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Options
Q: Are all option contracts based on 100 shares?
A: All options that trade on listed exchanges in the United States are based on 100 shares of stock. Occasionally, there are some exceptions, chiefly when two companies with listed options merge. When this happens and you own an option on one of the companies’ shares, it’s best to check with your broker to see if there are any changes in the option.
Q: When I buy an option, who do I buy it from?
A: On the floor of the exchange are members who are called “market makers.” These professional traders provide liquidity in option trading by risking their own capital for personal trading, and they are the backbone of the option market. They take the opposite side of public orders by competing in an open outcry auction market. When you buy a call, they sell you the call. When you sell a call, they buy the call. They may be acting on their own behalf or they may be acting on behalf of a customer who is willing to take the other side of the trade.
Q: What does it mean to exercise an option?
A: When you buy an option, you have the right to either purchase or sell a stock at a predetermined price. When — and if — you choose to purchase (in the case of call options) or sell stock (in the case of put options) at the predetermined price, you are said to be “exercising your right.”
Q: Since options depreciate in value over time, is it better to buy a nearby option or a longer dated option?
A: The closer an option is to expiration, the less time you will have to be right about the direction and magnitude of a stock’s move and the more rapid the price decay. The decision about what expiration month to use will vary according to your expectations for the stock. Generally, the more time you buy, the more room for error. The flip side of that is that you generally get less leverage, since the longer-term option costs more than a shorter- term option.
Q: What is the contract size of an equity option?
A: The amount of the underlying asset controlled by the options contract. In stocks, it is 100 shares. So an option selling for 3 points would cost you $300 (3 points x $100 per point).
Q: What are the types of orders used to trade options?
A: There are four basic orders for both calls and puts. They are: 1. Buy To Open — The investor or trader buys a call or put option. 2. Sell To Close — The investor or trader sells an existing call or put option to offset or liquidate a prior purchase. 3. Sell To Open — The investor or trader sells a new call or put, without previously owning the position. Selling a call or put can give you unlimited risk and limited profit potential — exactly the opposite situation when purchasing an option. That’s one reason we refrain from recommending this strategy. 4. Buy To Close — The trader buys back a call or put sold short.
Q: How many stock option exchanges are there in the United States?
A:
- American Stock Exchange (AMEX; www.amex.com)
- Chicago Board Options Exchange (CBOE; www.cboe.com)
- International Securities Exchange (ISE; www.iseoptions.com)
- Philadelphia Stock Exchange (PHLX; www.phlx.com)
Q: What is an option’s “open interest”?
A: Open interest is the number of outstanding contracts on a particular option class or series. Open interest increases when an investor initiates a new position. For example, if a trader buys a new call, open interest on that particular option will increase by the number of contracts the trader purchased. Conversely, when an option contract is offset or liquidated, open interest will decline.
Q: Do dividends influence option prices?
A: Investors often rush to purchase a stock just before it’s scheduled to pay dividends. So, following a dividend payout, the value of the stock may fall due to a drop-off in buyers. This can hurt the holder of a call option, but help a put option holder. That’s because the general effect of a dividend payment is to lower the value of a call option and increase the value of a put option on that stock.
Q: When a stock splits, how are options on that stock affected?
A: Options on a stock that splits will be appropriately adjusted by a procedure established by the Option Clearing Corporation (OCC). A simple split, such as 2 for 1, will yield twice as many options at half of the previous strike price. For example, if you own one Aug. ZYX 100 call and the stock splits 2 for 1, you will now hold two Aug. ZYX calls with a strike price of 50. If the split is something like 3 for 2, things get a little more complicated. Example: You have purchased one Oct. ABC 60 call and the stock splits 3 for 2 (or 150 shares for each 100 shares you own; 3/2 = 150), you will now be holding one Oct. ABC 40 call, which represents a contract equal to 150 shares. Splits such as this can cause the usual “100 options in a contract” standard to be adjusted to fit the split.
Q: What will happen to an option if the company spins off one of its divisions?
A: That depends on the terms of the spin-off. After a spin-off, an option will likely represent some combination of the two companies — for example, 50 shares of the parent and 50 shares of the spin-off, or 70 shares of the parent and 30 shares of the spin-off. Another example would be company A that spins off subsidiary B by distributing 1.5 shares of “B” for each share of “A.” Outstanding “A” options could then be adjusted to deliver 100 “A” shares and 150 “B” shares. In any event, it’s best to check with your broker or the exchange your option is listed on to see how it will be adjusted.
