LEAPS®: Options for the Long Term
 

When considering any options strategy, you may want to think about Long-Term Equity AnticiPation Securities® (LEAPS®) if you are prepared to carry the position for a longer term. While using LEAPS® does not ensure success, having a longer amount of time for your position to work is an attractive feature for many investors. In addition, there are several other factors that make LEAPS® useful in many situations.

Stock Alternative
LEAPS® offer investors an alternative to stock ownership. LEAPS® calls enable investors to benefit from stock price rises while placing less capital at risk than is required to purchase stock. Should a stock price rise to a level above the exercise price of the LEAPS®, the buyer may exercise the option and purchase shares at a price below the current market price. The same investor may sell the LEAPS® calls in the open market for a profit.

Diversification
Investors also use LEAPS® calls to diversify their portfolios. Historically, the stock market has provided investors significant and positive returns over the long term. Few investors purchase shares in each company they follow. A buyer of a LEAPS® call has the right to purchase shares of stock at a specified date and price up to three years in the future. Thus, an investor who makes decisions for the long term can benefit from buying LEAPS® calls.

Hedge
LEAPS® puts provide investors with a means to hedge current stock holdings. Investors should consider purchasing LEAPS® puts if they are concerned with potential price drops on stock that they own. A purchase of a LEAPS® put gives the buyer the right to sell the underlying stock at the strike price up to the option's expiration.

What's the Downside?
If you are a buyer of LEAPS® calls or LEAPS® puts, the risk is limited to the price you paid for the position. If you are an uncovered seller of LEAPS® calls, there is unlimited risk, or a seller of LEAPS® puts, significant risk. Risk varies depending upon the strategy followed, and it is important for an investor to understand fully the risk of each strategy.

Stock Versus LEAPS®
There are many differences between an investment in common stock and an investment in options. Unlike common stock, an option has a limited life. Common stock can be held indefinitely, while every option has an expiration date. If an option is not closed out or exercised prior to its expiration date, it ceases to exist as a financial instrument. As a result, even if an option investor correctly picks the direction the underlying stock will move, unless the investor also correctly selects the time frame that movement will take place, the investor will not profit as desired.

Options investors run the risk of losing their entire investment in a relatively short period of time and with relatively small movements of the underlying stock. Unlike a purchase of common stock for cash, the purchase of an option involves "leverage," whereby the value of the option contract generally will fluctuate by a greater percentage than the value of the underlying interest.

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How LEAPS® Work

LEAPS® are simply long-term options that expire at dates up to 2 years and 8 months in the future, as opposed to shorter-dated options that expire within one year.

LEAPS® grant the buyer the right to buy, in the case of a call, or sell, in the case of a put, shares of a stock at a predetermined price on or before a given date. Equity LEAPS® are American-style options, and therefore may be exercised and settled in stock prior to the expiration date. The expiration date for Equity LEAPS® is the Saturday following the third Friday of the expiration month.

LEAPS® are quoted and traded just like any other exchange listed option. In fact, many of the features of LEAPS® are the same for shorter-term options:

Number of shares covered by the contract (100)

Exercise and assignment procedures

Trading procedures

Margin and commission costs

However, LEAPS® differ from shorter-term options in several ways including availability, pricing, time erosion vs. delta effect, symbols and strategies.

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Availability of LEAPS®

Several factors impact the availability of LEAPS®. When options are listed for trading on a particular stock, most times LEAPS® are not immediately available. After a period of time, and if interest warrants it, the exchanges listing the shorter-term options may decide to list LEAPS® options, after consulting with the market-makers or specialists assigned to trade the stock options. The reason for this is that LEAPS® options are difficult to price because of their long life. The exchanges ensure that sufficient interest is present in the market, and that market-makers or specialists are prepared to price and trade longer-dated options once they are listed. The result is that LEAPS® are not available on every stock which has options traded on it. LEAPS® are initially listed with three strike prices, at the current price and 20 to 25% above and below the price of the underlying stock. Strikes may be added as the underlying stock moves. LEAPS® only have one expiration month: January in two different years.

As LEAPS® draw within one year of their expiration and it becomes necessary to list new LEAPS® series, the existing LEAPS® options continue to be listed and traded until their expiration. However, because of the shorter length of time until expiration, they then trade as ordinary shorter-term options and they lose their distinctive LEAPS® symbols. New LEAPS® options with expiration dates in the future are then added.

In order to determine if LEAPS® are available on a stock that interests you, get a stock/index quote and choose 'Option chains' to see a list of all options for that specific security. LEAPS® account for approximately 10% of all options listed. LEAPS® are proving themselves very attractive to an ever-increasing number of options investors and traders.

