Option Status Relative to the Underlying Stock

ITM
A call option is said to be ITM when the underlying stock is trading for
more than the option's strike price. By contrast, a put option is ITM when
the underlying stock is trading for less than the option's strike price.
When the strike price of a call option is less than the current price of the
underlying security, the call holder can exercise the option and effectively
acquire the underlying stock for less than the current market price. On
the other hand, the put holder can exercise the put in order to sell the
underlying stock for more than its current market price. For example, if
XYZ is trading at $53, an April 50 call is considered ITM by $3-while the
April 55 put is considered $2 ITM. Note that the value of an option is at
its greatest when it is ITM.

ATM
An option is said to be ATM when the underlying stock is trading at the
same level as the option strike price. In this case, the investor stands to
neither gain nor lose on the option (that is, over and above the initial
capital outlays). For example, the XYZ April 50 call and put will both be
trading ATM when XYZ is trading at $50. Although technically an
option is ATM only when the underlying stock is trading at exactly the
strike price, whenever the underlying stock is trading close to a strike
price, the common practice is to refer to the options at that strike as
ATM options.

OTM

A call option is said to be OTM when the underlying stock is trading for
less than the option's strike price.A put option, by contrast, is OTM when
the underlying stock is trading for more than the option's strike price. The
value of an option is at its lowest when it is OTM.

Therefore, in the case of a call, if the strike of a call is more than the
current price of the underlying security, then the call is said to be OTM
because the holder has the right to purchase stock at a higher price than
the underlying stock's current price. For example, when XYZ is trading at
$48, the April 50 call is said to be OTM by $2.

Similarly, if the strike price of a put is less than the current price of
the underlying security, the put is said to be OTM. You have the right to
sell the underlying stock for the put option for less than the value at
which the stock is trading in the marketplace. Therefore, ifXYZ is trading
at $48, the April 50 put will be ITM by $2. But ifXYZ increases to $53,
the April 50 put will now be OTM by $3 (and, correspondingly, the April
50 call will be ITM by $3).

For an overview, suppose that XYZ is trading at $50 a share. The various
April calls and puts shown next would be in, at, or out-of-the-money as
follows: Figure 4-1 is an example of option strike prices where the underlying
is trading $50/share. As the underlying price fluctuates the options
will fluctuate from being in, at, and out-of-the-money:
Read More: Option Status Relative to the Underlying Stock

Options Execution

The options trading floor is still an open-outcry system, but technology
is changing rapidly: Many orders are still executed the old way (floor
execution), with hand signals, screaming, and paper and pencil. As this
style oftrading gives way to faster methods of execution, brokerage firms
can pass along savings by bypassing the staff that is needed to execute
orders in the traditional floor-execution method.

The option exchanges of today are actually hybrids of an open-outcry
system and a fully electronic execution, as with NASDAQ. As far as electronic
execution, the auto-exchange system of the trading floor is fully
automated-involving only the investor and the exchange computer systems.

This system eliminates the need for floor and retail brokers.
Let's walk through the three methods of executing an options orderfrom
the traditional floor execution to the extremely fast fully automated
system.

Floor Execution.
The most common way to trade options is to phone
your broker, who will then send your request to the trading floor (where the

order will be given to a floor broker). A floor broker is an individual who
executes orders on a commission basis on the trading floor ofan exchange.
The floor broker will then announce the order in the trading pit, where the
options on that specific issue trade. Open-outcry bidding for the order
ensues among the market makers who are in the pit. Open outcry is a
method of trading in which the floor broker calls out the specific details of
a buy or sell order so that the information is available to all of the traders
in the trading crowd. Ifyour order is a market order and states that you are
willing to pay (sell) the ask/offer (bid) listed by the market maker, your
order will be executed (traded) right away and the broker will contact your
brokerage firm to notify you. The option contract(s) will then be placed in
your trading account, where you will have an open position (an existing
position that has not yet been closed out). In order to close out the position,
you must either 1) sell the option(s) that you bought, 2) buy back the
option(s) that you sold, or 3) exercise your option(s), thereby converting
your position into a position in the underlying security.

Phone Orders. 
Placing phone orders has almost become outdated.
This process generally takes a long time to execute by today's standards
because of all of the individuals who are involved.
Step by step, here is the process:
• The customer calls his or her broker in order to place an order.
• The broker calls the phone clerk on the trading floor.
• The phone clerk hands the order to a runner.
• The runner runs the order to the floor broker.
• The floor broker asks for the market and trades the order.
• The floor broker hands the filled order back to the runner.
• The runner runs the completed order back to the phone clerk.
• The phone clerk calls the retail broker to tell him or her that the
order is filled and at what price.
• The retail broker calls the customer to let him or her know that the
order is filled and at what price.

As you can see, there are many people in the middle (which slows
down the process), and communication becomes important. If anyone in
the chain forgets something or misunderstands something, the order can
be executed incorrectly.
Read More: Options Execution

Options: A Conceptual Overview

The intent of this book is to provide the tools that you need to effectively
trade stock options. The most basic definition of a stock option is a contract
that enables its owner to buy and/or sell stock under certain, specified
conditions. As an option investor, you would purchase or sell this
right (or option) in order to buy or sell stock; although importantly, this
technique is not the same thing as actually purchasing or selling the
stock itself Rather, you are purchasing the right to benefit from movement
in the market related to the underlying stock, which will (in turn)
influence the public's potential demand for that security: Because an
option is defined in terms of its relationship to an underlying security,
options are known as derivative products. Now, however, we will focus on
familiarizing the reader with options in general.

