Michael C. Thomsett
Options



ISBN 978-1-5474-1614-1
e-ISBN (PDF) 978-1-5474-0009-6
e-ISBN (EPUB) 978-1-5474-0011-9
Library of Congress Control Number: 2018949270
Bibliographic information published by the Deutsche Nationalbibliothek
The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie;
detailed bibliographic data are available on the Internet at .
© 2018 Michael C. Thomsett
Published by Walter de Gruyter Inc., Boston/Berlin
www.degruyter.com


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Acknowledgments to the Tenth Edition
I owe thanks to many options insiders and practitioners who have guided me through the years.
First, my gratitude must be extended to Karl Weber, the editor who first acquired this book in
1987 when he was at John Wiley & Sons. At the time, options was a young industry and he fought for
publication of that first edition of the book despite a widespread belief that the market for such a book
was tiny.
Second, I thank the folks at the Chicago Board Options Exchange (CBOE), especially two people
who became good friends as well as advisers. Marty Kearney and Jim Bittman were my mentors and
teachers in many respects over the years.
Third, thanks to the many readers of the previous nine editions who wrote to the publisher or to
me with questions or with discovered errors. I appreciate the feedback and the many helpful
suggestions. Notable among my readers are numerous friends I found and connected with on social
media, especially on LinkedIn.
Fourth, I must mention the unwavering support of my webmaster and partner at Thomsett’s
Investment Guide (), Michael Stoppa, who has encouraged me to continue
with my efforts at education and development of training material for a growing audience of options
enthusiasts.
Fifth, a special thanks go out to the editorial team at my newest publisher, De Gruyter. My editor
and dedicated fact checker, Jeffrey Pepper, is a determined and relentless publishing professional
who insists on simplicity, accuracy, and thorough explanations of the many complexities of options.
Additional editing and fact checking were executed skillfully by the De Gruyter editorial team,
notably including Mary Sudul and Jaya Dalal. This team put exceptional energy into editing the book,
making sure that I explained myself as well as possible in every word, phrase and paragraph. These
folks are the best!
Michael C. Thomsett
June 2018



Contents
Part I:

The Basics

Chapter 1: Calls and Puts: Defining the Field of Play
Equity Investments
Debt Investments
Investments with No Tangible Value: Options
Trading Options on Exchanges
Calls and Puts
The Call Option
The Long-Term Call Option
Investment Standards for Call Buyers
How Call Selling Works
The Put Option
Option Valuation
Picking the Right Stock
Intrinsic Value and Time Value
Chapter 2: The Life of an Option
Expiration and Exercise
What is “Clearing”?
Bid and Ask
Order Entry
Types of Orders
Who Are the Players?
Chapter 3: Opening and Tracking: How It All Works
Terms of the Option (Standardized Terms)

Strike Price
Expiration Date
Type of Option
Underlying Stock
A Note on the Expiration Cycle
Opening and Closing Option Trades
Using the Daily Options Listings
Understanding Option Abbreviations
Calculating the Rate of Return for Sellers
Chapter 4: Buying Calls: Maximizing the Rosy View
Understanding the Limited Life of the Call
Judging the Call
Call Buying Strategies


Strategy 1: Calls for Leverage
Strategy 2: Limiting Risks
Strategy 3: Planning Future Purchases
Strategy 4: Insuring Profits
Strategy 5: Premium Buying
Strategy 6: Pure Speculation
Defining Profit Zones
Chapter 5: Buying Puts: The Positive Side of Pessimism
The Limited Life of the Put
Judging the Put
Put Buying Strategies
Strategy 1: Gaining Leverage
Strategy 2: Limiting Risks
Strategy 3: Hedging a Long Position
Strategy 4: Pure Speculation

Defining Profit Zones
Chapter 6: Selling Calls: Conservative and Profitable
Selling Uncovered Calls
Assessing Uncovered Call Writing Risks
A Question of Suitability
Selling Covered Calls
Assessing Covered Call Writing Risks
Calculating the Rate of Return
Chapter 7: Selling Puts: The Overlooked Strategy
Analyzing Stock Value
Evaluating Risks
Put Strategies
Strategy 1: Producing Income
Strategy 2: Using Idle Cash
Strategy 3: Buying Stock
Strategy 4: Writing a Covered Put on Short Stock
Strategy 5: Creating a Tax Put

Part II: Closing the Position
Chapter 8: Closing Positions: Profit, Exercise, or Roll
Defining Possible Outcomes of Closing Options
Results for the Buyer
Results for the Seller
Exercising the Option


