Q:

What is a stock option?

A:

A stock option is a contract that gives the owner the right, but not the obligation, to buy or sell a particular stock at a fixed price (the strike price) for a specific period of time (the expiration date). The contract also obligates the seller or writer to meet the terms of delivery if the contract right is exercised by the owner. For more comprehensive education, take the online, interactive Options Basic class.

Q:

What is a call?

A:

A call is an option contract that gives the owner the right to buy the underlying stock at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For example, an American-style XYZ Corp. July 60 call entitles the buyer to purchase 100 shares of XYZ Corp. common stock at $60 per share at any time prior to the option's expiration date in July. For a call option writer, or seller, the contract represents an obligation to sell the underlying stock if the option is assigned. For more comprehensive education, take the online, interactive Options Basic class.

Q:

What is a put?

A:

A put is an option contract that gives the owner the right to sell the underlying stock at a specified price (its strike price) for a certain, fixed period of time (until its expiration). For example, an XYZ Corp. July 60 put entitles the owner to sell 100 shares of XYZ Corp. common stock at $60 per share at any time prior to the option's expiration date in July. For the writer, or seller, of a put option, the contract represents an obligation to buy the underlying stock from the option owner if the option is assigned. For more comprehensive education, take the online, interactive Options Basic class.

Q:

What do the terms American-style and European-style mean when referring to options?

A:

An American-style option may be exercised at any time prior to its expiration. A European-style option may be exercised only during a specified period before the option expires. Currently, every European-style option is exercisable only on its expiration date.

Currently, all exchange-traded equity options are American-style. Most index options are European-style. I would check each index product that you are interested on trading to verify, among other things, the options exercise style.

Q:

How do LEAPS® differ from conventional options?

A:

LEAPS® or Long-term Equity AnticiPation Securities are options, both calls and puts, with expirations as far out as two and one-half years. Conventional options will typically offer contracts with expirations up to nine months in the future. Currently, equity LEAPS® will have two series at any time with January expirations. For example, in August 2002, LEAPS® for a particular stock might be available with expirations of January 2004 and January 2005. Since equity LEAPS® expire only in January of these years, these LEAPS® will have different options "root symbols" to distinguish one year from another.

For an explanation of LEAPS® cycles, visit our LEAPS® FAQ's.

For information on various strategies using these versatile instruments, see LEAPS®.

Q:

What is an Exchange?

A:

In the financial markets, an exchange refers to a securities exchange where stocks, options and/or futures contracts are traded by members of the exchange or their own accounts and the accounts of their customers. These exchanges are registered with and regulated by the Securities and Exchange Commission (SEC). The five U.S. exchanges that list and trade equity, ETF and index options contracts are:

The American Stock Exchange (AMEX)
The Chicago Board Options Exchange (CBOE)
The International Securities Exchange (ISE)
The Pacific Exchange (PCX)
The Philadelphia Stock Exchange (PHLX)

Q:

What is the Options Disclosure Document?

A:

Known as The Characteristics and Risks of Standardized Options, this booklet has been written to meet the requirements of an SEC rule that requires the U.S. options markets to prepare, and brokerage firms to distribute, a booklet that briefly and generally describes the characteristics of options and the risks to investors of maintaining positions in options. Prior to buying or selling an option, investors must read a copy of this disclosure document. It explains the characteristics and risks of exchange traded options. You may view an online copy of this document in pdf format.

Q:

Can I exercise my right to buy the stock at any time up to the expiration date?

A:

As the holder of an equity call option, you can exercise you right to buy the stock throughout the life of the option up to the exercise cut-off time on the last trading day before expiration. Options exchanges have a cut-off time of 5:30pm, Eastern Standard Time, for receiving an exercise notice. However, most brokerage firms have an earlier cut-off time that should be determined in advance since it may affect when you receive delivery of the stock.

Q:

What is the difference between American-style exercise and European-style exercise?

A:

All standardized equity options use American-style exercise. American-style exercise means that operationally you can exercise your contract any day that the market is open before the expiration date. The last day to exercise an American-style option is usually the third Friday of the month in which the contract expires (expiration Friday). Most index options, however, use European-style exercise. This means that the only time you can operationally exercise your contract is the last trading day (usually Friday) before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration.

Q:

Are all index options European style exercise?

A:

Not all index options are European style, but most index options, it does seem, are European style. For example, the OEX S&P 100 index option is American style. A primary reason that most cash-settled indexes are European style is probably that since there is no actual delivery of the underlying the whole concept of exercise is skewed. (Why exercise an option for cash, when you can sell the option into the market and receive cash?) In addition, early exercise causes serious timing imbalances for combination strategies using cash-settled options.

A second reason might be the mechanics of establishing a settlement price. For an American style index option like the OEX, a settlement price has to be calculated every day and the mechanics of exercise seem to argue for using the closing prices of the component stocks. But back in the 1980's the industry moved toward using the opening prices of the component stocks for calculating final settlement prices in order to reduce the volatility associated with the 'triple witching' phenomenon.

Important to remember: Thursday before Expiration is typically the last trading day for European style index options!

Q:

If I exercise an in-the-money call option, how soon can I sell the stock?

