270  •   The Intelligent Option Investor
Short Investment Time Horizons
When the scholars developing the BSM were researching financial
markets for the purpose of developing their model, the longest-tenor
options had expirations only afew months distant. Most market partic-
ipants tended to trade in the front-month contracts (i.e., the contracts
that will expire first), as is still mainly the case. Indeed, thinking back
to our preceding discussion about price randomness, over short time
horizons, it is very difficult to prove that asset price movements are not
random.
As such, the BSM is almost custom designed to handle short time
horizons well.
Perhaps not unsurprisingly, agents
1 are happy to encourage clients to
trade options with short tenors because
1. It gives them more opportunities per year to receive fees and com-
missions from their clients.
2. They are mainly interested in reliably generating income on the
basis of the bid-ask spread, and bid-ask spreads differ on the basis
of liquidity, not time to expiration.
3. Shorter time frames offer fewer chances for unexpected price
movements in the underlying that the market makers have ahard
time hedging.
In essence, agood option market maker is akin to aused car sales-
man. He knows that he can buy at alow price and sell at ahigh one, so his
main interest is in getting as many customers to transact as possible. With
this perspective, the market maker is happy to use the BSM, which seems
to give reasonable enough option valuations over the time period about
which he most cares.
In the case of short-term option valuations, the theory describes
reality accurately enough, and structural forces (such as wide bid-ask
spreads) make it hard to exploit mispricings if and when they occur.
To see an example of this, let’stake alook at what the BSM assumes is
areasonable range of prices for acompany with assumed 20 percent
volatility over aperiod of 30 days.

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272  •   The Intelligent Option Investor
It is important to realize that the fact that options are usually
efficiently priced in the short term does not prevent us from transacting
in short-tenor options. In fact, some strategies discussed in Part III are
actually more attractive when an investor uses shorter-tenor options or
combines short- and long-tenor options into asingle strategy.
Hopefully, the distinction between avoiding short-tenor option
strategies and making long-term investments in short-tenor options is
clear after reading through Part III.
Fungible Underlying Assets
Again, returning for amoment to the foundation of the BSM, the scholars built
their mathematical models by studying short-term agricultural commodity
markets. Acommodity is, by definition, afungible or interchangeable asset;
one bushel of corn of acertain quality rating is completely indistinguishable
from any other bushel of corn of the same quality rating.
Stocks, on the other hand, are idiosyncratic assets. They are intangible
markers of value for incredibly complex systems called companies, no two
of which is exactly alike (e.g., GM and Ford—the pair that illustrates the
idea of “paired” investments in many people’sminds—are both American
car companies, but as operating entities, they have some significant differ-
ences. For example, GM has amuch larger presence in China and has adifferent capital and governance structure since going bankrupt than Ford,
which avoided bankruptcy during the mortgage crisis).
The academics who built the BSM were not hesitant to apply amodel
that would value idiosyncratic assets such as stocks because they had as-
sumed from the start that financial markets are efficient—meaning that
every idiosyncratic feature for agiven stock was already fully “priced in”
by the market. This allowed them to overlook the complexity of individual
companies and treat them as interchangeable, homogeneous entities.
The BSM, then, did not value idiosyncratic, multidimensional
companies; rather, it valued single-dimensional entities that the scholars
assumed had already been “standardized” or commoditized in some sense
by the communal wisdom of the markets. You will see in the next sec-
tion that the broad, implicit assumption by option market participants
that markets are efficient actually brings about the greatest opportunity

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276  •   The Intelligent Option Investor
If someone wanted to make extra income by selling calls to accept expo-
sure to the stock’supside, what price would they likely charge for someone
wanting to buy this call option?
a. Almost nothing
b. Alittle
c. Agood bit
Obviously, the correct answer to the put option question is c. This option
would be pretty expensive because its range of exposure overlaps with so
much of the BSM cone. Conversely, the answer to the call option question
is a. This option would be really cheap because its range of exposure is well
above the BSM cone.
Remember, though, that we have our crystal ball, and we know
that this stock will likely be somewhere between $70 and $110 per share
in afew years. With this confidence, wouldn’tit make sense to take the
opposite side of both the preceding trades? Doing so would look like
this:
5/18/2012
10
20
30
40
50
60
70
80
90
100
110
120
5/20/2013 249 499 749 999
Date/Day Count
Advanced Building Corp. (ABC)
Stock Price
Best Case, 110
Worst Case, 70
-
GREEN
RED
In this investment, which Iexplain in detail in Chapter 11, we are
receiving agood bit of money by selling an expensive put and paying

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Appendix A: Choose Your Battles Wisely   • 277
very little money to buy acheap call. It may happen that the money we
receive for selling the put actually may be greater than the money we
pay for the call, so we actually get paid anet fee when we make this
transaction!
We can sell the put confidently because we know that our worst-case
valuation is $70 per share; as long as we are confident in our valuation—atopic covered in Part II of this book—we need not worry about the price
declining. We do not mind spending money on the call because we think
that the chance is very good that at expiration or before the call will be
worth much, much more than we paid for it.
Truly, the realization that the BSM is pricing options on inefficiently
priced stocks as if they were efficiently priced is the most profound and
compelling source of profits for intelligent investors. Furthermore, finding
grossly mispriced stocks and exploiting the mispricing using options rep-
resents the most compelling method for tilting the risk-reward equation in
our direction.
The wonderful thing about investing is that it does not require you to
swing at all the pitches. Individual investors have agreat advantage in that
they may swing at only the pitches they know they can hit. The process of
intelligent investing is simply one of finding the right pitches, and intel-
ligent option investing simply uses an extremely powerful bat to hit that
sweet pitch.
Bimodal Outcomes
Some companies are speculative by nature—for instance, adrug company
doing cancer research. The company has nothing but some intangible as-
sets (the ideas of the scientists working there) and agreat deal of costs
(the salaries going to those scientists, the payments going to patent attor -
neys, and the considerable costs of paying for clinical trials). If the research
proves fruitful, the company’svalue is great—let’ssay $500 per share. If
the clinical trials show low efficacy or dangerous side effects, however, the
company’sworth goes to virtually nil. What’smore, it may take years before
it is clear which of these alternatives is true.

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278  •   The Intelligent Option Investor
Given what you know about the BSM, does this seem like the kind of
situation conducive to accurate option pricing? This example certainly does
not sound like the pricing scenario of ashort-term agricultural commodity,
after all. If this hypothetical drug company’sstock price was sitting at $50 per
share, what is the value of the upper range the option market might be
pricing in? Let’sassume that this stock is trading with aforward volatility of
100 percent per year (on the day Iam writing this, there are only four stocks
with options trading at aprice that implies aforward volatility of greater than
100 percent). What price range does this 100 percent per year volatility imply,
and can we design an option structure that would allow us to profit from abig
move in either direction? Here is adiagram of this situation:
5/18/2012
-
500
50
100
150
200
250
300
350
400
450
5/20/2013 249 499
Date/Day Count
Advanced Biotechnology Co. (ABC)
Stock Price
749 999
GREEN
GREEN
Indeed, even boosting volatility assumptions to avery high level,
it seems that we can still afford to gain exposure to both the upside and
downside of this stock at avery reasonable price. You can see from the pre-
ceding diagram that both regions of exposure on the put side and the call
side are outside the BSM cone, meaning that they will be relatively cheap.
The options market is trying to boost the price of the options enough so
that the calls and puts are fairly priced, but for various reasons (including
behavioral biases), most of the time it fails miserably.

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280  •   The Intelligent Option Investor
Clearly, there is not much of adifference between the BSM expected
value (shown by the dotted line) and the dot representing a 10 percent
upward drift in the stock. However, if we extend this analysis out for three
years, look what happens:
5/18/2012 5/20/2013 249 499
Date/Day Count
Advanced Building Corp. (ABC)
749 999
20
30
40
50
60
70Stock Price
80
With the longer time horizon, our assumed stock price is significantly
higher than what the BSM calculates as its expected price. If we take “assumed
future stock price” to mean the price at which we think there is an equal chance
that the true stock price will be above or below that mark, we can see that the
difference, marked by the double-headed arrow in the preceding diagram, is the
advantage we have over the option market.
3 This advantage again means that
downside exposure will be overvalued and upside exposure will be undervalued.
How, you may ask, can this discrepancy persist? Shouldn’tsomeone
figure out that these options are priced wrong and take advantage of an
arbitrage opportunity? The two reasons why these types of opportunities
tend to persist are
1. Most people active in the option market are trading on avery
short-term basis. Long-term equity anticipated securities
(LEAPS)—options with tenors of ayear or more—do exist, but

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Appendix A: Choose Your Battles Wisely   • 281
generally the volumes are light because the people in the option
markets generally are not willing to wait longer than 60 days for
their “investment” to work out. Because the time to expiration for
most option contracts is so short, the difference between the BSM’sexpected price based on a 5 percent risk-free rate and an expected
price based on a 10 percent equity return is small, so no one real-
izes that it’sthere (as seen on the first diagram).
2. The market makers are generally able to hedge out what little ex-
posure they have to the price appreciation of LEAPS. They don’tcare about the price of the underlying security, only about the size
of the bid-ask spread, and they always price the bid-ask spread on
LEAPS in as advantageous away as they can. Also, the career of an
equity option trader on the desk of abroker-dealer can change agreat deal in asingle year. As discussed in Part II, market makers
are not incentivized in such away that they would ever care what
happened over the life of a LEAPS.
Congratulations. After reading Part Iof this book and this appendix,
you have abetter understanding of the implications of option investing
for fundamental investors than most people working on Wall Street.
There are many more nuances to options that Idiscuss in Part III of this
book—especially regarding leverage and the sensitivity of options to input
changes—but for now, simply understanding how the BSM works puts you
at agreat advantage over other market participants.