Timing the Decision
Avoiding Exercise
Chapter 9: Paper Trading: A Test Run of the Theory
The Case for Paper Trading

Sites Worth Checking
www.Optionsxpress.com
marketwatch.com
www.investopedia.com
Proceeding with a Paper Trading Plan
The Dangers of Paper Trading
Chapter 10: Calculating the Return: A Complex Aspect to Options
Finding a Realistic Method
Annualizing Models and Guidelines
An Overview of Basic Calculations for Calls
You Close the Position and Calculate Option-Based Net Return
You Close the Position and Calculate Net Return Based on the Entire Position
The Covered Call is Exercised, and You Calculate Option and Stock Profits Separat
ely
Any Covered Call Outcome Is Computed Strictly Based on Capital on Deposit
Anticipating the Likely Return
Chapter 11: The Basics of Risk: What Every Trader Needs to Know
Volatility as the Definition of Risk
Historical Volatility
Implied Volatility
Pricing Models
Risk and Human Nature
Confirmation Bias
Anchoring
Herding
Framing
Selective Memory
Loss Aversion
Chapter 12: Strategies in Volatile Markets: Uncertainty as an Advantage
Avoiding 10 Common Mistakes

Modifying Your Risk Tolerance
The Nature of Market Volatility
Market Volatility Risk
Options in the Volatile Environment


Part III: Advanced Strategies
Chapter 13: Combinations and Spreads: Creative Risk Management
Overview of Advanced Strategies
The Spread
The Hedge
The Straddle
The Strangle
Vertical Spread Strategies
Bull Spreads
Bear Spreads
Box Spreads
Debit and Credit Spreads
Horizontal and Diagonal Spread Strategies
Altering Spread Patterns
Varying the Number of Options
Expanding the Ratio
Strategies with Moneyness Close to Underlying Prices
Variations on the Butterfly
Multi-Leg Option Orders
In Conclusion
Chapter 14: Hedges and Straddles: More Creativity
The Two Types of Hedges
Hedging Beyond Coverage
Hedging Option Positions

Partial Coverage Strategies
Straddle Strategies
Middle Loss Zones
Middle Profit Zones
Theory and Practice of Combined Techniques
In Conclusion
Chapter 15: Options for Specialized Trading: Leveraging the Technical Approach
Swing Trading Basics
The Setup Signal
Testing the Theory
A Strategic View of Option for Swing Trading
Selection of Stocks Based on Value
A Stock’s Price Volatility
Price History (Recent and Potential)
The Price-To-Earnings (P/E) Ratio of the Stock
Fundamental and Technical Tests of the Company and Stock


Options Used for Other Trading Strategies
Swing- and Day-Trading Advanced Strategies
Taking Partial Profits
Partial Exercise
Add More Option Contracts in Times of Price Momentum
In Conclusion
Chapter 16: Options on Futures: Leveraging Your Leverage
Important Distinctions
Regulatory Differences
In Conclusion
Chapter 17: Synthetic Positions: Tracking the Stock
Synthetic Put (Protected Short Sale)

Synthetic Long Call (Insurance Put, or Married Put)
Synthetic Long Stock
Synthetic Short Stock
Split Strike Strategy (Bullish)
Split Strike Strategy (Bearish)
Collars
Synthetic Straddles
In Conclusion

Part IV: Risk Evaluation
Chapter 18: Risk: Rules of the Game
Identifying the Range of Risk
Margin and Collateral Risk
Personal Goal Risks
Risk of Unavailable Market
Risk of Disruption in Trading
Brokerage Risks
Trading Cost Risk
Lost Opportunity Risks
Tax Consequence Risk
Evaluating Your Risk Tolerance
In Conclusion
Chapter 19: Taxes: The Wild Card of Options Trading
Tax Rules for Options
Qualified Covered Calls—Special Rules
Looking to the Future
In Conclusion


Chapter 20: Choosing Stocks: Finding the Right Ingredients

Developing a Covered Call Action Plan
Selecting Stocks for Call Writing
Benefiting from Price Appreciation
Analyzing Stocks
Fundamental Tests
Technical Tests
Deciding Which Tests to Apply
Applying Analysis to Options—the “Greeks”
Beta
Delta
The Rest of the Greeks
Acting on Good Information
Putting Your Rules Down on Paper
In Conclusion
Glossary
Index


Introduction to the Tenth Edition
Learning options is not an easy proposition. The logic of options trading involves thinking in a
different, sometimes mind-bending, way. In this tenth edition, the book was reviewed by novices to
ensure that every sentence was made clear, that repetition and examples, so important to learning
options, were included where needed. The result, we believe, is that if you read carefully, you will
truly understand the many choices available to you as an options trader. As one reviewer said,
“finally a book that makes me really understand options.”

