Hi, Paul.

PE>        A brief explanation of options
PE>        ------------------------------

Some notes on "A brief explanation of options" :-)

PE> Written by Paul Edwards

Written by FIM.

PE> Released to the Public Domain

Ditto.

PE> Note - this documents my understanding of options, because
PE> I lost my brochure that explained it, so I thought I would

Your friendly stockbroker will put one in the mail to you tomorrow
(Monday). There's a new version just released, BTW - quite a bit more
comprehensive.

PE> take a guess at it, and then ask for corrections.
PE> Corrections please!

Herewith! :-)

PE> Ok, there are two different sorts of options, put options
PE> and get options.  Put is when you put up shares as security,
PE> Get is when you put up money.

There are two different sorts of options - call options and put options.
A call option gives the *buyer* (also known as the "taker") the right
(but not the obligation) to buy the underlying physical (in this
treatise I guess we're talking about shares as the physical) at the
specified "exercise" or "strike" price.

A put option gives the buyer the right but not the obligation to sell
the underlying shares at the specified strike price.

In both cases the option buyer "puts up the money" and the seller
receives it - but will have to pay margin calls or lodge shares as
collateral.

Conversely, the *seller* (also known as the "writer") of a call
option has the obligation (but not the right) to sell the underlying
shares at the strike price, and of course the seller of a put option has
the obligation but not the right to buy the underlying shares. The
process whereby the buyer of the option requires the underlying shares
to be bought from or sold to him is called "exercising" his option.

You also have different possibilities for exercising - American or
European. American exercise options can be exercised at any time up to
and including the expiry date; European options only in some defined
period(s), possibly only on the expiry date. Exchange traded options in
Australia are all American, "company" options (listed along with shares
by ASX) can be American or European.

In brief:
Buying a call option gives you exposure to upward movement in the share
price, with the downside limited to the premium you paid. You pay the
value of the premium to the seller.

Buying a put option allows you to profit from a downward movement in the
share price, with the downside (if the share price goes up) once again
limited to the premium. You pay the value of the premium to the seller.

Selling a call option gives you the premium cash in hand, but with
*unlimited* exposure to an upward movement of the share price. You
receive the value of the premium from the buyer, but need to lodge cash
or shares as collateral.

Selling a put option once again gives you the premium in hand, with your
exposure being the amount of the exercise price (if the share price
falls to zero). You receive the value of the premium from the buyer, but
need to lodge cash or shares as collateral.

PE> Scenario 1:

PE> You have 1 share in BHP.  BHP is currently worth $10.  You
PE> go to the options broking house and say "I will sell you
PE> 1 BHP share for $9 in 1 months time, how much will you
PE> give me for me letting you have this OPTION of BUYING 1 BHP
PE> share for this price?".  Now let's say the market thinks
PE> that BHP is going to stay rock-solid for the next month.

Option pricing in fact has very little to do with market sentiment,
except insofar as that sentiment is reflected in the price of the
underlying share. What it *does* depend on is the price of the share,
the exercise price of the option, the time to expiry, expected interest
rates over that time, and the expected "volatility" of the share over
that time. And of course, supply and demand.

PE> Well, they will give you $1 for that option.  You put up
PE> your share as security, and you pocket the $1.  If after
PE> 1 month the stock falls to $8.99, the person won't be
PE> interested in buying the stock for $9, and so you get $1
PE> profit, which helps make you not feel so bad about your
PE> BHP share falling in value.  Because in actual fact, you
PE> will have lost just 1c.  If the stock was still worth $10
PE> at the end of the 1 month, then the person will indeed be
PE> interested in buying your stock, so you will have broken
PE> even.  If the stock was worth $11 after a month, then
PE> you've just missed $1 worth of gain, because the other guy
PE> will get that gain instead, when he buys your stock for
PE> just $9 (or you buy the right off him for $2).  Basically,
PE> this allows you to buy insurance against your stock dropping
PE> in value.  If you are more concerned about your stock
PE> dropping than you are about missing out on possible gains,
PE> then this is the way to go.  From the other guys perspective,
PE> he is paying $1, which would actually DOUBLE in value if the
PE> stock went from $10 to $11.  To have bought the share, and
PE> then sell it after a month, would have cost him $10.  This
PE> way he gets into BHP for just $1.  He takes the risk of the
PE> share being worth $10 or less at the end of the month,
PE> meaning he loses his $1 completely.