Options, in their traditional form, evolved as a type transaction
between the owner of certain property and a non-owner. The landlordtenant
and lender-borrower relationships, with which the reader is likely
much more familiar, are similar types of transactions. In the landlordtenant
situation, the landlord exchanges his or her right to use a portion
of his or her property to the tenant for a rental fee. The lender allows the

borrower to use the lender's money in exchange for an interest charge
and the borrower's pledge to return the borrowed funds pursuant to a
schedule of payments.

Owning property brings with it certain consequences that people
sometimes refer to as the benefits and burdens of ownership. These consequences
include the following:
• The right to benefit from appreciation in the value of the property
• The right to use the property as you see fit
• The risk that the value of the property will decline
• The right to determine when, and at what price, to sell the property

Options are contracts in which specific attributes of ownership are
transferred from the owner of the asset to another party in exchange for
compensation. Where a benefit of ownership is involved, the owner
receives the compensation. Where a risk of ownership is transferred, the
owner pays the consideration. Later in this book, we will look in detail at
the technical aspects of publicly traded stock. For now, though, let's consider
several common examples.

Example: Undeveloped Land
A real estate developer has a problem. He wants to build an apartment
complex on a vacant lot that he does not own. In addition to obtaining rights
to develop the vacant lot, he will need to obtain certain land-use approvals
and a loan commitment from a lender in order to finance construction costs.

Additionally; he must raise money from investors. The developer does not
want to purchase the vacant lot until he knows that the project will go forward,
but he cannot get investors until he has obtained rights to the property.

He also cannot get financing until he obtains the land-use approvals.
The solution is to purchase the right, but not the obligation (option), to purchase
the lot from the owner of the vacant lotby a certain date for an
agreed-upon price. With this right, the developer can attempt to put all of
the pieces together. Ifhe is successful, he has the resources to exercise his
right (option) to buy the property and move forward with the project. Ifhis
efforts fail, he just walks away from the project-losing only the amount
paid for the option. The motivation of the developer to purchase the option
is clear. What can we say about the motivation of the owner of the vacant
lot? Why would he sell the option to the developer? There could be two reasons:
first, the owner gets to keep the compensation paid for the option; second,
the agreed-upon purchase price is likely to be higher than the owner
could obtain if he sold the property without first obtaining the land-use
approvals. These factors might be sufficient incentive to the owner of the
vacant lot to sell the option to the developer. We refer to this type of option
as a call option. The purchaser ofthe option has the right, but not the obligation,
to acquire the property for a specific price (prior to a specified date).

After that date, the holder ofthe option no longer has the right to purchase
the property: The option is said to expire at that point.


Example: Property/Health Insurance
Auto insurance, health insurance, and homeowner's insurance are all
examples of put options. These options transfer the risk of loss from the
owner to the seller of the put (the insurance company).
We hope that we have made several important points in this general
introduction to options:
• Options have legitimate commercial applications.
• They are similar to other more common transactions such as landlordtenant
and lender-borrower relationships.
• They are not some new casino game designed to suck in the unwary.
With this background in place, we will now focus on how exchangetraded
stock options can be intelligently and prudently used to reduce
investment risk and increase investment and/or trading profitability.
Read More: Options: A Conceptual Overview

History of Options

The Earliest History
The use of options in an attempt to ensure economic security or financial
gain dates back in our history much farther than most people would
expect. The first published account of options use was in Aristotle's
Politics, published in 332 B.C. According to Aristotle, Thales, a fellow
philosopher, was said to be the creator of options. Thales was not only a
great philosopher but also a great astronomer and mathematician. In
response to criticism that his profession had no merit, Thales used his
ability to read the stars in order to forecast future weather patterns. His
skill enabled him to predict a large olive harvest in the coming year.

Thales, however, had little money and was unable to secure the use of
the olive presses for their full value, so he put deposits on all of the
presses that existed for miles and miles. In doing so, he used a small
amount ofmoney to secure the right to use the presses come harvest season.

When olive-picking time came around and the presses were in great
demand, Thales was able to sell his options for a great deal more than he
paid for them. Unknowingly, perhaps, Thales had created the first option
contract. He purchased the right to use the presses, not the presses them~
selves. In doing so, he was able to use considerably less money than he
would have if he purchased the presses themselves. Owning the right
gave Thales the ability to use the presses during harvest time himself (or
to sell his options when, due to the demand, they would be worth considerably
more than when he entered the contract). The seller, on the other
hand, was happy to sell the right to use the presses, because it ensured
that the seller would receive income whether the harvest was successful
or not. In securing a price for the presses, however, the seller gave up the
right to charge the customers more for use ofthe presses during a record
harvest. Thales' foresight enabled him to reap this benefit. Clearly, then,
Thales was able to redeem philosophy and astronomy from any accusations
that its practitioners had their heads in the clouds.