The Evolution of Options Trading
In the previous nine editions of this work, the scope and exploration of the options market has
evolved. This has occurred along with the dramatic evolution of the market itself. When the first
edition was published in 1989, the market was still young and few stock traders dared venture into

what was perceived as a high-risk and complex market, appropriate only for speculators.
Today, a more expansive and enlightened population of traders recognizes that options are
applicable to many forms of trading: speculation, generation of income, conservative trading, and
hedging of risk.
In 1989, trading itself was primitive when compared to modern markets. There was no internet
and very limited discount brokerage. Trading was expensive and the cost of a single trade could
easily exceed $100, compared to today’s single-option trading fee averaging $5 to $6—quite a
change.
The internet has made it possible for traders to execute their own trades usually with almost
instantaneous fulfillment of the order. Online information is easily accessed and is free, and the role
of the stockbroker has been made obsolete for many options traders. In the past, when traders had to
rely on a stockbroker’s advice, it often was difficult to determine whether the advisor had adequate
knowledge and experience to provide good advice. The internet has also made it possible for the
stock, options, and futures market to expand to new high volume levels. In 1990, for example, the first
full year in which the first edition of this book was available, the Dow Jones Industrial Average
ranged between 2,350 and 3,000, about one-tenth of levels as of the beginning of 2018, close to
25,000. The 1990 record of the DJIA is summarized in Figure I.1.


Figure I.1: DJIA, 1990

Features of the Book
The record of this book – with over 300,000 sales in previous editions – reflects a guiding standard:
full explanations of all attributes and strategies, illustrations, examples, and checklists. The purpose
in all editions, including this tenth edition, is to acknowledge what every investor and trader desires:
Sensible combinations of desirable attributes in the portfolio: diversification, leverage, safety, and
profitability.
This is a big order. How can you create all of these elements in the same portfolio? Tradition
advises that if you want profits, you have to give up safety, and that if you want to use leverage, you
have to take on greater risk. In this book, these traditional problems are challenged by demonstrating

how to combine the desirable attributes while managing and even eliminating the undesirable ones.
Options, once reserved for speculators and those able to tolerate high risk, have become
mainstream devices for portfolio management. Many advanced option strategies can be applied so
that risks are held down or even hedged entirely, while even conservative investors may create
profits by combining options with stock positions.
Can options be used in a conservative manner? Yes; in fact, one of the best aspects to this market
is that they can be designed to fit a range of risk tolerance profiles. The highly conservative investor
may use options to reduce risk in long stock positions. On the far end of the spectrum, the speculator
can continue to use options to swing trade, leverage, and seek fast profits. The range of strategies
covers the entire risk spectrum.
This book demonstrates how market volatility works as an advantage when options are properly
used to profit from uncertainty. The later chapters in the book examine some very interesting option
strategies for even greater profits than those available from option trading combined with stock
positions. Options on futures are one example; since futures are leveraged instruments already,
options on futures are “leverage on leverage.” Trading options is much safer than trading directly in
futures, however. Just as trading options on stocks is cheaper and often safer than trading shares
directly, you can trade options on futures directly or through commodities-based exchange-traded


funds (ETFs), index options and index funds. These choices open up many possibilities for large
profits, while limiting risks to the relatively low cost of the option. An index option provides built-in
diversification and broad exposure, in comparison to the very limited diversification available when
trading only in shares of stock.
The flexibility of options opens many additional possibilities, including trading not in the
underlying security, but in synthetic stock positions. The use of offsetting options is low-cost or nocost (because the cost of long options is covered by income from short options); and the synthetic
position moves exactly like the underlying security. Using synthetics allows traders to benefit from
changes in the security price, but without needing to place a large amount of capital at risk.
The discussion of risk itself is often left out of investment and trading books, and this is a mistake.
Clearly, risks have to exist in all markets, especially in options, or there would be no opportunity for
profit. In options, traders need to understand the range of risks before placing capital into strategies.