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287
Appendix c
PUT-cALL PArITy
Before the Black-Scholes-Merton model (BSM), there was no way to
directly calculate the value of an option, but there was away to triangulate
put and call prices as long as one had three pieces of data:
1. The stock’sprice
2. The risk-free rate
3. The price of acall option to figure the fair price of the put, and vice
versa
In other words, if you know the price of either the put or acall, as long
as you know the stock price and the risk-free rate, you can work out the
price of the other option. These four prices are all related by aspecific rule
termed put-call parity.
Put-call parity is only applicable to European options, so it is not ter-
ribly important to stock option investors most of the time. The one time it
becomes useful is when thinking about whether to exercise early in order
to receive astock dividend—and that discussion is abit more technical. I’ll
delve into those technical details in amoment, but first, let’slook at the big
picture. Using the intelligent option investor’sgraphic format employed in
this book, the big picture is laughably trivial.
Direct your attention to the following diagrams. What is the differ -
ence between the two?

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288  •   The Intelligent Option Investor
-
20
5/18/2012 5/20/2013
40
60
80
100
120Stock Price
140
160
180
200
-
20
5/18/2012 5/20/2013
40
60
80
100
120Stock Price
140
160
180
200
GREENGREEN
REDRED
If you say, “Nothing, ” you are practically right but technically
wrong. The image on the left is actually the risk-reward profile of apur -
chased call option struck at $50 paired with asold put option struck at
$50. The image on the right is the risk-reward profile of astock trading
at $50 per share.
This simple comparison is the essence of put-call parity. The parity
part of put-call parity just means that accepting downside exposure by sell-
ing aput while gaining upside exposure by buying acall is basically the
same thing as accepting downside exposure and gaining upside exposure
by buying astock.
What did Isay? It is laughably trivial. Now let’sdelve into the details
of how the put-call parity relationship can be used to help decide whether
to exercise acall option or not (or whether the call option you sold is likely
to be exercised or not).
Dividend Arbitrage and Put-call Parity
Any time you see the word arbitrage , the first thing that should jump to
mind is “small differences. ” Arbitrage is the science of observing small dif-
ferences between two prices that should be the same (e.g., the price of IBM

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Appendix C: Put-Call Parity   • 289
traded on the New York Stock Exchange and the price of IBM traded in
Philadelphia) but are not. An arbitrageur, once he or she spots the small
difference, sells the more expensive thing and buys the less expensive one
and makes aprofit without accepting any risk.
Because we are going to investigate dividend arbitrage, even abig-
picture guy like me has to get down in the weeds because the differences we
are going to try to spot are small ones. The weeds into which we are wading
are mathematical ones, I’mafraid, but never fear—we’ll use nothing more
than alittle algebra. We’ll use these variables in our discussion:
K = strike price
C
K = call option struck at K
PK = put option struck at K
Int = interest on arisk-free instrument
Div = dividend payment
S = stock price
Because we are talking about arbitrage, it makes sense that we are
going to look at two things, the value of which should be the same. We
are going to take adetailed look at the preceding image, which means that
we are going to compare aposition composed of options with aposition
composed of stock.
Let’ssay that the stock at which we were looking to build aposition is
trading at $50 per share and that options on this stock expire in exactly one
year. Further, let’ssay that this stock is expected to yield $0.25 in dividends
and that the company will pay these dividends the same day that the op-
tions expire.
Let’scompare the two positions in the same way as we did in the
preceding big-picture image. As we saw in that image, along call and ashort put are the same as astock. Mathematically, we would express this
as follows:
C
K − PK = SK
Although this is simple and we agreed that it’sabout right, it is not
technically so.
The preceding equation is not technically right because we know that
astock is an unlevered instrument and that options are levered ones. In the

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290  •   The Intelligent Option Investor
preceding equation, we can see that the left side of the equation is levered
(because it contains only options, and options are levered instruments),
and the right side is unlevered. Obviously, then, the two cannot be exactly
the same.
We can fix this problem by delevering the left side of the preceding
equation. Any time we sell aput option, we have to place cash in amar -
gin account with our broker. Recall that ashort put that is fully margined
is an unlevered instrument, so margining the short put should delever
the entire option position. Let’sadd amargin account to the left side and
put $Kin it:
C
K − PK + K = S
This equation simply says that if you sell aput struck at Kand put $Kworth of margin behind it while buying acall option, you’ll have the same
risk, return, and leverage profile as if you bought astock—just as in our
big-picture diagram.
But this is not quite right if one is dealing with small differences.
First, let’ssay that you talk your broker into funding the margin ac-
count using arisk-free bond fund that will pay some fixed amount of
interest over the next year. To fund the margin account, you tell your
broker you will buy enough of the bond account that one year from
now, when the put expires, the margin account’svalue will be exactly
the same as the strike price. In this way, even by placing an amount less
than the strike price in your margin account originally, you will be able
to fulfill the commitment to buy the stock at the strike price if the put
expires in the money (ITM). The amount that will be placed in margin
originally will be the strike price less the amount of interest you will
receive from the risk-free bond. In mathematical terms, the preceding
equation becomes
C
K − PK + (K – Int) = S
Now all is right with the world. For anon-dividend-paying stock, this fully
expresses the technical definition of put-call parity.
However, because we are talking about dividend arbitrage, we have to
think about how to adjust our equation to include dividends. We know that
acall option on adividend-paying stock is worth less because the dividend

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Appendix C: Put-Call Parity   • 291
acts as a “negative drift” term in the BSM. When adividend is paid, theory
says that the stock price should drop by the amount of the dividend. Be-
cause adrop in price is bad for the holder of acall option, the price of acall
option is cheaper by the amount of the expected dividend.
Thus, for adividend-paying stock, to establish an option-based position
that has exactly the same characteristics as astock portfolio, we have to keep
the expected amount of the dividend in our margin account.
1 This money
placed into the option position will make up for the dividend that will be
paid to the stock holder. Here is how this would look in our equation:
C
K − PK + (K − Int) + Div = S
With the dividend payment included, our equation is complete.
Now it is time for some algebra. Let’srearrange the preceding equa-
tion to see what the call option should be worth:
CK = PK + Int − Div + (S − K)
Taking alook at this, do you notice last term (S – K )? Astock’sprice
minus the strike price of acall is the intrinsic value. And we know that
the value of acall option consists of intrinsic value and time value. This
means that
/dncurlybracketleft/dncurlybracketmid/horizcurlybracketext/horizcurlybracketext/dncurlybracketright/horizcurlybracketext/horizcurlybracketext/dncurlybracketleft/dncurlybracketmid/dncurlybracketright=+ −−CP SKKK IntD iv + ()
Time valueI ntrinsic value
So now let’ssay that time passes and at the end of the year, the stock
is trading at $70—deep ITM for our $50-strike call option. On the day
before expiration, the time value will be very close to zero as long as the op-
tion is deep ITM. Building on the preceding equation, we can put the rule
about the time value of adeep ITM option in the following mathematical
equation:
P
K + Int − Div ≈ 0
If the time value ever falls below 0, the value of the call would trade for less
than the intrinsic value. Of course, no one would want to hold an option
that has negative time value. In mathematical terms, that scenario would
look like this:
P
K + Int − Div < 0

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292  •   The Intelligent Option Investor
From this equation, it follows that if
PK + Int < Div
your call option has anegative implied time value, and you should sell the
option in order to collect the dividend.
This is what is meant by dividend arbitrage . But it is hard to get the
flavor for this without seeing areal-life example of it. The following table
shows the closing prices for Oracle’sstock and options on January 9, 2014,
when they closed at $37.72. The options had an expiration of 373 days in
the future—as close as Icould find to one year—the one-year risk-free rate
was 0.14 percent, and the company was expected to pay $0.24 worth of
dividends before the options expired.
Calls Puts
Bid Ask Delta Strike Bid Ask Delta
19.55 19.85 0.94 18 0.08 0.13 −0.02
17.60 17.80 0.94 20 0.13 0.15 −0.03
14.65 14.85 0.92 23 0.25 0.28 −0.05
12.75 12.95 0.91 25 0.36 0.39 −0.07
10.00 10.25 0.86 28 0.66 0.69 −0.12
8.30 8.60 0.81 30 0.97 1.00 −0.17
6.70 6.95 0.76 32 1.40 1.43 −0.23
4.70 4.80 0.65 35 2.33 2.37 −0.34
3.55 3.65 0.56 37 3.15 3.25 −0.43
2.22 2.26 0.42 40 4.80 4.90 −0.57
1.55 1.59 0.33 42 6.15 6.25 −0.65
0.87 0.90 0.22 45 8.25 8.65 −0.75
0.31 0.34 0.10 50 12.65 13.05 −0.87
In the theoretical option portfolio, we are short aput, so its value to
us is the amount we would have to pay if we tried to flatten the position by
buying it back—the ask price. Conversely, we are long acall, so its value to
us is the price we could sell it for—the bid price.
Let’suse these data to figure out which calls we might want to exercise
early if adividend payment was coming up.