Options sprang up again during the tulip mania of 1636. Tulips were
first imported into Europe from Turkey in the 1500s. These brightly colored
flowers gained in popularit)T, and the demand increased for all types
of bulbs. By the early 17th century; tulips had become a symbol of afflu...
ence; demand began to outweigh supply; and tulip bulb prices rose dramaticall)
T. As popularity increased to include all levels of society, Dutch

growers and dealers (with Holland being the largest producer of tulip
bulbs) began to trade tulip bulb options. With options being less expensive
than the direct purchase ofthe bulbs, greater numbers ofpeople speculated
on future price increases. Initiall~ this strategy proved profitable, because
prices did continue to rise. This situation only caused the speculative frenzy
to grow. People mortgaged their homes and businesses in order to cash in
on the free money: Tulip bulb prices continued to soar even higher.

The bubble burst in 1637.As prices dropped, the buying frenzy became
a selling panic. The Dutch economy began to crumble. People lost their
homes and their livelihoods, banks failed, and fortunes were lost. Although
the real causes of this financial fiasco were greed, reckless speculation,
and the use of borrowed funds to invest, people blamed options. This was
the first public black eye for options, because tulip options were responsible
for enabling people to speculate with small amounts of money and
large amounts of leverage. We must remember, then, that leverage can
work against a trader just as easily as it can work to his or her favor.

In 1872, an American financier named Russell Sage invented the first
call and put stock options. Like today's options, Sage's options gave the
holder the right to purchase (call) or sell (put) a set amount of stock at a
set price within a given time period. Sage began trading options in an
over-the-counter (OTC) fashion and made millions of dollars in the
process. These options were not standardized, and each contract had specific
characteristics that made them difficult to trade out of once they
were entered into. For this reason, it was unlikely that anyone aside from
the original buyer/seller would trade out of the contract with the option
holder. Furthermore, because the public was unfamiliar with stock
options, Sage was able to use them to manipulate securities-taking large
positions in the underlying stock without the knowledge of the public or
the company: At one point, by using stock options to manipulate the security,
Sage purchased such a large amount of a company's stock through
the use of options that he gained control of the New York City elevated
transit lines. After losing a great deal ofmoney by trading options during
the stock market crash of 1884, however, Sage stopped trading options
altogether. Yet, options continued to trade without him.
Read More: History of Options

OPTIONS

An option is a bet that a specific stock, index, or future will reach or exceed a specific price within a specific time. Please stop and reread that sentence. Notice that the word specific occurs in it three times. You must choose the right stock, predict the extent of its move, and forecast how fast it’ll get there. You must make three choices—if you’re wrong on just one, you’ll lose money.

When you buy an option, you have to jump through three hoops in a single leap. You have to be right on the stock or the future, right on its move, and right on its timing. Ever tried tossing a ball through three rings at an amusement park? This triple complexity makes buying options a deadly game.

Options offer leverage—an ability to control large positions with a small outlay of cash. The entire risk of an option is limited to the price you pay for it. Options allow traders to make money fast when they’re right, but if the market reverses, you can walk away and owe nothing! This is the standard flow of brokerage house propaganda. It attracts hordes of small traders who cannot afford to buy stocks but want a bigger bang for their buck. What usually gets banged is the option buyer’s head.

My company, Financial Trading, Inc., has been selling books to traders for years. Whenever a person comes back to buy another book, it is a sign that he is active in the markets. Many clients buy books on stocks or futures every few months or years. But when a first-time buyer orders a book on options, he never returns. Why? Does he make so much money so fast that he doesn’t need another book? Or does he wash out?

Many beginners buy calls because they can’t afford stocks. Futures traders who get beat up sometimes turn to options on futures. Losers switch to options instead of dealing with their own inability to trade. Using a shortcut to weasel out of trouble instead of facing a problem never works.

Successful stock and futures traders sometimes use options to reduce risks or protect profits. Serious traders buy options rarely and only in special situations, as we will see later in this book. Options are hopeless for poor people who use them as substitutes for stocks because they can’t afford the real thing.

Professionals take full advantage of starry-eyed beginners crowding into options. Their bid-ask spreads are terrible. If an option is bid 75 cents, offered at a dollar, you are 25% behind the game as soon as you buy. The expression “your loss is limited to what you paid for an option” means you can lose 100%! What’s so great about losing everything? A client of mine was a market-maker on the floor of the American Stock Exchange. She came to my classes on technical analysis because she was pregnant and wanted to get off the floor and trade from home. “Options,” she said, “are a hope business. You can buy hope or sell hope.

I am a professional—I sell hope. I come to the floor in the morning and find what the public wants. Then I price that hope and sell it to them.” Professionals are more likely to write options than buy them. Writing is a capital-intensive business. You need hundreds of thousands of dollars to do it right, and most successful options writers operate with millions. And even theirs is not a risk-free game. Several years ago a friend who used to be one of the nation’s top money managers landed on the front page of The Wall Street Journal after he lost 20 years’ worth of profits in a single bad day of writing naked puts.

There are two types of option writers. Covered writers buy a stock and write an option against it. Naked writers write calls and puts on stocks they don’t own, backing their writes with cash in their accounts. Writing naked options feels like taking money out of thin air, but a violent move can put you out of business. Writing options is a serious game, suitable only for disciplined and well-capitalized traders.

