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
Index   • 307
C
CAGR (compound annual growth
rate), 46
Call options (calls):
BSM cone for, 50–55
buying, for growth, 22
covered, 240–248
defined, 11
delta for, 151
dividend arbitrage with, 292–293
leverage with, 167–168
on quotes, 145
short, 14, 221
tailoring exposure with, 24
visual representation of, 12–16
and volatility, 68–74
(See also Covered calls; Long calls;
Short-call spreads)
Capital:
investment, 183–184
strategic vs. working, 297n1
(Chapter 4)
Capital asset pricing model (CAPM),
88, 298n4
Capital expense, 80
Career risk, 263
Cash, hedge size and, 257
Cash flows:
on behalf of owners, 80–82
expansionary, 82, 104–108
in golden rule of valuation, 77
present value of future, 87–89
summing, from different time periods,
87–89
(See also Free cash flow to owners
[FCFO])
“Catalysts, ” 137
CBOE (see Chicago Board Options
Exchange)
Central counterparties, 8
Change (option quotes), 146–147
Chanos, Jim, 202
Chicago Board Options Exchange
(CBOE), 4, 8, 47
Chicago Mercantile Exchange, 8
China, joint ventures in, 84
Cisco Systems, 299n6 (Chapter 5)
Closet indexing, 133
Closing prices:
change in, 146–147
defined, 146
Collars, 258–262
Commitment, counterparties’ , 211
Commodities, options on, 6–7
Companies:
with bimodal outcomes,
277–278
drivers of value for (see Value
drivers)
economic life of, 82–86, 93–94
economic value of, 137–139
operational details of, xiii–xiv,
110–111
Complex investment strategies, 142
Compound annual growth rate
(CAGR), 46
Condors, 27–28
Confidence, accuracy vs., 119–121
Contingent loans, call options as,
167–168
Contract size, 146
Counterparties:
central, 8
commitments of, 211
for options contracts, 295n1
(Chapter 1)
Counterparty risk, 7–8
Covered calls, 23, 240–248,
301n4
about, 241–242
BSM cone, 240–244
execution of, 242–245
pitfalls with, 245–248
with protective puts, 259–262
Covering positions, 219, 228
Cremers, Martijn, 133
C-system, 115–118
Customer “flow, ” 299n5 (Chapter 6)
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
Index   • 309
Expiration of options, 187
Explicit forecast stage, 93–96
Exposure:
accepting, 14, 18–20
canceling out, 18–20
gaining, 13, 18–20
notional, 173
tailoring level of, 24
(See also Ranges of exposure)
Exposure-accepting strategies,
211–2


tegies:
collars, 259–262
covered calls, 242–245
protective puts, 250–252
Exercising options, 13,
296n2 (Chapter 1)
Expansionary cash flows, 82, 104–108
Index   • 309
Expiration of options, 187
Explicit forecast stage, 93–96
Exposure:
accepting, 14, 18–20
canceling out, 18–20
gaining, 13, 18–20
notional, 173
tailoring level of, 24
(See also Ranges of exposure)
Exposure-accepting strategies,
211–232
margin requirements for, 211–212
short call, 220–230
short put, 212–220
short straddle, 230–232
short strangle, 231–232
Exposure-gaining strategies, 187–209
and expiration of options, 187
long call, 189–201
long put, 201–205
straddle, 208–209
strangle, 205–207
Exposure-mixing strategies, 233–262
collar, 258–262
covered call, 240–248
long diagonal, 235–237
and OTM vs. ATM options, 233–234
protective put, 248–258
short diagonal, 238–240
Exxon, 299n4 (Chapter 5)
F
False precision, 93, 96–97
Fama, Eugene, 42
Fat-tailed distribution, 45
FCFO (see Free cash flow to owners)
“Fight or flight” response, 118
Financial crises, 302n2 (Chapter 11)
Financial leverage:
defined, 285–286
investment vs., 164
and level of investment leverage,
197–199
Financial statements, xv
Flexibility (with option investing), 20–28
Float, 185
Ford, 103, 272
Forward prices:
adding ranges to, 36–39
calculating, 34–36
defined, 35–36
ranges of exposure and, 50–56
Forward volatility:
choosing forward volatility number,
156–160
defined, 59–61
and strike–stock price ratio, 67–74
Free cash flow to owners (FCFO):
defined, 82
and drivers of value, 111–112
in joint ventures, 84
and supply-side constraints, 83
Front-month contracts, 270
Fungible assets, 272–273
G
Gains, levered vs. unlevered, 165
Gaussian distribution (see Normal
distribution)
GDP (gross domestic product),
104–108
Gillette Razors, 84
GM, 272
Goals, for hedges, 257
“Going long, ” 10, 21
“Going short, ” 21
Golden rule of valuation, 77–89
cash flows generated on behalf of
owners in, 80–82
and definition of assets, 78–80
and drivers of value, 91–92
and economic life of company, 82–86
and summing cash flows from
different time periods, 87–89
Google, 84, 127–130, 190
“Greeks, ” xiv, 295n3
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)
Index   • 311
J
Jaguar, 103
Joint ventures (JVs), 84–85
JP Morgan Chase, 236–237
K
Kahneman, Daniel, 42, 123, 126
Keen, Steven, 43
Keynes, John Maynard, 263
Kroger, 100
K/S (see Strike–stock price ratio)
L
Lambda, 169–173
Large numbers, law of, 85, 297n2
(Chapter 4)
Last (option quotes), 146
LEAPS (see Long-term equity
anticipated securities)
Legs (option structure), 27
Lehman Brothers, 264
Lenovo, 299n5 (Chapter 5)
Leptokurtic distribution, 45
Leverage, 163, 282–286
financial, 164, 197–199, 285–286
operating (operational), 101,
197–199, 282–284
(See also Investment leverage)
Leverage ratio, 228–229
Levered investments, portfolios with,
176–183
Liabilities, hidden, 110–111
Life insurance companies, 135
Liquidity risk, 256, 263
Listed look-alike option market, 6
Literary work, options on, 5–6
Lo, Andrew, 42
Load, 132, 134
Loans, call options as,
167–168
Lognormal curve, 37
Lognormal distribution,
36–37
Long calls, 13, 189–201
about, 189
BSM cone, 189
in long diagonals, 235–237
portfolio management with,
196–201
strike price for, 192–196
tenor for, 190–192
Long diagonals, 235–237
Long puts, 201–205
about, 201–202
BSM cone, 201
portfolio management with,
204–205
in short diagonals, 238–240
strike price for, 203
tenor for, 202–203
Long straddles, 208–209
Long strangles, 26–27, 205–207, 209
Long-term equity anticipated
securities (LEAPS), 153, 191,
280–281
Loss leverage:
conventions for, 182–183
formula, 178–179
with short puts, 211–212
Losses:
with levered vs. unlevered
instruments, 165–166
locking in, 245–247
on range of exposure, 15
unrealized, 175–176
(See also Realized losses)
M
MacKinlay, Craig, 42
Margin calls, 168
Margin of safety, 197–199
Margin requirements, 211–212
Market conditions, 59–74
assumptions about drift and
dividend yield, 67
simultaneous changes in, 67–74
312  •   Index
Market conditions (continued)
time-to-expiration assumptions, 64–67
and types of volatility, 59–60
volatility assumptions, 6

eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf


exposure, 15
unrealized, 175–176
(See also Realized losses)
M
MacKinlay, Craig, 42
Margin calls, 168
Margin of safety, 197–199
Margin requirements, 211–212
Market conditions, 59–74
assumptions about drift and
dividend yield, 67
simultaneous changes in, 67–74
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
Index   • 313
Optionality, 4
Options, 3–28
buying (see Exposure-gaining
strategies)
characteristics of, 4
defined, 4
directionality of, 9–20
examples of, 5–6
expiration of, 187
history of, 6–9
investment leverage from, 166–168
misconceptions about, 1
mispriced, 143–162
(See also specific types)
Options Clearing Corporation (OCC), 8
Options contracts:
counterparties for, 295n1 (Chapter 1)
examples of, 5–6
front-month, 270
private, 6–8
Oracle, 107–108, 144, 146, 148–153,
155, 157, 159–162
Organic revenue growth, 97
Out-of-the-money (OTM) options:
ATM options vs., 233–234
call vs. put, 27
collars, 258–262
defined, 13, 16, 17
investment leverage for, 171–172
levered strategy with, 180, 181
long calls, 193, 195–197
long diagonals, 235–237
long puts, 203, 204
long strangles, 205–207
and market makers, 147
pricing of, 150
protective puts, 248, 250–253
realized losses and, 187
rising volatility and, 70–74
short diagonals, 238–240
short puts, 213, 215
short strangles, 231
short-call spreads, 221–224
time decay for, 66–67
unrealized losses, 187
Overconfidence, 118–122
Overexposure, 247
Overlays, 23, 234
Owners:
cash flows generated on behalf of,
80–82
free cash flow to (see Free cash flow
to owners (FCFO))
Owners’ cash profit (OCP):
defined, 82
nominal GDP growth vs., 104–108
profitability as, 99–102
P
Parity, 288
Pattern recognition, 114–118
Peaks (business-cycle):
operational leverage in, 284
and troughs, 302–303n2
Pension funds, 135, 136
Percent delta, 169–173
Percent profit, 172–173
Percentage return, 229
Portfolio management:
for long calls, 196–201
for long puts, 204–205
for long strangles, 207
for short puts, 216–220
for short-call spreads, 228–230
Portfolios:
hedging, 251–252
investment leverage in, 174–183
Precision, false, 93, 96–97
Premium, 13
Prepaid interest, 170
Present value of future cash flows, 87–89
Pricing power, 98
Principal (financial), 168
Principals, agents vs., 131–132
Problem solving, X- vs. C-system,
115–118
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