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Appendix C: Put-Call Parity   • 293
Strike Call
Put
(a)
Interest2
(b)
Put + Interest
(a + b) Dividend P + I − D Notes
18 19.55 0.13 0.03 0.16 0.24 (0.08) P + I < D,
arbitrage
20 17.60 0.15 0.03 0.18 0.24 (0.06) P + I < D,
arbitrage
23 14.65 0.28 0.03 0.31 0.24 0.07 No arbitrage
25 12.75 0.39 0.04 0.43 0.24 0.19 No arbitrage
28 10.00 0.69 0.04 0.73 0.24 0.49 No arbitrage
30 8.30 1.00 0.04 1.04 0.24 0.80 No arbitrage
32 6.70 1.43 0.05 1.48 0.24 1.24 No arbitrage
35 4.70 2.37 0.05 2.42 0.24 2.18 No arbitrage
37 3.55 3.25 0.05 3.30 0.24 3.06 No arbitrage
40 2.22 4.90 0.06 4.96 0.24 4.72 No arbitrage
42 1.55 6.25 0.06 6.31 0.24 6.07 No arbitrage
45 0.87 8.65 0.06 8.71 0.24 8.47 No arbitrage
50 0.31 13.05 0.07 13.12 0.24 12.88 No arbitrage
There are only two strikes that might be arbitraged for the
dividends—the two furthest ITM call options. In order to realize the
arbitrage opportunity, you would wait until the day before the ex-dividend
date, exercise the stock option, receive the dividend, and, if you didn’twant
to keep holding the stock, sell it and realize the profit.

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295
Notes
Introduction
1. Options, Futures, and Other Derivatives by John C. Hull (New York:
Prentice Hall, Eighth Edition, February 12, 2011), is considered the
Bible of the academic study of options.
2. Option Volatility and Pricing by Sheldon Natenberg (New York:
McGraw-Hill, Updated and Expanded Edition, August 1, 1994), is
considered the Bible of professional option traders.
3. The Greeks are measures of option sensitivity used by traders to man-
age risk in portfolios of options. They are named after the Greek
symbols used in the Black-Scholes-Merton option pricing model.
4. “To invest successfully over alifetime does not require astratospheric
IQ, unusual business insights, or inside information. What’sneeded
is asound intellectual framework for making decisions and the abil-
ity to keep emotions from corroding that framework. ” Preface to The
Intelligent Investor by Benjamin Graham (New York: Collins Business,
Revised Edition, February 21, 2006).
Chapter 1
1. In other words, if all option contracts were specific and customized,
every time you wanted to trade an option contract as an individual in-
vestor, you would have to first find acounterparty to take the other side
of the trade and then do due diligence on the counterparty to make
sure that he or she would be able to fulfill his or her side of the bargain.
It is hard to imagine small individual investors being very interested in
the logistical headaches that this process would entail!

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296 •   Notes
2. One more bit of essential but confusing jargon when investing in
options is related to exercise. There are actually two styles of exercise;
one can be exercised at any time before expiration—these are termed
American style—and the other can only be exercised at expiration—
termed European style. Confusingly, these styles have nothing to do
about the home country of agiven stock or even on what exchange
they are traded. American-style exercise is normal for all single-stock
options, whereas European-style exercise is normal for index futures.
Because this book deals almost solely with single-stock options (i.e.,
options on IBM or GOOG, etc.), Iwill not make abig deal out of this
distinction. There is one case related to dividend-paying stocks where
American-style exercise is beneficial. This is discussed in Appendix C.
Most times, exercise style is not aterribly important thing.
3. Just like going to Atlantic City, even though the nominal odds for rou-
lette are 50:50, you end up losing money in the long run because you
have to pay—the house at Atlantic City or the broker on Wall Street—
just to play the game.
Chapter 3
1. We adjusted and annualized the prices of actual option contracts so
that they would correspond to the probability levels we mentioned
earlier. It would be almost impossible to find astock trading at exactly
$50 and with the option market predicting exactly the range of future
price that we have shown in the diagrams. This table is provided simply
to give you an idea of what one might pay for call options of different
moneyness in the open market.
2. Eighty-four percent because the bottom line marks the price at which
there is only a 16 percent chance that the stock will go any lower. If
there is a 16 percent chance that the stock will be lower than $40 in
one year’stime, this must mean that there is an 84 percent chance
that the stock will be higher than $40 in one year’stime. We write
“alittle better than 84 percent chance” because you’ll notice that the
stock price corresponding to the bottom line of the cone is around
$42—alittle higher than the strike price. The $40 mark might corre-
spond to achance of, let’ssay, 13 percent that the stock will be lower;

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Notes  • 297
this would, in turn, imply an 87 percent chance of being higher than
$40 in ayear.
3. Tenor is just aspecialty word used for options and bonds to mean the
remaining time before expiration/maturity. We will see later that op-
tion tenors usually range from one month to one year and that special
long-term options have tenors of several years.
4. We’re not doing any advanced math to figure this out. We’re just eye-
balling the area of the exposure range within the cone in this diagram
and recalling that the area within the cone of the $60 strike, one-year
option was about the same.
5. In other words, in this style of trading, people are anchoring on recent
implied volatilities—rather than on recent statistical volatilities—to
predict future implied volatilities.
6. Note that even though this option is now ITM, we did not pay for any
intrinsic value when we bought the option. As such, we are shading the
entire range of exposure in green.
Chapter 4
1. The “capital” we have discussed so far is strategic capital. There is an-
other form of tactical capital that is vital to companies, termed working
capital. Working capital consists of the short-term assets essential for
running abusiness (e.g., inventory and accounts receivables) less the
short-term liabilities accrued during the course of running the busi-
ness (e.g., accounts payable). Working capital is tactical in the sense
that it is needed for day-to-day operation of the business. Acompany
may have the most wonderful productive assets in the world, but if it
does not have the money to buy the inventory of raw materials that will
allow it to produce its widgets, it will not be able to generate revenues
because it will not be able to produce anything.
2. The law of large numbers is actually alaw of statistics, but when most
people in the investing world use this phrase, it is the colloquial version
to which they are referring.
3. Apple Computer, for instance, was aspecialized maker of computers
mainly used by designers and artists in the late 1990s. Through some

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300 •   Notes
4. The original academic paper discussing prospect theory was published
in Econometrica, Volume 47, Number 2, in March 1979 under the title:
“Prospect Theory: An Analysis of Decision Under Risk. ”
5. Over the years, the paradigm for broker-dealers has changed, so some
of what is written here is abit dated. Broker-dealers have one part of
its business dedicated to increasing customer “flow” as is described
here. Over the last 20 years or so, however, they have additionally
begun to capitalize what amounts to in-house hedge funds, called
“proprietary trading desks” or “prop traders. ” While the prop traders
are working on behalf of corporations that were historically known as
broker-dealers (e.g., Goldman Sachs, Morgan Stanley), they are in fact
buy-side institutions. In the interest of clarity in this chapter, Itreat
broker-dealers as purely sell-side entities even though they in fact have
elements of both buy- and sell-sides.
Chapter 7
1. Round-tripping means buying asecurity and selling it later.
2. This bit of shorthand just means abid volatility of 22.0 and an ask
volatility of 22.5.
Chapter 8
1. This is one of the reasons why Icalled delta the most useful of the
Greeks.
2. When Ipulled these data, Ipulled the 189-day options, so my chance
of this stock hitting that high aprice in this short time period is slim,
but the point Iam making here about percentage versus absolute re-
turns still holds true.
3. Atool to calculate all the downside and upside leverage figures shown
in this chapter is available on the intelligent option investor website.
4. “Buffett’s Alpha, ” Andrea Frazzini, David Kabiller, and Lasse H. Ped-
ersen, 2012, National Bureau of Economic Research, NBER Working
Paper No. 19681.

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Notes  • 303
Appendix B
1. The idea behind this process is to match the timing of the costs of
equipment with revenues from the items produced with that equip-
ment. This is akey principle of accountancy called matching.
2. The problem is that troughs, by definition, follow peaks. Usually, just
like the timing of large acquisitions, companies decide to spend huge
amounts to build new production capacity at just about the same time
that economic conditions peak, and the factories come online just as
the economy is starting to sputter and fail.
Appendix C
1. Apenny saved is apenny earned. We can think of the option being
cheaper by the amount of the dividend, so we will place the amount
that we save on the call option in savings.
2. This is calculated using the following equation:
Interest = strike × r × percent of 1 year
In the case of the $18 strike, interest = 18 × 0.14% × (373 days/365 days
per year) = $0.03.

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305
A
Absolute dollar value of returns,
172–173
Accuracy, confidence vs., 119–121
Acquisitions (see Mergers and
acquisitions)
Activist investors, 110
Against the Gods (Peter Bernstein), 9
Agents:
buy-side, 132–136
defined, 131
investment strategies of, 137–138
principals vs., 131–132
sell-side, 136–137
AIG, 301n1
Allocation:
and leverage in portfolios,
174–183
and liquidity risk, 256
and portfolio management with
short-call spreads, 228–229
Alpha, 134
American-style options, 296n2
(Chapter 1)
Analysis paralysis, 120
Anchoring, 60, 97
Announcements:
and creating BSM cones, 156, 157
market conditions following, 68–69,
72–73
tenor and trading in expectation
of, 192
AOL, 103
Apple Computer, 101, 250–251,
297–298n3
Arbitrage:
defined, 288–289
dividend, 223, 288–293
Ask price, 147
Asset allocation, liquidity risk
and, 256
Assets:
defined, 78–79
fungible, 272–273
in golden rule of valuation, 77
hidden, 110, 111
idiosyncratic, 272
interchangeable, 272–273
mispriced, 274–277
operating, 110
price vs. value of, 79–80
underlying, 33–34, 272–273
Assets under management (AUM), 132
Assignment:
with covered calls, 247–248
defined, 222–223
Assumptions:
BSM model, 32–33, 40–47, 78, 150
dividend yield, 67
with forward volatility number,
156–157
time-to-expiration, 64–67
volatility, 60–64
At-the-money (ATM) options:
BSM cone for, 53
collars, 259
covered calls, 242–243, 245, 246
defined, 13, 16, 17
long calls, 189
long diagonals, 235–237
Index