Markets are like pumps that suck money out of the pockets of the poorly informed majority and pump it into the pockets of a savvy minority. People who service those pumps, such as brokers, vendors, regulators, and even janitors who sweep exchange floors, are paid from the stream of money flowing through the markets. Since markets take money from the majority, pay help, and give what’s left to the savvy minority, the majority, by definition, must lose. You can be sure that whatever the majority of traders does, believes, and says, is not worth doing, believing, and saying. You have to stand apart from the crowd in order to succeed. Smart traders look for situations where a large majority does something one way, while a small, moneyed minority goes the opposite way.

In options the majority buys calls and, to a lesser degree, puts. The insiders almost exclusively write options. Professionals use their heads, while amateurs are driven by greed and fear. Options take full advantage of those feelings.

Greed is the engine of option-selling propaganda. You must have heard the slogan: “Control a large block of stock with just a few dollars!” An amateur may be bullish on a $60 stock, but doesn’t have $6,000 to buy 100 shares. He buys some $70 calls with two months of life left in them for $500 each. If that stock rises to 75, those options will acquire $500 of intrinsic value, while maintaining some time value, and a speculator can double his stake in a month! The amateur buys calls and sits back to watch his money double.

Strange things begin to happen. Whenever the stock rises two points, his calls go up only one, but when the stock falls or even pauses, his calls fall briskly. Instead of seeing his money double in a hurry, the amateur is soon staring at a 50% paper loss, while the clock starts ticking louder and louder. The expiration date is nearing, and even though the stock is higher than it was when he bought his calls, they are now cheaper, showing a paper loss. Should he sell and salvage some money or hold and wait for a rally? Even if he knows the right thing to do, he’s not going to do it. His greed does him in. He hangs on until his options expire worthless.

Another great motivator for buying options is fear, especially in options on futures. A loser takes a few painful hits—his analysis was wet and money management nonexistent. He sees an attractive trade but fears losing. He hears the siren song—“unlimited gains with limited risk”—and buys options on futures. Speculators buy options like poor people buy lottery tickets. A person who buys a lottery ticket risks 100% of what he paid. Any situation where you risk 100% looks like an odd case of limited risk. Limited to 100%!?! Most speculators ignore this ominous figure.

Option buyers have a dismal track record. They may make a few dollars on a few trades, but I’ve never seen anyone build equity buying options. The odds in this game are so bad that after a few trades they are sure to kick in and destroy a buyer. At the same time, options have a high entertainment value. They provide a cheap ticket to the game, an inexpensive dream, just like a lottery ticket.

You need a minimum of one year of successful trading experience in stocks or futures before touching options. If you are new to the markets, do not even dream of using options in lieu of stocks. No matter how small your account, find some stocks and learn to trade them. WHERE DO I GO FROM HERE? The all-time bestseller on options, and deservedly so, is Lawrence MacMillan’s Options as a Strategic Investment. It is a veritable mini-encyclopedia that covers all aspects of options trading, better than his other book.
Read More : OPTIONS

Options Volatility Measurement

As we saw in the previous chapter, the one real variable that enters into
a pricing model is volatility. All of the other inputs-stock price, option
strike price, days until expiration, applicable interest rates, and dividends
-are essentially readily determinable. The validity of a pricing model's
output depends on the accuracy of all input amounts, but the quality of
the volatility input plays an important role. As the saying goes, "Garbage
in, garbage out." But what is the appropriate measure ofvolatility that we
should use? There are, in fact, a handful ofways in which we can measure
volatility.

The ideal volatility input for a pricing model would be the one that
most closely reflects the actual future movement of the underlying security.
Let's refer to this input as the future volatility: Absent a crystal ball,
however, we do not know the future volatility. Therefore, most traders
turn (for good measure) to the performance ofthe stock in the past, which
we call the historical volatility. Next, the trader will factor into the historical
volatility any special circumstances that he or she anticipates
prior to expiration. This foresight enables the trader to generate a forecast
volatility; which is essentially the trader's best guess at future volatility.

Armed with his or her forecast volatility, the trader is then able to
draw a comparison between the volatility indicated by the market price of
the option and the volatility determined by this market (referred to as the
implied volatility). Let's examine these measures more closely:

Measures of Volatility
Historical volatility; as its name implies, is a measure of actual price
changes in an underlying issue over a specific period in the past. Through
the statistical analysis ofhistorical data, a trader attempts to predict the
future volatility of the underlying issue. You should note, however, that
there is not just one measure of historic volatility. You can calculate historic
volatility over any time period that you choose. The trader will have
to decide which period(s) he or she wants to analyze: a week, a month, or
a year. In addition, he or she must also ask which price comparisons (closing
price to closing price, opening price to opening price, or the daily
highllow range) upon which he or she should base volatility assessments.
Different price comparisons will calculate different volatilities. Generally,
the trader calculates historical volatilities over both a short term (one to
two months) and a long term and then decides how to weight each calculation
when forecasting future volatility.