Q: Can I trade options on an IPO?
A: No, options are not available when a company has an initial public offering. The earliest you can trade options on a new stock is 3 months after the offering. To become eligible for options, a stock must maintain a minimum average daily share price of $7.50 over the latest 3-month period. There must be at least 7,000,000 shares owned by people other than insiders and there must be at least 2,000 shareholders. Lastly, the trading volume of the underlying stock in the last 12 months must be a minimum of 2,400,000 shares.
Q: What is a “triple-witching” day?
A: Four times a year — on the third Friday of every third month just before the quarter comes to an end — you will hear comments in the media about triple-witching day. On these days, expiration for options, index options, and options on futures contracts all occur simultaneously. Usually, this results in some wild price swings.
Q: What is the VIX Index that I read about in various option articles?
A: VIX is the oldest and best-known measurement of options volatility. It’s the volatility of the stock market as measured by the S&P 100 (OEX) options. This measurement has been the benchmark of market volatility for more than 15 years. With the emergence of Nasdaq stocks over the last few years, a separate volatility measurement index was needed for those stocks — the VXN, a volatility measurement of the Nasdaq-100 (NDX) options using the same methodology as the VIX. Historical data on both indices is available on the CBOE website at: www.cboe.com. When these indices are rising, it’s a sign that investors are nervous. When they are declining, it tends to indicate complacency.
Q: One day, an option will move in “lock step” or move exactly the same with the stock. But another day, it may not. Why?
A: The five variables presented in the previous question explain most of the reason. Plus, options are influenced by the laws of supply and demand. It is not uncommon for options to rise in price as demand increases. Anticipated earnings and news stories also influence option pricing. Follow this example: On Monday, the Boogie Company is trading at 42. The market is expecting some good news. Volatility is at 40. The option is priced at 4¾. On Tuesday, the market finds out that the news was a “non-event” and the stock has not budged. It is still at 42. Volatility has dropped to 20. And the option is now priced at 3 ¼. What changed? Not the price of the stock. All that changed was that volatility, which dropped from 40 to 20.
Q: Can I use options with other investments?
A: Certainly, options can be used to lock in profits, hedge investments and increase portfolio rates of returns. There are dozens of option strategies suited for varied market conditions and objectives. But before you use any of these strategies, we recommend you seek professional guidance.
Q: I heard that most options expire worthless. Is that true?
A: For novice option buyers, it may be true, but we tend to choose options that have favorable risk/rewards. Our option model uses fundamental and technical analysis as well as human judgment. Plus, with options, it is possible to hit a few grand slam home runs which can more than compensate for the strike outs.
Treasuries
Q: What is the difference between a Treasury Bill, a Treasury Note, and a Treasury Bond?
A: T-bills are short-term government debt instruments with maturities of 3, 6 or 12 months. T-notes are longer term government debt instruments with maturities from one to 10 years. T-bonds are government debt instruments with maturities over 10 years.
Q: Treasury-only funds invest in derivatives, right? That makes them risky.
A: No. They do invest in repurchase agreements or “repos” (very short-term loans that are at least 100% collateralized by Treasury securities). And, technically speaking, repos are classified as “derivatives.” But that doesn’t make them risky. Quite to the contrary, the repos bought by Treasury-only funds are in the same safety category as Treasury bills themselves.
Q: Most of my retirement is in a Treasury-only money market fund and a “prime” or a general-purpose money market fund. Since these are not insured, are they absolutely safe?
A: These are money market funds that maintain a $1-per-share value and are similar to a savings deposit at your bank. The Treasury-only money market fund invests strictly in short-term Treasury securities, which are 100% guaranteed by the Treasury Department. However, the same cannot be said for a prime or general purpose money market fund. It holds only a portion of its portfolio in U.S. Treasuries, with the rest of the money in other obligations such as prime commercial paper and foreign bank obligations that are not guaranteed against default.
Q: My banker says a CD is better than a short-term Treasury security because it’s insured. How do you respond to that?