9
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
Index   • 315
Rolling, 200–201
Round-tripping, 148–149, 300n1
(Chapter 7)
S
Safeway, 100
Schiller, Robert, 43
Scholes, Myron, 8–9
Secular downturns, 302n2 (Chapter 11)
Secular shifts, profitability and,
101–102
Sell-side structural impediments,
136–137
Settlement prices, 146
Shiller, Robert, 42
Short calls, 14, 221
Short diagonal, 238–240
Short puts, 211–220
about, 213–214
BSM cone, 212
covered calls and, 241–244
in long diagonals, 235–237
loss leverage with, 211–212
portfolio management with, 216–220
protective puts vs., 248–250
returns for, 245
strike price for, 215
tenor for, 214–215
Short straddles, 230–232
Short strangles, 231–232
Short-call spreads, 220–230
about, 221–222
BSM cone, 220
portfolio management with,
228–230
in short diagonals, 238–240
strike price for, 222–228
tenor for, 222
Short-term trading strategies:
implied volatility in, 63–64
intelligent investing vs., 267–268
and market risk, 264–265
Slovic, Paul, 119
Smolan, Rick, 114
Solvency risk, 256, 263
S&P 500 (see Standard & Poor’s 500
Index)
Special-purpose vehicles, 110
Spreads:
bid-ask, 147–149
short-call (see Short-call spreads)
SPX ETF , 251–252
Standard & Poor’s 500 Index (S&P
500):
correlation of hedge funds and, 134
distribution of returns, 44–46
protective puts on, 252–254
Startup stage, 86
Statistical volatility, 60
Stock investing, xiii
choices in, 20–22
visual representation of, 10–11
Stock prices:
BSM model assumption about, 32,
34–35, 40–47
directional predictions of, 68–74
of dividend-paying stocks, 35–36
predicting, with BSM model, 32–39
(See also Forward prices; strike–
stock price ratio [K/S])
Stock-split effect, 42
Stop loss, 229
Straddles:
long, 208–209
short, 230–232
Straight-line depreciation, 283
Strangles:
long, 26–27, 205–207, 209
short, 231–232
Strategic capital, 297n1 (Chapter 4)
Strike prices:
and BSM cone, 52–54
defined, 12
long call, 192–196
long diagonal, 236–237
long put, 203
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
Index   • 317
Value:
of companies, 137–139
intrinsic, 56–59, 171
time, 56–59, 87, 93–95
Value drivers, 91–112
balance-sheet effects, 108–111
investing level and efficacy, 103–108
profitability, 99–103
revenue growth, 97–99
in valuation process, 91–97
Value investing, 79
Volatility (vol.):
amplifying directional predictions
with, 71–74
changing assumptions about, 60–64
in earnings season, 301n5
failing to offset directional
predictions with, 70–71
historical, 60
offsetting directional predictions
with, 68–70
statistical, 60
types of, 59–60
(See also Forward volatility; Implied
volatility)
Volatility smile, 45, 150, 152
W
Walmart, 105–108
Whole Foods Market, 100, 101
Working capital, 297n1
(Chapter 4)
Writing options, 215, 301n3
x
X-system, 115–118
This page intentionally left blank
ABOUT THE AUTHOR
erik Kobayashi-Solomon, a veteran from the investment banking and
hedge fund world, is the founder and principal of IOI, LLC a financial
consultancy for individual and institutional investors. In addition to
publishing an institutional investor-focused subscription product, Erik
runs option and investment “boot camps” and consults on risk control,
option strategies, and stock valuations for individual and institutional
investors.
Before starting IOI, Erik worked for Morningstar in its stock research
department for over six years. At Morningstar, he first managed a team of
semiconductor industry analysts before becoming the coeditor and driv-
ing force of Morningstar’s OptionInvestor newsletter and serving as the
company’s Mar


control,
option strategies, and stock valuations for individual and institutional
investors.
Before starting IOI, Erik worked for Morningstar in its stock research
department for over six years. At Morningstar, he first managed a team of
semiconductor industry analysts before becoming the coeditor and driv-
ing force of Morningstar’s OptionInvestor newsletter and serving as the
company’s Market Strategist.
In addition to coauthoring a guide to fundamental investing and
option strategies used in the Morningstar Investor Training Options
Course and popular weekly articles about using options as a tool for in-
vestment portfolios, Erik was the host of several popular webinars such as
“Covered Calls A to Z” and “Hedging 101. ” His video lecture about avoid-
ing behavioral and structural pitfalls called “Making Better Investment
Decisions” was so popular that he was invited to be the featured speaker at
several investment conferences throughout the United States. In addition,
he represented Morningstar on television and radio, was interviewed by
magazines and newspapers from Dallas to Tokyo to New Delhi, and was
a frequent guest contributor to other Morningstar/Ibbotson publications.
Erik started his career in the world of finance at Morgan Stanley
Japan, where he ultimately headed Morgan’s listed derivatives operations
in Tokyo. After returning to the United States, Erik founded a small hedge
fund based on his original research in the field of Behavioral Finance and
later became the Risk Manager for a larger investment fund. There, he de-
signed option hedges for the fund’s $800 million global equity portfolio
and advised the portfolio manager on quantitative investment strategies
and Japanese stock market investments.
Erik, the son of a NASA scientist father and a concert violin-
ist mother, graduated Magna Cum Laude and Phi Beta Kappa from the
University of Texas at Austin, where he majored in Asian Studies and
Japanese. After working in Japan for several years as a teacher, translator,
and television actor, he won a full-ride scholarship to study business at
the number one ranked school for international business in the United
States—Thunderbird—in Glendale, Arizona. There, he worked as a research
assistant to Dr. Anant Sundaram (Finance, presently at Dartmouth) from
whom he gained a love for finance and economics, Dr. Graeme Rankine
(Accounting) who introduced him to Behavioral Finance, and Dr. Charles
Neilson (Marketing) who taught him the importance of strategic thinking.
Erik graduated Summa Cum Laude and was selected as the outstanding
student of his graduating class.
Erik lives in Chicago, Illinois with his family and enjoys long distance
running and reading. In his spare time, he volunteers at the local Japanese
school to teach children Kendo—the Japanese art of swordsmanship.