A:

As soon as you tell your broker you would like to exercise your right to buy the stock (strictly speaking, given "irrevocable instructions") you are deemed to be a stock owner. Because of the irrevocable nature of the call exercise, you will be buying the stock at the strike price, and you can sell those shares immediately after giving instructions to exercise.

Q:

If my option closes .05 in-the-money on expiration Friday, what is my likelihood of being assigned?

A:

It may be profitable for an investor to exercise an option that is in-the-money by as little as .05 and the option HOLDER has the right to exercise his contract whether the option is in or out of the money. However, for this example, the option is not in-the-money by The Option Clearing Corporation's (OCC's) automatic exercise threshold, an investor is certainly within his right to instruct their broker to exercise (or not to exercise) their option contract. Investors who do not want to be subject to assignment risk can simply close their expiring position.

Investors should consult with their broker concerning their brokerage firm's exercise policy i.e. what is the firm's automatic exercise policy and the firms deadline to submit exercise instructions?

For more information in regards to OCC's exercise policy, refer to the Characteristics and Risks of Standardized Options.

Q:

What is the risk in selling a covered call at a strike price considerably higher than the stock price at the time I wrote the call? If the option is exercised, I will profit from the call premium plus the difference between the stock purchase price and the strike price. It seems to me that the only risk is less profit if the call is exercised. What am I missing?

A:

Whenever you write a covered call, you first have to decide that you would be happy to lose the stock at the net effective sale price (NESP= call strike price plus call premium). If NESP does not provide you with the profit you anticipated when you first acquired the stock, you probably should not write the call. Keep in mind that writing a deep out-of-the-money call (or, as you stated, "a call at a strike price considerably higher than the stock price") may offer very little premium. You will want to ask yourself if the net premium, after the transaction costs, is enough to justify the transaction. There is a rule of thumb often employed by many covered call writers: the potential return, if the stock is called, should be about twice the risk-free (Treasury bill) rate. As an example, if a 60-day Treasury yields 5% per annum, a two-month covered call write should produce an annualized 10% return.

A corollary is that the return engendered by the covered write should at least equal the risk-rate if the stock remains static. Another guideline regarding premium is that the downside protection gained by call writing should at least equal 3% of the stock's current market price.

Q:

I sold a naked call and then bought the same call. Is my naked call now covered?

A:

Generally, if someone purchases the same call that was sold, it's likely that the two transactions would be matched as opening and closing transactions and the position would be eliminated. While not common, there may be some strategies where an investor wishes to remain long and short on the same contract. If this is the case, the naked margin requirement would be eliminated, but the position still bears the risk assignment on the short call option.

Q:

I am working on a project involving American options. I would like to obtain information about a trading strategy that involves: buying an American put option and selling simultaneously the same American put option. Is this trading strategy feasible? Are the two trades offset, or does both a long and a short position appear in my account if I engage in the above trading strategy?

The motivation for buying and simultaneously selling the same American put option is that as a buyer I can use an optimal exercise policy for the American put option and then expect as a seller that someone has a sub-optimal exercise policy. I profit from this trading strategy if I am "lucky" to be chosen to buy the underlying asset when an agent who bought an American put option exercises the option sub-optimally.

A:

First of all, if you simultaneously buy an option and sell the same option you will have a flat position with regard to that option. Of course, if you did the trades in different accounts or with different brokers the positions would not offset, but since you would be simultaneously long and short the same asset, from a strictly economic point of view you would still be flat. The simultaneous purchase and sale of identical securities on behalf of the same entity could be considered a manipulation of the market and in violation of various rules and regulations.

Secondly, you would have to enter into the trade. If you bought the ask and sold the bid, you would already be behind by the bid/ask spread. Putting out a bid between the existing bid/ask and then trying to hit your own bid with a sell order, assuming that there is no change of beneficial ownership, is definitely a violation of the rules.

Lastly, exercising your long put when it is optimal means entering into a short sale and earning interest. This means that your risk/reward profile would have changed radically, and if the stock should suddenly rally that position could suffer significant losses. And of course the whole profitability of the strategy involves earning interest on the proceeds of the short sale ¹ how much of the interest earned does your broker rebate to you?

Q:

Can I perform a spread by purchasing an at the money LEAPS call , and selling a front month out of the money call?

A:

Yes, the strategy you described is also known as a "diagonal call spread." When considering implementing this strategy, you should be aware of the risks associated with the strategy, along with the (potential) rewards. In the worst case scenario, should you be assigned on the front month call and then exercise your LEAPS to cover the assignment, your loss would be the net debit paid to establish the position less the difference between the strike prices of the two options.

It is more difficult to establish a maximum gain for this strategy, which in many ways resembles the Covered Call. The best case scenario is for the stock to go sideways or gradually rise over the life of the LEAPS call, thus allowing you to roll out your front-month option every month at a credit. Review the various LEAPS strategies, including spreads in the LEAPS section of The Option Industry Council's (OIC) Learning Center.

Q:

What is the difference between a Call and a Put - and why does my broker tell me that I can't sell a Put when I'm long the stock?

