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Options Trading Strategy Guide: Foreword

Hiten Jhaveri/StockWhizo

In Global Financial Markets, for many years, options have been a means of conveying rights from one party to another at a specified price on or before a specific date. Options to buy and sell are commonly executed in real estate and equipment transactions, just as they have been for years in the securities markets. There are two types of option agreements: CALLS and PUTS.

• A CALL OPTION is a contract that conveys to the owner the right, but not the obligation, to purchase a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date.
• A PUT OPTION is a contract that conveys to the owner the right, but not obligation, to sell a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date.

Consequently, if the market in a security were expected to advance, a trader would purchase a call and, conversely, if the market in a security were expected to decline, a trader would purchase a put. With the advent of listed options, the inconvenience and difficulties originally associated with transacting options have been greatly diminished.

The purpose of this book is to provide an introduction to some of the basic equity option strategies available to option and/or stock investors. Exchange-traded options have many benefits including flexibility, leverage, limited risk for buyers employing these strategies, and contract performance guaranteed by Stock Exchanges. Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing (selling) options, to earn premium income. Options give you options. You're not just limited to buying, selling or staying out of the market. With options, you can tailor your position to your own financial situation, stock market outlook and risk tolerance.

Whether you are a conservative or growth-oriented investor, or even a short-term, aggressive trader, your broker can help you select an appropriate options strategy. The strategies presented in this book do not cover all, or even a significant number, of the possible strategies utilizing options. These are the most basic strategies, however, and will serve well as building blocks for more complex strategies.

Despite their many benefits, options are not suitable for all investors. Individuals should not enter into option transactions until they have read and understood the risk disclosure section coming later in this document which outlines the purposes and risks thereof. Further, if you have only limited or no experience with options, or have only a limited understanding of the terms of option contracts and basic option pricing theory, you should examine closely another industry document.

STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE. This documents, and many others, can be obtained from your brokerage firm or by either calling 91-22-6921781/82, 6340779 or visiting www.stockwhizo.com or sending an email to info@stockwhizo.com

An investor who desires to utilize options should have well-defined investment objectives suited to his particular financial situation and a plan for achieving these objectives.

Options are currently traded on the following Indian exchanges: Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Like trading in stocks, options trading is regulated by the SEBI. These exchanges seek to provide competitive, liquid, and orderly markets for the Purchase and sale of standardized options. It must be noted that, despite the efforts of each exchange to provide liquid markets, under certain conditions it may be difficult or impossible to liquidate an option position. Please refer to the disclosure document for further discussion on this matter.

All strategy examples described in this book assume the use of regular, listed, American-style equity options, and do not take into consideration margin requirements, transaction and commission costs, or taxes in their profit and loss calculations. You should be aware that in addition to SEBI margin requirements, each brokerage firm may have its own margin rules that can be more detailed, specific or restrictive. In addition, each brokerage firm may have its own guidelines with respect to commissions and transaction costs. It is up to you to become fully informed on the specific procedures, rules and/or fee and commission schedules of your specific brokerage firm(s).

The successful use of options requires a willingness to learn what they are, how they work, and what risks are associated with particular options strategies. Individuals seeking expanded investment opportunities in today's markets will find options trading challenging, often fast moving, and potentially rewarding.

BRIEF OPTIONS HISTORY

Ancient Origins

Although it isn't known exactly when the first option contract traded, it is known that the Romans and Phoenicians used similar contracts in shipping. There is also evidence that Thales, a mathematician and philosopher in ancient Greece used options to secure a low price for olive presses in advance of the harvest. Thales had reason to believe the olive harvest would be particularly strong. During the off-season when demand for olive presses was almost non-existent, he acquired rights-at a very low cost-to use the presses the following spring. Later, when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent the equipment to others at a much higher price.

In Holland, trading in tulip options blossomed during the early 1600s. At first, tulip dealers used call options to make sure they could secure a reasonable price to meet the demand. At the same time, tulip growers used put options to ensure an adequate selling price. However, it wasn't long before speculators joined the mix and traded the options for profit. Unfortunately, when the market crashed, many speculators failed to honor their agreements. The consequences for the economy were devastating. Not surprisingly, the situation in this unregulated market seriously tainted the view most people had of options. After a similar episode in London one hundred years later, options were even declared illegal.

Early Options in the US

In the US, options appeared on the scene around the same time as stocks. In the early 19thCentury, call and put contracts-known as "privileges"-were not traded on an exchange. Because the terms differed for each contract, there wasn't much in the way of a secondary market. Instead, it was up to the buyers and sellers to find each other. This was typically accomplished when firms offered specific calls and puts in newspaper ads.

Not unlike what happened in Holland and England, options came under heavy scrutiny after the Great Depression. Although the Investment Act of 1934 legitimized options, it also put trading under the watchful eye of the newly formed Securities and Exchange Commission (SEC).