NUIF
NEW YORK INSTITUTE OF FINANCE
NEW YORK • TORONTO • SYDNEY • TOKYO • SINGAPORE
NEW YORK INSTITUTE OF FINANCE
NYIF and New York Institute of Finance ar; trademarks of Executive Tax Reports, Inc.,
used under license by Penguin Putnam Inc.
This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with
the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or
other expert assistance is required, the services of a competent professional person should be sought.
-From a Declaratlon of Principles jointly adapted by a Committee of the American Bar Association and a Committee of Publishers
and Associations.
Copyright © 2002 by Penguin Putnam Inc,
Prentice Hall® is a registered trademark of Pearson Education, Inc.
All rights reserved. No part of this book may be reproduced in any form or by any means, without per
mission in writing from the publisher.
Library of Congress Cataloging-in-Publication Data
McMillan, L. G. (Lawrence G.)
Options as a strategic investment/ Lawrence G. McMillan. - 4th ed.
p.cm.
Includes index.
ISBN 0-7352-0197-8 (cloth)
1. Options (Finance) I. Title.
HG6042.M35 2001
332.63'228-dc21
Associate Publisher: Ellen Schneid Coleman
Production Editor: Mariann Hutlak
Interior Design/Formatting: Inkwell Publishing Services
Printed in the United States of America
10 9 8 7 6 5 4 3
ISBN 0-7352-0197-8
00-053319
Most NYIF and New York Institute of Finance books are available at special quantity discounts for
bulk purchases for sales promotions, premiums, fund-raising, or educational use. Special books, or
book excerpts, can also be created to fit specific needs.
For details, write: Special Markets, Penguin Putnam Inc., 375 Hudson Street, New York, New York
10014.
Contents
Preface .......................................................... xv
Part I
BASIC PROPERTIES OF STOCK OPTIONS
Chapter 1
Definitions ................................................. 3
Elementary Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Factors Influencing the Price of an Option .... ........................... 9
Exercise and Assignment: The Mechanics ............................... 15
The Option Markets . ............................................... 22
Option Symbology . ................................................ 23
Details of Option Trading ........................................... 27
Order Entry . ..................................................... 32
Profits and Profit Graphs ........................................... 34
Part II
CALL OPTION STRATEGIES
Chapter2
Covered Call Writing . ....................................... 39
The Importance of Covered Call Writing ............................... 39
Covered Writing Philosophy ......................................... 42
The Total Return Concept of Covered Writing ........................... 45
Computing Return-on Investment ..................................... 47
iii
iv Contents
Execution of the Covered Write Order ................................. 56
Selecting a Covered Writing Position . .................................. 58
Writing against Stock Already Owned . ................................. 62
Diversifying Return and Protection in a Covered Write .................... 66
Follow-Up Action ........ .......................................... 70
Special Writing Situations ........................................... 87
Covered Call Writing Summary ...................................... 93
Chapter3
Call Buying . ............................................... 95
Why Buy? ....................................................... 95
Risk and Reward for the Call Buyer ................................... 97
Which Option to Buy? .............. ............................... 101
Advanced Selection Criteria ........................................ 103
Follow-Up Action ............... .................................. 107
A Further Comment on Spreads ..................................... 117
Chapter4
Other Call Buying Strategies ................................ 118
The Protected Short Sale (or Synthetic Put) ............................ 118
Follow-Up Action . ................................................ 122
The Reverse Hedge (Simulated Straddle) ...... ......................... 123
Follow-Up Action ...... ........................................... 126
Altering the Ratio of Long Calls to Short Stock . ......................... 128
Summary . ...................................................... 131
Chapter 5
Naked Call Writing ........................................ 132
The Uncovered (Naked) Call Option .... .............................. 133
Investment Required ............ .................................. 135
The Philosophy of Selling Naked Options .............................. 137
Risk and Reward ................................................. 138
Summary ....................................................... 144
Chapter 6
Ratio Call Writing ......................................... 146
The Ratio Write .................................................. 146
Investment Required .... ..................... _ ..................... 150
Contents V
Selection Criteria . ................................................ 151
The Variable Ratio Write . .......................................... 155
Follow-Up Action . ................................................ 158
An Introduction to Call Spread Strategies .. ............................ 168
Chapter7
Bull Spreads .............................................. 172
Degrees of Aggressiveness .......................................... 175
Ranking Bull Spreads ............................................. 176
Follow-Up Action . ................................................ 179
Other Uses of Bul