Too many option traders take on greater risks that they can not afford, not so much because they don’t
understand risk but because they are attracted to the trade itself. You are far better off settling for
smaller and more consistent profits than going for broke ... and going broke. The risk discussion is
always one of the most important and essential elements in any investment strategy.
A later chapter explains how taxes work on option trading. As odd as the tax code is, rules for
options are among the most complicated. This chapter by no means provides a comprehensive
explanation of the technical rules applied to option profits and losses; but it does highlight the major
considerations every trader needs to be aware of and should discuss with a tax adviser before
entering into advanced option trading strategies.
This book is designed to provide you with all of the tools you need to master the strategic and
management aspects of advanced option trading. These attributes include:
Definitions in Context. Every term is defined in the space next to the text as it is introduced. All
definitions are also summarized in the Glossary at the end of the book.
Illustrations. The book includes dozens of illustrations designed to visually summarize key points
and to show how strategies play out and are applied.
Key Points. These highlighted, brief statements provide you with the brief major points to be
taken away from each section as it is presented.
Valuable Resources. These link you to the world of options resources and provide the benefits of
access to topics and features that will improve your trading capabilities.
Examples. The text includes many examples that emphasize the points being offered, and show
how strategies apply when put into trading modes.
Applying options as a strategic approach to portfolio management is intriguing because you can
design your own level of risk as a first step in folding options into a broader risk-reduction strategy.
Portfolio health should always be a primary goal and purpose for every investor. In spite of the longstanding reputation of options as having high risk and not being appropriate for most people, this book
shows you how these amazing intangibles can be used to reduce risks while increasing profits.
Michael C. Thomsett
June 2018




Chapter 1
Calls and Puts: Defining the Field of Play
Nine-tenths of wisdom is being wise in time.
̶ Theodore Roosevelt, speech, June 14, 1917

Options are amazing tools that can help you expand your control over your portfolio, protect
positions, reduce market risk, and enhance current income. Some strategies are very high risk, while
others are extremely conservative. This is what makes the options market so interesting. The variety
of creative uses of options makes it possible to lock in profits in the most uncertain of conditions, to
pursue income opportunities, or to hedge risk, without being exposed to volatile markets.
Because the option is an intangible device, its cost—known as the premium—is only a fraction of
the stock price. This makes it possible to control shares of stock without assuming the market risks.
Each option controls 100 shares, so for between 3 and 10 percent of the cost of buying shares in a
company, you can use an option to create the same profit stream. This makes your capital go further
while keeping risks very low. The actual percentage of an option’s value depends on its time to
expiration, proximity to the underlying price, and level of volatility.
Definition
Premium: The price of an option, expressed in dollars and cents but without dollar signs in hundreds of dollars. For
example, if an option has a premium of $200, it is expressed as 2; if an option has a premium of $325, it is expressed as
3.25.

This idea—using intangible contracts to duplicate the returns you expect from wellpicked stocks—is
revolutionary to anyone who has never explored options trading. Most people are aware of the two
best-known ways to invest money: equity and debt.

Equity Investments
An equity investment is the purchase of a share of stock or many shares of stock, which represents a
partial interest in the company itself. Shares are sold through stock exchanges or over the counter
(trades made on companies not listed on an exchange). For example, if a company has one million
shares outstanding and you buy 100 shares, you own 100/1,000,000ths, or .0001 percent of the

company.
Definition
Equity investment: An investment in the form of part ownership, such as the purchase of shares of stock in a corporation.

When you buy 100 shares of stock, you are in complete control over that investment. You decide how
long to hold the shares and if or when to sell. Stocks provide you with tangible value, because they
represent part ownership in the company. Owning stock entitles you to dividends if they are declared,
and gives you the right to vote in elections offered to stockholders (some special nonvoting stock


lacks this right). If the stock rises in value, you will gain a profit. If you wish, you can keep the stock
for many years, even for your whole life. Stocks are traded over public exchanges and can be used as
collateral to borrow money.
Example
An equity investment: You purchase 100 shares at $27 per share, and place $2,700 plus trading fees
into your account. You receive notice that the purchase has been completed. This is an equity
investment, and you are a stockholder in the corporation.
Example
Part equity, part borrowed: You buy an automobile for $20,000. You put down $6,000 and finance
the difference of $14,000. Your equity is limited to your down payment of $6,000. You are the
licensed owner, but the financed balance of $14,000 is not part of your equity.

Debt Investments
The second broadly understood form of investing is a debt investment, or debt instrument. This is a
loan made by the investor to the company, government, or government agency, which promises to
repay the loan plus interest as a contractual obligation. The best-known form of debt instrument is the
bond. Corporations, cities and states, the federal government, agencies, and subdivisions finance their
operations and projects through bond issues, and investors in bonds are lenders, not stockholders.
When you own a bond, you also own an asset with tangible value, not in stock but in a contractual
right with the lender. The bond issuer promises to pay you interest and to repay the amount loaned by

a specific date. Like stocks, bonds can be used as collateral to borrow money. They also rise and fall
in value based on the interest rate a bond pays compared to current rates in today’s market. In the
event an issuer goes broke, bondholders are usually repaid before stockholders as part of their
contract, so bonds have priority over stocks.
Example
Lending versus owning: You purchase a bond currently valued at $9,700 from the U.S. government.
Although you invest your funds in the same manner as a stockholder, you have become a bondholder;
this does not provide you with any equity interest. You are a lender and you own a debt instrument.
Example
Lending to a friend: A good friend wants to buy a car for $20,000, but has only $6,000 in cash. This
friend asks you to lend him the balance of $14,000 and offers to pay interest to you. The $14,000 you
contribute is a debt investment, and the interest you earn is income on that investment. When you act
as a lender, you have made a debt investment.