For the next several decades, growth in option trading remained slow. By 1968, annual volume still didn't exceed 300,000 contracts. For the most part, early over-the-counter options failed to attract a following because they were cumbersome and illiquid. In the absence of an exchange, all trades were done by phone. To make matters worse, investors had no way of knowing what the real market for a given contract was. Instead, the put-call dealer functioned only to match the buyer and seller. Operating without a fixed commission, the dealer simply kept the spread between the price paid and the price sold. There was no limit to the size of this spread. Worse yet, all option contracts had to be exercised in person. If the holder of the option somehow missed the 3:15 pm deadline, the option would expire worthless regardless of its intrinsic value.

Chicago Board of Trade

In the late 1960s, as exchange volume for commodities began to shrink, the Chicago Board of Trade (CBOT) explored opportunities for diversification into the option market. Joseph W. Sullivan, Vice President of Planning for the CBOT, studied the over-the-counter option market and concluded that two key ingredients for success were missing. First, Sullivan believed that existing options had too many variables. To correct this, he proposed standardizing the strike price, expiration, size, and other relevant contract terms. Second, Sullivan recommended the creation of an intermediary to issue contracts and guarantee settlement and performance. This intermediary is now known as the Options Clearing Corporation.

To replace the put-call dealers, who served only as intermediaries, the CBOT created a system in which market makers were required to provide two-sided markets. At the same time, the presence of multiple market makers made for a competitive atmosphere in which buyers and sellers alike could be assured of getting the best possible price.

Chicago Board Options Exchange (CBOE)

After four years of study and planning, the Chicago Board of Trade established the Chicago Board Options Exchange (CBOE) and began trading listed call options on 16 stocks on April 26, 1973. The CBOE's first home was actually a smoker's lounge at the Chicago Board of Trade. After achieving first-day volume of 911 contracts, the average daily volume skyrocketed to over 20,000 the following year. Along the way, the new exchange achieved several important milestones.

As the number of underlying stocks with listed options doubled to 32, exchange membership doubled from 284 to 567. About the same time, new laws opened the door for banks and insurance companies to include options in their portfolios. For these reasons, option volume continued to grow. By the end of 1974, average daily volume exceeded 200,000 contracts.

The newfound interest in options also caught the attention of the nation's newspapers, which voluntarily began carrying listed option prices. That's quite an accomplishment considering that the CBOE initially had to purchase news space in The Wall Street Journal in order to publish quotes.

The Emergence of Put Trading

After repeated delays by the SEC, put trading finally began in 1977. Determined to monitor the situation closely, the SEC only permitted puts to be traded on five stocks. Despite the rapid acceptance of puts and the rising interest in options, the SEC imposed a moratorium halting the listing of additional options. Nevertheless, annual volume at the CBOE reached 35.4 million in 1979.

Today, more than ever, option volume and open interest continues to climb. In 1999 alone, option volume at the CBOE doubled. By the end of 1999, the number of open contracts reached almost 60 million. Today, options on all sorts of financial instruments are also traded at the Chicago Mercantile Exchange, the CBOT, and other exchanges.

Employee Stock Options

With the rapid growth in Internet companies over the past few years and the enormous wealth created by employee stock options, more and more people are developing an interest in the concept of owning and trading options. Although there are fundamental differences between the options granted to an employee by a company and the options traded on the floor of an exchange, there are important similarities.

When a company grants stock options to an employee, it gives that person the right to buy a certain number of shares at a price often well below market value. Although the options granted by a company eventually expire, they are usually good for extended periods (e.g., 10 years). Generally speaking, options issued by a company are not transferable. Therefore, they cannot be sold or traded to a third party. However, if the company is publicly traded, the employee can exercise the options and convert it to stock. This stock can then be sold on the open market.

For example, the person might have options to buy 1,000 shares at an exercise (strike) price of 120 per share when the stock (in the case of a public company) is actually trading at 250. In this case, the person pays Rs.120,000 for stock that is worth Rs.250,000 on the open market. Not a bad deal at all.

Exchange Traded Options

Although there are a variety of different types of options (e.g., stock options, index options), this section will focus exclusively on stock options. Once you understand the basic principles, they can easily be applied to the other financial instruments. Exchange-traded stock options, also known as equity options, differ from those granted to employees by their company in a number of important ways.

First, they typically have shorter-term expirations. Options granted by companies are often good for several years. During that period, they can be exercised (converted to stock) at any point. However, employee stock options cannot usually be sold or transferred. In contrast, exchange traded options (with the exception of LEAPS) are generally valid for only a few months and can be bought or sold at any time prior to expiration.

To many people, it seems odd that exchange-traded options are not issued by the companies themselves. Instead, they are issued by the Exchange Options Clearing (EOC). By centralizing and standardizing options trading, the EOC has created a more liquid market.

Unless otherwise specified, each option contract controls 100 shares of stock. In simplest terms, an option holder has the right, but not the obligation, to buy or sell a particular stock at a set price (strike) on or before the day of expiration (assignment). For example, someone holding a Nifty June 1120 Call would have the right to buy 200 units of Nifty for 1120 per unit. Likewise, a Nifty June 1120 Put gives the holder the right to sell 200 units of Nifty for 1120 per unit.

Copyright 2001 by Hiten Jhaveri, StockWhizo Investments. All rights reserved worldwide.

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