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf


.... 158
An Introduction to Call Spread Strategies .. ............................ 168
Chapter7
Bull Spreads .............................................. 172
Degrees of Aggressiveness .......................................... 175
Ranking Bull Spreads ............................................. 176
Follow-Up Action . ................................................ 179
Other Uses of Bull Spreads ......................................... 180
Summary .... ................................................... 185
Chapter 8
Bear Spreads Using Call Options ............................ 186
The Bear Spread ................................................. 186
Selecting a Bear Spread ... ......................................... 189
Follow-Up Action . ................................................ 190
Summary ......... .............................................. 190
Chapter9
Calendar Spreads .......................................... 191
The Neutral Calendar Spread ..... .................................. 192
Follow-Up Action . ................................................ 194
The Bullish Calendar Spread ... ..................................... 196
Follow-Up Action ........ ......................................... 197
Using All Three Expiration Series .................................... 198
Summary . ...................................................... 199
Chapter 10
The Butterfly Spread ....................................... 200
Selecting the Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Follow-Up Action ... .............................................. 206
Summary ....................................................... 209
Chapter 11
Ratio Call Spreads ......................................... 210
Differing Philosophies ............................................. 213
vi Contents
Follow-Up Action ..... ............................................ 217
Sumniary ....................................................... 221
Chapter 12
Combining Calendar and Ratio Spreads ...................... 222
Ratio Calendar Spread ............................................ 222
Choosing the Spread .............................................. 225
Follow-Up Action ... .............................................. 226
Delta-Neutral Calendar Spreads ....... .............................. 227
Follow-Up Action ... .............................................. 229
Chapter 13
Reverse Spreads ........................................... 230
Reverse Calendar Spread . .......................................... 230
Reverse Ratio Spread (Backspread) . .................................. 232
Chapter 14
Diagonalizing a Spread . .................................... 236
The Diagonal Bull Spread .......................................... 236
Owning a Call for "Free" ............ ............................... 239
Diagonal Backspreads ............................................. 240
Call Option Sumniary ............................................. 241
Part III
PUT OPTION STRATEGIES
Chapter 15
Put Option Basics . ....................................... ~ " 245
Put Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
Pricing Put Options ............................................... 247
The Effect of Dividends on Put Option Premiums ........................ 248
Exercise and Assignment ........................................... 250
Conversion . ..................................................... 253
Chapter 16
Put Option Buying . ........................................ 256
Put Buying versus Short Sale .. ...................................... 256
Selecting Which Put to Buy . ........................................ 258
Contents vii
Ranking Prospective Put Purchases ................................... 261
Follow-Up Action . ................................................ 262
Loss-Limiting Actions ............................................. 267
Equivalent Positions .. ............................................. 270
Chapter 17
Put Buying in Conjunction with Common Stock Ownership ..... 271
Which Put to Buy ................................................ 273
Tax Considerations ............................................... 275
Put Buying As Protection for _the Covered Call Writer .................... 275
No-Cost Collars . ................................................. 278
Chapter18
Buying Puts in Conjunction with Call Purchases ............... 281
Straddle Buying . ................................................. 282
Selecting a Straddle Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
Follow-Up Action . ................................................ 285
Buying a Strangle ................................................ 288
Chapter 19
The Sale of a Put ..................................... : .... 292
The Uncovered Put Sale . ........................................... 292
Follow-Up Action .......... ....................................... 295
Evaluating a Naked Put Write . ...................................... 296
Buying Stock below Its Market Price . ................................. 299
The Covered Put Sale ............................................. 300
Ratio Put Writing . ................................................ 300
Chapter 20
The Sale of a Straddle ...................................... 302
The Covered Straddle Write ........................................ 302
The Uncovered Straddle Write ...................................... 305
Selecting a Straddle Write .......................................... 307
Follow-Up Action ....... .......................................... 308
Equivalent Stock Position Follow-Up . ................................. 312
Starting Out with the Protection in Place ..............................


....................... 302
The Uncovered Straddle Write ...................................... 305
Selecting a Straddle Write .......................................... 307
Follow-Up Action ....... .......................................... 308
Equivalent Stock Position Follow-Up . ................................. 312
Starting Out with the Protection in Place .............................. 313
Strangle (Combination) Writing ..................................... 315
Further Comments on Uncovered Straddle and Strangle Writing . ........... 318
viii Contents
Chapter21
Synthetic Stock Positions Created by Puts and Calls ............ 321
Synthetic Long Stock . ............................................. 321
Synthetic Short Sale . .............................................. 323
Splitting the Strikes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Summary ....................................................... 328
Chapter22
Basic Put Spreads . ......................................... 329
Bear Spread . .................................................... 329
Bull Spread ..................................................... 332
Calendar Spread ................................................. 333
Chapter 23
Spreads Combining Calls and Puts . .......................... 336
The Butterfly Spread . ............................................. 336
Combining an Option Purchase and a Spread . .......................... 339
A Simple Follow-Up Action for Bull or Bear Spreads ..................... 342
Three Useful but Complex Strategies . ................................. 345
Selecting the Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Summary ........................................................ 356
Chapter 24
Ratio Spreads Using Puts ................................... 358
The Ratio Put Spread . ............................................. 358
Using Deltas . .................................................... 361
The Ratio Put Calendar Spread . ..................................... 361
A Logical Extension (The Ratio Calendar Combination) .... ............... 364
Put Option Summary . ............................................. 366
Chapter 25
LEAPS ................................................... 367
The Basics ...................................................... 368
Pricing LEAPS . .................................................. 369
Comparing LEAPS and Short-Term Options ............................ 374
LEAPS Strategies . ................................................ 375
Speculative Option Buying with LEAPS ............................... 382
Selling LEAPS ................................................... 390
Contents ix
Spreads Using LEAPS ............................................. 403
Sum111ary ....................................................... 409
PartIV
ADDITIONAL CONSIDERATIONS
Chapter 26
Buying Options and Treasury Bills ........................... 413
How the Treasury Bill/Option Strategy Operates ......................... 413
Sum111ary ....................................................... 421
Chapter 27
Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
Basic Put and Call Arbitrage ("Discounting") . .......................... 423
Dividend Arbitrage ............................................... 425
Conversions and Reversals . ......................................... 428
More on Carrying Costs ............................................ 430
Back to Conversions and Reversals ................................... 431
Risks in Conversions and Reversals ................................... 433
Sum111ary of Conversion Arbitrage ................................... 437
The "Interest Play" .... ............................................ 438
The Box Spread .................................................. 439
Variations on Equivalence Arbitrage .................................. 443
The Effects of Arbitrage . ........................................... 444
Risk Arbitrage Using Options ....................................... 445
Pairs Trading .................................................... 454
Facilitation (Block Positioning) ...................................... 455
Chapter 28
Mathematical Applications . ................................. 456
The Black-Scholes Model . .......................................... 456
Expected Return ................................................. 466
Applying the Calculations to Strategy Decisions ......................... 472
Facilitation or Institutional Block Positioning ........................... 482
Aiding in Follow-Up Action . ........................................ 485
Implementation .................................................. 488
Sum111ary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
X Contents
PartV
INDEX OPTIONS AND FUTURES
Chapter 29
Introduction to Index Option Products and Futures . ............ 493
Indices ............................................ : ............ 493
Cash-Based Options .............................................. 500
Futures ........................................................ 506
Options on Index Futures .......................................... 512
Standard Options Strategies Using Index Options ........... ............. 516
Put-Call Ratio ................................................... 520
Summary ....................................................... 523
Chapter30
Stock Index Hedging Strategies . ............................. 531
Market Baskets .................................................. 531
Program Trading ................................................. 537
Index Arbitrage .................................................. 547
Follow-Up


