Column 3. Getting Started With options

Last week we discussed using an option (a rain check at the supermarket) from our everyday experiences. This week we are going to look at options for which the underlying is stock.

With very few exceptions, the underlying asset for any call or put option is 100 shares of the specified stock.

Strike Prices: (The price at which the option owner can buy or sell the underlying)

Strike prices are available at specific intervals

Every 2 ½ points from 5 through 22 ½ (although sometimes higher)

Every five points from 25 through 200

Every 10 points from 210 and higher

Every stock has at least 2 strike prices. One is above the current stock price, and one is below. If the stock price changes over time, new strike prices are added so that there is always at least one strike price above and at least one below the (then) current stock price.

Expiration months

Some options expire every month. Each stock has four different expirations trading at any one time. Some stocks have 2 additional long-term options, called LEAPS, giving them a total of 6 expirations. For all options, the last day of trading is the third Friday of the specified expiration month. After expiration, the option that just expired is no longer a valid contract and the owner no longer has any rights. On the Monday following expiration, a new expiration month is added. Thus, there are always 4 (6 if the stock has LEAPS) expirations months available.

Standardizaion of options

As a result of being listed on exchanges, options have known strike prices and known expiration dates, and are thus considered to be standardized . Before exchange trading, options were traded in a haphazard manner (through newspaper advertisements) and had random strike prices and expirations

Options exchanges

These puts and call on stocks can be traded on several options exchanges around the world, including those in the United States:

AMEX : American Stock Exchange in NY

CBOE : Chicago Board Options Exchange

PHLX : Philadelphia Stock Exchange

To visit any of these exchanges, click on the link.

Options Clearing Corporation

Exchange trading of options began in 1973 when the CBOE listed options in 16 stocks. The Options Clearing Corporation (OCC) began operations at the same time. In simple terms, the OCC keeps records of who is long (owns) and who is short (has sold without owning) every existing options contract. When an option owner chooses to exercise his option, the OCC verifies the person actually owns the option and has the right to exercise it. Then the OCC randomly selects one of the accounts in which the option has been sold short, and assigns an exercise notice to the owner of that account. The person assigned must either sell to the call exerciser, or buy from the put exerciser, the underlying at the strike price.

Vocabulary : Assignment

As part of our ongoing education in the world of options, we are going to be encountering new words. The new word for today’s discussion is assign or assignment. If you receive an assignment notice, it is your notification that an owner of an option that you are currently short has chosen to exercise his rights and that you have been randomly selected by the OCC as the person who must honor the obligations of the option contract. This means that if the option is question is a call (the call owner has the right to buy), you must sell the underlying to that person for the strike price. If the option is a put (the put owner has the right to sell), then you must buy the underlying for the strike price.

At any time, if you do not remember the definitions of the words in the discussion, please visit the glossary for clarification.

Glossary

You now understand the exercise/ assignment process. Next time we will discuss what you have to do in order to get started trading options.