in premium youkeep, however, results in a net selling price of $5,400.27

The $6 per share difference between this net sellingprice ($54) and the current market value ($60) of thestock represents the “opportunity cost” of writing thiscall option.Of course, you are not limited to writing an optionwith a strike price equal to the price at which youbought the stock. You might choose a strike pricethat is below the current market price of your stock(i.e., an in-the-money option). Since the optionbuyer is already getting part of the desired benefit— appreciation above the strike price — he will bewilling to pay a larger premium, which will provideyou with a greater measure of downside protection.However, you will also have assumed a greater chancethat the call will be exercised.On the other hand, you could opt for writing a calloption with a strike price that is above the currentmarket price of your stock (i.e., an out-of-the-money28Write XYZ 50 Call at $4 +$400Own 100 Shares Bought at $50 –$5000Underlying Stock Fallsto $40 & Premium Fallsto 0Retain stock *Call expires 0Option premiumincome +$400Profit on option +$400*stock has unrealized lossof $1000Underlying Stock Risesto $60 & Premium Risesto $10Stock called awayat 50 +$5000Cost of stock –$5000Option premiumincome +$400Profit on option +$400Write XYZ 45 Call at $6 +$600Own 100 Shares Bought at $50 –$5000Underlying Stock Fallsto $40 & Premium Fallsto 0Retain stock *Call expires 0Option premiumincome +$600Profit on option +$600*stock has unrealized lossof $1000Underlying Stock Risesto $60 & Premium Risesto $15Stock called awayat 45 +$4500Cost of stock –$5000Option premiumincome +$600Profit +$100

option). Since this lowers the buyer’s chances ofbenefiting from the investment, your premium willbe lower, as will the chances that your stock will becalled away from you.Write XYZ 55 Call at $0.90 +$90Own 100 Shares Bought at $50 –$5000Underlying Stock Fallsto $40 & Premium Fallsto 0Retain stock *Call expires 0Option premiumincome +$90Profit on option +$90*stock has unrealized lossof $1000In short, the writer of a covered call option, in returnfor the premium he receives, forgoes the opportunityto benefit from an increase in the stock price which exceedsthe strike price of his option. However, he continuesto bear the risk of a sharp decline in the valueof his stock which will only be slightly offset by thepremium he received for selling the option.II. Uncovered Call WritingUnderlying Stock Risesto $60 & Premium Risesto $5Stock called awayat 55 +$5500Cost of stock –$5000Option premiumincome +$90Profit +$590A call option writer is uncovered if he does not ownthe shares of the underlying security represented bythe option. As an uncovered call writer, your objectiveis to realize income from the writing transaction withoutcommitting capital to the ownership of the underlyingshares of stock. An uncovered option is also referred toas a naked option. An uncovered call writer must depositand maintain sufficient margin with his brokerto assure that the stock can be purchased for deliveryif and when he is assigned.The potential loss of uncovered call writingis unlimited. However, writing uncovered calls canbe profitable during periods of declining or generallystable stock prices, but investors consideringthis strategy should recognize the significantrisks involved:29

1) If the market price of the stock rises sharply,the calls could be assigned. To satisfy yourdelivery obligation, you may have to buy stockin the market for more than the option’s strikeprice. This could result in a substantial loss.2) The risk of writing uncovered calls is similar tothat of selling stock short, although as an optionwriter your risk is cushioned somewhat bythe amount of premium received.As an example, if you write an XYZ July 65 call fora premium of $6, you will receive $600 in premiumincome. If the stock price remains at or below $65,you may not be assigned on your option. Because youhave no stock position, the price decline has no effecton your $600 profit. On the other hand, if the stockprice subsequently climbs to $75 per share, you likelywill be assigned and will have to cover your positionat a net loss of $400 ($1,000 loss on covering the callassignment offset by $600 in premium income). As acall writer, your losses will continue to increase withsubsequent increases in the stock price.As with any option transaction, provided thatan exercise notice has not been assigned to his position,an uncovered call writer may cancel his obligationby executing a closing purchase transaction. Anuncovered call writer also can mitigate his risk at anytime during the life of the option by purchasing theunderlying shares of stock, thereby becoming acovered writer.Selling Equity PutsSelling a put obligates you to buy the underlyingshares of stock at the option’s strike price upon assignmentof an exercise notice. You are paid a premiumwhen the put is written to partially compensateyou for assuming this risk. As a put writer, you mustbe prepared to buy the underlying stock at any timeduring the life of the option.30