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LEAPS® Pricing

Options pricing models contain five factors that are used to determine a theoretical value for an option: stock price, strike price, time to expiration, interest rates (less dividends) and volatility of the underlying stock.

With shorter-term options, it is fairly straightforward to use an interest rate which approximates the "risk-free" interest rate; most people use the U.S. Treasury-bill rate (90-day). However, to price a LEAPS® option, it is necessary to predict the volatility (expectation of price fluctuation) of the underlying stock and interest rates over 2 1/2 years; this is difficult even for most professionals.

In short, pricing longer-term options is more difficult than pricing shorter-term options. Of the five factors mentioned above, interest rates play a more significant role in the pricing of longer-dated options, due to the length of time involved. For these reasons, professionals are not ready to instantly quote prices of options with maturity dates far into the future, since the predictability of the inputs is so much more unreliable than for shorter-term options.

Despite these difficulties, investors will find that exchange policies generally require market-makers and specialists to offer quotations (both bid and offer) for up to 10 contracts. This allows investors to find a market for LEAPS® whenever the decision is made to use them.

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LEAPS® Symbols

In order to differentiate LEAPS® from shorter-dated options, LEAPS® have a different set of symbols for retrieval on quotation systems. While other options have fixed symbols, LEAPS® symbols change to reflect the expiration year.

Motorola (MOT)

This feature makes it easy to distinguish a longer-term option from a shorter-term option in data listings.

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Time Erosion vs. Delta Effect

One of the most challenging aspects of shorter-term options is the erosion of the "time premium" portion of the option's price. Time premium refers to the amount of the option's price that exceeds its intrinsic value. As an option nears its expiration date and the time period shortens, the marketplace is less and less willing to pay any premium over intrinsic value until, at expiration, an option is trading purely for intrinsic value.

As a seller of shorter-term options, time premium erosion works in your favor. Conversely, the option buyer has to overcome the erosion of time premium to make a profit from a long option position. The graph below is a representation of theoretical time erosion for longer-dated options:

Note: The prices presented in this graph are for illustrative and educational purposes only. They do not represent any actual options prices and are not intended to. Options prices on actual stocks may differ significantly from those shown.

As you can see from the graph, time erosion of options premium is not linear (i.e. it does not occur in a straight line). The mathematical reasons for this are complex, but the result is that the erosion of time premium in the earlier months of an option's life is much less dramatic than the erosion that occurs in the last few months. Because of the long time frame of LEAPS® options, this effect is even more pronounced. The time erosion that occurs in the first several months of a LEAPS® option is minimal.

However, when LEAPS® options become shorter-term options (time to expiration is less than one year), they behave like all other shorter-term options, as the graph shows. Time erosion becomes more pronounced and has a greater impact, especially in the last 90 days of the option's life.

What does this mean to options investors? Buyers of LEAPS® options have less time premium erosion to fight than buyers of shorter-dated options. The tradeoff, however, is that LEAPS® options offer less "leverage." The deltas of LEAPS® options will not increase dramatically as with shorter-dated options since there is so much time remaining until expiration. Any increase in option value due to an increase in the price of the underlying stock will be tempered by this lower "gamma" effect.

The slow time erosion will frustrate LEAPS® sellers. However, the premiums available to writers, because of the increased time in LEAPS® options, can provide a good rate of return in covered writing and other strategies.

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LEAPS® Strategies

Buy LEAPS® Calls

An investor anticipates that the price of ZYX stock will rise during the next two years. This investor would like to profit from the increase without having to purchase shares of ZYX.

ZYX is currently trading at 50½ and a ZYX LEAPS® call option, with a two-year expiration and a strike price of 50, is trading for a premium of 8½ or $850 per contract. The investor buys five contracts for a total cost of $4,250, which represents the total risk of the call position. The calls give the investor the right to buy 500 shares of ZYX between now and expiration at $50 per share regardless of how high the price of the stock rises. To be profitable, though, at expiration, the stock must be trading for more than 58½, the total of the option premium (8½) and the strike price of 50. The buyer's maximum loss from this strategy is equal to the total cost of the options or $4,250. The break-even point for this strategy is 58½.

The following are possible outcomes of this strategy at expiration.

Stock above the break-even point
If ZYX advances to 65 at expiration, the LEAPS® will have a value of approximately 15 (the stock price of 65 less the strike price of 50). The investor may choose to exercise the calls and take delivery of the stock at a price of 50, or may sell the LEAPS® calls for a profit.

Stock below the strike price
If ZYX, at expiration, is trading for less than the strike price, or below 50 in this example, the unexercised calls will expire worthless. In this case, the investor will incur the maximum loss of $4,250.