Expected/forecast volatility is what a trader attempts to predict based
upon his or her informed and/or educated speculation. More specifically;
forecast volatility is an estimate of the volatility of the underlying issue
for a specific period in the future. For most traders, the starting point of

volatility forecasting is a review of one or more historical volatilities.
Knowing that news events move markets, the trader adds to the equation
his or her assessment of how anticipated news events will affect volatility

For example, volatility usually rises in the period just prior to a quarterly
earnings announcement. If the company is the subject of a
government investigation or is involved in major litigation, you should
not ignore the possibility of news involving a major development. For
these reasons, volatility assessment is a highly subjective process that
offers no guarantee of accuracy.

Implied volatility is the marketplace's assessment of the future
volatility of the underlying issue. This implied volatility measures the
level of volatility that is implicitly assumed within the current market
price ofthe option. You could also consider implied volatility as a measure
of the market consensus of expected volatility of the underlying stock.
Implied volatility can be derived from running a pricing model backwards.
In other words, the trader can enter the current market price ofan
option into a pricing model along with the underlying price, strike price,
time until expiration, interest rate, and any applicable dividends. When
he or she then runs the model, then, it will solve for the unknown-the
volatility that the marketplace is using to price the option. This number
represents the implied volatility.
Implied volatility might or might not be equal to the future volatility
assumption ofan underlying issue. When the volatility assumption that we
are using to determine the theoretical value of an option differs from the
volatility that marketplace is using to determine the value ofan option, we
are able to enter all ofthe data into the pricing (as we have done below).
We exclude the volatility assumption and enter the theoretical value that
we have previously solved for in order to determine what volatility the marketplace
is giving the option.

In this example, we see that the marketplace has placed a higher
value on the March 40 call than on the trader who generated an informed

volatility prediction based on current movement in the underlying, historical
volatility and an expectation of market sentiment. What explains
this divergence? Generally; this disparity anticipation of news might
result in a large move in the price of the underlying issue (whether that
move is up or down).
Read More: Options Volatility

Standardised Options And Costumised Options

STANDARDISED OPTIONS
Currencies traded – the Philadelphia Stock Exchange (PHLX) lists six dollar-based standardised
currency option contracts, which settle upon exercise in the actual physical currency, while
the Chicago Mercantile Exchange (CME) lists 14 currency option contracts, which includes
crosses, for example European euro against the Swiss franc.

Contract size – the amounts of currency controlled by the various currency options contracts
are geared to the needs of the widest possible range of participants. For example, the sizes
expressed in units of currency for each option on the PHLX are:
US dollar vs Australian dollar 50 000 Australian dollar (units)
US dollar vs British pound 31 250 British pound (units)
US dollar vs Canadian dollar 50 000 Canadian dollar (units)
US dollar vs European euro 62 500 European euro (units)
US dollar vs Japanese yen 6 250 000 Japanese yen (units)
US dollar vs Swiss franc 62 500 Swiss franc (units)

Exercise style – Both American and European style options are available for mid-month and
month-end options. However, longer-term options are European style options only.

Expirations – the exchange offers a variety of expirations, including mid-month, month-end
and some longer-term options. For example, currency options are available for trading with
fixed quarterly months of March, June, September and December.

Exercise prices – prices are expressed in terms of American cents per unit of foreign currency.
For example, a call option on euros with an exercise price of 95 would give the option buyer
the right to buy euros at 95 cents per euro. On the exchange, exercise prices are set at certain
intervals surrounding the current spot or market price for a particular currency. When significant
price changes take place, additional options with new exercise prices are listed and commence
trading. Also, strike price intervals vary for the different expiration time frames. They are
narrower for the near-term and wider for the long-term options.

Premium quotation – premiums for dollar-based options are quoted in American cents per
unit of the underlying currency (with the exception of Japanese yen which are quoted in

hundredths of a cent). For example, a premium of 0.95 for a given European euro option is
($0.0095) per euro. Since each option is for 62 500 euros, the total option premium would be
$593.75 (62 500 × $ 0.0097).

CUSTOMISED OPTIONS
Customised currency options can be traded on any combination of the currencies currently
available for trading. Currently, the Australian dollar and the Mexican peso may be matched
with the American dollar only, and must be denominated in American dollars.

Underlying currency – the underlying currency is that currency which is purchased (in the case
of a call) or sold (in the case of a put) upon exercise of the contract.

Base currency – the base currency is that currency in which terms the underlying is being
quoted, i.e. strike price.

Expiration/Last trading day – expirations can be established for any business day up to two
years from the trade date. Customised option contracts expire at 10:00am Eastern Time on the
expiration day in contrast with standardised options, which expire at 2:30pm Eastern Time on
the expiration day. In addition, the exercise and assignment process for customised options is
more akin to the OTC market in terms of expiration time frame. Unlike the process utilised
for standardised options, exercise notices must be received by 10:00am Eastern Time and the
writer is then notified of the number of contracts assigned.

Contract size – the underlying currency determines the contract size and is the same size
as standardised contracts. In the case where the dollar is the underlying, the contract size is
$50 000. Note that the Mexican peso is only available in the customised environment.

Underlying currency:
Australian dollar 50 000 Australian dollar (units)
British pound 31 250 British pound (units)
Canadian dollar 50 000 Canadian dollar (units)
European euro 62 500 European euro (units)
Japanese yen 6 250 000 Japanese yen (units)
Swiss franc 62 500 Swiss franc (units)
Mexican peso 250 000 Mexican peso (units)
American dollar 50 000 American dollars (units)

Exercise prices – exercise or strike prices may be expressed in increments out to four characters.
For example, a $/£ option could have an exercise price of 1.5430.

