CHAPTER
2

How Options Work

In This Chapter

• Reading option quotes
• Understanding option premiums
• Managing margin through the mark to market
• Moneyness—it’s a thing

Now that you have the basic vocabulary down, it’s time to get into the details of how options work. The contracts have lots of different specifications, and the more you understand about them, the more successful you’ll be.

The exchanges that handle options have different rules, and they sometimes change the specifications of different contracts. It is very important for you to review the rules for each contract with the exchange itself before you begin. Doing so ensures you won’t be surprised if your option doesn’t work quite the way you thought it did.

That being said, there is a lot of common ground with different options and different exchanges. Read on for more information.

Price quotes such as these are known as an options chain or options series. It is the list of all of the options for a particular expiration date.

In the following tables, the strike price is the transaction price at which the option may be executed. The contract name, also called the ticker symbol, starts with the ticker symbol of the stock, the date of expiration, the type of option, and the strike price.

A standard option with the ticker symbol JNJ1721H95-E is broken down as follows:

JNJ An option on Johnson & Johnson

1721H With an expiration on August 21, 2017 (month H, the eighth month of the year and the eighth letter in the alphabet)

95 With a strike price of $95

E European-style

The month of expiration is reported as a letter, as shown in the following table.

Month	Call Expiration	Put Expiration
January	A	M
February	B	N
March	C	O
April	D	P
May	E	Q
June	F	R
July	G	S
August	H	T
September	I	U
October	J	V
November	K	W
December	L	X

As new types of options are developed, the ticker symbols have become longer. For example, a weekly option with the ticker symbol JNJ170612C00095000 is broken down as follows:

JNJ An option on Johnson & Johnson

170612 With an expiration on June 12, 2017

C Is a call option

00095000 And has a strike price of $95

The next columns in the option chain, moving from left to right, show the last trade price, the bid, the ask, the change in price in dollar terms, and then the change in price in percentage terms.

A note on how volume is reported: the volume number shows the number of options traded in units of 100. The option premium shows the price per option, but you have to buy or sell at least 100. Hence, a volume of 2 means options on 200 shares.

Basics of Orders

The options chain shows you all the available contracts and their price quotes. You can choose:

• The contract you want.
• The type of transaction.
• How you want the order to be executed.

Once you find a put or a call with a strike price and expiration that meet your needs, you place the order. The open interest column reports on how many of these contracts are outstanding, and the implied volatility column shows just that—the volatility of the price of the underlying asset based on the current price of the option.

Option Transactions

All of the intricate strategies discussed later in this book use the following four basic transactions to open and close positions:

• A buy-to-open transaction gets you a contract to establish a new long position in a put or a call.
• A sell-to-close order would close out or end an existing long contract.
• A sell-to-open order is used to write a put or a call and to establish a new short position.
• A buy-to-close transaction is used to end an existing short position.

Basic Order Types

An options transaction can be executed several different ways, using specifications the trader sets when the order is placed. Almost all brokerage firms handling options allow all customers to set these basic parameters since they meet the needs of an average investor.

Many of these order types are based on prices:

Market orders Market orders are orders to buy and sell at the best price on the exchange at the time the order is placed. These are the most common type of orders.

Limit orders Limit orders are orders to buy or sell only at a specific price or better (higher for a sell order, lower for a buy order). The broker will only execute the order within this restriction. If you place a limit order on a call option at $6 when the option is trading at $8, and the price calls to $6.01, your order will not be executed. Limit orders help enforce discipline, but they might lead to missed opportunities.

Stop orders Stop orders are orders to buy or sell once an option hits a specific price. These are usually entered to limit losses from a position by ordering an automatic close if a particular price is hit. Not only are stop orders used differently than limit orders, but they also continue to be executed if the stop is hit. If you place a stop order of $6 to close out a call position currently priced at $6.50, it will be executed as soon as the price hits $6, even if the order ends up being filled at a worse price.

Stop-limit orders Stop-limit orders are combinations of stop and limit orders. The order is only executed when the stop price is hit. However, the order is only executed at the limit price or better.

Traders also set time limits on their orders:

• Day orders will be filled the day they are received and are cancelled if they cannot be filled.
• Good ’til date (GTD) orders are in place until the date specified, if they cannot be filled earlier.
• Good ’til cancelled (GTC) orders remain in place until they are filled or until the trader requests it be cancelled.

In addition, a trader can request All or None for the order, meaning all or none of the options in the order are bought or sold at the specifications given. Without that qualification, the trader might receive a partial fill, meaning only part of the order is filled.

Advanced Order Types

Most people who trade options want more control over their orders. That’s why some brokerage firms offer additional types of orders that may prove useful:

Contingent orders Contingent orders are those executed only if the underlying security reaches the specified price. As with stop orders, they will be filled even if the price moves away from the contingent price.

