Mechanics of Options

We’ve now covered enough of the basics so that you will have a solid understanding of real call and put options. To demonstrate how they work, we’re going to start with some generic examples and then we’ll take a look at the more detailed calls and puts using real option prices.

Contracts are the Unit of Trade
Because options are binding contracts, they are traded in units called contracts. Stocks are traded in shares; options are traded in contracts. An option contract, just like a pizza coupon, will always be designated by the underlying stock it controls along with the expiration month and strike price. For example, let’s take a look at a hypothetical option on Microsoft:

Microsoft June $30 call

Using your understanding of pizza coupons, what do you suppose the buyer of one contract is allowed to do? The buyer of this call has the right (not the obligation) to purchase 100 shares of the underlying stock (Microsoft) for $30 per share at any time through the third Friday in June. (Recall that the expiration date for stock options is always the third Friday of the expiration month.) The buyer of this coupon is “locked in” to the $30 purchase price no matter how high Microsoft may be trading. Obviously, the higher Microsoft trades, the more valuable the call option becomes.

To understand why, imagine that you are in possession of our earlier $10 pizza coupon. If pizza prices are $10, there’s not going to be too much demand for your coupon. But now assume that the price of pizzas rises to $30. Even if you have no plans to ever use the coupon there will certainly be others who would like to have it.

Theoretically someone should be willing to pay $20 for the coupon since they would be indifferent between buying the pizza for $30 in the store and buying your coupon for $20 and then spending $10 for the pizza. Both cases create a $30 pizza purchase price.

That’s exactly what happens in the world of options. Other traders will bid higher for your call option as the price of the underlying stock rises. Traders just simply buy and sell the coupons (call options) back and forth in an attempt to profit from price changes.

Now let’s go back to our call option example. How much will it cost you to use (exercise) your call option? Because you are buying 100 shares of stock, the strike price must be multiplied by 100 as well. (The “100” contract size is sometimes referred to as the “multiplier” since it represents the number you must multiply by to find the total exercise value as well as the price of an option. As we said earlier, the contract size (multiplier) can change for reasons such as stock splits and mergers. For this course though, always assume the multiplier is 100 unless otherwise stated.

If you were to exercise this call option, you would pay the $30 strike price * 100 shares = $3,000 cash. This is called the total contract value or the exercise value.

In exchange for that payment, you’d receive 100 shares of Microsoft from the OCC (Options Clearing Corporation). When do you receive the shares? The shares settle in your account in three business days which is exactly the same as if you had purchased shares in the open market without using your call option.

The mechanics of using a call option are identical to using a pizza coupon. You pay a fixed amount of cash and receive some type of underlying asset. Most brokers charge a standard stock commission if you exercise an option. If you exercised this call, your broker would probably charge you their regular commission for buying 100 shares of stock. After all, the long call option is simply a means for buying shares of stock. In addition, some brokers may charge a nominal fee (such as $15) to exercise the contract.

Now let’s take a look at the following put option:

Microsoft June $30 put

Think about our auto insurance policy analogy and try to figure out what this option allows you to do. If you buy this put option, you have the right to sell 100 shares of Microsoft for $30 per share at any time through the third Friday in June. Because you are locking in a selling price, put options become more valuable as the stock price falls.

If you exercise this put option, you will sell 100 shares of Microsoft. The OCC will deduct the shares from your account and deliver them to the exercising party. In return, you will receive the $30 strike * 100 shares = $3,000 cash. If you exercise this put, your broker would probably charge the regular stock commission for selling 100 shares of stock since the put option is simply a means for selling shares of stock.

If you wish to buy or sell fewer than 100 shares of stock that must be done in a roundabout way. Using the call example above, let’s say you only wanted to buy only 60 shares of Microsoft for $30. You would still exercise the call option for 100 shares and then immediately submit an order to sell 40 shares (which would carry a separate commission).

Each contract is good for 100 shares and you must buy and sell in that amount. But there’s nothing from stopping you from immediately entering another order to customize those amounts to suit your needs. Likewise, if you exercised a put option and only wanted to sell 60 shares of stock, you would have to exercise the put and sell 100 shares and then immediately place an order to buy 40 shares.

Options are Standardized Contracts
The reason that options are inflexible as to the number of shares is because options are standardized contracts. A standardized contract means there is a uniform process that determines the terms, which are designed to meet the needs of most traders and investors. There are pros and cons to using standardized contracts. For example, by using standardized contracts, we lose some flexibility in terms (such as the number of shares, strike prices, and expiration dates). However, we greatly increase the ease, speed, and security in which we can create the contracts.