A:

An equity option is a contract. The call contract conveys to its holder the right, but not the obligation, to buy shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). The put contract conveys to its holder the right, but not the obligation, to sell shares of the underlying security at the strike price on or before a given date (expiration day). After this given expiration date, the option contract ceases to exist. If assigned, the seller of an option is, in turn, obligated to sell (in the case a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price.

In the case of a covered call, the investor sells a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If an investor is assigned an exercise notice on the written contract he/she sells an equivalent number of shares at the call's strike price.

As for why your broker might have concerns about selling a put option while long the underlying stock, if the investor is assigned an exercise notice on the written contract he/she buys an equivalent number of shares at the put's strike price, effectively getting "longer" the underlying stock.

Q:

I understand that there are discrepancies in options pricing between puts and calls and among the different expirations. Sometimes front months trade at much higher volatility levels and at other times the higher volatility is in the back months. But it is not clear to me how to benefit or to take advantage of this situation. For how long do these discrepancies exist, and where can I learn more about them?

A:

It would be more appropriate to say that there are different levels of volatility and costs of carry for puts and calls and for different strikes and expirations. But this complexity is not artificial, it reflects actual differences in the factors that influence an options' price. For example, most options pricing modes are based on the Normal Distribution Function -- but stocks tend to deviate slightly from the Normal model, and traders compensate by tweaking the volatilities (skew) that they input into their model. In the case of puts and calls, the cost of carry tends to push calls to a premium and puts to a discount -- but the early-exercise feature prevents puts from falling below their intrinsic value, which distorts the put-call parity that would exist for European-style options.

Traders can and do take positions that benefit from changes in cost of carry, volatility skew, etc. But it's very difficult to calibrate such positions, and it generally requires making quite a few trades. So these types of strategies are usually only suitable for full-time investors who have very low marginal trading costs (although they often have high fixed costs, such as exchange memberships).

Q:

Do I need to hold my option until expiration when it turns profitable. If my option has increased in value but, still has time value, lets say two or three months, is it such a bad idea to close the position and collect a profit?

A:

In general, whether or not to hold a profitable position would depend on your outlook for the underlying stock and your risk/reward preference. If you think that the stock has experienced most or all of its anticipated move, you might want to close out your position and take the profit. If you think the underlying stock has a lot further to go, for even more profit, you might want to let your profits ride (and take the risk of a reversal in stock direction). And if you think the stock has further to go but want to take some money off the table, you might want to sell your options, or a portion of the position. One might even consider then buying some with a more distant strike, thereby earning a credit on the spread.

Q:

What are the advantages of "vertical spreads"? And, are there any disadvantages? (Submitted 5/03)

A:

One advantage is knowing what the risks and rewards are for that position. The vertical spread consists of buying one option and selling another with a different strike but both expiring in the same month.

Another advantage of a vertical spread versus a single option position is that it is possible to put a cap on the amount of risk the option writer (seller) assumes, and decrease the costs of the purchase if you are an option buyer.

Disadvantage(s):

One obvious disadvantage is that while limiting risk, the investor also sets a limit on their profit. So, the investor would put a cap on profit potential. Also, the investor should be aware that commissions and interest charges can effect the profitability of all spread strategies. It is suggested that the investor consult a tax advisor concerning the tax consequences of any spread strategy. Further, there are occasions where certain types of corporate actions may impact the profit/loss profile of a spread. Extraordinary dividends, tender offers and even mergers can alter the dynamics of a spread.

Q:

Why didn't my option move as much as the underlying stock?

A:

Options will not move as much as their underlying stock unless they are in-the-money and/or very close to expiration. There are valid mathematical reasons for this. The amount an option can be expected to move (all other conditions being equal) given a 1-point move in the underlying stock is called delta. Delta is derived from the Black-Scholes formula for pricing options and represents roughly how much the option behaves like the underlying stock. A delta of .50, for example, means that an option can be expected (all other things being equal) to move about fifty cents for every $1 move in the underlying stock. Delta will change with time to expiration as the option moves more in- or out-of-the-money, and will also be affected by the volatility of the underlying stock.

Q:

When an underling security (e.g. QQQ) is up (e.g. +1.36), why do some call options actually fall in value for the day?

A:

There are 6 inputs that determine an option's value: stock price, strike price, time to expiration, interest rate, dividend yield and volatility (over the life of the option). Normally, if the stock price goes up and the other factors remain the same then a call option also goes higher. So if the call option has gone down, then one of the other factors must have changed.

The passage of time can certainly push an option's value lower, although sometimes it can have the opposite effect. A dividend payment will also have an impact. But the real wild card is volatility. Sometimes, the market will bid up the volatility in anticipation of a market-moving event such as earnings release or a major speech by a Very Important Person. After the event, the volatility often drops sharply, especially if the event failed to have the expected impact.

§                       There is a calculator on our web site that is very helpful for making these types of comparisons.

• There is also a free, online, Options Pricing Course that you may take.

Q:

I'm curious why when interest rates rise, option prices also rise? This seems odd since stock prices drop in this situation.