A: Either he’s poorly informed or deliberately trying to mislead. It is widely agreed — by banking and Treasury officials alike — that U.S. Treasury securities are clearly higher on the ladder of relative safety than bank CDs. With a CD, your guarantee is by the FDIC. With Treasuries, it’s by the U.S. Treasury Department — stronger than the FDIC in terms of borrowing power and credit rating. With a CD, your guarantee is limited to $100,000 and wouldn’t even cover accrued interest above that limit. With Treasuries, your guaranteed amount is unlimited. Furthermore, CDs involve a penalty for early withdrawal; Treasuries can be sold at any time with no penalty. Income on CDs is subject to local and state income taxes; income on Treasuries is not. Best of all, despite all these advantages, yields are very similar.
Q: Can U.S. government securities be used as a substitute for Treasury securities? What does it mean to be backed by the “full faith and credit of the U.S. government”?
A: “U.S. government securities” is a broader category than “Treasury securities.” It includes not only securities issued by the U.S. Treasury but also those issued by government agencies, such as Ginnie Mae. Yes, these agencies are implicitly backed by a moral and legal commitment by Congress. But that’s not quite as good as being supported by the Treasury Department itself. A similar distinction holds for money funds. A “government-only” fund invests in Treasury securities plus government agency issues. A “Treasury-only” money fund invests 100% in Treasuries. Assuming there are no derivatives in either one, the differences in safety are hairsplitting right now. But if we have a serious fiscal crisis, we believe the Treasuries are ultimately safer.
Q: My broker has assured me that my Treasuries, which are held in my broker’s name, are safe, even if the firm should fail. That’s because of SIPC insurance, which insures accounts up to $500,000, the SIPC is a branch of the government similar to the FDIC. Is this accurate?
A: The Securities Investor Protection Corporation, or SIPC, is not a government agency. It is a nonprofit, membership corporation, funded by its member securities broker-dealers. If a brokerage firm fails, SIPC oversees the transition as it is sold off to another firm. In a massive industry-wide crisis, however, assets in “street name,” including Treasuries, could be frozen and you could be denied immediate access to your funds. If your Treasuries are short term, there would be no loss. But if they are long-term Treasuries and the market goes down during the freeze period, SIPC would not cover the loss.
Other
Q: What is the difference between debt and equity financing?
A: Companies must raise money to finance their ongoing operations. The two basic methods are debt and equity. With debt, money is borrowed under an agreement to repay over a specific time at a specific interest rate. Equity financing is the selling of an ownership stake in the company.
Q: I’ve heard that the Federal Deposit Insurance Corporation (FDIC) only insures the bank holding company, and not individual depositors. Is that true?
A: Quite the contrary, the FDIC insures depositors, not banks. So you are protected up to $100,000.
Q: My broker and my friends tell me the only stock market strategy that works is the long-term “buy-and-hold” approach. Do you agree?
A: No. To give you an idea of what’s possible, consider the results of a buy-and-hold strategy in 1973: Investors had to wait more than 10 years just to break even. Meanwhile, investors who bought in 1929 had to wait over 25 years — provided they avoided companies that went belly up!
Q: My broker says that if I want safety, I should dump all stocks but the blue chips. Then he wants me to take the proceeds and buy more blue chips. What do you think?
A: This is the worst advice we’ve heard in a long time, and yet it’s the same advice that thousands of brokers and advisers give every day. Even if he believes blue chips will continue to rise, it is still dead wrong to portray them as a “haven of safety.” For true safety, move out of the stock market entirely … and into Treasury bills or equivalent.
Q: What is the difference in risk between “street name” and “book entry” accounts at a brokerage firm?
A: It’s hairsplitting. In street name accounts, the broker holds the certificates; in book entry, the ownership is just recorded in the customers’ account records. But in both situations, if the broker fails and the authorities can’t find a buyer for the firm right away, your securities could be temporarily frozen. There are two ways to avoid this risk: The first is to take possession of the securities yourself, which entails extra costs and exposes you to a different kind of risk — theft, accidental loss, and low liquidity. The second and better solution is to stick with a strong brokerage firm.
Q: Exactly when is the next crash going to take place?