Not all stocks will have listed options. If the exchanges find there is not sufficient demand for options on a particular stock, they will not create those options. Most of the well-known companies have options available. If a stock has listed options, it is called an an optionable stock. Microsoft and General Electric, for example, are optionable. There are currently over 2,300 optionable stocks so the list is quite large and growing.

Options Have Fixed Strike Price Increments
Another limitation of standardized contracts is that they have fixed strike price increments. If the stock price is below $50, you will find options available in $2.50 increments. If the stock price is between $50 and $200, option strikes will be in $5 increments. And if the stock price is over $200, you will find option strikes in $10 increments.

It is possible to find situations where these relationships appear to not hold. That’s because the increments are based on the stock’s price at the time the options start trading. If a stock’s price has been fluctuating wildly, you might find different increments for different months. For instance, you may find $2.50 increments for the first two expiration months and $5 increments in later expiration months. This just tells you that the stock’s price was above $25 when the later months started trading.

Recent changes are also changing these relationships. Many of the larger, actively traded securities now trade in $1-increments even though their prices are between $50 and $200, which would have made them trade in $2.50 increments under the old rules. Likewise, many of the options formerly listed in $2.50 increments now trade in $1 increments. There are even conditions that allow some options to trade in 50-cent increments. Part of the changes are due to the increasing demand for options and various strike prices. They are also due to the increased technology that allows for the vast amounts of data to be processed. Regardless, the main point to understand is there is a standardized process but it is evolving. Whenever you are looking at option quotes, they may not have the same strike increments but what you see is what you get. 

By having standardized strikes, we can quickly bring new contracts to market to meet the needs of the vast majority of people. Think how overwhelming the task would be if the exchanges tried to meet everybody’s needs by creating strike prices at every possible price such as $30, $30.01, $30.02, etc. and then matched those with every possible expiration date such as June 1, June 2, June 3, etc. It would be a near impossibility. To solve these problems, the exchanges created standardized contracts so that we can have some flexibility while still keeping the list manageable.

What if you really want a customized contract? Is it possible to get one? Technically, there is nothing illegal about two people having a contract drawn up by an attorney that specifies the terms on which they agree to buy and sell stock. You could therefore have an attorney write a contract for you and another trader thus creating your own call or put option. A contract drawn in this manner is completely flexible - but it is also very time consuming and costly.

In addition, even though you may have a legally binding contract, there is an added risk in that the seller may not honor his obligation if the long position decides to exercise. If that happens, you're now tied up in court trying to get the seller to conform to the terms of the contract. Failure for one party to comply with the terms is called performance risk. It is the OCC that ensures the sellers will perform their part of the agreement if the buyer exercises.  

By having the OCC act as a middleman, this arrangement ensures that all contract obligations will be met if the buyer decides to exercise their option. In fact, since the inception of the OCC in 1973, not one person has ever lost on an option due to a seller not upholding their side of the agreement. That is, all option exercises have gone smoothly according to the terms of the contract. Standardization increases confidence and influences the progress toward a smooth running, liquid market.

Besides having an attorney draw up a contract, there is another way to get flexible contracts. You can buy FLEX contracts through the Chicago Board Options Exchange (CBOE) that are totally customizable but they also require an extremely large contract size – usually over one million dollars. Because FLEX options are traded through the OCC they are not exposed to performance risk despite their large contract sizes.

Because of the size requirements though, FLEX options are mostly used by institutions such as banks, mutual funds, and pension funds. The standardized market is the solution for the rest of us.

Understanding a Real Call Option
Now that you know how call and put options work, let’s take a look at some real call and put options. Let’s pull up some quotes and see if we can make some sense of what we’ve been discussing up to this point.

You can pull up option quotes for any optionable stock by going to any of the exchanges that trade options. Currently there are six options exchanges:




I usually use CBOE when looking up quotes on the web since it is the largest options exchange in the world and their quotes will have sufficient volume for you to gauge prices. 
(You can get to their quotes by going to www.cboe.com then click on the tab “Quotes” and then “Delayed Quotes.”)

If you are looking for options on eBay, for example, you’d just type the ticker symbol “EBAY” and hit enter.

Once you do, you’ll get a list of quotes similar to those shown in Table 1 below. Notice that the call options are listed on the left side (red box) while the put options are on the right (blue box):

Table 1: EBAY Option Quotes




At the time these quotes were taken, the shortest term options on eBay were July ’05 (26 days until expiration) and the longest term was January ’08 with 943 days to expiration (not shown). The lowest strike is $32.50 and the highest is $80 (not shown). So even though option contracts are standardized, there are many to choose from. Table 1 only shows some of the shorter-term options available. If you were on the CBOEs website, you could page through all of the expiration months and strikes available.

