calls and puts on stocks: simple derivative instruments

In a recent post on the Macau gambling industry, I wrote that I had sold covered calls on WYNN, something I said I never would have done as a professional portfolio manager.

I want to explain what I’ve done, why, and why I’m willing to do it now when I wouldn’t do it then.

I’m going to do so in two posts.  Today I’m going to write about what (American) options are and the mechanics of buying and selling.  Tomorrow, I’ll write about why.

what they are: tons of terminology

As with most areas of finance, the basic ideas behind options are relatively simple.  Things get complicated, however, because there’s jargon to learn and because the markets can’t resist the urge to tweak the basics a bit to offer something slightly different.  As time progresses, the steady accumulation of simple tweaks creates the impression of incredible complexity, when it’s only simple ideas applied numerous times.

Here’s my attempt to untangle the options story:

general

Derivative instruments are securities whose value derives from that of some other, benchmark, security.

Stock options are a type of derivative contract.  Options give the holder the right–but not the obligation–to transact in a given stock during a specified time period.

Calls give the holder the right to buy the underlying stock from the person on the other side of the contract at the specified price.

Puts give the holder the right to sell the underlying stock to the person on the other side at the specified price.

American-style stock options are exercisable at any time during the life of the contract; European-style (I’ve never owned one) are exercisable only at expiration.

Most stock options in the US are exchange-traded; that is, they have uniform characteristics and are regulated/guaranteed by the Options Clearing Corporation, which matches buyers and sellers.  There are also over-the-counter options, which are private contracts between an investor and an investment banker, but this isn’t anything we need to worry about.

The OCC has established standard contracts for options.  Under normal circumstances, contracts:

–involve 100 shares of the underlying stock

–have an exercise or strike price that’s set at a standard amount and at a specified interval from other options on the same stock, usually $5, and

–expire at a standard time during the third week of the month.

buying and selling

Not everyone can buy and sell options.  You have to satisfy your broker, usually by filling out a standard form, that you understand the risks of options trading and have the means to settle any trades you may make.

four possibilities

There are four possible positions for an options trader to be in:

1.  long a call, meaning you own the right to buy a given stock at the specified price,

2.  short a call, meaning you have agreed to sell the stock in question at the specified price to a buyer in the #1 position, if he exercises his right.

3.  long a put, meaning you have the right to sell the given stock to the person on the other side of the contract at the specified price.

4.  short a put, meaning you have the obligation to buy the stock in question at the specified price, if the buyer in #3 exercises his right.

In cases 2 and 4, the trader has to  set aside collateral to show he can satisfy his obligation, if need be.  In the case of the seller of the call (#2), he may already own the stock in question.  If so, he is said to be selling a covered call, meaning he can satisfy his obligation by delivering the stock he owns to the buyer.  The stock is his collateral.

finding prices

If you get a price quote and chart for any stock on Google, Yahoo or on your broker’s website, there should be a link on the page that’s labelled “option chain.”  Clicking that will get you a list of all the available puts and calls on the stock, organized by expiration date and by strike price.

The list will show you the last trade, the bid-asked spread, today’s volume, and the “open interest,” meaning the total number of contracts outstanding for that strike price and expiration date.  The prices shown will be per share amounts, so you have to multiply that number by 100 to get the total dollar amount involved in buying or selling a single contract.

valuation

Professional options traders use highly complex mathematical models to price options.  The main components of valuation end up being the volatility of the stock in question and the time remaining until the expiration date.

In very simple terms, value can also be separated into two components:

— intrinsic value, meaning any portion of the option price accounted for by the price of the underlying stock.  Example:  if the option strike price is $25, the option is trading for $5 and the stock is trading at $28, the option would have $3 in intrinsic value.

time value, meaning anything other than intrinsic value.  In the case above, time value would be $2.

That’s (more than) enough for today.  Tomorrow’s post will be on using this information.