A:

We believe you are asking why a CALL option price rises when interest rates rise. That is because options are priced on a risk-neutral basis, i.e. on a delta-neutral or fully hedged basis. So a long call would be paired with a short-stock, and a short-stock position generates interest revenue. That makes the call option worth more. If interest rates go up, the interest revenue from the short stock position increases, which makes the call worth still more. Note that for put options it works the opposite way. Dividends also work in the opposite direction.

A stock's value is equal (theoretically) to the present value of all its future dividends, so an increase in the interest rate used to discount the future dividends will reduce the value of the stock. When someone says higher interest rates make call options worth more, there is an implicit assumption of ALL OTHER THINGS BEING EQUAL. As a practical matter, all other things are rarely equal, and the decline in a stock's price due to an interest rate increase will often overwhelm the effect of the higher interest rate on the option itself.

Q:

I am a new investor and I'm interested in trading options. I have spent about six months studying chart patterns (Japanese candlesticks). My question is: What is the correlation between options and the candlesticks? Secondly, will it help me in option trading?

A:

"Candlesticks" is a charting technique used in trying to predict the future behavior of the market, and as such really doesn't have anything directly to do with options. However, if the charting technique allows you to successfully forecast market movement for an underlying, then options could prove to be very valuable when implementing various strategies. To that extent, we offer a wonderful educational software program that illustrates over 40 different option strategies.

Q:

Recently It seems that option prices have been out of line (with intrinsic value, underling security, etc.) Why?

A:

The price of an option is really a function of "the market" -- buyers and sellers. In other words, when more people want to own an option, there may be a rise in the price as the forces of supply and demand become more pronounced. In times of large market movement the secondary markets may experience some increased volatility. To view the various components of option pricing, in addition to supply and demand, please visit Options Pricing.

Q:

What does the term "triple witching hour" mean?

A:

Triple witching is the third Friday of March, June, September and December, when options, index futures, and options on index futures expire concurrently. Massive trades in options and underlying stocks by hedge strategists and arbitrageurs can cause above average volume and added market volatility.
Derivative contracts based on stock indices do not generally involve the actual exchange of any underlying security, but rather are cash-settled based on some fair market value at a specified time. Many arbitrage strategies involve simultaneous, offsetting transactions in a basket of stocks representing an index and a derivatives contract on the index. When the derivatives contract reaches expiration, the usual practice is to buy or sell the basket of stocks at the exact price used for cash-settling the derivatives contract.

In the early 1980's when organized futures and options exchanges began trading standardized contracts based on stock indices, that final value of those indices for cash-settlement purposes was usually the close of trading on the third Friday of the month. Every month there is an expiration on options and options on the futures. But expiration of the futures, where a large proportion of the arbitrage activity takes place, only occurs once a quarter. So on the third Friday of the last month of each quarter, stock exchanges would be deluged with orders to buy or sell huge quantities of stock at exactly the closing price used for cash-settling the derivatives contracts. This combined expiration of options, futures and options on futures came to be known as the Triple Witching Hour.

Because these arbitrage strategies were market-neutral, simply taking advantage of price discrepancies between the index and derivatives on the index, they didn't represent any real opinion on the market's direction. But unwinding only one side of the strategy with a market order and letting the other side cash-settle sometimes caused huge gyrations in the markets during the final hour of trading on the third Friday of that month.

Eventually, many of these expiring contracts switched from using Friday's closing price to using the opening price or trading range for each of the component stocks in determining their settlement values. This lessened the pressure for immediate execution at any price, and allowed the possibility of delayed openings for order imbalances at exchanges that have such procedures in place. So while the triple expiration of options, futures and options on futures can still have an impact on how the market opens on that day, the kinds of gyrations that routinely occurred in those early days is rarely observed today.

Q:

Why do options expire on the third Friday of the month?

A:

Technically speaking, standardized options expire on the Saturday following the third Friday of the month. The reason that equity and index options expire on this day is due to the fact that this day offers the least number of scheduling conflicts, i.e. holidays. See expiration calendar.

Q:

I want to set a stop-loss order on my option position. Should I use the stock price or the option price as the "trigger" to set the stop-loss order?

A:

It is a matter of personal preference. Most exchanges allow stop-loss orders in options; however, most brokerage firms do not allow them for various reasons. Stop-loss orders are a way of attempting to limit your losses on an investment once that investment goes a certain amount in the "wrong" direction. Generally, most people who set stop-loss orders use the actual price of the investment (in this case the option price) for the "trigger" which decides when to liquidate a losing position. On the other hand, some people use options to execute a strategy based on technical analysis of the underlying stock. For example, an investor might feel that a certain chart pattern in a stock makes him believe that the stock is due for a rally. To "monetize" that opinion, the investor buys calls. He may then believe that if the stock instead drops to a certain price, that bullish opinion is no longer warranted, and he would not want to be "long" anymore. In this case, the investor might prefer to use the stock price as the trigger for the stop-loss order. As always, check with your broker to see if he accepts these types of orders. Once "triggered," the stop order can be of two different types: a market order or a limit order. This is another decision for you. Again, personal preferences would rule; there is no better or worse choice.

Q:

Is it true that when executing buy-write order(s), there needs to be two orders and that both are executed at the ASK price?