Before we continue, we need to cover some more terminology that has been deliberately withheld until now for the fact that it will be easier to understand at this point. There are three main classifications for options. First, as mentioned before, there are two types of options, calls and puts.

Second, all options of the same type and same underlying represent a class of options. So all eBay calls or all eBay puts (regardless of expiration) make up a class. So all options listed in the red box form a class. Likewise, all options listed in the blue box form another class.

Third, all options of the same class, strike price, and expiration date make up a series. For instance, all July $32.50 calls form a series. Therefore, any individual line is a series.

At the time these quotes were taken, eBay shares were trading for $37.11, which you can see in the upper right corner of Table 1. The first call option in the upper left corner of the list is 05 Jul 32.50. The “05 Jul” tells us that the contract expires in July '05 and the “32.50” designates that it is a $32.50 strike price.

The last trading day for this option will be the third Friday in July ‘05. All you have to do is look at a calendar and find the third Friday for July '05 and that is the last day you can trade the option (this happens to be July 15 for 2005). Remember, you can buy, sell, or exercise this option on any day but the last day to do so is July 15. All 05 July options will expire on the same date regardless of the strike price or whether they are calls or puts.

Next to the July 32.50 call, you’ll see the letters XBAGZ-E in parenthesis. That is the symbol for that option. Just as every stock has a unique trading symbol, each option carries a unique symbol. However, you can forget about the “dash E” as the letter E is a unique identifier for the CBOE, which just tells us these quotes are coming from that exchange. If you wanted buy or sell this option online, you’d enter the symbol “XBAGZ.”

Each option symbol is a standardized symbol that does not change from broker to broker. However, your broker may have their own required identifiers. For example, some brokers require you to follow this symbol with “.O” to designate that it is an option (for example, XBAGZ.O). Your broker will make it very clear if they have these requirements but the actual symbol (XBAGZ in this example) will always remain the same regardless of which brokerage firm you use.

If you are trading online, most brokerage firms allow you to click on the option you want and the symbol will load automatically. Just be aware that every option month and strike has a unique identifying code.

Incidentally, your brokerage firm may call the option symbols “OPRA” codes (pronounced "opera"). The committee named for consolidating all of the option quotes and reporting them to the various services is called the Options Price Reporting Authority or “OPRA.” An OPRA code is the same thing as the option symbol. You can read more about OPRA at www.opraData.com. 

The $32.50 strike means that the owner of this "coupon" has the right, not the obligation, to buy 100 shares of eBay for $32.50 through the third Friday of Jul '05. No matter how high of a price eBay may be trading, the owner of this call option is locked into a $32.50 purchase price.

Now this seems like a pretty good deal since the stock is trading much higher at $37.11. It appears that if you got the $32.50 call, you could make an immediate profit of $37.11 - $32.50 = $4.31. In other words, it appears that if we could get our hands on this coupon, we could buy the stock for $32.50 and immediately sell it for the going price of $37.11 thus making an immediate profit of $4.31. However, you must remember that call options, unlike pizza coupons, are not free. It will cost us some money to get our hands on it.

How much will it cost to buy this coupon? We can find out by looking at the "ask" column in Table 1, which shows how much you will have to pay to buy the option. (We’ll talk more about bid and ask prices in the upcoming section.) The asking price shows a price of $4.90 to buy this call. This means the apparently free $4.31 is no longer free since you’re paying $4.90 for $4.31 worth of immediate benefit. In fact, we’ll show later in the course that you must always pay for any immediate advantage that any call or put option gives you. The main point is that you shouldn’t get any ideas about using options to collect “free money” in the market.

Why would someone pay $4.90 for $4.31 worth of immediate benefit? Because there is time remaining on the option. It is certainly possible that the option will, at some point in time, have more than $4.31 worth of benefit and traders are willing to pay for that time.

The $4.90 price is called the premium. The premium really represents the price per share. Since each contract controls 100 shares of stock, the total cost of this option will be $4.90 * 100 = $490 plus commission to buy one contract. So if you spend $490, you can control 100 shares of eBay through expiration. That’s certainly a lot less than the $3,711 it would cost to buy 100 shares of stock. If you buy two contracts, you would be controlling 200 shares, which would cost $980 etc.

One of the biggest benefits of options is that it allows users to form a partition of the stock’s price. If you purchase eBay for $32.50, you benefit from all price appreciation above $32.50. However, in exchange for that benefit, you are holding all of the downside risk; that is, all stock prices below $32.50 create losses. 