Investments with No Tangible Value: Options


The third form of investing is less well known. Equity and debt contain a tangible value that we can
grasp and visualize. Part ownership in a company and the contractual right for repayment are basic
features of equity and debt investments. Not only are these tangible, but they have a specific lifespan
as well. Stock ownership lasts as long as you continue to own the stock and cannot be canceled unless
the company goes broke; a bond has a contractual repayment schedule and ending date. The third form
of investing does not contain these features; it disappears—expires—within a short period of time.
You might hesitate at the idea of investing money in a product that evaporates and then ceases to have
any value. In fact, there is no tangible value at all.
An option’s value is derived from the underlying security on which it is based. This is why
options are also called “derivatives.” Their value is derived from price behavior in an equity
position.
Key Point: Options are intangible and have a limited lifespan. The main advantage is that options allow you to control 100
shares of stock without having to buy those shares.


This third type of investment involves no tangible value, and it will be absolutely worthless on its
pre-determined expiration date, which can be within a few months. To make this even more
perplexing, imagine that the value of this intangible is certain to decline just because time passes by.
To confuse the point even further, imagine that these attributes can be an advantage or a disadvantage,
depending on how you decide to use these products.
Valuable Resource: For a complete summary of risk, complete with disclosures about the options market, download a
copy of the industry prospectus, Characteristics and Risks of Standardized Options at />ations/character-risks.jsp

The attributes of options—lack of tangible value, worthlessness in the short term, and declining value
over time—make options seem far too risky for most people. But there are good reasons to look
beyond these limiting features. Not all methods of investing in options are as risky as they might seem;
some are conservative because the features just mentioned can work to your advantage. In whatever
way you use options, the many possible strategies make options one of the more interesting avenues
for investors. The more you study options, the more you realize that they are flexible; they can be used
in numerous situations to create opportunities; and, most intriguing of all, they can be either
exceptionally risky or downright conservative.
This makes options both flexible and suitable for a broad range of investors. On one end is the
speculator willing to increase risk, and on the other is the conservative investor who seeks ways to
reduce risk.
Key Point: Option strategies range from high risk to extremely conservative. The risk features on one end of the spectrum
work to your advantage on the other. Options provide you with a rich variety of choices.

The role of options is not without controversy. Citing the potential for manipulation, speculation, and
volatility, one paper offers the theory that options trading adds to instability in the markets:
Overall, most economists recognize that derivatives have made a positive contribution to the economy, but since the global
crisis of 2007-2010, critics have become much more frequent and virulent and the perception of derivatives has changed
quite a lot. Although the usefulness of derivatives is not called into question on the whole, a number of voices have been
clamoring about the risks that derivatives place on the stability of financial markets.1



However, manipulation, speculation, and volatility cannot be assigned to options trading exclusively.
There have been instances of abuses in all of the publicly traded markets, and these are well-known.
But when used to hedge market risk, or when speculation is moderated, the options market is more
likely to expand opportunities for trading, rather than harming it. This is accomplished with strategies
set up to offset equity risk, or to hedge it. As a starting point in the analysis of the options market, it
makes sense to understand not only what options are, but the benefits and risks they provide.
An option is a contract that provides you with the right to execute a stock transaction—that is, to
buy or sell 100 shares of stock. (Each option refers to a 100-share unit.) This right includes a specific
stock and a specific price per share (strike price) that remains fixed until a known date in the future.
When you have an open option position, you do not have any equity in the stock, neither do you have
any debt position. You have only a contractual right to buy or to sell 100 shares of the stock at the
strike price.
Since you can always buy or sell 100 shares at the current market price, you might ask: “Why do I
need to purchase an option to gain that right?” The answer is that the option fixes the price of the
stock, and this is the key to an option’s value. This fixed price is known as the strike price, also
known as the striking price.
Definition
Strike price: The fixed price to be paid for 100 shares of stock, specified in the option contract; the transaction price per
share of stock upon exercise of that option, regardless of the current market value of the stock.