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306  •   Index
At-the-money (ATM) options: (continued)
long straddles, 208–209
OTM options vs., 233–234
protective puts, 250–251, 253
short diagonals, 238, 240
short puts, 215, 216
short straddles, 230
short-call spreads, 222–225
AUM (assets under management), 132
B
Balance-sheet effects, 92, 108–111
Behavior, efficient market hypothesis
as model for, 41–42
Behavioral biases, 114–130
overconfidence, 118–122
pattern recognition, 114–118
perception of risk, 123–130
Behavioral economics, 42, 114
Bentley, 97–98
Berkshire Hathaway, 185
Bernstein, Peter, 9
Biases, behavioral (see Behavioral
biases)
Bid price, 147
Bid-ask spreads, 147–149
Bimodal outcomes, companies with,
277–278
Black, Fischer, 8–9
BlackBerry, 208–209
Black-Scholes-Merton (BSM) model, 9
assumptions of, 32–33, 40–47, 78, 150
conditions favoring, 269–273
conditions not favoring, 273–281
incorrect facets of, 29
predicting future stock prices from,
32–39
ranges of exposure and price
predictions from, 50–56
theory of, 32
(See also BSM cone)
Bonds, investing in short puts vs.,
213–214
Booms, leverage during, 199
Breakeven line, 25
for call options, 15, 16
for long strangle, 26–27
for put options, 17, 18
(See also Effective buy price [EBP])
Broker-dealers, 137, 299–300n5
Brokers, benefits of short-term trading
for, 64
BSM cone:
for call options, 50–55
for collars, 258
for covered calls, 240–244
creating, 156–160
defined, 38–39
delta-derived, 151–155
discrepancies between valuation and,
160–162
for ITM options, 57–58
for long calls, 189
for long diagonals, 235
for long puts, 201
for long strangles, 205
overlaying valuation range on, 160
for protective puts, 248, 249
for put options, 54–55
for short diagonals, 238
for short puts, 212, 216, 217
for short straddles, 230
for short strangles, 231
for short-call spreads, 220
with simultaneous changes in variables,
68–74
and time-to-expiration assumptions,
64–67
and volatility assumptions,
60–64
BSM model (see Black-Scholes-Merton
(BSM) model)
Bubbles, 42–43
Buffett, Warren, xv, 184–185
Buying options (see Exposure-gaining
strategies)
Buy-side structural impediments,
132–136

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308  •   Index
d
Debt, investment leverage from, 165–166
Dell, 101
Delta, 151–155, 300n1 (Chapter 8)
Demand-side constraints, 84–86
Depreciation, 282–284
Diagonals, 233
long, 235–237
short, 238–240
Directionality of options, 9–20
calls, 12–16
and exposure, 18–20
importance of, 27–28
puts, 16–18
and stock, 10–11
volatility and predications about,
68–74
Discount rate, 87–89, 298n5
Dispersion, 302n1 (Chapter 11)
Distribution of returns:
fat-tailed, 45
leptokurtic, 45
lognormal, 36–37
normal, 32, 36, 40, 43–45
Dividend arbitrage, 223, 288–293
Dividend yield, 67
Dividend-paying stocks, prices of,
35–36
Dividends, 86
Downturns, short puts during, 214–215
Drift:
assumptions about, 32, 35–36
effects of, 67
and long calls, 202–203
and long puts, 191
and long strangles, 206
Drivers of value (see Value drivers)
e
Early exercise, 223
Earnings before interest, taxes,
depreciation, and amortization
(EBITDA), 99
Earnings before interest and taxes
(EBIT), 99
Earnings per share (EPS), 99
Earnings seasons:
and tenor of short puts, 217–218
volatility in, 301n5
EBIT (earnings before interest and
taxes), 99
EBITDA (earnings before interest,
taxes, depreciation, and
amortization), 99
EBP (see Effective buy price)
Economic environment, profitability
and, 101
Economic life of companies:
and golden rule of valuation,
82–86
improving valuations by
understanding, 93–94
Economic value of companies,
137–139
Effective buy price (EBP), 24–25,
213, 244
Effective sell price (ESP), 25–26
Efficacy (see Investing level and
efficacy)
Efficient market hypothesis (EMH),
33, 34, 40–43
Endowments, 135, 136
Enron, 110
EPS (earnings per share), 99
ESP (effective sell price), 25–26
European-style options, 296n2
(Chapter 1)
Exchange-traded funds (ETFs),
options on, 251–252
Execution of option overlay strategies:
collars, 259–262
covered calls, 242–245
protective puts, 250–252
Exercising options, 13,
296n2 (Chapter 1)
Expansionary cash flows, 82, 104–108

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310  •   Index
Gross domestic product (GDP), 104–108
Growth:
buying call options for, 22
nominal GDP , 104–108
revenue, 92, 97–99
structural growth stage, 94, 95
H
Hedge funds, 132–134, 136
Hedge funds of funds (HFoF), 134
Hedges:
reinvesting profit from, 254–255
size of, 255–258
timing of, 252–254
Hedging:
planning for, 255–258
for portfolios, 251–252
Herding, 138, 299n1
HFoF (hedge funds of funds), 134
Historical volatility, 60
Hostile takeovers, 110
The Human Face of Big Data (Rick
Smolan), 114
I
IBM, 224–230, 299n5 (Chapter 5),
301n6
Idiosyncratic assets, 272
Immediate realized loss (IRL), 180, 183
Implied volatility:
bid/ask, 149–151
changing assumptions about, 60–64
and short puts, 216–217
Income, selling put options for, 23
Indexing, closet, 133
Insurance, 5, 250
Insurance companies, 135, 136
Intel, 175
Interchangeable assets, 272–273
Interest:
calculating, 303n2
options and payment on, 168
prepaid, 170
Interest rates, 67
In-the-money (ITM) options:
calls vs. puts, 27
covered calls, 242
defined, 13, 16, 17
investment leverage for, 170–172
levered strategy with, 176–180
long calls, 189, 193–197
long diagonals, 236
long puts, 204
managing leverage with, 183–184
and market risk, 263–264
pricing of, 56–59, 150
protective puts, 249–251
short puts, 213–215
short-call spread, 222, 223
time decay for, 66–67
Intrinsic value, 56–59, 171
Investing level and efficacy, 92,
103–108
Investment capital, leverage and,
183–184
Investment leverage, 163–185
from debt, 165–166
defined, 164
managing, 183–185
margin of safety for, 197–199
measuring, 169–173
from options, 166–168
and portfolio management,
196–197
in portfolios, 174–183
unlevered investments, 164–165
Investment phase (investment stage),
86, 93–96
Investors:
activist, 110
risk-averse, 123, 125–127
risk-neutral, 124–126
risk-seeking, 123, 125–127
IRL (immediate realized loss),
180, 183
ITM (see In-the-money options)

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312  •   Index
Market conditions (continued)
time-to-expiration assumptions, 64–67
and types of volatility, 59–60
volatility assumptions, 60–64
Market efficiency, 32–34, 40–43
Market makers, 147, 281
Market risk, 263–265
Matching, 302n1 (Appendix B)
Maximum return, 225
Mergers and acquisitions:
strike prices selection and, 195–196
tenor and, 191–192
Merton, Robert, 8–9
Miletus, 6–7
Mispriced assets, 274–277
Mispriced options, 143–162
deltas of, 151–155
reading option quotes, 144–151
and valuation risk, 266
and valuation vs. BSM range, 155–162
Moneyness of options:
calls, 13–14
puts, 16–17
Morningstar, 132
Most likely (term), 38
Motorola Mobility Systems, 84
Mueller Water, 148–149, 154, 158–160
Multiples-based valuation, 99–100
Mutual funds, 132–133, 136
n
Nominal GDP growth:
owners’ cash profit vs., 104–108
as structural constraint, 104
Normal distribution, 32, 36, 40, 43–45
Notional amount of position, 173
Notional exposure, 173
O
OCC (Options Clearing
Corporation), 8
OCP (see Owners’ cash profit)
Operating assets, 110
Operating leverage (operational
leverage):
defined, 282–284
and level of investment leverage,
197–199
and profitability, 101
Operational details of companies,
xiii–xiv, 110–111
Option investing:
choices in, 22–24
conditions favoring BSM, 269–273
conditions not favoring BSM, 273–281
flexibility in, 20–28
long-term strategies, 1
misconceptions about, 1
risk in, 268
shortcuts for valuation in, 93–97
stock vs., 21–22
strategies for, 142 (See also specific
types of strategies)
structural impediments in, 131–139
three-step process, xiv
valuation in, 75
Option pricing, 29–47, 49–74
and base assumptions of BSM, 40–47
market conditions in, 59–74
predicting future stock prices from,
32–39
and ranges of exposure, 50–56
theory of, 30–32
time vs. intrinsic value in, 56–59
Option pricing models:
base assumptions of, 40–47
history of, 8–9
operational details of companies in,
xiii–xiv
predicting future stock prices with,
32–39
ranges of exposure and price
predictions from, 50–56
(See also Black-Scholes-Merton
[BSM] model)
Option quotes, 144–151