I. Covered Put WritingA put writer is considered to be covered if he has acorresponding short stock position. For purposes ofcash account transactions, a put writer is also consideredto be covered if he deposits cash or cash equivalentsequal to the exercise value of the option withhis broker. A covered put writer’s profit potential islimited to the premium received plus the differencebetween the strike price of the put and the originalshare price of the short position. The potential loss onthis position, however, is substantial if the price of thestock increases significantly above the original shareprice of the short position. In this case, the short stockwill accrue losses while the offsetting profit on the putsale is limited to the premium received.II. Uncovered Put WritingA put writer is considered to be uncovered if he doesnot have a corresponding short stock position orhas not deposited cash equal to the exercise value ofthe put. Like uncovered call writing, uncovered putwriting has limited rewards (the premium received)and potentially substantial risk (if prices fall and youare assigned). The primary motivations for most putwriters are:1) to receive premium income; and/or2) to acquire stock at a net cost below the currentmarket value.If the stock price declines below the strike price ofthe put and the put is exercised, you will be obligatedto buy the stock at the strike price. Your cost will,of course, be offset at least partially by the premiumyou received for writing the option. You will begin tosuffer a loss if the stock price declines by an amountgreater than the put premium received. As with writinguncovered calls, the risks of writing uncovered putoptions are substantial. If instead the stock price rises,your put will most likely expire out-of-the-moneyand with no value.Assume you write an XYZ July 55 put for apremium of $5 and the market price of XYZ stock31

subsequently drops from $55 to $45 per share. If youare assigned, you must buy 100 shares of XYZ for acost of $5,000 ($5,500 to purchase the stock at thestrike price minus $500 premium income received).If the price of XYZ had dropped by less thanthe premium amount, say to $52 per stock, you mightstill have been assigned, but your stock cost of $5,000would have been less than the stock’s current marketvalue of $5,200. In this case, you could have then soldyour newly acquired (as a result of your put being assigned)100 shares of XYZ on the stock market witha profit of $200.Had the market price of XYZ remained at orabove $55, it is highly unlikely that you would be assignedand the $500 premium would be your profit.32

ConclusionThe intended purpose of this booklet is to provide anintroduction to the fundamentals of buying and writingequity options, and to illustrate some of the basicstrategies available.You have been shown that exchange-tradedoptions have many benefits including flexibility,leverage, and limited risk for buyers employing thesestrategies, and contract performance under the systemcreated by OCC’s By-Laws and Rules. Optionsallow you to participate in price movements withoutcommitting the large amount of funds needed tobuy stock outright. Options can also be used tohedge a stock position, to acquire or sell stock at apurchase price more favorable than the current marketprice, or, in the case of writing options, to earnpremium income.Whether you are a conservative or growthorientedinvestor, or even a short-term, aggressivetrader, your broker can help you select an appropriateoptions strategy. The strategies presented in thisbooklet do not cover all, or even a significant number,of the possible strategies utilizing options. These arethe most basic strategies, however, and understandingthem will serve as building blocks for the more complexstrategies available.Despite their many benefits, options involverisk and are not suitable for everyone. An investorwho desires to utilize options should have welldefinedinvestment objectives suited to his particularfinancial situation and a plan for achieving theseobjectives. The successful use of options requires awillingness to learn what they are, how they work,and what risks are associated with particularoptions strategies.Armed with an understanding of the fundamentals,and with additional information and assistancethat is readily available from many brokeragefirms and other sources, individuals seeking expandedinvestment opportunities in today’s markets will findoptions trading challenging, often fast moving, andpotentially rewarding.33