Stock prices may rise or fall, at times significantly. Price movement of the stock is unpredictable,
which makes stock market investing interesting and risky. As an option owner, you can buy or sell
100 shares at a price that is frozen for as long as the option remains in effect. So, no matter how much
price movement takes place, your price is fixed to the strike price in the event that you decide to
purchase or sell 100 shares of that stock. Ultimately, an option’s value is going to be determined by a
comparison between the strike price and the stock’s current market price.
A few important restrictions come with options:
1. The right to buy or to sell stock at the strike price is never indefinite; in fact, time is one of the
most critical factors because the option exists for a limited time that is unchangeable and defined

when the option is created. When the deadline has passed, the option becomes worthless and
ceases to exist. Because of this, the option’s value is going to fall as the deadline approaches,
and in a predictable manner.
2. Each option also applies only to one specific stock and cannot be transferred to any other stock.
3. Each option applies to exactly 100 shares of stock, no more and no less.

Trading Options on Exchanges
Prices of listed options—those traded publicly on exchanges like the Chicago, New York, and
Philadelphia stock exchanges—are established through supply and demand. Those are the forces that
dictate whether market prices rise or fall for stocks. As more buyers want stocks, prices are driven


upward by their demand; and as more sellers want to sell shares of stock, prices decline due to
increased supply. The supply and demand for stocks, in turn, affects the market value of options. The
option itself has no direct fundamental value or underlying financial reasons for rising or falling; its
market value is a by-product of the fundamental and technical changes in the stock. Thus, options are
broadly called derivatives—their value is derived from the value in the underlying security.
Key Point: The market forces affecting the value of stocks in turn affect market values of options. The option itself has no
direct fundamental value; its market value is formulated based on the stock’s fundamental and technical indicators.

The orderly process of buying and selling stocks, which establishes stock price values, takes place on
the exchanges through trading available to the general public. This overall public trading activity, in
which prices are being established through ever-changing supply and demand, is called the auction
market, because value is not controlled by any forces other than the market itself. These forces
include economic news and perceptions, earnings of listed companies, news and events affecting
products and services, competitive forces, and Wall Street events, both positive and negative.
Individual stock prices also rise or fall based on index motion, the Dow Jones Industrial Averages,
for instance.
As clear and obvious as this all seems, stock price behavior (and as a result, options price
behavior) is not always rational. The so-called efficient market theory claims that stock prices are

efficiently adjusted for all known information. However, this includes information that is true as well
as information that is false. The efficient market theory does not claim that price movement in the
market is efficient, only that discounting of stock prices for information takes place efficiently, even
when the information is based only on rumor. However, an analysis of how prices react to news
should be distinguished between expected and unexpected news:
One of the major premises of efficient market theory is that the market quickly impounds any publicly available information,
including macroeconomic information, that might be used to predict stock prices. It is only new—and especially new and
unpredictable—information that moves prices, and yet many studies examine only announcements that have a predictable
component.2

This observation is cautionary for all options traders. The expectation that stock or options pricing
will react rationally to information is uncertain. The distinction between expected information (such
as earnings reports) and unexpected information (announcement of a merger, for example) should be
expected to have different price reactions, and these reactions should not be expected to unfold
rationally or efficiently.
Valuation is uncertain as a consequence. The cause and effect is seen in how many active options
exist and in how their valuation changes from one day to the next. This is further distorted by a
comparison between the limited number of shares of stock, versus the unlimited possible number of
options opened and closed.
Stocks issued by corporations are limited in number, but the exchanges will allow investors to
buy or sell as many options as they want. The number of active options is unlimited. However, the
values in option contracts respond directly to changes in the stock’s value. The three primary factors
affecting an option’s value are time to expiration, proximity between the option and the underlying,
and market value of the stock.
Key Point: Option value is affected by movement in the price of the stock and by the passage of time. Supply and demand


affect option valuation only indirectly.

There is always a ready market for the option at the current market price. That means that the owner

of an option should not have a problem selling that option. However, if the current market value of the
option is lower than the original premium, it results in a loss.
Definition
Ready market: A liquid market, one in which buyers can easily sell their holdings, or in which sellers can easily find buyers,
at current market prices.