However, if you buy the $32.50 call, you still participate in all stock price appreciation above $32.50 but do not participate in all of the downside risk. You have, in effect, formed a partition of the stock’s price at $32.50. Of course, for the benefit of not holding all of the downside risk you must pay for the option, which creates a new risk. That risk is that the stock price is $32.50 or below at expiration and you lose the entire $490.

By purchasing the $32.50 call, you have effectively shifted your risk from a stock price of zero to $32.50. This means it is more likely that you could lose the option premium (since it is more likely for the stock price to fall below $32.50 than it is to zero). At the same time, you know with 100% certainty that the most you can lose is $4.90, which is a claim the long stock owner cannot make.

Options allow users to take slices of the entire range of possible stock prices and participate only in those areas. No other financial asset allows you to do this and, as you’ll find out later, there are some fascinating strategies that emerge from this ability.

Bid and Ask Prices

We mentioned the terms bid and ask in the last section but let’s take a brief detour here to talk more about what these numbers represent as they can be confusing to new traders.

Notice that the $32.50 call in Table 1 shows a bid price of $4.70 and an ask price of $4.90. You have to remember that the options market, just like the stock market, is a live auction. There are traders continuously placing bids to buy and offers to sell. The bid price is the highest price that someone is willing to pay at that moment. The asking price is the lowest price at which someone will sell at that moment.

If these terms are confusing, think of the terms you use when buying or selling a home. If you wish to buy a home, you submit a bid. Buyers place bids. If you are selling your home, you’d say I am “asking” such-and-such for it. Sellers create asking prices. Sometimes you will hear the word “offer” instead of “ask” but they mean the same thing.

If the bid represents the highest price that someone is willing to pay that means you can receive that price if you are selling your option. You are selling to a buyer and the trade can get executed. Notice that you cannot sell at the $4.90 asking price because that is a seller too and you cannot execute a trade by matching a seller with a seller.

Likewise, if you are buying this option, you should refer to the asking price to see how much it will cost you. Since the asking price shows the lowest price that someone will sell, we know you can buy the option for that price. In this case, you are buying from a seller and the trade can get executed. This is important to remember since the price you pay or receive depends on the bid and ask. Maybe this trade appears to be a good deal if you could sell for $4.90 but you would be disappointed if you find that you only received $4.70.

You need to be aware of which price applies to your intended action. In summary, if you are selling then you should reference the bid price. If you are buying, you should look at the asking price. This is especially critical for options traders since the volume on options is not as high as it is for the stock and, consequently, options will have larger spreads between the bid and ask.

For example, take another look at Table 1, which has been reproduced below:

Table 1 (Reproduced)



You can see in the upper right hand corner that the stock is bidding $37.10 and asking $37.11, which represents a one-cent spread between the buyers and sellers. However, the $32.50 call option is bidding $4.70 and asking $4.90, which is a 20-cent spread. The bigger that spread, the more critical it is to understand what the bid and ask mean, otherwise you could be in for an unpleasant surprise when trading.



Okay, let's try the next call on the list in Table 1, the 05 Jul 35 call. (Notice that eBay is below $50 and the strikes are in $2.50 increments, which are in agreement with what we said in a previous section). If you buy this call option, you have the right, not the obligation, to buy 100 shares of eBay for $35 per share through the third Friday in July '05. Since eBay is trading for $37.11, we know that anybody holding this option has an immediate advantage of $37.11 - $35 = $2.11 by buying this call and we now know that this advantage must be reflected in the price.

You can verify that the asking price is $2.70, which means the apparently free $2.11 benefit is not free. Again, the reason traders will pay more than the $2.11 benefit is because there is time remaining on the option and it certainly could end up with more value. If you want to buy this contract, it will cost you $2.70 * 100 shares = $270 per contract + commissions. If you buy two contracts, you would control 200 shares and that would cost $540 and so on.

While we’re talking about the prices in Table 1, let’s explain what the rest of the columns mean. The LAST SALE column shows the price of the last trade of the option. Option traders rarely look at this since that price could have occurred during the last minute but it also could have been last week. We don’t know when that trade took place. We just know that was the price when it last traded. For stock traders, the last sale will generally be very close to the bid and ask of the stock because optionable stocks generally have high volume but that is not necessarily true for their options.

In Table 1, you can see that the last trade on eBay was $37.11 with the bid and ask at $37.10 to $37.11. The last sale is very close to the current bid and ask and this will usually be the case. But notice that the last trade for the $32.50 call was $4.40 with the bid and ask at $4.70 to $4.90. This shows that the last trade is somewhat stale and that’s why option traders generally do not look at the last sale numbers. If you were buying this option, the last sale would lead you to believe that it would cost $4.40 when it would really cost $4.90. If you were selling the option, the last sale may make you decide against it since it appears you would only receive $4.40 when, in actuality, you get $4.70.