A: A crash is like a volcano. You can see and even measure the forces building up toward an explosion. You know it will happen soon. But no one can pinpoint the exact timing. That’s why we recommend strategies that should do well whether it happens tomorrow or not.
Q: The P/E (price-to-earnings) ratio doesn’t match other quotes that I’ve seen from other sources? Why the discrepancy?
A: You would think that this equation would be identical no matter where you found it, but, in fact, there are several ways to calculate the P/E ratio of a stock or an index. It all depends on which earnings number the calculation uses. Some P/E ratios are calculated using current price and earnings that EXCLUDE so-called extraordinary (one-time) losses. Since losses dilute these earnings, the P/E ratio is lower than it would be if these losses were included. Others prefer to use forward looking earnings estimates against current share prices. As these earnings estimates are very often inflated, the P/E ratio ends up being lower than it would be if current earnings were used. Our calculations, therefore, use the current price and current earnings data supplied by Bloomberg Data.
Q: Can you evaluate my portfolio and tell me which investments I should keep and which to sell?
A: We cannot give individualized advice. As a financial publication, we are constrained by law and the SEC in giving any advice about an individual’s portfolio or financial holdings. We cannot, by law, make recommendations about your specific holdings.
Q: What is the “bid” and “ask”?
A: The bid is the highest price a buyer is willing to pay. The ask is the lowest price a seller is willing to sell at. The difference between bid and ask prices is called the “spread” and is the way market makers earn their living. Bid/Ask 1¼ / 1¾
Q: What is more accurate — the last sale or the closing price?
A: The ask price is a closer measure of how much you will need to pay to buy an option. That’s because the last sale when the option was bought could have been several days earlier and not a reflection of the current position of the underlying stock. Always check the ask price.
Q: What happens to my order after I enter it with my broker?
A: Your order may take many routes depending on your broker and the firm that represents them on the trading floor. If you trade stock options, most likely it will be routed electronically to the CBOE’s Order Routing System (ORS). ORS is a network of communication lines from retail exchange member firms’ computers that collect and route orders to the exchanges’ trading floor, where it will be handled by a floor broker. Some options are traded electronically rather than through open outcry or auction.
Q: I keep hearing option traders talking about the Black and Scholes model. Do I need to know about it?
A: Fisher Black and Myron Scholes were the founders of the Black-Scholes model for pricing an option. The model has five key determinants of an option price: 1. Stock price 2. Strike price 3. Volatility 4. Time of expiration 5. Short-term (risk-free) interest rate. We use a mixture of variations on that model when we present our option ideas to you.
Q: Do I need a full-service broker when I use your services?
A: Since we do most of the work and the research, you may want to shop around for competitive rates.
Q: Explain support and resistance levels. Can you explain….
A: Support is the price level at which demand is presumed to be strong enough to stop the price from decreasing. Resistance is the price level at which selling is presumed to be strong enough to stop the price from increasing.
Q: What should I do with my stock dividends?
A: You have two basic choices:
- Stock distribution (reinvest)
- Cash distribution (live)
Many investors like to take their dividends in the form of additional stock in the company. It’s a disciplined way to build a long-term position over time. You don’t incur brokerage fees. And you benefit from compounding effects.
Now, the goal for many – if not most – of those investors is to maybe one day live off their portfolio. That means taking their dividends in the form of cash they can use to pay day-to-day expenses in retirement.
Please consider: Does it make sense to take cash and then deploy it in pursuit of, say, diversification? Yes, it does. Another consideration is portfolio balance. Does the size of a particular position itself represent increased risk to the overall portfolio?
Always, too, the performance of the underlying company is important. While you may not be at the point of liquidating your position, you may want to re-assert control over how that dividend is allocated.
Q: What happens when a stock splits?
A: All the stock’s attributes, including its dividend, simply get divided by the split factor. For example, a stock that paid a $1-a-share annual dividend would pay $0.50 after a 2-for-1 split. The only immediate benefit of a stock split is that the shares become more affordable for the average investor to buy in round lots (i.e., 100 shares at a time). Effectively, of course, they’re getting the same earnings power and the same dividends for the money they invest.
Q: What is a stock’s “ex-dividend” date?
