Trading Equity and Index Options
The Listed Market
This article will examine equity based options. In contrast to the fixed income and currency markets, much of the use of equity derivatives involves the use of listed, as opposed to over-the-counter, derivatives. Over the counter financial products are traded by customers of financial institutions. In this hub we will concentrate on the listed market. Below are the categories of equity products that are actively traded in the U.S. and the United Kingdom and the exchanges on which they trade.
Equity Options - CBOE, AMEX, NYSE, PHLX, PSE, LIFFE
Index Options – CBOE, CME, LIFFE
AMEX - American Stock Exchange
CBOE - Chicago Board Options Exchange
CME - Chicago Mercantile Exchange
NYSE - New York Stock Exchange
PHLX - Philadelphia Stock Exchange
PSE - Pacific Stock Exchange
LIFFE – London International Financial Futures Exchange
Equity options are securities options that are based on a single stock, like IBM, Exxon, AT&T, etc. There are individual options based on roughly 3000 U.S. and UK stocks, traded on 7 securities exchanges.
Index options are securities options that are based on an index of stocks, like the S&P 500 index. In the U.S., the CBOE holds almost the entire market share for this category.
Long Call Pay Off Diagram
Principle Terms Used in the Options Markets
An option is a contract between the buyer and the seller which gives the buyer the right, but not the obligation, to buy or sell 100 shares of the underlying stock, or the cash index value, at a predetermined price, on or before a specified date in the future.
For the privilege of having the right without the obligation, the buyer pays the seller a premium, which is retained whether or not the option is exercised.
Options are securities, traded on organized securities exchanges, and are regulated by the Securities and Exchange Commission. If you are going to trade them then it is wise to become acquainted with each of the principle terms used in the options markets.
Call Options -- Calls offer the buyer the right to buy the underlying stock or index at a strike price until the expiration date.
Put Options -- Puts offer the buyer the right to sell the underlying stock or index at a strike price until the expiration date.
Premium is the price of the option, or the amount the buyer pays the seller for the right to exercise. Below are prices for IBM options as of early March. The buyer of a March 49 call will pay the seller 2 dollars per share for 100 shares or $20 for the right to sell IBM stock at $50 share up to the March expiration date.
IBM Close 50
Index Option Pay Off Diagram
The underlying instrument for equity derivatives is either 100 shares of a particular common stock or the cash value of an index. For example, the holder of an AT&T call would receive 100 shares of AT&T common stock if exercised. In the case of index options, which are settled in cash rather than stock, the holder of an S&P 500 call option would receive cash.
Similar to equity options, which are based on 100 underlying shares, index options are based on 100 multiplied times the index level. This is referred to as the index multiplier.
For example, an investor may purchase an S&P 500 call option at a strike price of 750 for $14.45 per share. This gives the investor the right tobuy at 750 for the length of the contract. If investor cashes in the option with the S&P at 770, he or she will receive a 5.25 per share return on the investment. This represents the 20 points the S&P rose, minus the value of the original 14.45 investment. Since these contracts are usually sold in lots of 100, the investor would have invested $1,445 and would have received $525 in addition to the original investment.
Strike Priceis the specific price stated in the option contract at which the stock or index is bought or sold if the option is exercised.
GM 49 call is $49 per share for GM common stock.
The strike price is one of the terms specified by the contract. For example, the holder of a GM 49 call would pay $49 per share for 100 shares of GM common stock if exercised. He would exercise the option and purchase GM for $49 if the stock were trading at some higher price than $51 dollars, the strike price plus the premium paid.
The two main kinds of exercise are European and American style. The style indicates when the option may be exercised by the buyer. Index options are primarily European style exercise; however, equity options are American style.
a. European Style - exercise at expiration only
b. American Style - exercise at any time
The expiration date is the date after which the option contract ceases to exist. If an option is not exercised prior to close of business on the expiration date, the option is said to expire worthless.
For example, the holder of a June GM 50 call has the right to purchase 100 shares of GM common stock at $50 per share up to and including its June expiration date. After that date, the holder has no further rights against the seller.
Let’s just recap on a few things we have discovered so far.
Jun Sep Dec
GM 50 call 4 3/4 6 7/8 9 1/4
GM 50 put 2 1/2 4 1/2 5 1/4
Looking at the above quotations how much do you think an individual would pay for the right to sell 100 shares of GM stock up to December? Yes you probably worked out that the right to sell stock in this case is a December put. The buyer would pay 5 1/4 times 100 shares for a total of $525.
Now let’s look at an index option example.
Mar Apr May
S&P500 640 call 4 1/4 14 3/8 19
S&P500 640 put 4 1/2 12 1/2 16 3/4
Again looking at the above quotations how much do you think an individual would receive if he sold the right to buy the S&P 500 Index at 640 up to May? That’s right, the right to buy stock in this case is the May call. The seller would receive the $19 premium times the multiplier of 100 for a total of $1,900.
Some Final Option Terms
Moving along to new terms, In-the-money, at-the-money and out-of-the-money are terms that describe the relationship of an option’s strike price to the current price of the stock or the current level of the index.
GM 50 call is “in-the-money” when the stock price is trading above $50 per share.
GM 50 call is “at-the-money” when the stock price is trading at $50 per share.
GM 50 call is “out-of-the-money” when the stock price is trading below $50 per share.
The above are some examples for the call. The put is exactly the opposite in that it is in the money when the stock is trading below the strike price. Obviously, the put is more valuable the lower the stock price falls, since the holder is able to exercise the option and sell the stock for a higher price than the going market value.
If for example the price of GM stock today closed at $49 1/8 and the buyer holds a June 65 call, is the call in-the-money, at-the-money or out-of-the-money? Well as the current price is less than the strike price it is therefore “out-of-the-money.”
Intrinsic and Time Value
Intrinsic Value and Time Value
Now let's consider what determines the value of an option. An option price or premium has two portions, the “intrinsic value” and the “time value.” The intrinsic value is equal to the amount by which an option is in-the-money. For example, if the S&P 500 Index is at 674.21, a 665 call might be priced at 25 ¼. This call is in-the-money by $9.21, which is its intrinsic value. The remaining $16.04 is known as its time value.
For example an Intel March 50 strike put price closed at 1/8 when the stock closed at 55 1/4. What would be the intrinsic and time values of this option? The stock price of 55 1/4 is above the put strike price of 50, so this put is out-of-the-money and, therefore, has no intrinsic value. Consequently, the entire option price is time value.
My next hub on the topic of options is 'Option Trading Strategies Using P&L Diagrams'. Drop in and take a look.
More by this Author
Understanding potential benefit and potential risk is an important first step in determining whether a particular option trading strategy is appropriate in a specific situation.
A currency option pay off diagram visually shows the potential profit and loss and the break even points of an options contract.
Test the knowledge of your colleagues at your local pub or sports and social club with this pub quiz (3) which covers general knowledge and some interesting specialised subjects. Answers are supplied.