...................... 520
Summary ....................................................... 523
Chapter30
Stock Index Hedging Strategies . ............................. 531
Market Baskets .................................................. 531
Program Trading ................................................. 537
Index Arbitrage .................................................. 547
Follow-Up Strategies . ............................................. 557
Market Basket Risk ............................................... 560
Impact on the Stock Market . ........................................ 561
Simulating an Index . .............................................. 566
Trading the Tracking Error .... ..................................... 574
Summary ....................................................... 577
Chapter31
Index Spreading ........................................... 579
Inter-Index Spreading .. ........................................... 579
Summary ....................................................... 588
Chapter32
Structured Products ........................................ 589
Part I: "Riskless" Ownership of a Stock or Index ........................ 590
The "Structure" of a Structured Product . .............................. 590
Cash Value . ..................................................... 593
The Cost of the Imbedded Call Option ................................ 594
Price Behavior Prior to Maturity . .................................... 595
SIS ............................................................ 596
Contents xi
Computing the Value of the Imhedded Call When the Underlying
Is Trading at a Discount ......................................... 602
The Adjustment Factor ............................................ 602
Other Constructs ................................................. 607
Option Strategies Involving Structured Products ........................ 613
Lists of Structured Products ........................................ 618
Part II: Products Designed to Provide "Income" ......................... 618
PERCS ......................................................... 618
Call Feature . .................................................... 620
A PERCS Is a Covered Call Write .................................... 622
Price Behavior . .................................................. 623
PERCS Strategies ................................................ 625
PERCS Summary ................................................ 636
Other Structured Products ......................................... 637
Structured Product Summary ....................................... 640
Chapter33
Mathematical Considerations for Index Products ............... 641
Arbitrage ....................................................... 641
Mathematical Applications ......................................... 644
Chapter34
Futures and Futures Options ................................ 652
Futures Contracts ................................................ 653
Options on Futures ............................................... 660
Futures Option Trading Strategies .. .................................. 674
Commonplace Mispricing Strategies .................................. 683
Summary . ...................................................... 695
Chapter 35
Futures Option Strategies for Futures Spreads ................. 696
Futures Spreads . ................................................. 696
Using Futures Options in Futures Spreads ............................. 704
Summary ....................................................... 720
xii Contents
Part VI
MEASURING AND TRADING VOLATILITY
Chapter36
The Basics of Volatility Trading . ............................. 727
Definitions of Volatility ............................................ 728
Another Approach: GARCH ........................................ 731
Moving Averages ................................................. 732
Implied Volatility . ................................................ 732
The Volatility of Volatility .......................................... 734
Volatility Trading . ................................................ 743
Why Does Volatility Reach Extremes? . ................................ 744
Summary ....................................................... 7 48
Chapter37
How Volatility Affects Popular Strategies ..................... 749
Vega ........................................................... 749
Implied Volatility and Delta ........................................ 753
Effects on Neutrality .... .......................................... 755
Position Vega .................................................... 757
Outright Option Purchases and Sales ................................. 757
Time Value Premium is a Misnomer .................................. 762
Volatility and the Put Option . ....................................... 765
Straddle or Strangle Buying and Selling ............................... 766
Call Bull Spreads . ................................................ 767
Vertical Put Spreads .............................................. 775
Put Bear Spreads . ................................................ 777
Calendar Spreads ................................................ 778
Ratio Spreads and Backspreads . ..................................... 780
Summary ....................................................... 782
Chapter38
The Distribution of Stock Prices ............................. 783
Misconceptions about Volatility ...................................... 783
Volatility Buyer's Rule! ............................................ 787
The Distribution of Stock Prices ..................................... 789
What This Means for Option Traders ................................. 795
Stock Price Distribution Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 796
Contents xiii
The Pricing of Options .


..................... 783
Volatility Buyer's Rule! ............................................ 787
The Distribution of Stock Prices ..................................... 789
What This Means for Option Traders ................................. 795
Stock Price Distribution Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 796
Contents xiii
The Pricing of Options . ............................................ 798
The Probability of Stock Price Movement .............................. 798
EX'f)ected Return ................................................. 809
Summary . ...................................................... 810
Chapter39
Volatility Trading Techniques ............................... 812
Two Ways Volatility Predictions Can Be Wrong ......................... 813
Trading the Volatility Prediction ..................................... 814
Trading the Volatility Skew ......................................... 837
Volatility Trading Summary ............ ............................. 844
Chapter40
Advanced Concepts ........................................ 846
Neutrality ...................................................... 846
The "Greeks" .................................................... 848
Strategy Considerations: Using the "Greeks" . ........................... 866
Advanced Mathematical Concepts . ................................... 901
Summary ....................................................... 907
Chapter41
Taxes . .................................................... 908
History .. ....................................................... 908
Basic Tax Treatment . .............................................. 910
Exercise and Assignment ........................................... 913
Special Tax Problems .............................................. 922
Summary ....................................................... 925
Tax Planning Strategies for Equity Options . ............................ 925
Summary ....................................................... ·930
Chapter42
The Best Strategy? ......................................... 932
General Concepts: Market Attitude and Equivalent Positions ............... 932
What Is Best for Me Might Not Be Best for You ......................... 934
Mathematical Ranking . ............................................ 936
Summary ....................................................... 937
Postscript . ................................................ 938
xiv
Appendix A
Part VII
APPENDICES
Contents
Strategy Summary ......................................... 943
AppendixB
Equivalent Positions ....................................... 945
AppendixC
Formulae ................................................. 947
AppendixD
Graphs ................................................... 957
Appendix E
Qualified Covered Calls .................................... 961
Glossary . ....................................................... 963
Index .......................................................... 983
Preface
When the listed option market originated in April 1973, a new world of investment
strategies was opened to the investing public. The standardization of option terms
and the formation of a liquid 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 a call option is, what the CBOE is, and how to find and read
option quotes in a newspaper. 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 a more
thorough treatment than others, this is by no means a book about only one or two
strategies. Current literature on stock options generally does not treat covered call
writing in a great 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
xviii Preface
are made for using the computer as a tool 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 a little
different viewpoint than regular short-term options. For example, short-term inter
est rates have a much more profound influence on a longer-term option than on a
short-term one. Strategies are presented for using LEAPS as a substitute for stock
ownership, as well as for using LEAPS in standard strategies.
PERCS are actually a type of preferred stock, with a redemption feature bu