This scenario covered selling a call option. The payoff for that is that
if the share price remains below the exercise price ($9), you "pocket
the $1". If the share price exceeds the exercise price, you will keep
less and less of your $1 until $10, when you lose the lot. Above $10 you
are losing cent-for-cent for every cent the share price rises.

Actually, it's more complicated. The scenario actually described being
long (owning) a BHP share *and* selling a call. That's equivalent to
selling a put naked (without owning the stock) and the payoff from the
total position is that you "pocket the $1" (the premium) if the share
price remains *above* the exercise price, and lose cent-for-cent if it
falls below.

If indeed "you are more concerned about your stock dropping than you
are about missing out on possible gains", you should buy a put option.
If the share price goes down your loss is limited to approximately the
value of the premium, whereas you still participate in any gains. (But
to a lesser extent - the value of the premium - than if you just owned
the share.) This strategy is called a "protective put".

Another comment (near the end of the scenario) - the buyer doesn't
actually "get into BHP" for $1 (he'd also have to pay the $9 exercise
price if he wanted to do that), but he is positively exposed to BHP's
share price for the period the option has to run, for just $1.

PE> Scenario 2:

PE> You have the same BHP share.  This time you want to sell
PE> the share for $11 in 1 months time.  The market doesn't
PE> think BHP is going to go up.  But there is a small chance
PE> it will, and in fact, there is a small chance it could even
PE> be worth $12 after 1 month.  Someone is likely to pay you
PE> 2c for that OPTION to BUY.  If the price goes up to $12,
PE> they stand to make 98c, a massive profit.  If the price
PE> stays below $11, they will lose their 2c.  Basically, you
PE> are hoping to make 2c for slightly risking your share, whilst
PE> they are hoping to make a 4900% profit by taking a much
PE> larger risk.  For just 2c, someone gets the profit of a $10
PE> share rocketting to $12, ie a massive gearing.

This is slightly confusing, and I'm not quite sure if we're talking
about buying a put or selling a call. "...sell the share for $11 in 1
months time." implies buying a put. "Someone is likely to pay you 2c for
that OPTION to BUY" implies selling a call. The payoffs against a range
of possible share prices are totally different in each case, and
complicated once again by the *total* position - you are also long the
stock.

PE> Scenario 3:

PE> If you think BHP is extremely volatile, and will either go
PE> below $9 in the next month, or go above $11, what you can
PE> do is combine the two, and put up your shares, plus some
PE> money, to cover both angles.  I'll have to think about that
PE> one.

What you actually do if you think BHP is volatile, ie you think that in
the next month (say) the price will be anywhere *except* where it is now
(approximately), is take a "straddle" position - you buy a call and a
put at the same exercise price. You make money if the share price ends
up a long way in either direction from where it is; you lose the most if
it stays exactly at the exercise price, and you lose a little bit if it
is a few cents (maybe 10s of cents, depending on the actual numbers)
either side.

This assumes you *don't* own the stock. If you do, you can achieve the
same effect by selling your share, and buying 2 call options. This is
called a "reverse ratio".

PE> Anyway, as far as I'm aware, these scenarios cover all the
PE> common buy/sell options.

You should probably concentrate on getting a clear understanding of the
"naked" positions first - buying and selling a call, buying and selling
a put. And, because they become part of the more complex strategies,
also consider the (straightforward) payoffs from buying (or holding) the
underlying share and selling (possibly short) the underlying share.

The most common option transaction by the general public (GP) would
appear to me to be buying a call option. Of course there must be a
seller, but that usually seems to be the dealer. Second most common
(by the GP) seems to be buying a put or selling a call; least common,
probably even less than some of the simpler combination strategies,
might be selling a put.

When you buy a call or a put you must pay for it, with money. When you
sell a call or a put you will receive money for it, but will be required
to pay margin calls. A margin call can be paid in cash, and you receive
this back when you close the position, if the share price hasn't moved
against you. You are paid interest on that money. Alternatively, you can
lodge shares as collateral for your "short" position.

A margin call for which you pay cash is likely to significantly exceed
the $ you received for selling the option. Of course, the margins are
"marked to market" daily, so if the share price moves quickly in your
favour, you'll soon get a lot of it back. (And if it goes the other way,
you'll have to pay more! :-))

There are a large number of combination strategies. A computer program I
wrote describes 36 (including the naked positions) and what you have to
do to execute them. They have exotic names like "long condor", "put
ratio backspread" and "short strip", as well as the ones
I've mentioned
in the course of the discussion above.

Regards, FIM.

 * * One crow will not peck out another crow's eyes.
@EOT:

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