Exercise style – European style only.

Minimum transaction size – since customised currency options were designed for the institutional
market, there is a minimum opening transaction size, which equals or exceeds
50 contracts. For example, 55 contracts would be acceptable.


Contract terms – an option strike price may be expressed in either American terms or European
terms (inverse terms). For example, an option in American terms would have exercise prices
quoted in terms of dollars per unit of foreign currency. An option in European or inverse terms
would have exercise prices quoted in terms of units of foreign currency per dollar.

Trading process – trading is conducted in an open outcry auction market, just as in standardised
option contracts.

Premiums – premiums may be expressed either in terms of the base currency per unit of the
underlying currency or in per cent of the underlying currency (based on contract size). For
example, the premium for an option on the dollar versus the euro (dollar being the base currency
and the euro being the underlying currency) could be expressed in American cents per euro or
as a percentage of 62 500 euros.

Position limits – position limits are the maximum number of contracts in an underlying
currency that can be controlled by a single entity or individual. Currently, position limits are
set at 200 000 contracts on each side of the market (long calls and short puts or short calls
and long puts) for each currency, except the Mexican peso, which is 100 000 contracts. For
purposes of computing position limits, all options involving the dollar against another currency
will be aggregated with each other for each currency (i.e. usd/eur and jpy/eur on the same side
of the market will be aggregated – usd/eur long calls and short puts with jpy/eur short calls
and long puts).
Read More: Standardised Options And Costumize Options

Factors Affecting the Price of an Option

The general context for discussing an option's price is always the current
price ofthe underlying security. Here, we refer to the intrinsic value ofan
option, which corresponds to the amount that an option is said to be ITM.
(Note that only ITM options have intrinsic value. Fortunately, we do not
need any computer programs to calculate intrinsic value; rather, we only
need a simple subtraction formula.) Figure 4-2 illustrates the formula
used to determine the intrinsic value of an in-the-money option.

As we can see, then, the intrinsic value of an ITM depends upon the
relationship of the option's strike to the current price of the underlying

securit~ Because the option's strike price is a constant, the intrinsic value
of an option will fluctuate dollar for dollar with any price change of the
underlying security (as long as the option remains ITM). As soon as the
price ofthe underlying security moves below a call option's strike price or
above a put option's strike price, that option would become ATM or OTM
and would have no intrinsic value. To summarize:

1. The intrinsic value ofan option is the amount that an option is ITM.
2. OTM and ATM options have no intrinsic value.

Extrinsic Value
Although intrinsic value plays a fundamental role in determining the
price of an option, it alone is not responsible for the overall pricing of the
option. In fact, intrinsic value is only one component of the price of an
option. Stock options have both intrinsic and extrinsic value. The price of
an option is the sum of its intrinsic aDd extrinsic values.

The extrinsic value of an option is that part of its price that is determined
by certain variables other than the price ofthe underlying security
and the strike price. These variables are as follows:
1. Time to expiration
2. Interest rates
3. Volatility
4. Dividends of the underlying security (if applicable)


We will examine the impact of each of these variables on option pricing
separately: First, however, let's look at the simple formula for identifying
extrinsic value. Figure 4-3 is an example of the formula used to
determine the extrinsic value of an option.

Before proceeding, we should give you a few words about terminology:
In the industry, extrinsic value is frequently referred to in a number of
ways (such as time value, time premium, or premium value). Informally,
this concept is often referred to as the juice or fluff ofthe option. From this
point forward, we will use the term time premium interchangeably with
extrinsic value. But although we are using the word time premium, we
should keep in mind that extrinsic value is influenced by more than just
time until expiration. To complicate matters a bit more, an option's overall
(or total) price-its intrinsic and extrinsic values combined-is frequently
referred to in the industry as the option's premium. In this book,
when we refer to an option's premium, we are speaking about the overall
price of the option. When we talk about the time premium, on the other
hand, we refer to the extrinsic value of a particular option.

Having reviewed these basic formulas, we can now gain some insight
as to how the time to expiration, interest rates, and volatility impact the
price of an option. In the following example, consider how differing input
variables will affect the price outcome for options that are listed for two
different stocks.


Assume the following:
1. Stocks ABC and XYZ are both trading at $52.
2. ABC is an Internet company:
3. XYZ is a well-established, traditional retailer.
4. April options have 30 days until expiration.
5. May options have 58 days until expiration.
6. You are interested in purchasing stock in both ABC and XYZ.

Consider the role of interest rates and the time to expiration when
comparing the purchase of April 40 calls on both ABC and XYZ to buyingstock:
1. By buying the stock, you pay $52 per share now. Ifyou purchase the
April 40 call, you defer payment of the $40 per share exercise price
until you exercise the option. In the meantime, you can invest this
$40 per share and earn interest. The amount of interest earned
depends on the time until exercise and the interest rate that you will
be paid on the funds. This economic benefit has a value that will be
reflected in the price of the option. We need to make two important
observations here:
a. Benefit is the same for ABC and XYZ. This benefit is measured
solely by the amount of money involved ($40 per share in this
case), the interest rate, and the time until expiration. Therefore,
the benefit would be the same whether you were considering an
investment inABC or XYZ.
b. The more time until exercise, the larger the economic benefit.
You could earn more interest-in fact, approximately twice the
amount-by delaying exercise until May: Thus, the price of the
May 40 calls will include a larger fee for the right to earn interest
by investing the amount needed to exercise the calls until
option exercise.