uire a little
different viewpoint than regular short-term options. For example, short-term inter
est rates have a much more profound influence on a longer-term option than on a
short-term one. Strategies are presented for using LEAPS as a substitute for stock
ownership, as well as for using LEAPS in standard strategies.
PERCS are actually a type of preferred stock, with a redemption feature built
in. They also pay significantly larger dividends than the ordinary common stock. The
redemption feature makes a PERCS exactly like a covered 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 a larger 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 a knowledge of futures options. A chapter 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 a great 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.
A new 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 a position at points in the future is
described.
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 a result, 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 a much larger
and more comprehensive chapter on another relatively new trading vehicle - struc
tured products. Structured products encompass a fairly 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 a new Part 6 - Measuring
And Trading Volatility. This new part of the book goes in-depth into why one should
trade volatility (it's easier 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 a
volatility trade. A number of relatively new techniques regarding measuring and pre
dicting volatility are presented in these chapters. Personally, I think 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
a high probability of success, but it also requires only a modest amount of work to
monitor the position after it has been established. This means that a volatility buyer
can have a "life" outside of watching a screen 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
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 a high-volatility environment - the strategy becomes much more viable.
Another strategy that receives expanded treatment is the "collar" - the purchase
of a put and simultaneous


on 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 a high-volatility environment - the strategy becomes much more viable.
Another strategy that receives expanded treatment is the "collar" - the purchase
of a put and simultaneous sale of a call against an underlying instrument. In fact, a
similar strategy can be used - with a slight adjustment - by the outright buyer of an
option (see the chapter on Spreads Combining Puts and Calls).
I am certain that many readers of this book expect to learn what the "best"
option strategy is. While there is a chapter 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
a public customer employed in another full-time occupation. Moreover, one's partic
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 a decision on his or her own to trade options is to attemptto acquire
a knowledge of the subject.
Several years ago, I wrote that "the option market shows every sign of becom
ing a stronger 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.
I would 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-
Preface xxi
kerage business; to Art Kaufman, whose broad experience in options helped to crys
tallize many of these strategies; to Peter Kopple for his help in reviewing the chap
ter on arbitrage; to Shelley Kaufman for his help on the third and fourth editions in
designing the graphs and in the massive task of proofreading and editing; to Ben
Russell and Fred Dahl for their suggestions on format and layout of the initial book;
and to Jim Dalton (then president of the CBOE) for recommending a little-known
option strategist when the New York Institute of Finance asked him, in 1977, if he
had any suggestions for an author for a new book on options. Special thanks go to
Bruce Nemirow for his invaluable assistance, especially for reading and critiquing the
original manuscript. Most of all, I am grateful to my wife, Janet, who typed the orig
inal manuscript, and to Karen and Glenn, our children, all of whom graciously with
stood the countless hours of interrupted family life that were necessary in order to
complete this work.
LAWRENCE G. MCMILLAN

I
PART I
--·····-·····u·-a•-s·•···i~ Prop· ertie····s··· ·
............... ~. . ..... ····••· . : ;· ...... .. . . /"•. ··•··· ..
·····•o·· ·· i:. ····s·····t·· ··o·c··k··•· •• .. O····· ·:·p·· · ··t···1·.·o···· ··:n.··. ·. ·::.·.s· ···· ,-" ~,~, ,:1,-,,, o ,,,,- V ,. •• '' ,,' '' "' ,,,., ,,,, ,,,,, " ''' • ,•,- ~t•" ,,,, . . .
~··"·" '•''"~ .,. ,_,,,,
INTRODUCTION
Each chapter in this book presents information in a logically sequential fashion.
Many chapters build on the information presented in preceding chapters. One
should therefore be able to proceed from beginning to end without constantly refer
ring to the glossary or index. However, the reader who is using the text as a refer
ence - perhaps scanning one of the later chapters - many find that terms are being
encountered that have been defined in an earlier chapter. In this case, the extensive
glossary at the back of the book should prove useful. The index may provide aid as
well, since some subjects are described, in varying levels of complexity, in more than
one place in the book. For example, call buying is discussed initially in Chapter 3;
and mathematical applications, as they apply to call purchases, are described in
Chapter 28. The latter chapters address more complex topics than do the early
chapters.
2
CHAPTER 1
Definitions
The successful implementation of various investment strategies necessitates a sound
working knowledge of the fundamentals of options and option trading. The option
strategist must be familiar with a wide range of the basic aspects of stock options
how the price of an option behaves under certain conditions or how the markets
function. A thorough understanding of the rudiments and of the strategies helps the
investor who is not familiar with options to decide not only whether a strategy 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's primary objectives are income and
safety of principal, then bonds, rather than stocks, would be more suitable. The need
to assess the suitability of