Stock between the strike price and the break-even point
If ZYX, at expiration, has risen to 56, the calls will be valued at approximately 6 (the stock price of 56 less the strike price of 50) and will represent a partial loss given the break-even point of 58½. The calls purchased by the investor for 8½ will, upon exercise, then be worth approximately 6, creating a loss of 2½ points or $250 per contract. If the investor does not exercise or sell these options, the investor will lose all of the initial investment, or $850 per contract.

Prior to expiration, the LEAPS® may trade at a price that is somewhat higher than the difference between the 50 strike price and the actual stock price This difference is due to the remaining time value of the contract and the possibility that the stock price may increase by expiration. Time value is one of the components of an option premium and generally decreases as expiration approaches.

Buy LEAPS® Puts

The purchase of LEAPS® puts to hedge a stock position may provide investors protection against declines in stock prices. This strategy is often compared to purchasing insurance on one's home or car, and may give investors the confidence to remain in the market. The amount of protection provided by the put and the cost of the protection, sometimes evaluated as a percentage of the stock's cost, should be considered.

For example, ZYX is trading at 45 and a ZYX LEAPS® put with a three-year expiration and a strike price of 42½ is selling for 3½ or $350 per contract. These puts provide protection against any price decline below the break-even point, which for this strategy is 39 (strike price less the premium). The investor's risk or maximum loss is limited to the total amount paid for the put options or $350 per contract. The following are possible outcomes of this strategy at expiration.

Stock above the break-even point
If ZYX is trading at 48 at expiration, the unexercised put would generally expire worthless, representing a loss of the option premium or $350 per contract.

Stock below the strike price
The put would be profitable if the stock closed below 39 at expiration. If ZYX is trading at 37½ at expiration, the 42½ put, upon exercise, would have a value of 5 or $500, representing a profit of 1½ points or $150 per contract. This profit will partially offset the decline in the value of the stock.

Stock between the strike price and the break-even point
If ZYX is trading at 41½ at expiration, the 42½ put would be valued at approximately 1. This means that, upon exercise, a portion of the option premium would be retained and the loss would then be 2½ points or $250 per contract. If the contract is not exercised or sold, the investor will lose all of the initial investment, or $350 per contract.

Sell LEAPS® Covered Calls

The covered call, which is selling (writing) a call against stock, is a widely used conservative options strategy. This strategy is utilized to increase the return on the underlying stock and to provide a limited amount of downside protection.

The maximum profit from an out-of-the-money covered call is realized when the stock price, at expiration, is at or above the strike price. The profit is equal to the appreciation in the stock price (the difference between the stock's original purchase price and the strike price of the call) plus the premium received from selling the call.

Investors should be aware of the risks involved in a covered call strategy. Call writers cannot realize additional appreciation in the stock above the strike price since they are obligated, upon assignment, to sell the stock at the call's strike price. The downside protection for the stock provided by the sale of a call is equal to the premium received in selling the option. The covered call writer's position will begin to suffer a loss if the stock price declines by an amount greater than the call premium received.

The following example illustrates a covered call strategy utilizing an out-of-the-money LEAPS® call. ZYX is currently trading at 39½, and a ZYX LEAPS® call option with a two-year expiration and a strike price of 45 is trading at 3¼.

An investor owns 500 shares of ZYX at $39½ per share and sells five of ZYX LEAPS® calls with a strike price of 45 at 3¼ each or a total of $1,625. The investor's objective is to obtain profits without selling the stock. The break-even point for this covered call strategy is 36¼ (the stock price of 39½ less the premium received of 3¼). This represents downside protection of 3¼ points. A loss will be incurred if ZYX declines to below 36¼. Possible outcomes of this strategy at expiration are as follows.

Stock above the strike price
If ZYX advances to 50 at expiration, the covered call writer, upon assignment, will obtain a net profit of $875 per contract (the exercise price of 45 less the price of the stock when the option was sold plus the option premium received of 3¼ X 100).

Stock below the break-even point
If ZYX is trading at 34 at expiration, the unexercised LEAPS® calls would generally expire worthless and the unassigned covered call writer would have a theoretical loss of $1,125 (a present theoretical loss of $2,750 on the stock position less the $1,625 premium received). This investor will incur additional losses in his/her stock position if ZYX continues to decline in value.

Stock between the strike price and the break-even point
If ZYX advances to 40 at expiration, the LEAPS® calls will be out-of-the-money. Therefore, the call writer will generally not be assigned and exercised, and will retain the 500 shares of ZYX and the option premium of 3¼ per share.

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LEAPS® Contract Specifications

Unit of Trade: Generally 100 shares of stock per unadjusted contract.