Trailing stop orders Trailing stop orders start out like stop orders. They are orders to buy or sell once an option hits a specific price. Unlike stop orders, they can be set to move with the market to prevent being exercised when it is no longer advantageous to do so. Trailing stop orders are set as a percentage above or below the option’s current market price. If the price moves in a favorable direction, the stop is automatically reset.

One cancels other (OCO) orders OCO orders are two orders placed together that can be used to automatically close positions when a specified profit or loss target is hit. If one order’s stop price is hit, then the other order will be cancelled automatically.

One triggers other (OTO) orders OTO orders are a combination of two orders placed at the same time. When one is executed, so is the other. For example, if a stop order causes one option position to be closed, another can be opened automatically with the OTO order.

Floor Execution

Almost all market markets work electronically these days, but there are a few exceptions. On the Chicago Board Options Exchange, the VIX (options on market volatility) and SPX (options on the S&P 500 Index) still trade in open outcry pits, with actual human beings on the trading floor in Chicago placing orders to buy and sell.

In addition to the VIX and SPX, some exchanges allow very large trades in single-stock options to be executed through the market maker in person rather than electronically. This might allow for less price disruption in both the option and the price of the underlying asset than a series of large orders sent electronically. It is highly unlikely an individual trader would ever need this service. An institution that wants to use open outcry execution can request it through its broker.

Marking to Market and Margin

Options have built-in leverage. That’s good, except the exchange needs to make sure everyone can pay up if necessary when the order to exercise comes around.

You can’t place an options trade unless you have money in your account. This is known as margin, and it is collateral for your obligations, should you have to meet them. The exact percentage varies with the contract in question, and it is a complicated relationship between the proceeds from writing the option, the value of the option, and the likelihood of the option being exercised.

Every evening after the market closes, the options clearinghouse—the organization that manages money for the exchange—will check the value of each account relative to the value of its option position. This is a process called marking to market, and it will determine if there is enough margin to support your position. Depending on whether there is enough margin, one of the following will happen:

• If yes, you are free to continue holding your position into the next trading day.
• If no, you will receive a margin call, which is a demand from your broker for money to deposited in your account. If you can’t come up with the funds, then your position will be sold.

Moneyness

Yes, moneyness is a word—at least in the world of options trading. It is used to describe whether or not an option is in the money—or profitable to exercise—relative to the price of the underlying asset. Moneyness has a few different aspects to it.

An option is said to be in the money if it is profitable to exercise. It is out of the money if it is not profitable. The relationship of the underlying price to the strike price depends on the type of option involved.

In other words, a long call is in the money if the strike price is less than the underlying price. You could make money by exercising the option, taking the underlying asset, and then selling it at a higher price in the market. If the underlying is less than the strike price, then the option is out of the money. Of course, the trader who wrote the option has the opposite situation. The short trader’s option will be out of the money when the price of the underlying asset is greater than the strike price and in the money when the price of the underlying asset is less than the exercise.

The situation is reversed for the put position. Let’s say a put option has a strike price of $35. If the underlying is trading at more than $35, it would not be profitable to exercise, so the long put position would be out of the money. The long put would be in the money if the underlying were to trade at less than $35. For the short put position, an underlying price of more than $35 would mean the option would not be exercised, so the writer could keep the premium. If the underlying price were to go below $35, though, the option would be exercised and the short position would be out of the money.

The following table offers a neat summary of it all.

The Moneyness of an Option

Position	In the Money	Out of the Money
Long call	U > E	U < E
Short call	U < E	U > E
Long put	U < E	U > E
Short put	U > E	U < E

U = underlying price
E = exercise price

If the strike price and the underlying price are the same, then the option is at the money. This is the same whether the option is a put or a call, or whether you are long or short.

Moneyness is not affected by the style of option. Sure, an American option can be exercised at any time, but that doesn’t affect how often it is in, out, or at the money.

Open Interest

Open interest is the total number of outstanding options contracts. For the market as a whole, it is used as a measured of sentiment. It is not the same as the number of options traded because many options trades are made to close out existing positions.

Each trader has his or her own open interest, of course. Brokerage firms may set their limits on how many outstanding contracts an account may have based on the amount of margin in the account and the experience of the trader.

Expiration and Exercise

Options aren’t in place forever. They expire at regular intervals, creating the need for a set of decisions that go beyond simply whether to buy or to sell. The concepts are related, especially because European-style options cannot be exercised until expiration.

Expiration

First, the expiration, sometimes known as the maturity: this is the date on which the option expires. Most options expire on the third Friday of a given month, either in the A.M. or the P.M. However, some high-volume options have expiration dates every Friday. The last time to trade the option is at the close of the market immediately before the option expires. Some options close earlier (the closing time would be specified for the option, so you’d know it before you bought or sold):

• A.M. options stop trading at the close of business on the Thursday before expiration
• P.M. options stop trading at noon Eastern time on the expiration day

Some options are issued on a Monday and close the same Friday. These so-called weeklys take advantage of very short-term moves in the market and they have proven popular.

The option period, also called the time to expiration, is the time period that starts with the creation of an option and ends with its expiration.