GlossaryAmerican-style option: An option contract thatmay be exercised at any time between the date of purchaseand the expiration date.Assignment: The allocation of an exercise noticeto an option writer (seller) that obligates him to sell(in the case of a call) or purchase (in the case of a put)the underlying security at the specified strike price.At-the-money: An option is at-the-money if thestrike price of the option is equal to the market priceof the underlying security.Call: An option contract that gives the holder theright to buy the underlying security at a specifiedprice for a certain, fixed period of time.Class of options: Option contracts of the same type(call or put) and style (American or European) thatcover the same underlying security.Closing purchase: A transaction in which thepurchaser’s intention is to reduce or eliminate a shortposition in a given series of options.Closing sale: A transaction in which the seller’sintention is to reduce or eliminate a long position in agiven series of options.Covered call option writing: A strategy in whichone sells call options while simultaneously owning anequivalent position in the underlying security.Covered put option writing: A strategy in whichone sells put options and simultaneously is short anequivalent position in the underlying security.Derivative security: A financial security whosevalue is determined in part from the value and characteristicsof another security, the underlying security.Equity options: Options on shares of an individualequity interest.34

Exercise: To implement the right under whichthe holder of an option is entitled to buy (in the caseof a call) or sell (in the case of a put) the underlyingsecurity.Exercise-by-Exception: OCC procedures (alsoreferred to as Ex-by-Ex) to facilitate the submissionof exercise notices by clearing members of certainexpiring in-the-money option contracts. Generally,OCC will exercise any expiring option, call or put,that is in-the-money by a specified threshold amountin a clearing member’s clearing account unless it isnotified by the clearing member not to exercise thatoption. Each brokerage firm may additionally haveits own requirements for customers to submit exercisenotices in respect of expiring equity calls andputs that are in-the-money by an amount other thanOCC’s threshold.Exercise notice: A notice submitted to OCC byclearing members to reflect their desire to exercise anoption contract.Exercise price: See Strike price.Expiration cycle: An expiration cycle relates tothe dates on which equity options on a particularunderlying security expire. A given equity option,other than LEAPS, Weeklys and Quarterlys, will beassigned to one of three cycles, the January cycle, theFebruary cycle or the March cycle (See Appendix).At any point in time, an option will have contractswith four expiration dates outstanding, the two neartermmonths and two further-term months.Expiration date: The day in which an optioncontract becomes void. All holders of options mustindicate their desire to exercise, if they wish to do so,by this date.Expiration time: The time of day by which all exercisenotices must be received on the expiration date.Hedge: A conservative strategy used to limit investmentloss by effecting a transaction which offsets anexisting position.Holder: The purchaser of an option.35

In-the-money: A call option is in-the-money ifthe strike price is less than the market price of theunderlying security. A put option is in-the-money ifthe strike price is greater than the market price of theunderlying security.Intrinsic value: The amount by which an option isin-the-money.LEAPS : Long-term Equity AnticiPation Securities,or LEAPS, are long-term equity or index options.Long position: A position wherein an investor’sinterest in a particular series of options is as a netholder (i.e., the number of contracts bought exceedsthe number of contracts sold).Margin requirement (for options): For customerlevel margin, the amount an option writer is requiredto deposit and maintain with his broker to cover aposition. The margin requirement is calculated daily.Naked writer: See Uncovered call writing andUncovered put writing.Opening purchase: A transaction in which thepurchaser’s intention is to create or increase a longposition in a given series of options.Opening sale: A transaction in which the seller’sintention is to create or increase a short position in agiven series of options.Open interest: The number of outstanding optioncontracts in the exchange market or in a particularclass or series.Out-of-the-money: A call option is out-of-themoneyif the strike price is greater than the marketprice of the underlying security. A put option is outof-the-moneyif the strike price is less than the marketprice of the underlying security.Premium: The price of an option contract, determinedin the competitive marketplace, which thebuyer of the option pays to the option writer for therights conveyed by the option contract.36