A:

The short answer is an unequivocal "maybe". It's possible that with a multi-part order (such as a buy-write) that the options part of the trade MIGHT occur at the ask price, but there is no guarantee. When traders enter buy-writes, they are usually entered on a single ticket, for a "Net Debit". In this case, the prices received for the call, and paid for the stock matter only in the sense that the net dollars spent should not exceed the (debit) limit. For further information regarding buy-writes, review our new on-line Covered Call class.

Q:

Who sets the width between the bid-ask on the options exchanges?

A:

Basically, anyone who trades does! However, there are rules on each exchange regarding the maximum width that those quotes may be. Generally speaking, the maximum bid/ask differentials are the same at the exchanges that trade options. Please be aware that there are occasions and market situations on the various trading floors that may necessitate the maximum bid ask differentials can be modified or waived.

The 5 US options exchanges that list options have rules that specify the maximum bid ask differentials in option contracts. The members of these exchanges are are obligated, under normal circumstances, to honor their displayed quote for a minimum number of contracts. The number of contracts can vary, depending on the stock or index in question, but it is usually at least 10 contracts, and in many circumstances could be 20, 50 or even 250 contracts!

For example, if a stock offered 8 different strikes per month, you could say that there are 64 different contracts available (8 calls, 8 puts and four expiration months)!

You quickly realize the amount of capital these ladies and gentleman are willing to risk at any time. Then, multiply this number of strikes by 10 (most of these specialists/market makers work between 10-15 different stocks) and you can see the daunting task these traders have.

Q:

How does open interest affect my order? Should there be a certain amount of open interest to execute the trade? If not, what is open interest telling us? I have 8,500 shares of XYZ. If I were to write 85 contracts, do I get filled at the bid or ask?

A:

We doubt that open interest will have any affect on the execution of your order. Open interest is simply the number of outstanding contracts; it expands and contracts as investors and traders open and close positions. If you enter a market sell order, you will be filled at the best available bid price -- if the quantity at that bid price is less than your order size, then you'll sell the number of contracts on that bid and the balance of your order at the next-best bid price, and so on and so forth.

The impact of selling 85 call contracts will probably have a similar effect to that of selling 8,500 shares, so if you feel the market would have problems digesting that many shares then it might be appropriate to spread that quantity out over the course of the trading day. In any case, if you're worried about the price you would receive upon entering a market order, you might consider the use of a limit order, where the limit is the lowest price you would be willing to accept.

Q:

I was assigned on my March 40 put option when the stock value went below $38, even though it wasn't expiration. On another stock, I had a covered write position where I was short a 70 call which went in-the-money by $7, and the call wasn't assigned until expiration day. How can I tell when I will be assigned?

A:

The short answer is that you can never tell when you will be assigned. Once you sell an option (put or call), you have the potential for being assigned to fulfill your obligation to receive (and pay for) or deliver (and get paid for) shares of stock on any business day. In some circumstances, you may be assigned on a short option position while the underlying shares are halted for trading, or perhaps while they are the subjects of a buyout or takeover. To ensure fairness in the distribution of equity and index option assignments, The Options Clearing Corporation utilizes a random procedure to assign exercise notices to the accounts maintained with OCC by each Clearing Member. The assigned firm must then use an exchange approved method (usually a random process or the "first-in, first-out" method) to allocate those notices to accounts which are short the options.

Having said that, there are some generalizations which might help you understand when you might be more likely to be assigned on a short-option position.

Only about 10% of options end up being exercised; the percentage hasn't varied much over the years. That does not mean that you can only be assigned on 10% of your short option, however. It means that, in general, option exercises are not that common.

The majority of option exercises (and the corresponding assignments) take place as the option gets closer to expiration. Without getting into the math too much, it usually doesn't make sense to exercise an option, which has any time premium over intrinsic value. For most options, that doesn't occur until close to expiration.

In general terms, a put which goes in-the-money is more likely to be exercised than a call which goes in-the-money. Why? Think about the result of an exercise. An investor who exercises a put uses it to sell shares and receive cash. A person exercising a call option uses it to buy shares and must pay cash. People are more likely to exercise options if it means they can receive cash sooner. The opposite is true for calls, where exercise means you have to pay cash sooner.

The bottom line is that you really don't have any sure-fire way to predict when you will be assigned on a short option position; it can happen any day the stock market is open for trading.

Q:

How could I be assigned if my covered calls are in-the-money?

A:

The option holder has the right to exercise his or her options position prior to expiration regardless of whether the options are in- or out-of-the-money. You can be assigned if an investor or market professional holding calls of the same series as your short position submits an exercise notice to his or her brokerage firms, which in turn, submitted an exercise notice to The Options Clearing Corporation (OCC) (or if the brokerage firm is not an OCC Clearing Member, then it would submit the notice to a firm that is an OCC Clearing Member, and that Member would then submit the notice to OCC). OCC randomly assigns exercise notices to Clearing Members in whose accounts have short positions of the same series. The Clearing Member then assigns the exercise to one of its short positions using a fair assignment method, though not necessarily random. You should ask your brokerage firm how it assigns exercise notices to its customers.