This feature is of critical importance. For example, if there were constantly more buyers than sellers
of options, then market value would be distorted beyond reason. To some degree, distortions do
occur on the basis of rumor or speculation, usually in the short term. But by and large, option values
are directly formulated on the basis of stock prices and time until the option will cease to exist. If
buyers had to scramble to find a limited number of willing sellers, the market would not work
efficiently. Demand between buyers and sellers in options is rarely equal because options do not
possess supply-and-demand features of their own. Consequently, the Options Clearing Corporation
(OCC) acts as the seller to every buyer, and as the buyer to every seller. That is, the OCC performs
the transaction based on the market price of the option that day (given its expiration date) by matching
a seller of an option to a buyer.
In normal conditions, moderating the imbalances between buyers and sellers is facilitated (by the
OCC), enabling the market to operate without such distortions or imbalances. In extraordinary times,
this facilitation is equally important even when unexpected:
Options traders, corporate managers, security analysts, exchange officials, regulators, prosecutors, policy makers, and—at
times—the public at large have an interest in knowing whether unusual option trading has occurred around certain events. A
prime example of such an event is the September 11 terrorist attacks, and there was indeed a great deal of speculation
about whether option market activity indicated that the terrorists or their associates had traded in the days leading up to
September 11 on advance knowledge of the impending attacks. This speculation, however, took place in the absence of an
understanding of the relevant characteristics of option market trading.3

There was a time when the markets following the terrorist attacks could have fallen into disarray if
the facilitation role were not provided by the OCC. The speculation that there had been advance
knowledge was disproven by a detailed analysis of data provided by the OCC concerning volume of
activity in options, especially in puts (the right to sell the underlying stock, see Calls and Puts section

later in this chapter). The service the OCC provides extends beyond facilitation of imbalances
between calls and puts, or between long and short; it also provides insight to the data it gathers and
provides.
Valuable Resource: Learn more about the Options Clearing Corporation (OCC) at their web site, www.theocc.com. This
page includes current market information, resources for options trading, and educational links.

Calls and Puts


Each option contract applies to 100 shares, whether you act as a buyer or as a seller. There are two
types of options: calls and puts.
A call grants its owner the right to buy 100 shares of stock in a company. When you buy a call, it
is as though the seller is saying to you, “I will allow you to buy 100 shares of this company’s stock, at
a specified price, at any time between now and a specified date in the future. For that privilege, I
expect you to pay me the current call’s price.”
Definition
Call: An option acquired by a buyer or granted by a seller to buy 100 shares of stock at a fixed price within a specified time
period.

Each option’s value changes according to changes in the price of the stock. If the stock’s value rises,
the value of the call option will generally follow suit and rise as well. And if the stock’s market price
falls, the call option generally will also lose value. When an investor buys a call and the stock’s
market value rises after the purchase, the investor profits because the call becomes more valuable.
The value of an option actually is predictable—it is affected by the passage of time as well as by the
ever-changing value of the stock.
Key Point: Changes in the stock’s value affect the value of the option directly, because while the stock’s market price
changes, the option’s specified price per share remains the same. The option’s value varies based on movement of the
stock and on the time left before expiration.

The other type of option is the put. This is the opposite of a call in that it grants a selling right instead

of a purchasing right. The owner of a put contract has the right to sell 100 shares of stock. When you
buy a put, the seller is saying to you, “I will allow you to sell me 100 shares of a specific company’s
stock, that you may not currently own, at a specified price per share, at any time between now and a
specific date in the future. For that privilege, I expect you to pay me the current put’s price.”
For an investor owning shares, having a put allows them to sell those shares to someone else,
which is beneficial if shares have declined in value below the original premium. However, all types
of options can be opened at any time, whether shares of stock are owned or not. Anyone who is
approved by a brokerage firm for trading options is able to open a position.
Definition
put: An option acquired by a buyer (or granted by a seller) to sell 100 shares of stock at a fixed price within a specified time
period.

The attributes of calls and puts can be clarified by remembering that either option can be bought or
sold. This means there are four possible permutations to option transactions:
1. Buy a call (buy the right to buy 100 shares).
2. Sell a call (sell to someone else the right to buy 100 shares from you).
3. Buy a put (buy the right to sell 100 shares).
4. Sell a put (sell to someone else the right to sell 100 shares to you).


Another way to keep the distinction clear is to remember these qualifications: A call buyer believes
and hopes that the stock’s value will rise, but a put buyer is looking for the price per share to fall. If
the belief is right in either case, then a profit may occur.
The opposite is true for sellers of options. A call seller hopes that the stock price will remain the
same or fall, and a put seller hopes the price of the stock will rise.
Key Point: Option buyers can profit whether the market rises or falls, the trick is calculating ahead of time which direction
the market will take. If the option becomes more valuable, the buyer can sell the option and take a profit.