Premium (Price) Quotations: Stated in points and fractions; one point equals $100. The minimum price change for series trading below 3 is .05 ($5) and for all other series is .10 ($10) per contract.

Exercise: Equity LEAPS® are American-style options. The option may be exercised prior to the expiration date.

Exercise Settlement: A holder that tenders an exercise notice on any business day will receive delivery of the underlying stock on the fifth business day following the date of exercise. The exercise settlement price equals the strike price multiplied by 100 (multiplier) for unadjusted series.

Expiration Cycle: Equity LEAPS® expire in January of each year.

Expiration Date: Expiration occurs on the Saturday following the third Friday of the expiration month.

Position Limits: LEAPS® positions are aggregated with other options with the same underlying asset. Limits vary according to the number of outstanding shares and trading volume. Hedge exemptions may be available. Contact exchanges for details.

Trading System: Market Maker/Designated Primary Market Maker/Lead Market Maker/Specialist/Registered Option Trader (depending on the exchange).

Trading Hours:
8:30 a.m. to 3:02 p.m. (Central Time)
9:30 a.m. to 4:02 p.m. (Eastern Time)

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 Important Note: Option trading entails significant risk and is not appropriate for all investors. Prior to trading options, you must receive from Jaypee International Inc a copy of "Characteristics and Risks of Standardized Options" by clicking on the hyperlink text, and contact us to be approved for option trading.
Content Licensed by the Options Industry Council. All Rights Reserved. The articles in this section are provided by The Options Industry Council and is intended for educational purposes only and does not in any way constitute recommendations or advice from Jaypee International, Inc. Accordingly, Jaypee International, Inc is not responsible for the accuracy, completeness, or correctness of the information provided in these articles. Options involve risk and are not suitable for all investors.
 

Index Options: An Introduction

Benefits of Listed Index Options

Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace.

Diversification
Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the costs and complexities of doing so.

Predetermined Risk for Buyer
Unlike other investments where the risks may have no limit, index options offer a known risk to buyers. An index option buyer absolutely cannot lose more than the price of the option, the premium.

Leverage
Index options can provide leverage. This means an index option buyer can pay a relatively small premium for market exposure in relation to the contract value. An investor can see large percentage gains from relatively small, favorable percentage moves in the underlying index. If the index does not move as anticipated, the buyer's risk is limited to the premium paid. However, because of this leverage, a small adverse move in the market can result in a substantial or complete loss of the buyer's premium. Writers of index options can bear substantially greater, if not unlimited, risk.

Guaranteed Contract Performance
An option holder is able to look to the system created by OCC's Rules and Bylaws (which includes the brokers and Clearing Members involved in a particular option transaction) and to certain funds held by OCC rather than to any particular option writer for performance. Prior to the existence of option exchanges and OCC, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient means of closing out one's position prior to the expiration of the contract.

OCC, as the common clearing entity for all exchange-traded option transactions, resolves these difficulties. Once OCC is satisfied that there are matching orders from a buyer and a seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer. As a result, the seller can buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver cash equal to the exercise amount of the option to OCC. This will in no way affect the right of the original buyer to sell, hold or exercise his option. All premium and settlement payments are made to and paid by OCC.

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What is an Index?
A stock index is a compilation of several stock prices into a single number. Indexes come in various shapes and sizes. Some are broad-based and measure moves in broad, diverse markets. Others are narrow-based and measure more specific industry sectors of the marketplace. Understand that it is not the number of stocks that comprise the average that determine if an index is broad-based or narrow-based, but rather the diversity of the underlying securities and their market coverage. Different stock indexes can be calculated in different ways. Accordingly, even where indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation.

Capitalization-Weighted
An index can be constructed so that weightings are biased toward the securities of larger companies, a method of calculation known as capitalization-weighted. In calculating the index value, the market price of each component security is multiplied by the number of shares outstanding. This will allow a security's size and capitalization to have a greater impact on the value of the index.

Equal Dollar-Weighted
Another type of index is known as equal dollar-weighted and assumes an equal number of shares of each component stock. This index is calculated by establishing an aggregate market value for every component security of the index and then determining the number of shares of each security by dividing this aggregate market value by the current market price of the security. This method of calculation does not give more weight to price changes of the more highly capitalized component securities.

Other Types
An index can also be a simple average: calculated by simply adding up the prices of the securities in the index and dividing by the number of securities, disregarding numbers of shares outstanding. Another type measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.