2. In this example, consider the role ofvolatility and time to expiration:
a. If the stock plunges to $30 prior to April expiration (the anticipated
time that you would exercise your call), you would lose $22
per share if the stock were purchased (but only the price of the
call ifyou acquired that instead). This reduction in your risk has
a value that will also be reflected in the price ofthe option.
b. The benefit is different for ABC and XYZ. You would probably
assess that the risk of this significant price move prior to April
expiration is greater for ABC than for XYZ and would therefore
be willing to pay more for this risk protection in the case ofABC
than XYZ. Surely the seller of the April 40 calls would charge
more for assuming this risk of a large move in the price of the
stock prior to April option expiration in the case ofABC than for
XYZ. For this reason, the price ofthe ABC April 40 call will likely
be greater than the price of the XYZ April 40 call.
c. The more time until exercise, the greater the risk to the seller.


For the same, obvious reason that the premium on a 60-day
health insurance policy for an individual is greater than the premium
on the same policy for the same individual if the term is
only 30 days, the price of the May 40 calls in ABC will include a
larger amount that is attributable to the risk that the stock price
will move away from $40 by May expiration than the Apr 40 calls
by April expiration.

Without attempting to calculate the fair value of the benefits offered
by the April 40 calls over the immediate purchase of the stock, it should
now be clear that the factors of time, interest rate, and anticipated stock
price volatility all impact the price of an option. We will now turn our
attention to methods that are available for quantifying the value ofthese
and other factors in order to address the question posed at the beginning
of this chapter: "How can I tell if an option is fairly priced?"
Read More: Factors Affecting the Price of an Option

Risk and Return Characteristics of Options

Now let’s look at the risk and return characteristics of the four basic
option positions: buying a call option (long a call option), selling a call
option (short a call option), buying a put option (long a put option),
and selling a put option (short a put option). We will use stock options
in our example. The illustrations assume that each option position is
held to the expiration date and not exercised early. Also, to simplify the
illustrations, we assume that the underlying for each option is for 1
share of stock rather than 100 shares and we ignore transaction costs.

Buying Call Options
Assume that there is a call option on stock XYZ that expires in one
month and has a strike price of $100. The option price is $3. The profit
or loss will depend on the price of stock XYZ at the expiration date.
The buyer of a call option benefits if the price rises above the strike
price. If the price of stock XYZ is equal to $103, the buyer of this call
option breaks even. The maximum loss is the option price; there is a
profit if the stock price exceeds $103 at the expiration date.

It is worthwhile to compare the profit and loss profile of the call
option buyer with that of an investor taking a long position in one share
of stock XYZ. The payoff from the position depends on stock XYZ’s
price at the expiration date. An investor who takes a long position in
stock XYZ realizes a profit of $1 for every $1 increase in stock XYZ’s
price. As stock XYZ’s price falls, however, the investor loses, dollar for
dollar. If the price drops by more than $3, the long position in stock
XYZ results in a loss of more than $3. The long call position, in contrast,
limits the loss to only the option price of $3 but retains the upside
potential, which will be $3 less than for the long position in stock XYZ.

Writing Call Options
To illustrate the option seller’s, or writer’s, position, we use the same
call option we used to illustrate buying a call option. The profit/loss
profile at expiration of the short call position (that is, the position of the
call option writer) is the mirror image of the profit and loss profile of
the long call position (the position of the call option buyer). The profit
of the short call position for any given price for stock XYZ at the expiration
date is the same as the loss of the long call position. Conse-

quently, the maximum profit the short call position can produce is the
option price. The maximum loss is not limited because it is the highest
price reached by stock XYZ on or before the expiration date, less the
option price; this price can be indefinitely high.

Buying Put Options
To illustrate a long put option position, we assume a hypothetical put
option on one share of stock XYZ with one month to maturity and a
strike price of $100. Assume that the put option is selling for $2. The
profit/loss for this position at the expiration date depends on the market
price of stock XYZ. The buyer of a put option benefits if the price falls.

As with all long option positions, the loss is limited to the option
price. The profit potential, however, is substantial: the theoretical maximum
profit is generated if stock XYZ’s price falls to zero. Contrast this
profit potential with that of the buyer of a call option. The theoretical
maximum profit for a call buyer cannot be determined beforehand
because it depends on the highest price that can be reached by stock
XYZ before or at the option expiration date.

Writing Put Options
The profit/loss profile for a short put option is the mirror image of the
long put option. The maximum profit to be realized from this position is
the option price. The theoretical maximum loss can be substantial
should the price of the stock declines; if the price were to fall to zero,
the loss would be the strike price less the option price.
Read More : Risk and Return Characteristics of Options

AMERICAN AND EUROPEAN STYLE OPTIONS

Options can be priced as an European style option or as an American style option. The holder
of a “European-style” option has the right to exercise the option only on the expiration date,

while the writer of this option may be assigned only on the expiration date of the option. On
the other hand, the holder of an “American style” option has the right to exercise the option
on any day until expiry, while the writer of an American style option may be assigned on any
day until expiry.