If an option buyer—dealing either in calls or in puts—is correct in predicting the price movement in
the stock’s market value, then the action of buying the option will be profitable. Market value is the

price value agreed on by both buyer and seller, and is the common determining factor in the auction
marketplace. However, when it comes to options, you have an additional obstacle besides estimating
the direction of price movement: The change has to take place before the deadline attached to every
option. You might be correct about a stock’s long-term prospects, and as a stockholder you have the
luxury of being able to wait out long-term change. However, this luxury is not available to option
buyers. This is the critical point. Options are finite and, unlike stocks, they cease to exist and lose all
their value within a relatively short period of time—within a few months for every listed option.
(Some long-term options can also be traded and last up to 30 months.) Because of this daunting
limitation to options trading, time is one important factor in determining whether an option trader is
able to earn a profit.
Key Point: It is not enough to accurately predict the direction of a stock’s price movement. For option traders, that
movement has to occur quickly enough for that profit to materialize while the option still exists.

Why does the option’s market value change when the stock’s price moves up or down? The option is
an agreement relating to 100 shares of a specific stock and to a specific price per share.
Consequently, if the buyer’s timing is poor—meaning the stock’s movement doesn’t occur or is not
substantial enough by the deadline—the buyer will not realize a profit. The buyer can sell a
depreciated call and take a loss. But when the stock’s price movement is favorable, the option will
gain value and can be sold at a profit. In either case, the option can be sold at any time.
The option buyer is taking a risk, but a limited one. Most option buyers intend to sell the option
when its price has increased, so that a profit results. Even though the buyer has the right to trade 100
shares of stock, most traders are interested in generating short-term profits. In exchange for this, they
also must be willing to have shortterm but limited losses. The maximum loss can never exceed the
cost of the option.
When you buy a call, it is as though you are saying, “I am willing to pay the price being asked to
acquire a contractual right. That right provides that I may buy 100 shares of stock at the specified
strike price per share, and this right exists to buy those shares at any time between my option purchase
date and the specified deadline.” If the stock’s market price rises above the strike price indicated in
the option agreement, the call becomes more valuable. Imagine that you buy a call option granting you
the right to buy 100 shares at the price of $80 per share. Before the deadline, though, the stock’s

market price rises to $95 per share. As the owner of a call option, you have the right to buy 100
shares at $80, or 15 points below the current market value. This is the purchaser’s advantage in the
scenario described, when market value exceeds the contractual strike price indicated in the call’s


contract. In that instance, you as buyer would have the right to buy 100 shares 15 points below current
market value. You own the right, but you are not obligated to follow through. For example, if your
call granted you the right to buy 100 shares at $80 per share but the stock’s market price fell to $70,
you would not have to buy shares at the strike price of 80; you could elect to take no action. If you
prefer to take profits rather than buying shares, you can also sell the call at an appreciated value and
at any time.
The same scenario applies to buying puts, but with the stock moving in the opposite direction.
When you buy a put, it is as though you are saying, “I am willing to pay the asked price to buy a
contractual right. That right provides that I may sell 100 shares of the specified stock at the indicated
price per share, at any time between my option purchase date and the specified deadline.” If the
stock’s price falls below that level, you will be able to sell 100 shares above current market value.
For example, let’s say that you buy a put option providing you with the right to sell 100 shares at $80
per share. Before the deadline, the stock’s market value falls to $70 per share. As the owner of a put,
you have the right to sell 100 shares at the strike price of 80, which is $10 per share above the current
market value. You own the right, but you are not obligated to sell. For example, if your put granted
you the right to sell 100 shares at $70 but the stock’s market price rose to $85 per share, you would
not be required to sell at the strike price. You could sell at the higher market price, which would be
more profitable. The potential advantage to option buyers is found in the contractual rights that they
acquire. These rights are central to the nature of options, and each option bought or sold is referred to
as a contract. As an alternative, you can also sell the put and take a profit without being required to
trade shares of stock.
Definition
Contract: A single option, the agreement providing the buyer with the terms that option grants. Those terms include
identification of the stock (the ‘underlying’), the type of option (call or put), the date the option will expire, and the fixed price
per share of the stock to be bought or sold under the terms of the option.


The Call Option
A call is the right to buy 100 shares of stock at a fixed strike price at any time between the purchase
of the call and the specified future deadline. This time is limited. As a call buyer, you acquire the
right, and as a call seller, you grant the right of the option to someone else. (See Figure 1.1.)

Figure 1.1: The Call Option

Buyer of a call: When you buy a call, you hope that the stock will rise in value, because that will
result in a corresponding increase in value for the call. This will also create higher market value in
the call, which can be sold and closed at a profit. or you can exercise the option by buying the stock at