Adjustments & Accuracy
Securities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer thought to be representative of the types of stocks constituting the index. Securities may also be added to an index from time to time. Adjustments to indexes might be made because of such substitutions or due to the issuance of new stock by a component security. Such adjustments and other similar changes are within the discretion of the publisher of the index and will not ordinarily cause any adjustment in the terms of outstanding index options. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index's composition or method of calculation that, in the panel's determination, may cause significant discontinuity in the index level.

Finally, an equity index will be accurate only to the extent that:

the component securities in the index are being traded

the prices of these securities are being promptly reported

the market prices of these securities, as measured by the index, reflect price movements in the relevant markets.

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Equity vs. Index Options
An equity index option is an option whose underlying instrument is intangible – an equity index. The market value of an index put and call tends to rise and fall in relation to the underlying index. The price of an index call will generally increase as the level of its underlying index increases, and its purchaser has unlimited profit potential tied to the strength of these increases. The price of an index put will generally increase as the level of its underlying index decreases, and its purchaser has substantial profit potential tied to the strength of these decreases.

Pricing Factors
Generally, the factors that affect the price of an index option are the same as those affecting the price of an equity option: value of the underlying instrument (an index in this case), strike price, volatility, time until expiration, interest rates and dividends paid by the component securities.

Underlying Instrument
The underlying instrument of an equity option is a number of shares of a specific stock, usually 100 shares. Cash-settled index options do not relate to a particular number of shares. Rather, the underlying instrument of an index option is usually the value of the underlying index of stocks times a multiplier, which is generally U.S. $100.

Volatility
Indexes, by their nature, are less volatile than their individual component stocks. The up and down movements of component stock prices tend to cancel one another out, lessening the volatility of the index as a whole. However, the volatility of an index can be influenced by factors more general than can affect individual equities. These can range from investors' expectations of changes in inflation, unemployment, interest rates or other economic indicators issued by the government and political for military situations.

Risk
As with an equity option, an index option buyer's risk is limited to the amount of the premium paid for the option. The premium received and kept by the index option writer is the maximum profit a writer can realize from the sale of the option. However, the loss potential from writing an uncovered index option is generally unlimited. Any investor considering writing index options should recognize that there are significant risks involved.

Cash Settlement
The differences between equity and index options occur primarily in the underlying instrument and the method of settlement. Generally, when an index option is exercised by its holder, and when an index option writer is assigned, cash changes hands. Only a representative amount of cash changes hands from the investor who is assigned on a written contract to the investor who exercises his purchased contract. This is known as cash settlement.

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Purchasing Rights
Purchasing an index option does not give the investor the right to purchase or sell all of the stocks that are contained in the underlying index. Because an index is simply an intangible, representative number, you might view the purchase of an index option as buying a value that changes over time as market sentiment and prices fluctuate. An investor purchasing an index option obtains certain rights per the terms of the contract. In general, this includes the right to demand and receive a specified amount of cash from the writer of a contract with the same terms.

Option Classes
Available strike prices, expiration months and the last trading day can vary with each index option class, a term for all option contracts of the same type (call or put) and style (American, European or Capped) that cover the same underlying index. To determine the contract terms for the option class(es) you wish to employ, please contact either the exchange where the option is traded or The Options Industry Council.

Strike Price
The strike price, or exercise price, of a cash-settled option is the basis for determining the amount of cash, if any, that the option holder is entitled to receive upon exercise.

In-the-money, At-the-money, Out-of-the-money
An index call option is in-the-money when its strike price is less than the reported level of the underlying index. It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is greater than that level.

An index put option is in-the-money when its strike price is greater than the reported level of the underlying index. It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is less than that level.

Premium
Premiums for index options are quoted like those for equity options, in dollars and decimal amounts. An index option buyer will generally pay a total of the quoted premium amount multiplied by $100 for the contract. The writer, on the other hand, will receive and keep this amount.

The amount by which an index option is in-the-money is called its intrinsic value. Any amount of premium in excess of intrinsic value is called an option's time value. As with equity options, time value is affected by changes in volatility, time until expiration, interest rates and dividend amounts paid by the component securities of the underlying index.

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Exercise & Assignment
The exercise settlement value is an index value used to calculate how much money will change hands, the exercise settlement amount, when a given index option is exercised, either before or at expiration. The value of every index underlying an option, including the exercise settlement value, is the value of the index as determined by the reporting authority designated by the market where the option is traded. Unless OCC directs otherwise, the value determined by the reporting authority is conclusively presumed to be accurate and deemed to be final for the purpose of calculating the exercise settlement amount.

In order to ensure that an index option is exercised on a particular day before expiration, the holder must notify his brokerage firm before the firm's exercise cut-off time for accepting exercise instructions on that day. On expiration days, the cut-off time for exercise may be different from that for an early exercise (before expiration). Note: Different firms may have different cut-off times for accepting exercise instructions from customers, and those cut-off times may be different for different classes of options. In addition, the cut-off times for index options may be different from those for equity options.