European style option – an option where the purchaser has the right to exercise only
at expiration.

American style option – an option a purchaser may exercise for early value at any
time over the life of the option up to and including its expiration date.

For example, if an option expires on 28th March, with an American style option, the holder
could exercise the option on 5th March and expect delivery of the currencies involved to
take effect two business days later. With a European style option, exercise can only occur on
28th March, with delivery then two business days later. It must be remembered that there is
a difference in price between the two styles of option, but only sometimes. The difference
in price occurs because there is a difference in the interest rates each currency attracts. With
American options, the intrinsic value is priced against the spot or the forward outright price,
whichever is the most advantageous. This is because the American option can be exercised for
spot value at any time during the life of the option.

If the call currency (right to buy) of the option has a higher interest rate than the put currency
(right to sell), there will be an advantage in calculating the intrinsic value against spot rather
than against the forward outright rate. Therefore, the risk that the writer of the American
option has is that at some point in time, if the option is so far in-the-money that there is
negligible time value remaining, the holder may exercise early. This would mean the writer
would incur the differential interest cost of borrowing the higher interest rate currency and
lending the lower interest rate currency. If this happens, the option is said to be at logical
exercise.

As the American style option is more flexible, shouldn’t it be more expensive all the time?
Actually, the American option is not really more flexible than the European option. True, it
can be exercised early and therefore the intrinsic value can be realised immediately but unless
the option is at logical exercise, the holder would be better to sell the option back and receive
the premium. Remember, the premium represents the intrinsic value of an option plus time
value. This is true for both American and European options and in both cases, if the option is
not at logical exercise, and the aim is to realise maximum profit, it would be better to sell than
to exercise the option.

Examples of cases when it would be better to pay the extra premium and buy a more
expensive American style option are:

• In buying an option where the call currency has the higher interest rate and it is expected that the interest rate differential will widen significantly;
• In buying an option where the interest rates are close to each other and it is expected that the call interest rate will move above the put interest rate;
• In buying an out-of-the-money option with interest rates as in both above and it is expected that the option will move significantly into the money, then the American style option is more highly leveraged and will produce higher profits.

Read More: AMERICAN AND EUROPEAN STYLE OPTIONS

Short Selling and Basic Option Strategies

Buying puts or selling calls allows the investor to benefit if the price of a
stock or stock index declines.

Buying puts gives the investor upside potential if the price of the
underlying declines. The upside potential is reduced by the option price;
in exchange for the reduced upside potential due to the cost of purchasing
the put option, the loss is limited to the option price. Thus, in comparison
to short selling in the cash market by borrowing the stock, an
investor who buys puts will realize a lower profit due to the option price
if the price of the underlying declines. Effectively, the difference in profit
when the price of the underlying declines is less than the option price
due to the cost of borrowing the stock. In contrast to short selling in the
cash market by borrowing the stock, the loss is limited to the option
price if the price of the underlying increases.

In addition, buying a put option offers an investor leverage. This is
because for a given amount that the investor is prepared to invest in a

short selling strategy, greater exposure can be obtained. Of course, the
greater profit potential by using the leverage provided by buying puts
means that there is greater potential loss.

Now let’s look at selling calls in comparison to selling short in the
cash market by borrowing the stock. The profit from selling calls if the
price of the underlying declines is limited to the option price received,
regardless of how much the price of the underlying declines. However,
there is no protection if the price of the underlying increases. In comparison
to short selling in the cash market by borrowing the stock, selling
calls has limited profit potential if the price of the underlying declines.

The loss should the price of the underlying increase is less for the call
selling strategy because of the option price received. That is, selling calls
and short selling in the cash market have substantial downside risk but
the amount of the loss in the case of selling calls is reduced by the
option price received.
Read More : Short Selling and Basic Option Strategies

Differences Between Options and Futures

The fundamental difference between futures and options is that the
buyer of an option (the long position) has the right but not the obligation
to enter into a transaction. The option writer is obligated to transact
if the buyer so desires (i.e., exercises the option). In contrast, both
parties are obligated to perform in the case of a futures contract.

In addition, to establish a position, the party who is long futures does not
pay the party who is short futures. In contrast, the party long an option
must make a payment (the option price) to the party who is short the
option in order to establish the position.

The payout structure also differs between a futures contract and an
option contract. The option price represents the cost of eliminating or
modifying the risk/reward relationship of the underlying. In contrast,
the payout for a futures contract is a dollar-for-dollar gain or loss for
the buyer and seller. When the futures price rises, the buyer gains at the
expense of the seller, while the buyer suffers a dollar-for-dollar loss
when the futures price drops.

Thus, futures payouts are symmetrical, while options are skewed.
The maximum loss for the option buyer is the option price. The loss to
the futures buyer is the full value of the contract. The option buyer has
limited downside losses but retains the benefits of an increase in the
value of the underlying. The maximum profit that can be realized by the
option writer is the option price, but there is significant downside exposure.
The losses or gains to the buyer and seller of a futures contract are
completely symmetrical.
Read More : Differences Between Options and Futures