If you want to maintain the position at expiration rather than exercise the option, you roll—that is, you close your open position and simultaneously establish a new position at a different strike price or expiration.

Markets tend to be especially volatile on the third Friday in March, June, September, and December. These are the so-called Quadruple Witching Days, when equity options, index options, stock index futures, and single-stock futures contracts expire simultaneously.

Exercise

To exercise is to cash in an option. If you have a call option giving you the right to buy shares of Johnson & Johnson at $100 per share, and the stock is trading at $105, all you have to do is notify your broker that you want to exercise. The exercise happens automatically. Some brokers allow you to turn around and sell the stock immediately, while others require you to wait until the transaction settles.

At expiration, some brokers will automatically exercise any in-the-money (profitable) options you have, and others will not. In almost all cases, automatic exercise is preferable to sending instructions at expiration because everyone forgets important deadlines sometimes.

When it comes time to exercise a given option, the exchange doesn’t go back through the records to find out who sold it. Instead, it assigns the option, more or less at random, to the brokerage firm involved. This means that broker is responsible for exercising the particular option. The brokerage firm will then assign the exercise to one of its customers, usually at random, but brokers might use different methods to make assignment.

By the way, the vast majority of options expire unexercised. You might never receive an assignment.

Delivery and Settlement

Equity options, and some others, call for physical delivery, which means settling an exercised option with the underlying asset. When a call option on common stock is exercised, the writer has to transfer the shares to the option buyer’s account. If the writer does not own the stock already, he or she must buy the shares in the open market. Only the actual shares will settle the deal.

With cash settlement, the person whose option is profitable receives a cash payment from the person on the other side. This is a common feature of index options. The cash settlement value of an index call option at expiration is the difference between the value of the index and the strike price of the call, multiplied by the multiplier on the option. Here’s how that works: suppose an equity index option on the Idiot’s 200 Market Index has a multiplier of $100. At expiration, if the index is trading at 561 and the option has a strike price of 541, the cash settlement would be 561 – 541 = 20; 20 × $100 = $2,000. That’s the amount that will be transferred from the option writer’s account to the option owner’s account.

Some commodity options and futures require cash delivery from most traders but allow physical delivery for customers in the industry involved. The exchanges actually maintain warehouses and grain silos to make physical delivery possible for someone who does not otherwise have access to grain, or gold, or whatever underlying asset was traded.

Extrinsic and Intrinsic Value

Options have two primary sources of value. The intrinsic value is the amount of the option’s price that’s related to the price of the underlying asset. An option has intrinsic value only if it is in the money because it is the amount that you’d receive if you exercised the option. It may well be zero.

Time value, also known as extrinsic value, is the difference between the option’s price and the amount that it is in the money. Here’s the logic: the amount that an option is in the money is the amount you would receive if you exercised it today. It’s the intrinsic value, the hard cash value of the option.

Now, if you’re paying more than the intrinsic value of the option, the option is worth more today than what you’d receive if you exercised it. That means if you wait, you might end up with a larger profit or have more time on the insurance value of the option. The time value explains why people sometimes hold onto options even if they are profitable to exercise today.

Options have both extrinsic value and intrinsic value. The more you understand the components of an option’s price, the better you can value the option relative to your needs. Valuation is covered in more detail in Chapter 5, but for now, all you need to know is that both time value and intrinsic value come into play.

One additional concept here is parity. Parity is the point where an option is in the money but has no time value. Options generally don’t reach parity until just before expiration. Weekly options, on the other hand, have almost no time value.

Relationships Among Options

An underlying asset doesn’t have just one option. It has a whole range of puts and calls, at different expirations and strike prices. Options traders can find a lot of different ways to play an underlying asset, at a lot of different prices and a lot of different payout possibilities. That, in turn, leads to a range of strategies.

These relationships are described by the options cycle, options series, and options chain. Each has its own structure and its own implications for the market.

Options Cycle

The options cycle, also called the expiration cycle, is the traditional schedule of expiration dates for a single option. Most options are written for periods that are multiples of three months, but not all options expire on the same months. The options cycle is the pattern of the months on which options contracts expire.

The following table shows the January cycle (JAJO), which has expirations set for January, April, July, and October.

The following table shows the February cycle (FMAN), which has expirations set for February, May, August, and November.

The following table shows the March cycle (MJSD), which has expirations set for March, June, September, and December.

After March, of course, you go back to options on the January cycle.

Traders can take advantage of the options cycle to buy options for longer time periods in order to increase the likelihood of making a profit from a given expected event.

Although the introduction of new exchanges and new products has meant the introduction of new expiration schedules, many options traders rely on software that’s been programmed based on the traditional schedule, and so it has stuck.

The Least You Need to Know

• The options series gives you a lot of information about prices and trends.
• Orders to buy and sell are placed through brokerage firms.
• At the end of each trading day, profits and losses are noted in each account, a process called mark to market.
• If an option is in the money at expiration, it will be exercised and exchanges for the underlying security, or for cash.