A: When a company declares a cash dividend — known as the declaration date — it says something like, “This payment will go to shareholders of record as of January 5, 2007.” In other words, to be eligible for the dividend, you must own the stock by that record date. To make record keeping easier, and so that investors are clear on just what they’re getting, the stock exchanges (or the National Association of Securities Dealers, Inc.) set an ex-dividend date for each stock that will be paying an upcoming dividend. This date is generally two or three business days before the record date. If you buy the stock before the ex-dividend date, you’ll get the payment; if you buy it on or after the ex-dividend date, you won’t. By the way, when a stock begins trading ex-dividend, it will be marked with an “x” in the stock listings of your local newspaper.
Q: What do you think about share buybacks?
A: When companies aren’t using cash to repay debt or reinvest in their businesses, they have two other popular options — repurchasing shares or paying dividends. Share buybacks usually result in a lower number of shares outstanding, which means your existing stake in the company gets bigger with zero tax implications. We say “usually” because companies can offset buybacks by issuing new stock to take care of employee stock options. Buybacks can also make some of the stock’s fundamentals look better. For example, per-share earnings would rise (less shares divided by the same amount of profits). But who does this really benefit most? If a company’s management has its bonus plans and other incentives tied to the stock price, the waters start to get cloudy. Sure, shareholders like to see their stock increase in value, but whose best interests are really being served in such cases? One other important note: While companies often announce that large buybacks have been authorized, they don’t always follow through.
Glossary of Terms
American-style Option
“American style” is an option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style.
Cover (in relation to a short sale)
It means eliminating a short position by buying the underlying security.
Derivatives
Some derivatives are speculations or side bets on other investments. Example: Someone could bet you $1,000 that the euro will rise faster than the Japanese yen between now and June. Other derivatives are investments that have been artificially constructed by splitting up bonds into segments, such as the interest portion vs. the principal portion. Some portions or “tranches” are safe; some are risky.
Derivative Security
A derivative is a financial instrument whose value is based on and determined by another security or benchmark. This includes options, futures, interest-rate swaps, and floating-rate notes.
European-style Option
“European style” is an option contract that can only be exercised on the expiration date.
Futures Contracts
A commodity exchange agreement to sell or buy a specific amount of a commodity or security at a specific price and time.
Leverage
In investments, this is the control of a large amount of money by a smaller amount of money. In finance, this is the relationship of debt to equity on a company’s balance sheet. The higher the debt in relation to equity, the more leverage exists.
Market Capitalization
Market capitalization refers to the market value of a company’s outstanding shares. To calculate this figure, take the stock price and multiply it by the number of shares outstanding.
Protective Stop
A protective stop is used to help mitigate the risk of loss in a particular investment. For example, when you own a security, you could place an order with your broker to sell if the security falls below a certain point. In other words, you would use a protective stop to sell the security when its price falls to a point where the expected uptrend is no longer valid. In a short sale, a protective stop is an order to purchase the security when its price rises to a point where the expected downtrend is no longer valid. Note: Placing a protective stop does not guarantee that your order will be filled at the “stop price.” Depending on market conditions, the price your stop order is filled at may vary, either better or worse for you. Still, a protective stop can go a long way in helping you reduce overall risk.
Short Sale
A short sale is the act of selling a borrowed security that the investor does not own in the hopes of buying it back later at a lower price. Consider the following short-selling scenario: Let’s say you believe ABC Corporation, now selling at $50 a share, is going to plunge to $10. Here’s what you could do: First, you borrow 100 shares of ABC and sell it for $50 a share. That puts $5,000 in your account. Then, let’s say ABC falls to $10 a share as you expected. You buy back the 100 shares at $10 a share and return them to the original owner. But all it costs you is $1,000. You still have $4,000 in your account, a very hefty profit. The goal is the same as buying low and selling high — but in reverse. First, you sell high … then you buy low. But if ABC goes up, you lose. However, you can help control that risk by setting a stop-loss. In this case, for example, you could tell your broker to close out the transaction if ABC rises to $60 or more, helping to limit your loss to $1,000.
Technical Analysis
Technical analysis attempts to determine what trend will continue in the future via the examination of supply and demand in a market.
Zero Coupon Bonds
Zeros are created by private firms but are fully based on U.S. government securities. Since the principal and interest of the underlying securities are backed by the full faith and credit of the U.S. government, that guarantee flows through to the owner of the zeros.
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