Upon receipt of an exercise notice, OCC will assign it to one or more Clearing Members with short positions in the same series in accordance with its established procedures. The Clearing Member will, in turn, assign one or more of its customers, either randomly or on a first-in first-out basis, who hold short positions in that series. Upon assignment of the exercise notice, the writer of the index option has the obligation to pay this amount of cash. Settlement and the resulting transfer of cash generally occur on the next business day after exercise.

Note: Most firms require their customers to notify the firm of the customer's intention to exercise at expiration, even if an option is in-the-money. You should ask your firm to thoroughly explain its exercise procedures, including any deadline your firm may have for exercise instructions on the last trading day before expiration.

AM & PM Settlement
The exercise settlement values of equity index options are determined by their reporting authorities in a variety of ways. The two most common are: PM settlement – Exercise settlement values are based on the reported level of the index calculated with the last reported prices of the index's component stocks at the close of market hours on the day of exercise.

AM settlement – Exercise settlement values are based on the reported level of the index calculated with the opening prices of the index's component stocks on the day of exercise.

If a particular component security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used.

Investors should be aware that the exercise settlement value of an index option that is derived from the opening prices of the component securities may not be reported for several hours following the opening of trading in those securities. A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported. There could be a substantial divergence between those reported index levels and the reported exercise settlement value.

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American vs. European Exercise
Although equity option contracts generally have only American-style expirations, index options can have either American- or European-style.

In the case of an American-style option, the holder of the option has the right to exercise it on or at any time before its expiration date. Otherwise, the option will expire worthless and cease to exist as a financial instrument. It follows that the writer of an American-style option can be assigned at any time, either when or before the option expires, although early assignment is not always predictable.

A European-style option is one that can only be exercised during a specified period of time prior to its expiration. This period may vary with different classes of index options. Likewise, the writer of a European-style option can be assigned only during this exercise period.

Exercise Settlement
The amount of cash received upon exercise of an index option or when it expires depends on the closing value of the underlying index in comparison to the strike price of the index option. The amount of cash changing hands is called the exercise settlement amount. This amount is calculated as the dif-ference between the strike price of the option and the level of the underlying index reported as its exercise settlement value, in other words, the option's intrinsic value, and is generally multiplied by $100. This calculation applies whether the option is exercised before or at its expiration.

In the case of a call, if the underlying index value is above the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 79.55, the holder of a long call contract with a 78 strike price would exercise and receive $155 [(79.55 – 78) x $100 = $155]. The writer of the option would pay the holder this cash amount.

In the case of a put, if the underlying index value is below the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 74.88 the holder of a long put contract with a 78 strike price would exercise and receive $312 [(78 – 74.88) x $100 = $312]. The writer of the option would pay the holder this cash amount.

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Closing Transactions
As with equity options, an index option writer wishing to close out his position buys a contract with the same terms in the marketplace. In order to avoid assignment and its inherent obligations, the option writer must buy this contract before the close of the market on any given day to avoid notification of assignment on the next business day. To close out a long position, the purchaser of an index option can either sell the contract in the marketplace or exercise it if profitable to do so.

Basic Strategies
The versatility of index options stems from the variety of strategies available to the investor. The most basic uses of index options are explained in the following examples. These examples are based on hypothetical situations and should only be considered as examples of potential trading approaches. Other strategies that might be used with equity options, such as spreads and straddles, can be employed with index options. For more detailed explanations, contact your brokerage firm or the exchanges where index options are traded.

Note: For purposes of illustration, commission and transaction costs, tax considerations and the costs involved in margin accounts have been omitted from the examples in this booklet. These factors will affect a strategy's potential outcome, so always check with your brokerage firm and tax advisor before entering into any of these strategies. For illustrative purposes, the index option positions in all of the following examples are shown to be held until expiration. The premiums are intended to be reasonable, but in reality will not necessarily exist at or prior to expiration for a similar option.

Strategy 1: Buying Index Calls

Market Outlook: Bullish over the short term

Goal: Positioning to profit from an increase in the level of the underlying index

You are anticipating an advance in the broad market or market sector measured by the underlying index in the near future. You want to take an aggressive position that can provide a great deal of leverage. This decision is made with the understanding that there is a possibility you may lose the entire premium you pay for the option.

An index call option gives the purchaser the right to participate in underlying index gains above a predetermined strike price until the option expires. The purchaser of an index call option has unlimited profit potential tied to the strength of advances in the underlying index.