Q:

If I am short a call option (on a covered write) and I buy back my short call, is it possible for me to be assigned (and the stock position to be called away) that night?

A:

No, it is not possible. The assignments are determined based on net positions after the close of the market each day. Therefore, if you bought back your short call, you no longer have a short position at the end of the day, and therefore no possibility of being assigned.

Q:

I sold short 10 options contracts recently. Unfortunately, I was assigned early on each contract, one at a time. Couldn't all the contracts have been assigned at once?

A:

The exercise of an option prior to expiration is solely at the discretion of the buyer. The option buyer can also decide how many contracts in a multi-contract position to exercise at a given time. Once an exercise notice is tendered, The Options Clearing Corporation randomly selects for assignment a member brokerage firm carrying a short position in that series. The brokerage firm may, in turn, assign the notice randomly, or on a "first-in, first-out" basis. Regardless of what method is applied by the brokerage firm, equity options writers are subject to the risk each day that some or all of their short options may be assigned.

Q:

What time each day does the Clearing Firm receive information regarding assignments etc... from OCC?

A:

OCC's Clearing Members can submit exercise notices, on a daily basis, up to 7:00 PM Central Time, and in general each Clearing Member will establish its own (earlier) deadline for its customers. (There is a different set of procedures for expiring options.) As part of its nightly processing, OCC randomly assigns its Clearing Members based on the days exercises. This processing is completed at approximately 1:00 AM Central Time. OCC transmits the assignments to its Clearing Members and as part of the Member's nightly processing, they allocate the assignments to their customers on either a random basis or a first in - first out basis.

We understand the exchanges' rules are that customers should be notified of assignments in a timely manner. It is best that you and your broker determine what constitutes ‘timely manner' beforehand: Does ‘timely manner' mean a call the morning of the assignment? Is there an update to your account that you can view online? Will you receive a letter in the mail?

For expirations, OCC process all exercise/assignments on Saturday. OCC's processing is completed and transmitted to its Clearing Members late Saturday night. Clearing Members will process expiration exercises and assignments on Sunday and then notify their customers the next business day. Once again, you can probably get an approximation from your broker.

Q:

I recently wrote a call option. At the market close of expiration Friday, the stock was .41 cents in-the-money. I know that calls are automatically assigned when they are at least .75. cents in the money. Is there is a way that I can avoid being assigned?

A:

The Option Clearing Corporation's auto exercise threshold is 75 cents (.75) in the customer account. The automatic exercise threshold in firm and market maker accounts is 25 cents (.25). An option holder has the right to exercise their option regardless of the price of the underlying security. Is there a magic number that ensures that option writers will not be assigned? The answer would be 'NO'. Although unlikely, an investor may choose to exercise a slightly out of the money option or choose not to exercise an option that is in the money by greater than .75 cents A good rule of thumb might be, "when in doubt, close them out". This would ensure not being assigned on a contract that was barely in or out of the money.

Q:

What are cycles? And how are they affected when LEAPS® are listed?

A:

Options on a given stock are listed according to one of the following expiration cycles:

At any given time, there will normally be four different expiration months trading on a particular stock. All stocks will have options listed for the two upcoming expiration months along with two months from their expiration cycle. The table below illustrates the months listed for each cycle throughout the year, beginning on the first day of the year. The most recently listed months are highlighted in blue.

at start of calendar year...

the above months are listed

after January expires...

September is added to cycle 3

after February expires...

October is added to cycle 1

after March expires...

November is added to cycle 2

after April expires...

December is added to cycle 3

after May expires...

January is added to cycle 1

after June expires...

February is added to cycle 2

after July expires...

March is added to cycle 3

after August expires...

April is added to cycle 1

after September expires...

May is added to cycle 2

after October expires...

June is added to cycle 3

after November expires...

July is added to cycle 1

after December expires...

Q:

When are the exchanges going to list 2006 LEAPS®?

A:

Notice that January expirations for cycle 1 are normally listed after the May options expire. Since January 2004 LEAPS® are already trading, the following schedule is used to introduce a new series of LEAPS®:

Cycle 1:

Monday, May 12: January 2004 LEAPS® meld*.

Monday, May 19: Regular January Cycle 1 expirations listed

Tuesday, May 27: January 2006 LEAPS® listed

Cycle 2:

Monday, June 16: January 2004 LEAPS® meld*.

Monday, June 23: February expirations listed

Monday, June 30: January 2006 LEAPS® listed

Cycle 3:

Monday, July 14: January 2004 LEAPS® meld*.

Monday, July 21: March expirations listed

Monday, July 28: January 2006 LEAPS® listed

Please note that for cycle 2 and cycle 3 options, after the new LEAPS® have been listed there will be an extra month available (2 short-term expirations, 2 cycle expirations, 2 LEAPS® expirations, AND the January expiration that was originally a LEAPS®)

* To meld: change the symbol on a LEAPS® option to that of a µnormalã option. The terms of the option itself do not change.

Q:

Where can I find information on LEAPS® options and various strategies based on LEAPS®?

A:

See LEAPS®

Q:

What happens if I am short calls in the stock of a company which is subsequently taken over before the expiration date?