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314  •   Index
Procter & Gamble, 84
Productivity, 102
Profit:
from covered calls, 245
from hedging, 254–255
owners’ cash, 82
percent, 172–173
Profit leverage, 179–180, 182–183
Profitability:
and financial leverage, 285–286
and operational leverage,
283–284
as value driver, 92, 99–102
Proprietary trading desks (prop
traders), 300n5
Prospect theory, 123–127
Protective puts, 248–258
about, 248–250
BSM cone, 248, 249
with covered calls, 259–262
execution of, 250–252
pitfalls with, 252–258
Pure Digital, 299n6 (Chapter 5)
Put options (puts):
BSM cone for, 54–55
buying, for protection, 23
defined, 11
delta for, 151
on quotes, 145
selling, for income, 23
tailoring exposure with, 24
visual representation of, 16–18
(See also Long puts; Protective puts;
Short puts)
Put-call parity, 223, 287–293
defined, 287–288
and dividend arbitrage, 288–293
for non-dividend-paying stock,
289–290
Q
Qualcomm, 260–262
Quotes, option, 144–151
R
Random-walk principal, 41
Ranges of exposure, 3
for call options, 12–13, 15
for ITM options, 58–59
and option pricing, 50–56
Rankine, Graeme, 41–42
Ratioing, 206, 238
Realized losses:
and buying puts, 203
immediate, 180, 183
managing leverage to minimize,
183–185
and option buying, 187–188
unrealized vs., 175–176
Recessions, leverage during, 198, 199
Reflective thought processes, 116–118
Reflexive thought processes, 116–118
Return(s):
absolute dollar value of, 172–173
for covered calls, 244–245
maximum, 225
percentage, 229
for short puts, 245
(See also Distribution of returns)
Revenue growth, 92, 97–99
Risk, 263–268
career, 263
counterparty, 7–8
liquidity, 256, 263
market, 263–265
in option investing, 267–268
perception of, 123–130
and size of hedges, 255–256
solvency, 256, 263
valuation, 265–267
Risk-averse investors, 123, 125–127
Risk-free rate:
borrowing at, 32, 40, 46
BSM model assumption about, 32,
35–36, 40, 45–46
Risk-neutral investors, 124–126
Risk-seeking investors, 123, 125–127

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316  •   Index
Strike prices: (continued )
long strangle, 206–207
short diagonal, 239–240
short put, 215
short-call spread, 222–228
Strike–stock price ratio (K/S):
and change in closing price,
146–147
defined, 53–54
and forward volatility, 67–74
Structural constraints, 86, 104
Structural downturns, 302n2
(Chapter 11)
Structural growth stage, 94, 95
Structural impediments, 131–139
buy-side, 132–136
and investment strategies,
137–139
principals vs. agents, 131–132
sell-side, 136–137
Sun Microsystems, 108
Supply-side constraints, 83
Symmetry, bias associated with,
114–118
T
“Taking profit” with covered calls, 245
Taxes, BSM model assumption about,
32, 40, 46
Technical analysis, 115
Tenor, 297n3 (Chapter 3)
defined, 59
for long calls, 190–192
for long puts, 202–203
for long strangles, 206
for protective puts, 252–254
for short puts, 214–215
for short-call spreads, 222
Terminal phase, 86
Time decay, 65–67
Time horizons:
long, 279–281
short, 270–272
Time value:
intrinsic vs., 56–59
of money, 87, 93–95
Time Warner, 103
Time-to-expiration assumptions,
64–67
Toyota, 97
Trading restrictions, 32, 40, 46
Troughs (business-cycle):
operational leverage in, 283–284
and peaks, 302–303n2
Tversky, Amos, 123, 126
“2-and-20” arrangements, 134
U
Uncertainty, 118–119
Underexposure, 247
Underlying assets:
fungible, 272–273
and future stock price, 33–34
University of Chicago, 41
Unlevered investments:
levered vs., 164–165
in portfolios, 175–176, 178
Unrealized losses, 175–176
Unrealized profit, 254–255
Unused leg, long strangle, 207
U.S. Treasury bonds, 45–46
Utility curves, 124–126
V
Valuation:
golden rule of, 77–89
multiples-based, 99–100
shortcuts for, 93–97
value drivers in, 91–97
Valuation range:
BSM cone vs., 160–162
creating, 122
and margins of safety, 197–199
overlaying BSM cone with, 160
and strike price selection, 192–194
Valuation risk, 265–267

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Preface
When the listed option market originated in April 1973, anew world of investment
strategies was opened to the investing public. The standardization of option terms
and the formation of aliquid secondary market created new investment vehicles that,
adapted properly, can enhance almost every investment philosophy, from the con
servative to the speculative. This book is about those option strategies -which ones
work in which situations and why they work.
Some of these strategies are traditionally considered to be complex, but with
the proper knowledge of their underlying principles, most investors can understand
them. While this book contains all the basic definitions concerning options, little time
or space is spent on the most elementary definitions. For example, the reader should
be familiar with what acall option is, what the CBOE is, and how to find and read
option quotes in anewspaper. In essence, everything is contained here for the novice
to build on, but the bulk of the discussion is above the beginner level. The reader
should also be somewhat familiar with technical analysis, understanding at least the
terms support and resistance.
Certain strategies can be, and have been, the topic of whole books - call buy
ing, for example. While some of the strategies discussed in this book receive amore
thorough treatment than others, this is by no means abook about only one or two
strategies. Current literature on stock options generally does not treat covered call
writing in agreat deal of detail. But because it is one of the most widely used option
strategies by the investing public, call writing is the subject of one of the most in
depth discussions presented here. The material presented herein on call and put
buying is not particularly lengthy, although much of it is of an advanced nature -
especially the parts regarding buying volatility and should be useful even to sophis
ticated traders. In discussing each strategy, particular emphasis is placed on showing
why one would want to implement the strategy in the first place and on demonstrat-
xv

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xviii Preface
are made for using the computer as atool in follow-up action, including an example
printout of an advanced follow-up analysis.
THIRD EDITION
There were originally six new chapters in the third edition. There were new chapters
on LEAPS, CAPS, and PERCS, since they were new option or option-related prod
ucts at that time.
LEAPS are merely long-term options. However, as such, they require alittle
different viewpoint than regular short-term options. For example, short-term inter
est rates have amuch more profound influence on alonger-term option than on ashort-term one. Strategies are presented for using LEAPS as asubstitute for stock
ownership, as well as for using LEAPS in standard strategies.
PERCS are actually atype of preferred stock, with aredemption feature built
in. They also pay significantly larger dividends than the ordinary common stock. The
redemption feature makes a PERCS exactly like acovered call option write. As such,
several strategies apply to PERCS that would also apply to covered writers.
Moreover, suggestions are given for hedging PERCS. Subsequently, the PERCS
chapter was enveloped into alarger chapter in the fourth edition.
The chapters on futures and other non-equity options that were written for the
second edition were deleted and replaced by two entirely new chapters on futures
options. Strategists should familiarize themselves with futures options, for many prof
it opportunities exist in this area. Thus, even though futures trading may be unfamil
iar to many customers and brokers who are equity traders, it behooves the serious
strategist to acquire aknowledge of futures options. Achapter on futures concentrates
on definitions, pricing, and strategies that are unique to futures options; another chap
ter centers on the use of futures options in spreading strategies. These spreading
strategies are different from the ones described in the first part of the book, although
the calendar spread looks similar, but is really not. Futures traders and strategists
spend agreat deal of time looking at futures spreads, and the option strategies pre
sented in this chapter are designed to help make that type of trading more profitable.
Anew chapter dealing with advanced mathematical concepts was added near
the end of the book. As option trading matured and the computer became more of
an integral way of life in monitoring and evaluating positions, more advanced tech
niques were used to monitor risk. This chapter describes the six major measures of
risk of an option position or portfolio. The application of these measures to initialize
positions that are doubly or triply neutral is discussed. Moreover, the use of the com
puter to predict the results and "shape" of aposition at points in the future is
described.

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Preface xix
There were substantial revisions to the chapters on index options as well. Part
of the revisions are due to the fact that these were relatively new products at the time
of the writing of the second edition; as aresult, many changes were made to the prod
ucts - delisting of some index options and introduction of others. Also, after the crash
of 1987, the use of index products changed somewhat (with introduction of circuit
breakers, for example).
FOURTH EDITION
Once again, in the ever-changing world of options and derivatives, some new
important products have been introduced and some new concepts in trading have
come to the forefront. Meanwhile, others have been delisted or fallen out of favor.
There are five new chapters in the fourth edition, four of which deal with the most
important approach to option trading today - volatility trading.
The chapter on CAPS was deleted, since CAPS were delisted by the option
exchanges. Moreover, the chapter on PERCS was incorporated into amuch larger
and more comprehensive chapter on another relatively new trading vehicle - struc
tured products. Structured products encompass afairly wide range of securities -
many of which are listed on the major stock exchanges. These versatile products
allow for many attractive, derivative-based applications - including index funds that
have limited downside risk, for example. Many astute investors buy structured prod
ucts for their retirements accounts.
Volatility trading has become one of the most sophisticated approaches to
option trading. The four new chapters actually comprise anew Part 6 - Measuring
And Trading Volatility. This new part of the book goes in-depth into why one should
trade volatility (it'seasier to predict volatility than it is to predict stock prices), how
volatility affects common option strategies - sometimes in ways that are not initially
obvious to the average option trader, how stock prices are distributed ( which is one
of the reasons why volatility trading "works"), and how to construct and monitor avolatility trade. Anumber of relatively new techniques regarding measuring and pre
dicting volatility are presented in these chapters. Personally, Ithink that volatility
buying of stock options is the most useful strategy, in general, for traders of all levels
- from beginners through experts. If constructed properly, the strategy not only has
ahigh probability of success, but it also requires only amodest amount of work to
monitor the position after it has been established. This means that avolatility buyer
can have a "life" outside of watching ascreen with dancing numbers on it all day.
Moreover, most of the previous chapters were expanded to include the latest
techniques and developments. For example, in Chapter 1 (Definitions), the entire
area of option symbology has been expanded, because of the wild movements of