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Scenario

Assume the underlying index that interests you is symbolized as XYZ and is currently at a level of 200. You decide to purchase a 6-month XYZ 205 call for a quoted price of $4.75 per contract. Your net cost for this call is $475 ($4.75 x 100 multiplier). You are risking $475 if the underlying index level is not above the strike price of 205 when the XYZ call expires. The break-even point (BEP) at expiration is an XYZ index level of 209.75 (strike price 205 + premium paid $4.75) because the call will be worth its intrinsic value of $4.75, which is what you originally paid for it. The higher the XYZ index settlement value is above the break-even point at expiration, the greater your profit.

Possible Outcomes at Expiration

1. XYZ index level above the break-even point (209.75):

If at expiration XYZ index has advanced to 215, the XYZ 205 call will be worth its intrinsic value of $10 (settlement value 215 – strike price 205). Your net profit in this case would be $525 (settlement amount $1000 received from exercise – net cost of call $475).

Buy XYZ Index 205 Call at $4.75 with Index at 200
Net Cost for Call = $475

*Exclusive of commissions, transaction costs and taxes.

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2. XYZ index level between strike price (205) and break-even point (209.75):

If at expiration XYZ index has advanced to 207, the XYZ 205 call will be worth its intrinsic value of $2.00 (settlement value 207 – strike price 205). You could exercise the option and receive the settlement amount of $200 ($2.00 intrinsic value x 100 multiplier). This amount would be less than the net amount paid for the call ($475), but it would offset some of that cost. The net loss in this case would be $275 (net cost of call
$475 – settlement amount $200 received from exercise). This loss represents a little more than half of your initial investment.

3. XYZ index level below strike price (205): If at expiration XYZ index has declined to 198, the call would have no value because it is out-of-the-money. You will have lost all of your initial investment, a net of $475. The net premium paid for an index option represents the maximum loss for an option purchaser. Note: No matter how far XYZ declines below the strike price, the loss will not exceed $475.

Strategy 2: Buying Index Puts

Market Outlook: Bearish over the short term

Goal: Positioning to profit from a decrease in the level of the underlying index

You are anticipating a decline in the broad market or market sector measured by the underlying index in the near future. You want to take an aggressive position that can provide a great deal of leverage.

This decision is made with the understanding that there is a possibility you may lose the entire premium you pay for the option.

An index put option gives the purchaser the right to participate in underlying index declines below a predetermined strike price until the option expires. The purchaser of an index put option has substantial profit potential tied to the degree of declines in the underlying index.

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Scenario
Assume the underlying index that interests you is symbolized as XYZ and is currently at a level of 200. You decide to purchase a 6-month XYZ 195 put for a quoted price of $3.90 per contract. Your net cost for this call is $390 ($3.90 x 100 multiplier). You are risking $390 if the underlying index level is not below the strike price of 195 when the XYZ put expires. The break-even point (BEP) at expiration is an XYZ index level of 191.10 (strike price 195–premium paid $3.90) because the put will be worth its intrinsic value of $3.90, which is what you originally paid for it. The lower the XYZ index settlement value is below the break-even point at expiration, the greater your profit.

Possible Outcomes at Expiration

1. XYZ index level below the break-even point (191.10):

If at expiration XYZ index has declined to 185, the XYZ 195 put will be worth its intrinsic value of $10 (strike price 195 – settlement value 185). Your net profit in this case would be $610 (settlement amount $1000 received from exercise – net cost of put $390).

2. XYZ index level between strike price (195) and break-even point (191.10):

If at expiration XYZ index has declined to 193, the XYZ 195 put will be worth its intrinsic value of $2.00 (strike price 195 – settlement value 193). You could exercise the option and receive the settlement amount of $200 ($2.00 intrinsic value x 100 multi-plier). This amount would be less than the net amount paid for the put ($390), but it would offset some of that cost. The net loss in this case would be $190 (net cost of put $390 – settlement amount $200 received from exercise). This loss represents a little less than half of your initial investment.

3. XYZ index level above strike price (195): If at expiration XYZ index has advanced to 202, the put would have no value because it is out-of-the-money. You will have lost all of your initial investment, a net of $390. The net premium paid for an index option represents the maximum loss for an option purchaser. Note: No matter how far XYZ advances above the strike price, the loss will not
exceed $390.

Buy XYZ Index 195 Put at $3.90 with Index at 200
Net Cost for Put = $390

*Exclusive of commissions, transaction costs and taxes.