A:

Corporate actions such as mergers, acquisitions and spin-offs will often necessitate a change to the amount or name of security that is deliverable under the terms of the contract. When such adjustments occur, the short call position is responsible for delivering the adjusted security.

For example: The shareholders of company JKL Inc. have approved a takeover bid placed by Global Giant Co. As a result, holders of JKL stock will now be entitled to a 1/2 share of Global Giant for every share of JKL Inc. they own. Therefore, holders of JKL call options will now be entitled to a deliverable amount of 50 shares of Global Giant for every contract of JKL that they are long (100 shares per contract x .5 Global Giant). Investors with short positions in JKL call options would then be responsible for delivering 50 shares of Global Giant for every call option assigned.

For the sake of this example, a simple conversion ratio was used, though not all corporate actions result in such clearly defined terms. Often assignment will require the short position to deliver fractional shares plus cash equivalent. An adjustment panel consisting of representatives of the listing options exchanges and OCC (who only votes in case of a tie) makes a determination whether to adjust an option as a result of a particular corporate action by applying general adjustment rules. Again, whatever the terms, the short position has the potential obligation of delivering the adjusted underlying.

Q:

What happens with my options contracts when a company is delisted from an options exchange?

A:

If a stock fails to maintain the minimum standards for price, trading volume and float prescribed by the options exchange, option trading can be wound down even before the stock is delisted by its primary market. In that case, no new series would be added at expiration. Trading in existing series would continue until they go "off the board". If trading in the underlying stock is suspended by its primary market for an extraordinary reason before the expiration of outstanding options, the options exchange will specify a procedure for the orderly liquidation of option open interest in a special bulletin.

Q:

I was wondering if there is an industry standard to how options holdings are adjusted to reflect a stock split or stock dividend on the underlying security.

A:

You can see a basic discussion on how options are adjusted in Chapter III from Characteristics and Risks of Standardized Options or review an online class on option adjustments due to corporate actions.

Q:

XYZ Inc.'s stock was recently trading at .60 cents before undergoing a 1 for 10 reverse stock split and is now trading at $6.00. Is my call option with a strike of $5 that was outstanding at the time of the reverse split now in-the-money by $1.00?

A:

No. The call option should not be in-the-money. All XYZ Inc.'s option contracts that were outstanding on the effective date of the 1 for 10 reverse split have would be adjusted to reflect the reverse split. An option contract for a reverse split is typically adjusted as follows:

Strike Price - No change
Number of Contracts - No Change
Multiplier - Strike Price and Premium Multiplier remains 100
New Deliverable per Contract - 10 shares of XYZ Inc.

The value of 10 NEW shares of XYZ Inc stock @$6.00 per share is $60.00 dollars. The value of the strike price (if exercised) is $500.00. To determine the point at which the post-split stock needs to be for the $5.00 call to be in the money, divide the value of the strike ($500.00) by the number of shares that Underlies the contract (10). This would indicate that the stock would need to be trading above $50 per share for this adjusted contract to be in the money.

For additional educational information concerning adjustments to options due to splits and mergers please refer to our online interactive classes.

Q:

I currently have a covered call written against my AT&T stock position. How will my option contract be adjusted due to the AT&T spin-off of its broadband unit, the subsequent merger of the broadband unit with Comcast Corp and AT&T's 1:5 reverse stock split?

A:

As a general rule of thumb, if an investor is covered when he/she enters into an option contract, he/she is typically covered throughout the life of the option. The standard 100 share AT&T option will be adjusted in the same manner as 100 shares of AT&T stock. On the effective date of the spinoff/reverse split, the holder of 100 shares of AT&T will be the holder of 20 shares of "new" AT&T and approximately 32 shares of Comcast Corporation. The option contract will be adjusted in the same ratio as 100 shares of stock. The number of contracts and the strike and premium multiplier will remain 100. The new deliverable for the option contract will be 20 shares of "new" AT&T and approximately 32 shares of Comcast Corporation. Currently, adjusted options already exist for AT&T due to the spinoff of AT&T Wireless Services, symbol AWE. These options will be adjusted further to reflect the current spinoff/reverse split.

Q:

I own a September call option for company XYZ. News has come out stating that XYZ is the subject of a cash buyout that is expected to close in May. Assuming that the merger is approved, what can I expect to happen to the call option I own.

A:

When an underlying security is converted into a right to receive a fixed amount of cash, options on that security will generally be adjusted to require the delivery upon exercise of a fixed amount of cash, and trading in the options will ordinarily cease when the merger becomes effective. As a result, after such an adjustment is made all options on that security that are not in the money will become worthless and all that are in the money will have no time value.

Review an online class to learn more about how options are adjusted due to corporate actions.

Q:

How do you measure volatility?

A:

Volatility literally represents the standard deviation of day-to-day price changes in a security, expressed as an annualized percentage. Two measures of volatility are commonly used in options trading: historical and implied. Historical volatility depicts the degree of price change in an underlying security observed over a specified period of time using standard statistical measures. It is not a forecast of future volatility. Implied volatility is the market's prediction of expected volatility, which is indirectly calculated from current options prices using an option-pricing model. The exact formula for historical volatility is:

Where: N = number of observations
r¯ = mean return
ri = return at period i

Q:

Can you explain what the term "Zeta" means?