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xx Preface
stocks in the past few years. Also, the margin rules were changed in 2000, and those
changes are noted throughout the book.
Those chapters dealing with the sale of options - particularly naked options -
have been expanded to include more discussion of the way that stocks behave and
how that presents problems and opportunities for the option writer. For example, in
the chapter on Reverse Spreads, the reverse calendar spread is described in detail
because - in ahigh-volatility environment - the strategy becomes much more viable.
Another strategy that receives expanded treatment is the "collar" - the purchase
of aput and simultaneous sale of acall against an underlying instrument. In fact, asimilar strategy can be used - with aslight adjustment - by the outright buyer of an
option (see the chapter on Spreads Combining Puts and Calls).
Iam certain that many readers of this book expect to learn what the "best"
option strategy is. While there is achapter discussing this subject, there is no defin
itively "best" strategy. The optimum strategy for one investor may not be best for
another. Option professionals who have the time to monitor positions closely may be
able to utilize an array of strategies that could not possibly be operated diligently by
apublic customer employed in another full-time occupation. Moreover, one'spartic
ular investment philosophy must play an important part in determining which strat
egy is best for him. Those willing to accept little or no risk other than that of owning
stock may prefer covered call writing. More speculative strategists may feel that low
cost, high-profit-potential situations suit them best.
Every investor must read the Options Clearing Corporation Prospectus before
trading in listed options. Options may not be suitable for every investor. There are
risks involved in any investment, and certain option strategies may involve large risks.
The reader must determine whether his or her financial situation and investment
objectives are compatible with the strategies described. The only way an investor can
reasonably make adecision on his or her own to trade options is to attemptto acquire
aknowledge of the subject.
Several years ago, Iwrote that "the option market shows every sign of becom
ing astronger force in the investment world. Those who understand it will be able to
benefit the most." Nothing has happened in the interim to change the truth of that
statement, and in fact, it could probably be even more forcefully stated today. For
example, the Federal Reserve Board now often makes decisions with an eye to how
derivatives will affect the markets. That shows just how important derivatives have
become. The purpose of this book is to provide the reader with that understanding
of options.
Iwould like to express my appreciation to several people who helped make this
book possible: to Ron Dilks and Howard Whitman, who brought me into the bro-

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CHAPTER 1
Definitions
The successful implementation of various investment strategies necessitates asound
working knowledge of the fundamentals of options and option trading. The option
strategist must be familiar with awide range of the basic aspects of stock options
how the price of an option behaves under certain conditions or how the markets
function. Athorough understanding of the rudiments and of the strategies helps the
investor who is not familiar with options to decide not only whether astrategy seems
desirable, but also - and more important - whether it is suitable. Determining suit
ability is nothing new to stock market investors, for stocks themselves are not suitable
for every investor. For example, if the investor'sprimary objectives are income and
safety of principal, then bonds, rather than stocks, would be more suitable. The need
to assess the suitability of options is especially important: Option buyers can lose their
entire investment in ashort time, and uncovered option writers may be subjected to
large financial risks. Despite follow-up methods designed to limit risk, the individual
investor must decide whether option trading is suitable for his or her financial situa
tion and investment objective.
ELEMENTARY DEFINITIONS
Astock option is the right to buy or sell aparticular stock at acertain price for alim
ited period of time. The stock in question is called the underlying security. Acall
option gives the owner ( or holder) the right to buy the underlying security, while aput option gives the holder the right to sell the underlying security. The price at
which the stock may be bought or sold is the exercise price, also called the striking
price. (In the listed options market, "exercise price" and "striking price" are synony
mous.) Astock option affords this right to buy or sell for only alimited period of time;
3

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4 Part I: Basic Properties of Stodc Options
thus, each option has an expiration date. Throughout the book, the term "options" is
always understood to mean listed options, that is, options traded on national option
exchanges where asecondary market exists. Unless specifically mentioned, over-the
counter options are not included in any discussion.
DESCRIBING OPTIONS
Four specifications uniquely describe any option contract:
1. the type (put or call),
2. the underlying stock name,
3. the expiration date, and
4. the striking price.
As an example, an option referred to as an "XYZ July 50 call" is an option to buy (acall) 100 shares (normally) of the underlying XYZ stock for $50 per share. The option
expires in July. The price of alisted option is quo!_ed on aper-share basis, regardless
of how many shares of stock can be bought with the option. Thus, if the price of the
XYZ July 50 call is quoted at $5, buying the option would ordinarily cost $500 ($5 x
100 shares), plus commissions.
THE VALUE OF OPTIONS
An option is a "wasting" asset; that is, it has only an initial value that declines (or
"wastes" away) as time passes. It may even expire worthless, or the holder may have
to exercise it in order to recover some value before expiration. Of course, the holder
may sell the option in the listed option market before expiration.
An option is also asecurity by itself, but it is aderivative security. The option is
irrevocably linked to the underlying stock; its price fluctuates as the price of the
underlying stock rises or falls. Splits and stock dividends in the underlying stock
affect the terms of listed options, although cash dividends do not. The holder of acall
does not receive any cash dividends paid by the underlying stock.
STANDARDIZATION
The listed option exchanges have standardized the terms of option contracts. The
terms of an option constitute the collective name that includes all of the four descrip
tive specifications. While the type (put or call) and the underlying stock are self-evi
dent and essentially standardized, the striking price and expiration date require more
explanation.

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Chapter 1: Definitions s
Striking Price. Striking prices are generally spaced 5 points apart for stocks,
although for more expensive stocks, the striking prices may be 10 points apart.
A $35 stock might, for example, have options with striking prices, or "strikes," of
30, 35, and 40, while a $255 stock might have one at 250 and one at 260.
Moreover, some stocks have striking prices that are 2½ points apart - generally
those selling for less than $35 per share. That is, a $17 stock might have strikes
at 15, 17½, and 20.
These striking price guidelines are not ironclad, however. Exchange officials
may alter the intervals to improve depth and liquidity, perhaps spacing the strikes 5
points apart on anonvolatile stock even if it is selling for more than $100. For exam
ple, if a $155 stock were very active, and possibly not volatile, then there might well
be astrike at 155, in addition to those at 150 and 160.
Expiration Dates. Options have expiration dates in one of three fixed cycles:
Lthe January/April/July/October cycle,
2. the February/May/August/November cycle, or
3. the March/June/September/December cycle.
In addition, the two nearest months have listed options as well. However, at any given
time, the longest-term expiration dates are normally no farther away than 9 months.
Longer-term options, called LEAPS, are available on some stocks (see Chapter 25).
Hence, in any cycle, options may expire in 3 of the 4 major months (series) plus the
near-term months. For example, on February 1 of any year, XYZ options may expire
in February, March, April, July, and October - not in January. The February option
( the closest series) is the short- or near-term option; and the October, the far- or long
term option. If there were LEAPS options on this stock, they would expire in January
of the following year and in January of the year after that.
The exact date of expiration is fixed within each month. The last trading day for
an option is the third Friday in the expiration month. Although the option actually
does not expire until the following day (the Saturday following), apublic customer
must invoke the right to buy or sell stock by notifying his broker by 5:30 P.M., New
York time, on the last day of trading.
THE OPTION ITSELF: OTHER DEFINITIONS
Classes and Series. Aclass of options refers to all put and call contracts on the
same underlying security. For instance, all IBM options - all the puts and calls at
various strikes and expiration months - form one class. Aseries, asubset of aclass,

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6 Part I: Basic Properties of Stock Options
consists of all contracts of the same class (IBM, for example) having the same expi
ration date and striking price.
Opening and Closing Transactions. An opening transaction is the ini
tial transaction, either abuy or asell. For example, an opening buy transaction
creates or increases along position in the customer'saccount. Aclosing trans
action reduces the customer'sposition. Opening buys are often followed by clos
ing sales; correspondingly, opening sells often precede closing buy trades.
Open Interest. The option exchanges keep track of the number of opening
and closing transactions in each option series. This is called the open interest.
Each opening transaction adds to the open interest and each closing transaction
decreases the open interest. The open interest is expressed in number of option
contracts, so that one order to buy 5 calls opening would increase the open
interest by 5. Note that the open interest does not differentiate between buyers
and sellers - there is no way to tell if there is apreponderance of either one.
While the magnitude of the open interest is not an extremely important piece of
data for the investor, it is useful in determining the liquidity of the option in
question. If there is alarge open interest, then there should be little problem in
making fairly large trades. However, if the open interest is small - only afew
hundred contracts outstanding - then there might not be areasonable second
ary market in that option series.
The Holder and Writer. Anyone who buys an option as the initial transac
tion - that is, buys opening - is called the holder. On the other hand, the
investor who sells an option as the initial transaction - an opening sale - is called
the writer of the option. Commonly, the writer ( or seller) of an option is referred
to as being short the option contract. The term "writer" dates back to the over
the-counter days, when adirect link existed between buyers and sellers of
options; at that time, the seller was the writer of anew contract to buy stock. In
the listed option market, however, the issuer of all options is the Options
Clearing Corporation, and contracts are standardized. This important difference
makes it possible to break the direct link between the buyer and seller, paving
the way for the formation of the secondary markets that now exist.
Exercise and Assignment. An option owner ( or holder) who invokes the
right to buy or sell is said to exercise the option. Call option holders exercise to
buy stock; put holders exercise to sell. The holder of most stock options may
exercise the option at any time after taking possession of it, up until 8:00 P.M. on