The NET column shows the net change between the last trade and the last closing price just as it does for stocks. For the July $32.50 call, the last trade was $4.40 and that price was down $1.20 from its previous close, which means the option must have closed at  $4.40 + $1.20 = $5.60. If this option closed at $5.60 and the next trade was at $4.40 then that represents a $1.20 drop in price, which is what the NET column shows.

Again, the reason for the apparent big drop in price is because there was a big time delay between the last sale and the previous closing price. Remember, stocks have a lot of volume and they trade right up until the market close. That may not always be true for an option. This option’s closing $5.60 closing price may have occurred several days ago.

The VOL column shows us the volume, which is simply the number of contracts traded that day. For the stock market, volume refers to the number of shares traded; for the options market, it refers to the number of contracts but the idea is the same.

The OPEN INT column shows how many contracts are currently in existence, which is called the “open interest.”

Whenever you buy or sell a contract, you must specify whether you are entering or exiting the contract. If you are entering into the contract (or increasing the size of an existing position) then you are “opening” the contract. However, if you are exiting the contract (or decreasing the size of an existing position) then you are “closing” the contract.

Most brokerage firms require that you specify whether you are opening or closing the position. For instance, if you wish to buy 10 Microsoft July $30 calls you would enter the order as “buy to open” 10 Microsoft July $30 calls. You would not say “buy” 10 Microsoft July $30 calls. The reason is that the word “buy” alone doesn’t tell the broker if you are buying the calls to own them (opening transaction) or if you are buying the calls to close a short position (closing transaction). Using the words “to open” or “to close” clarifies your intentions.

Some of the newer firms do not require the use of the words “opening” or “closing.” Instead, they account for it based on the existing positions in your account. For instance, if you have no Microsoft July $30 calls then the above order is recognized to be an opening transaction. On the other hand, if you were short 10 Microsoft July $30 calls then the order is recognized to be a closing transaction.

Every time the buyer and seller are entering an “opening” order it adds to the open interest. For instance, if you are buying 10 contracts to open and the seller is selling 10 contracts to open then open interest is increased by 10.

If the buyer and seller were, instead, both entering “closing” transactions then open interest would decrease by 10 contracts. Finally, if one is entering an “opening” transaction while the other is entering a “closing” transaction then that order has no effect on the open interest.

Open interest provides a measure of how many contracts are currently in existence and therefore provides a measure of liquidity. That’s what the open interest column shows.

Understanding a Real Put Option

Now that we’ve looked at a couple of call options, let’s take a look at some real put options. Once again, Table 1 has been reproduced below. Take a look at the 05 Jul 32.50 in the right column (red box). What does this put option represent?

Table 1: (Reproduced)




If you buy this put, you have the right to sell 100 shares of eBay for $32.50 per share through the third Friday of July ’05. For that right, you would have to pay 0.20 * 100 = $20 plus commissions.

No matter how low of a price eBay may be trading, you are guaranteed to get $32.50 if you exercise this put option to sell your shares. Remember though, you do not need to own the shares of stock to buy a put. By purchasing this put, you have the right to sell shares for $32.50 and somebody else will be very willing to buy this from you if eBay falls below $32.50. If you think the price of eBay will fall, you can buy the put and then sell it to someone else thus capturing a profit without ever having the shares in your account.

Notice that with this option, there is no immediate benefit in owning the $32.50 put. If you owned shares of eBay and wanted to sell, you’d just sell the shares in the open market for $37.11. Once again, the reason there is any value to this $32.50 put at all is because there is time remaining and it may end up with a lot more value if eBay’s price falls. Traders are willing to pay for that time.

Let’s try another one on the list, the 05 July $37.50 put. If you buy this put, you have the right to sell 100 shares of eBay for $37.50 per share through the third Friday of July ’05. Now this put does appear to have an immediate value since we could sell the stock for a higher price than it is currently trading. It appears that if we buy this put, we could buy the shares for $37.11 and immediately use the put option and collect $37.50 for an immediate guaranteed profit of 39 cents.

As with our call option examples, any immediate benefit must be paid for and we can verify that by observing the $1.40 asking price. In other words, you’re paying $1.40 for that 39-cent immediate benefit. The market is willing to pay more than the immediate benefit since there is time remaining on the option. You cannot use options, whether calls or puts, to collect “free money.” 




Next Section: More Option Terminology

Website Builder