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 Important Note: Option trading entails significant risk and is not appropriate for all investors. Prior to trading options, you must receive from Jaypee International Inc a copy of "Characteristics and Risks of Standardized Options" by clicking on the hyperlink text, and contact us to be approved for option trading.
Content Licensed by the Options Industry Council. All Rights Reserved. The articles in this section are provided by The Options Industry Council and is intended for educational purposes only and does not in any way constitute recommendations or advice from Jaypee International, Inc. Accordingly, Jaypee International, Inc is not responsible for the accuracy, completeness, or correctness of the information provided in these articles. Options involve risk and are not suitable for all investors.
 

Volatility and the Greeks

Volatility

Volatility can be a very important factor in deciding what kind of options to buy or sell. Volatility shows the investor the range that a stocks price has fluctuated in a certain period. The official mathematical value of volatility is denoted as "the annualized standard deviation of a stocks daily price changes."

There are two types of Volatility: Statistical Volatility and Implied Volatility.

Statistical Volatility - a measure of actual asset price changes over a specific period of time.

Implied Volatility - a measure of how much the "market place" expects asset price to move, for an option price. That is, the volatility that the market itself is implying.

The computation of volatility is a difficult problem for mathematical application.

In the Black-Scholes model, volatility is defined as the annual standard deviation of the stock price. There is a way in which the strategist can let the market compute the volatility for him. This is called using the implied volatility - that is, the volatility that the market itself is implying. This is similar to an efficient market hypothesis. If there is enough trading interest in an option that is close to the money, that option will generally be fairly priced.

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The Black-Scholes Formula

The Black-Scholes formula was the first widely-used model for option pricing. This formula can be used to calculate a theoretical value for an option using current stock prices, expected dividends, the option's strike price, expected interest rates, time to expiration and expected stock volatility. While the Black-Scholes model does not perfectly describe real-world options markets, it is still often used in the valuation and trading of options.

The variables of the Black Scholes formula are:

Stock Price

Strike Price

Time remaining until expiration expressed as a percent of a year

Current risk-free interest rate

Volatility measured by annual standard deviation.

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The Greeks

The Greeks are a collection of statistical values (expressed as percentages) that give the investor a better overall view of how a stock has been performing. These statistical values can be helpful in deciding what options strategies are best to use. The investor should remember that statistics show trends based on past performance. It is not guaranteed that the future performance of the stock will behave according to the historical numbers. These trends can change drastically based on new stock performance.

Beta: a measure of how closely the movement of an individual stock tracks the movement of the entire stock market.

Delta: The Delta is a measure of the relationship between an option price and the underlying stock price. For a call option, a Delta of .50 means a half-point rise in premium for every dollar that the stock goes up. For a put option contract, the premium rises as stock prices fall. As options near expiration, in the money contracts approach a Delta of 1.

Gamma: Sensitivity of Delta to unit change in the underlying. Gamma indicates an absolute change in delta. For example, a Gamma change of 0.150 indicates the delta will increase by 0.150 if the underlying price increases or decreases by 1.0. Results may not be exact due to rounding.

Lambda: A measure of leverage. The expected percent change in the value of an option for a 1 percent change in the value of the underlying product.

Rho: Sensitivity of option value to change in interest rate. Rho indicates the absolute change in option value for a one percent change in the interest rate. For example, a Rho of .060 indicates the option's theoretical value will increase by .060 if the interest rate is decreased by 1.0. Results may not be exact due to rounding.

Theta: Sensitivity of option value to change in time. Theta indicates an absolute change in the option value for a 'one unit' reduction in time to expiration. The Option Calculator assumes 'one unit' of time is 7 days. For example, a theta of -250 indicates the option's theoretical value will change by -.250 if the days to expiration is reduced by 7. Results may not be exact due to rounding. NOTE: 7 day Theta changes to 1 day Theta if days to expiration is 7 or less.

Vega (kappa, omega, tau): Sensitivity of option value to change in volatility. Vega indicates an absolute change in option value for a one percent change in volatility. For example, a Vega of .090 indicates an absolute change in the option's theoretical value will increase by .090 if the volatility percentage is increased by 1.0 or decreased by .090 if the volatility percentage is decreased by 1.0. Results may not be exact due to rounding.

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 Important Note : Option trading entails significant risk and is not appropriate for all investors. Prior to trading options, you must receive from Jaypee International Inc a copy of "Characteristics and Risks of Standardized Options" by clicking on the hyperlink text, and contact us to be approved for option trading.
Content Licensed by the Options Industry Council. All Rights Reserved. The articles in this section are provided by The Options Industry Council and is intended for educational purposes only and does not in any way constitute recommendations or advice from Jaypee International, Inc. Accordingly, Jaypee International, Inc is not responsible for the accuracy, completeness, or correctness of the information provided in these articles. Options involve risk and are not suitable for all investors.