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O,apter 1: Definitions 7
the last trading day; the holder does not have to wait until the expiration date
itself before exercising. (Note: Some options, called "European" exercise
options, can be exercised only on their expiration date and not before - but they
are generally not stock options.) These exercise notices are irrevocable; once
generated, they cannot be recalled. In practical terms, they are processed only
once aday, after the market closes. Whenever aholder exercises an option,
somewhere awriter is assigned the obligation to fulfill the terms of the option
contract: Thus, if acall holder exercises the right to buy, acall writer is assigned
the obligation to sell; conversely, if aput holder exercises the right to sell, aput
writer is assigned the obligation to buy. Amore detailed description of the exer
cise and assignment of call options follows later in this chapter; put option exer
cise and assignment are discussed later in the book.
RELATIONSHIP OF THE OPTION PRICE AND STOCK PRICE
In- and Out-of-the-Money. Certain terms describe the relationship between
the stock price and the option'sstriking price. Acall option is said to be out-of-the
money if the stock is selling below the striking price of the option. Acall option is in
the-money if the stock price is above the striking price of the option. (Put options
work in aconverse manner, which is described later.)
Example: XYZ stock is trading at $47 per share. The XYZ July 50 call option is out
of-the-money, just like the XYZ October 50 call and the XYZ July 60 call. However,
the XYZ July 45 call, XYZ October 40, and XYZ January 35 are in-the-money.
The intrinsic value of an in-the-money call is the amount by which the stock
price exceeds the striking price. If the call is out-of-the-money, its intrinsic value is
zero. The price that an option sells for is commonly referred to as the premium. The
premium is distinctly different from the time value premium ( called time premium,
for short), which is the amount by which the option premium itself exceeds its intrin
sic value. The time value premium is quickly computed by the following formula for
an in-the-money call option:
Call time value premium = Call option price + Striking price - Stock price
Example: XYZ is trading at 48, and XYZ July 45 call is at 4. The premium - the total
price - of the option is 4. With XYZ at 48 and the striking price of the option at 45,
the in-the-money amount (or intrinsic value) is 3 points (48-45), and the time value
isl(4-3).

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8 Part I: Basic Properties ol Stoclc Options
If the call is out-of-the-money, then the premium and the time value premium
are the same.
Example: With XYZ at 48 and an XYZ July 50 call selling at 2, both the premium and
the time value premium of the call are 2 points. The call has no intrinsic value by
itself with the stock price below the striking price.
An option normally has the largest amount of time value premium when the
stock price is equal to the striking price. As an option becomes deeply in- or out-of
the-money, the time value premium shrinks substantially. Table 1-1 illustrates this
effect. Note that the time value premium increases as the stock nears the striking
price (50) and then decreases as it draws away from 50.
Parity. An option is said to be trading at parity with the underlying security if
it is trading for its intrinsic value. Thus, if XYZ is 48 and the xyz July 45 call is
selling for 3, the call is at parity. Acommon practice of particular interest to
option writers ( as shall be seen later) is to refer to the price of an option by relat
ing how close it is to parity with the common stock. Thus, the XY2 July 45 call
is said to be ahalf-point over parity in any of the cases shown in Table 1-2.
TABLE 1-1.
Changes in time value premium.
XYZ Stock XYZ Jul 50 Intrinsic Time Value
Price Call Price Value Premium
40 1/2 0 ¼
43 1 0 1
35 2 0 2
47 4 0 3
➔50 5 0 5
53 7 3 4
55 8 5 3
57 9 7 2
60 101/2 10 ¼
70 191/2 20 -1/20
asimplistically, adeeply in-the-money call may actually trade at adiscount from intrinsic value,
because call buyers are more interested in less expensive calls that might return better percentage
profits on an upward move in the stock. This phenomenon is discussed in more detail when arbitrage
techniques are examined.

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Cl,apter 1: Definitions 9
TABLE 1-2.
Comparison of XYZ stock and call prices.
XYZ July 45 XYZ Stock Over
Striking Price + Coll Price Price Parity
(45 + 45 1/2) 1/2
(45 + 21/2 47 ) 1/2
(45 + 51/2 50 ) ½
(45 + 151/2 60 ) 1/2
FACTORS INFLUENCING THE PRICE OF AN OPTION
An option'sprice is the result of properties of both the underlying stock and the terms
of the option. The major quantifiable factors influencing the price of an option are
the:
1.. price of the underlying stock,
2. striking price of the option itself,
3. time remaining until expiration of the option,
4. volatility of the underlying stock,
5. current risk-free interest rate (such as for 90-day Treasury bills), and
6. dividend rate of the underlying stock.
The first four items are the major determinants of an option'sprice, while the latter
two are generally less important, although the dividend rate can be influential in the
case of high-yield stock.
THE FOUR MAJOR DETERMINANTS
Probably the most important influence on the option'sprice is the stock price,
because if the stock price is far above or far below the striking price, the other fac
tors have little influence. Its dominance is obvious on the day that an option expires.
On that day, only the stock price and the striking price of the option determine the
option'svalue; the other four factors have no bearing at all. At this time, an option is
worth only its intrinsic value.
Example: On the expiration day in July, with no time remaining, an XYZ July 50 call
has the value shown in Table 1-3; each value depends on the stock price at the time.

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10 Part I: Basic Properties of Stock Options
TABLE 1-3.
XYZ option'svalues on the expiration day.
XYZ July 50 Coll
(Intrinsic) Value
XYZ Stock Price ot Expiration
40
45
48
50
52
55
60
0
0
0
0
2
5
10
The Call Option Price Curve. The call option price curve is acurve that
plots the prices of an option against various stock prices. Figure 1-1 shows the
axes needed to graph such acurve. The vertical axis is called Option Price. The
horizontal axis is for Stock Price. This figure is agraph of the intrinsic value.
When the option is either out-of-the-money or equal to the stock price, the
intrinsic value is zero. Once the stock price passes the striking price, it reflects
the increase of intrinsic value as the stock price goes up. Since acall is usually
worth at least its intrinsic value at any time, the graph thus represents the min
imum price that acall may be worth.
FIGURE 1-1.
The value of an option at expiration, its intrinsic value.
~
it
C:
.Q
15..
0 The intrinsic value line
bends at the
st~iking ~
pnce. ~
Stock Price

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Chapter 1: Definitions 11
When acall has time remaining to its expiration date, its total price consists of
its intrinsic value plus its time value premium. The resultant call option price curve
takes the form of an inverted arch that stretches along the stock price axis. If one
plots the data from Table 1-4 on the grid supplied in Figure 1-2, the curve assumes
two characteristics:
1. The time value premium ( the shaded area) is greatest when the stock price and
the striking price are the same.
2. When the stock price is far above or far below the striking price (near the ends
of the curve), the option sells for nearly its intrinsic value. As aresult, the curve
nearly touches the intrinsic value line at either end. [Figure 1-2 thus shows both
the intrinsic value and the option price curve.]
This curve, however, shows only how one might expect the XYZ July 50 call
prices to behave with 6 months remaining until expiration. As the time to expiration
grows shorter, the arched line drops lower and lower, until, on the final day in the life
of the option, it merges completely with the intrinsic value line. In other words, the
call is worth only its intrinsic value at expiration. Examine Figure 1-3, which depicts
three separate XYZ calls. At any given stock price (afixed point on the stock price
scale), the longest-term call sells for the highest price and the nearest-term call sells
for the lowest price. At the striking price, the actual differences in the three option
prices are the greatest. Near either end of the scale, the three curves are much clos
er together, indicating that the actual price differences from one option to another
are small. For agiven stock price, therefore, option prices decrease as the expiration
date approaches.
TABLE 1-4.
The prices of ahypothetical July 50 call with 6 months of time
remaining, plotted in Figure 1-2.
XYZ Stock Price
(Horizontal Axis)
40
45
48
➔SO
52
55
60
XYZ July 50
Call Price
(Vertical Axis)
2
3
4
5
61/2
11
Intrinsic
Value
0
0
0
0
2
5
10
Time Value
Premium
(Shading)
2
3
4
3
11/2
1

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Chapter 1: Definitions 13
This statement is true no matter what the stock price is. The only reservation is
that with the stock deeply in- or out-of-the-money, the actual difference between the
January, April, and July calls will be smaller than with XYZ stock selling at the strik
ing price of 50.
Time Value Premium Decay. In Figure 1-3, notice that the price of the 9-
month call is not three times that of the 3-month call. Note next that the curve
in Figure 1-4 for the decay of time value premium is not straight; that is, the rate
of decay of an option is not linear. An option'stime value premium decays much
more rapidly in the last few weeks of its life ( that is, in the weeks immediately
preceding expiration) than it does in the first few weeks of its existence. The rate
of decay is actually related to the square root of the time remaining. Thus, a 3-
month option decays (loses time value premium) at twice the rate of a 9-month
option, since the square root of 9 is 3. Similarly, a 2-month option decays at
twice the rate of a 4-month option (-..f4 = 2).
This graphic simplification should not lead one to believe that a 9-month option
necessarily sells for twice the price of a 3-month option, because the other factors
also influence the actual price relationship between the two calls. Of those other fac
tors, the volatility of the underlying stock is particularly influential. More volatile
underlying stocks have higher option prices. This relationship is logical, because if a
FIGURE 1-4.
Time value premium decay, assuming the stock price remains con
stant.
9 4
Time Remaining Until Expiration
(Months)
0

