Series 7

AAA

Derivatives - Calls and Puts


There are two types of options: a calls and puts.

  • Calls will be more familiar to you because the example used in Section 8.2 above to illustrate the whole concept of options involved a call.

    • A call is an option to buy an underlying stock at a specified exercise price, or strike price, within a certain period.

    • This may remind you of the earlier discussion of warrants in the section on equities; however there are differences between a call and a warrant:
      1. First, options are usually sold by parties unrelated to the company, so you need not hold any obligations of that company to buy an option on its stock.

      2. Second, the expiration date - the last day on which the option can be exercised - is typically a year or less on an exchange-traded call, but it can be anywhere from five years to forever on a warrant.

  • Puts are a fascinating piece of financial engineering. It is a way to make money should the price of the underlying stock decline, because it gives the holder the right to sell a stock at a specified strike price within a certain period of time.
    • For example, let's say you think XYZ's stock, now trading at $20, is going down by half in 60 days. You do not currently hold any XYZ stock. You buy a put giving you the right to sell 10,000 shares of it at $18.

      Turns out, you were right about XYZ and its stock does indeed drop to $10. You buy 10,000 shares on the open market at $10 each and sell them for $18 to the party who sold you the put.

      You just made $80,000 ($8 per share times $10,000), minus transaction costs, because a stock which you did not own went down in price.

    • In this example, the put holder did not own the underlying stock. Sometimes puts are purchased by investors who own significant amounts of a company's stock as a protective hedge against a catastrophic drop in share price.

A quick word about these examples: the savvy investor who bought the call in the first case and the put in the second comes away a big winner. The parties who sold those options in both cases look like saps. Derivatives are a zero-sum game with a winner and a loser every time an option is exercised. This game is exceedingly risky for people who do not understand it.


Look Out!
To sum up, there are two types of options: calls and puts.
Options can also be distinguished as follows:
  • Class: Options of the same type on the same stock.
  • Series: Options of the same class with the same strike price and expiration date.

To illustrate: A call on the stock of XYZ and a put on the stock of XYZ are unrelated according to this hierarchy. A call on the stock of XYZ and a call on the stock of ABC are of the same type. A call on the stock of XYZ that can be exercised in January at $20 and another call on the stock of XYZ that can be exercised in February or at $30 would be of the same class, but different series.


Option Writers
The seller of an option is called its writer. An opening transaction occurs whenever a writer sells an option to a buyer. An opening transaction has the effect of creating a long position, in which a party will pay for and receive the option, and an offsetting short position, in which a party takes payment for and writes the option.


Look Out!
Some people define "long" and "short" as the position relative to the underlying securities. That is, some would say the put writer is going long because she is going to pay for and receive shares if the option is exercised. That is not the way the writers of the Series 7 exam see it.
On the test, "long" means you bought the option and "short" means you sold it. Period.


The charge the buyer pays to the writer is called a premium. The amount of the premium varies with the difference between the underlying stock's current market, or spot price, and the option's strike price.


In the above examples, the premium for a $25 call on a $20 stock might be $3 per share, but the premium for an $18 put on that $20 stock might be $1 per share.

Closing Transactions
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