hether a strategy 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's primary 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 a short 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
A stock option is the right to buy or sell a particular stock at a certain price for a lim
ited period of time. The stock in question is called the underlying security. A call
option gives the owner ( or holder) the right to buy the underlying security, while a
put 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.) A stock option affords this right to buy or sell for only a limited period of time;
3
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 a secondary 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 (a
call) 100 shares (normally) of the underlying XYZ stock for $50 per share. The option
expires in July. The price of a listed option is quo!_ed on a per-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 a security by itself, but it is a derivative 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 a call
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.
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 a nonvolatile 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 a strike at 155, in addition to those at 150 and 160.
Expiration Dates. Options have expiration dates in one of three fixed cycles:
L the 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), a public 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. A class of options refers to all put and call contracts on the
same underlying security. For instance, all IBM op


option actually
does not expire until the following day (the Saturday following), a public 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. A class 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. A series, a subset of a class,
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 a buy or a sell. For example, an opening buy transaction
creates or increases a long position in the customer's account. A closing trans
action reduces the customer's position. 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 a preponderance 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 a large open interest, then there should be little problem in
making fairly large trades. However, if the open interest is small - only a few
hundred contracts outstanding - then there might not be a reasonable 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 a direct link existed between buyers and sellers of
options; at that time, the seller was the writer of a new 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
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 a day, after the market closes. Whenever a holder exercises an option,
somewhere a writer is assigned the obligation to fulfill the terms of the option
contract: Thus, if a call holder exercises the right to buy, a call writer is assigned
the obligation to sell; conversely, if a put holder exercises the right to sell, a put
writer is assigned the obligation to buy. A more 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's striking price. A call option is said to be out-of-the
money if the stock is selling below the striking price of the option. A call option is in
the-money if the stock price is above the striking price of the option. (Put options
work in a converse 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).
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


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).
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. A common 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 a half-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, a deeply in-the-money call may actually trade at a discount 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.
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's price 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's price, 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's price 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's value; 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.
10 Part I: Basic Properties of Stock Options
TABLE 1-3.
XYZ option's values 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 a curve that
plots the prices of an option against various stock prices. Figure 1-1 shows the
axes needed to graph such a curve. The vertical axis is called Option Price. The
horizontal axis is for Stock Price. This figure is a graph 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 a call is usually
worth at least its intrinsic value at any time, the graph thus represents the min
imum price that a call 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
Chapter 1: Definitions 11
When a call 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 a result, 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.


e 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 (a fixed 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 a given stock price, therefore, option prices decrease as the expiration
date approaches.
TABLE 1-4.
The prices of a hypothetical 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
12 Part I: Basic Properties of Stock Options
Example: On January 1st, XYZ is selling at 48. An XYZ July 50 call will sell for more
than an April 50 call, which in turn will sell for more than a January 50 call.
FIGURE 1-2.
Six-month July call option (see Table 1 ·4).
.g
a.
C
0
a
11
10
9
8
7
6
5
Greatest
Value for
Time Value
Premium
0 4 ----------------------
3
2
0
FIGURE 1-3.
40 45
represents the option's
time value premium.
--------L---------50\ 55 60
Stock Price Intrinsic value
remains at zero
until striking price
is passed.
Price Curves for the 3-, 6·, and 9-month call options.
/
Intrinsic Value
9-Month Curve
Striking Price
Stock Price
As expiration date draws
closer, the lower curve
merges with the intrinsic
value line. The option
price then equals its
intrinsic value.
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's time 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
14 Part I: Basic Properties ol Stodc Options
stock has the ability to move a relatively 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&T and Xerox sell for the same price (as they have been known to do), the
Xerox calls would be more highly priced than the AT&T calls because Xerox is a more
volatile stock than AT&T.
The interplay of the four major variables - stock price, striking price, time, and
volatility can be quite complex. While a rising stock price (for example) is directing
the price of a call 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 a loss even after a rise 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 a factor 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 a major 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 a call option's worth is strictly a function 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 a relatively low-priced stock with low volatility selling for $25 per
share. It pays a large annual dividend of $2 per share in four quarterly payments of
$.50 each. What is a fair price of an XYZ call with striking price 25?
A prospective buyer of XYZ options is determined to figure out a fair price


rs in keeping option premiums low on high-yielding
stock is the yield itself.
Example: XYZ is a relatively low-priced stock with low volatility selling for $25 per
share. It pays a large annual dividend of $2 per share in four quarterly payments of
$.50 each. What is a fair price of an XYZ call with striking price 25?
A prospective buyer of XYZ options is determined to figure out a fair 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's price remains unchanged except for the ex-dividend reductions, it will then
be $24. Moreover, since XYZ is a nonvolatile stock, it may not readily climb back to
25 after the ex-dividend reductions. Therefore, the call buyer makes a low bid - even
Chapter I: Definitions 15
for a 6-month call - because the underlying stock's price 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 a later 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 a bullish 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.
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, a member 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 a first-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 a
choice 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. A third 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 a
contract, 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 a day-trade margin of
Oapter 1: Definitions 17
the difference between the current price of XYZ and the delivery price of $45