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14 Part I: Basic Properties ol Stodc Options
stock has the ability to move arelatively large distance upward, buyers of the calls are
willing to pay higher prices for the calls - and sellers demand them as well. For exam
ple, if AT&Tand Xerox sell for the same price (as they have been known to do), the
Xerox calls would be more highly priced than the AT&Tcalls because Xerox is amore
volatile stock than AT&T.
The interplay of the four major variables - stock price, striking price, time, and
volatility can be quite complex. While arising stock price (for example) is directing
the price of acall upward, decreasing time may be simultaneously driving the price
in the opposite direction. Thus, the purchaser of an out-of-the-money call may wind
up with aloss even after arise in price by the underlying stock, because time has
eroded the call value.
THE TWO MINOR DETERMINANTS
The Risk-Free Interest Rate. This rate is generally construed as the current
rate of 90-day Treasury bills. Higher interest rates imply slightly higher option pre
miums, while lower rates imply lower premiums. Although members of the financial
community disagree as to the extent that interest rates actually affect option price,
they remain afactor in most mathematical models used for pricing options. (These
models are covered much later in this book.)
The Cash Dividend Rate of the Underlying Stock. Though not clas
sified as amajor determinant in option prices, this rate can be especially impor
tant to the writer (seller) of an option. If the underlying stock pays no dividends
at all, then acall option'sworth is strictly afunction of the other five items.
Dividends, however, tend to lower call option premiums: The larger the dividend
of the underlying common stock, the lower the price of its call options. One of
the most influential factors in keeping option premiums low on high-yielding
stock is the yield itself.
Example: XYZ is arelatively low-priced stock with low volatility selling for $25 per
share. It pays alarge annual dividend of $2 per share in four quarterly payments of
$.50 each. What is afair price of an XYZ call with striking price 25?
Aprospective buyer of XYZ options is determined to figure out afair price. In
six months XYZ will pay $1 per share in dividends, and the stock price will thus be
reduced by $1 per share when it goes ex-dividend over that time period. In that case,
if XYZ'sprice remains unchanged except for the ex-dividend reductions, it will then
be $24. Moreover, since XYZ is anonvolatile stock, it may not readily climb back to
25 after the ex-dividend reductions. Therefore, the call buyer makes alow bid - even

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Chapter I: Definitions 15
for a 6-month call - because the underlying stock'sprice will be reduced by the ex
dividend reduction, and the call holder does not receive the cash dividends.
This particular call buyer calculated the value of the XYZ July 25 call in terms
of what it was worth with the stock discounted to 24 - not at 25. He knew for certain
that the stock was going to lose 1 point of value over the next 6 months, provided the
dividend rate of XYZ stock did not change. In actual practice, option buyers tend to
discount the upcoming dividends of the stock when they bid for the calls. However,
not all dividends are discounted fully; usually the nearest dividend is discounted
more heavily than are dividends to be paid at alater date. The less-volatile stocks with
the higher dividend payout rates have lower call prices than volatile stocks with low
payouts. In fact, in certain cases, an impending large dividend payment can substan
tially increase the probability of an exercise of the call in advance of expiration. (This
phenomenon is discussed more fully in the following section.) In any case, to one
degree or another, dividends exert an important influence on the price of some calls.
OTHER INFLUENCES
These six factors, major and minor, are only the quantifiable influences on the price
of an option. In practice, nonquantitative market dynamics - investor sentiment -
can play various roles as well. In abullish market, call premiums often expand
because of increased demand. In bearish markets, call premiums may shrink due to
increased supply or diminished demand. These influences, however, are normally
short-lived and generally come into play only in dynamic market periods when emo
tions are running high.
EXERCISE AND ASSIGNMENT: THE MECHANICS
The holder of an option can exercise his right at any time during the life of an option:
Call option holders exercise to buy stock, while put option holders exercise to sell
stock. In the event that an option is exercised, the writer of an option with the same
terms is assigned an obligation to fulfill the terms of the option contract.
EXERCISING THE OPTION
The actual mechanics of exercise and assignment are fairly simple, due to the role of
the Options Clearing Corporation (OCC). As the issuer of all listed option contracts,
it controls all listed option exercises and assignments. Its activities are best explained
by an example.

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16 Part I: Bask Properties ol Stock Options
Example: The holder of an XYZ January 45 call option wishes to exercise his right to
buy XYZ stock at $45 per share. He instructs his broker to do so. The broker then
notifies the administrative section of the brokerage firm that handles such matters.
The firm then notifies the OCC that they wish to exercise one contract of the XYZ
January 45 call series.
Now the OCC takes over the handling. OCC records indicate which member
(brokerage) firms are short or which have written and not yet covered XYZ Jan 45
calls. The OCC selects, at random, amember firm that is short at least one XYZ Jan
45 call, and it notifies the short firm that it has been assigned. That firm must then
deliver 100 shares of XYZ at $45 per share to the firm that exercised the option. The
assigned firm, in tum, selects one of its customers who is short the XYZ January 45
call. This selection for the assignment may be either:
1. at random,
2. on afirst-in/first-out basis, or
3. on any other basis that is fair, equitable, and approved by the appropriate
exchange.
The selection of the customer who is short the XYZ January 45 completes the
exercise/assignment process. (If one is an option writer, he should obviously deter
mine exactly how his brokerage firm assigns its option contracts.)
HONORING THE ASSIGNMENT
The assigned customer must deliver the stock - he has no other choice. It is too late
to try buying the option back in the option market. He must, without fail, deliver 100
shares of XYZ stock at $45 per share. The assigned writer does, however, have achoice as to how to fulfill the assignment. If he happens to be already long 100 shares
of XYZ in his account, he merely delivers that 100 shares as fulfillment of the assign
ment notice. Alternatively, he can go into the stock market and buy XYZ at the cur
rent market price - presumably something higher than $45 - and then deliver the
newly purchased stock as fulfillment. Athird alternative is merely to notify his bro
kerage firm that he wishes to go short XYZ stock and to ask them to deliver the 100
shares of XYZ at 45 out of his short account. At times, borrowing stock to go short
may not be possible, so this third alternative is not always available on every stock.
Margin Requirements. If the assigned writer purchases stock to fulfill acontract, reduced margin requirements generally apply to the transaction, so
that he would not have to fully margin the purchased stock merely for the pur
pose of delivery. Generally, the customer only has to pay aday-trade margin of

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Oapter 1: Definitions 17
the difference between the current price of XYZ and the delivery price of $45
per share. If he goes short to honor the assignment, then he has to fully margin
the short sale at the current rate for stock sold short on amargin basis.
AFTER EXERCISING THE OPTION
The OCC and the customer exercising the option are not concerned with the actual
method in which the delivery is handled by the assigned customer. They want only to
ensure that the 100 shares of XYZ at 45 are, in fact, delivered. The holder who exer
cised the call can keep the stock in his account if he wants to, but he has to margin it
fully or pay cash in acash account. On the other hand, he may want to sell the stock
immediately in the open market, presumably at ahigher price than 45. If he has an
established margin account, he may sell right away without putting out any money. If
he exercises in acash account, however, the stock must be paid for in full - even if it
is subsequently sold on the same day. Alternatively, he may use the delivered stock to
cover ashort sale in his own account if he happens to be short XYZ stock.
COMMISSIONS
Both the buyer of the stock via the exercise and the seller of the stock via the assign
ment are charged afull stock commission on 100 shares, unless aspecial agreement
exists between the customer and the brokerage firm. Generally, option holders incur
higher commission costs through assignment than they do selling the option in the
secondary market. So the public customer who holds an option is better off selling the
option in the secondary market than exercising the call.
Example: XYZ is $55 per share. Apublic customer owns the XYZ January 45 call
option. He realizes that exercising the call, buying XYZ at 45, and then immediately
selling it at 55 in the stock market would net aprofit of 10 points - or $1,000.
However, the combined stock commissions on both the purchase at 45 and the sale
at 55 might easily exceed $100. The net gain would actually be only $900.
On the other hand, the XYZ January 45 call is worth (and it would normally sell
for) at least 10 points in the listed options market. The commission for selling one call
at aprice of 10 is roughly $30. The customer therefore decides to sell his XYZ
January 45 call in the option market. He receives $1,000 (10 points) for the call and
pays only $30 in commissions - for anet of $970. The benefit of his decision is obvi
ous.
Of course, sometimes acustomer wants to own XYZ stock at $45 per share,
despite the stock commissions. Perhaps the stock is an attractive addition that will

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18 Part I: Basic Properties of Stock Options
bring greater potential to aportfolio. Or if the customer is already short the XYZ
stock, he is going to have to buy 100 shares and pay the commissions sooner or later
in any case; so exercising the call at the lower stock price of 45 may be more desir
able than buying at the current price of 55.
ANTICIPATING ASSIGNMENT
The writer of acall often prefers to buy the option back in the secondary market,
rather than fulfill the obligation via astock transaction. It should be strJssed again that
once the writer receives an assignment notice, it is too late to attempt to buy back
(cover) the call. The writer must buy before assignment, or live up to the terms upon
assignment. The writer who is aware of the circumstances that generally cause the
holders to exercise can anticipate assignment with afair amount of certainty. In antic
ipation of the assignment, the writer can then close the contract in the secondary mar
ket. As long as the writer covers the position at any time during atrading day, he can
not be assigned on that option. Assignment notices are determined on open positions
as of the close of trading each day. The crucial question then becomes, "How can the
writer anticipate assignment?" Several circumstances signal assignments:
1. acall that is in-the-money at expiration,
2. an option trading at adiscount prior to expiration, or
3. the underlying stock paying alarge dividend and about to go ex-dividend.
Automatic Exercise. Assignment is all but certain if the option is in-the
money at expiration. Should the stock close even ahalf-point above the striking
price on the last day of trading, the holder will exercise to take advantage of the
half-point rather than let the option expire. Assignment is nearly inevitable even
if acall is only afew cents in-the-money at expiration. In fact, even if the call
trades in-the-money at any time during the last trading day, assignment may be
forthcoming. Even if aholder forgets that he owns an option and fails to exer
cise, the OCC automatically exercises any call that is ¾-point in-the-money at
expiration, unless the individual brokerage firm whose customer is long the call
gives specific instructions not to exercise. This automatic exercise mechanism
ensures that no investor throws away money through carelessness.
Example: XYZ closes at 51 on the third Friday of January (the last day of trading for
the January option series). Since options don'texpire until Saturday, the next day, the
OCC and all brokerage firms have the opportunity to review their records to issue
assignments and exercises and to see if any options could have been profitably exer-

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