Put: An option contract that gives the holder theright to sell the underlying security at a specifiedprice for a certain fixed period of time.Secondary market: A market in which holdersand writers may be able to close existing options positionsby offsetting sales and purchases.Series: All options of the same class that have thesame strike price and expiration date.Short position: A position wherein a person’s interestin a particular series of options is as a net writer(i.e., the number of contracts sold exceeds the numberof contracts bought).Strike price: The stated price per share for whichthe underlying security may be purchased (in the caseof a call) or sold (in the case of a put) by the optionholder upon exercise of the option contract.Time value: The portion of the option premiumthat is attributable to the amount of time remaininguntil the expiration of the option contract. Timevalue is whatever value the option has in addition toits intrinsic value.Type: The classification of an option contract as eithera put or a call.Uncovered call option writing: A short call optionposition in which the writer does not own anequivalent position in the underlying security representedby his option contracts.Uncovered put option writing: A short put optionposition in which the writer does not have a correspondingshort position in the underlying securityor has not deposited, in a cash account, cash or cashequivalents equal to the exercise value of the put.Underlying security: The property that is deliverableupon exercise of the option contract.Volatility: A measure of the fluctuation in themarket price of the underlying security. Mathematically,volatility is the annualized standard deviationof returns.Writer: The seller of an option contract.37

AppendixExpiration Cycle TablesThe cycles and their available expiration monthsillustrated below apply only to regular-term equityoptions. They do not apply to LEAPS, Weeklys orQuarterlys.January Sequential CycleCurrent Month Available Months*Jan Jan Feb Apr JulFeb Feb Mar Apr JulMar Mar Apr Jul OctApr Apr May Jul OctMay May Jun Jul OctJun Jun Jul Oct JanJul Jul Aug Oct JanAug Aug Sep Oct JanSep Sep Oct Jan AprOct Oct Nov Jan AprNov Nov Dec Jan AprDec Dec Jan Apr JulFebruary Sequential CycleCurrent Month Available Months*Jan Jan Feb May AugFeb Feb Mar May AugMar Mar Apr May AugApr Apr May Aug NovMay May Jun Aug NovJun Jun Jul Aug NovJul Jul Aug Nov FebAug Aug Sep Nov FebSep Sep Oct Nov FebOct Oct Nov Feb MayNov Nov Dec Feb MayDec Dec Jan Feb Maycontinued on following page38

March Sequential CycleCurrent Month Available Months*Jan Jan Feb Mar JunFeb Feb Mar Jun SepMar Mar Apr Jun SepApr Apr May Jun SepMay May Jun Sep DecJun Jun Jul Sep DecJul Jul Aug Sep DecAug Aug Sep Dec MarSep Sep Oct Dec MarOct Oct Nov Dec MarNov Nov Dec Mar JunDec Dec Jan Mar Jun* Available Months = the equity option expiration dates availablefor trading prior to the third Friday of the Current Month. Thereare always 2 near-term and 2 far-term months available. The mostrecently added expiration month is listed in bold-faced type. Thisnew expiration month is added on the Monday following the thirdFriday of the month prior to the Current Month. For example, inthe February Cycle, if the Current Month is September, the mostrecently added expiration (October) would have been added followingthe August expiration. These tables do not apply to equityLEAPS ® , which expire in January of their expiration year, or toWeeklys and Quarterlys.39

For More InformationBATS Options Exchangewww.batsoptions.comBOX Options Exchangewww.bostonoptions.comChicago Board Options Exchangewww.cboe.comC2 Options Exchangewww.c2exchange.comInternational Securities Exchangewww.ise.comMiami International Securities Exchange, LLCwww.miaxoptions.comNASDAQ OMX PHLXwww.nasdaqtrader.comNASDAQ Options Marketwww.nasdaqtrader.comNYSE Amex Optionswww.nyse.comNYSE Arca Optionswww.nyse.comOCCwww.theocccomThe Options Industry Councilwww.OptionsEducation.org40

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