A:

Zeta is the market value of an option, less its model value using the at-the-money implied volatility for the same expiration. It is a measure of the importance of using the volatility smile, rather than only ATM volatility.

Q:

I am perplexed when the option premium disappears from my options. I paid $6.40 for a $20 call with two years until expiration when the stock was trading at $20/share. Now the stock is above $50, but the premium has totally disappeared. The option still has 18 months to expiration and I don't understand why the premium went away so quickly, it seems like I lost $6.40 somewhere.

A:

What you have described below is the phenomenon of delta. Delta is defined as the ratio of the theoretical price change of the option to the price change of the underlying stock. The rule of thumb is that an at-the-money option has a delta of approximately 50%. Since your call option was right at-the-money when you bought it, for each $1 that the stock went up your option increased by 50 cents. As the stock continued to increase, so did the value of the option, but ALWAYS AT A SLOWER RATE THAN THE STOCK.

At some point the delta of your option approached 100% and it began to move at the same rate as the stock. But during that time, the movement of the stock outpaced that of the option by $6.40, the amount of your premium. If the stock fell back toward $20 the process would reverse itself and you would see some time value premium reappear.

Q:

What is a put/call ratio and how is it used?

A:

The put-call ratio is simply the number of puts traded divided by the number of calls traded. It can be computed daily, weekly, or over any time period. It can be computed for stock options, index options, or future options. Some market technicians suspect that a high volume of puts relative to calls indicates investors are bearish, whereas a high ratio of calls to puts shows bullishness.

Many market technicians find the put-call ratio to be a good contrary indicator, meaning when the ratio is high, market bottom is near, and when the ratio is low, a market top is imminent. The more highly traded options contracts produce a more reliable put-call ratio. Traders and investors generally buy more calls than puts where stock options are concerned. Therefore, the equity put-call ratio is a number far less than 1.00. If call buying is heavy, the equity put-call ratio may dip into the .30 range on a daily basis. Very bearish days may occasionally produce numbers of 1.00 or higher. An average day will produce a ratio of around .50 - .70.

Once again, the numbers are interpretive numbers. Here are some numbers that may be used for illustrative purposes:

Index P/C Ratio
Bullish 1.5 or higher
Bearish .75 or lower
Neutral .75-1.5

Equity P/C Ratio Bullish .75-1
Bearish .4 or lower
Neutral .4-.6

Q:

Can you please help me understand what is the meaning of "skew" in options?

A:

The basic idea behind skew is that options with different strike prices and different expirations tend to trade at different implied volatilities. When implied volatilities for options with the same expiration are plotted, the graph resembles a smile, with at-the-money volatility in the middle and out-of-the-money options forming the gently-rising sides. As options go into the money they gradually approach their intrinsic value, and an option trading at its intrinsic value has an implied volatility of zero, so for our graph we use call prices for strikes above the current underlying stock price and put prices for strikes below the current underlying stock price.

There is a mathematical reason that skew appears as the "volatility smile" described above: most option pricing models assume stock prices are log-normally distributed, but in the real world stock prices deviate slightly from that model. Specifically, the Normal Distribution underestimates the probability of extremely large moves. In order to compensate, traders .tweak' their models by using a higher volatility for out-of-money options.

But the skew also holds valuable information. An investor who takes the time and effort to carefully analyze the skew of a stock's options can gain important insights into how the market is pricing risk. In some cases, for example, the perceived downside risk may be greater than the perceived upside risk, which causes the graph to be more of a .smirk' than a .smile'.

Q:

What does the term "delta" mean?

A:

A measure of the rate of change in an option's theoretical value for a one-unit change in the price of the underlying stock. For example if the delta of a call option is 50 (or .50 to be more precise), for each one point move in the stock, the anticipated movement of the option would be a half point -- or 50%. (The delta would be described in negative percentages for puts as the movement is opposite.)

Q:

Is there an easy way to determine the first three characters of an options contract? I see that there can be multiple symbols for options on the same underlying stock.

A:

There is no easy way for determining options root symbols, so let me give you some general guidelines. For NYSE stocks, the options root and the stock root are usually the same. For example, IBM options begin with IBM, and T options begin with T. Options roots, however, can never have more than three letters. So options root symbols for NASDAQ stocks are different than the stock symbols. Microsoft, for example, has the symbol MSFT for the stock and MSQ for the root options symbol. And Intel has INTC for the stock and INQ for the options.

The last two letters after the options root symbol indicate (1) the options type and expiration month and (2) the strike price.

One complication is that, when a stock's price range is greater than $100, then the option root symbol has to change for every $100. Otherwise, the 105, 205 and 305 calls would have the same symbols, and that obviously cannot happen.

Another complication, as you pointed out, is that the same strike-price options sometimes have different root symbols. This typically occurs when there are 3-for-2 or other "non-even" stock splits. When these splits occur, there are "non-standard" options in addition to "standard" options. For standard options contracts, 100 shares typically underlie the contract, and non-standard options will have some other quantity. If a $60 stock splits 3-for-2, for example, then, after the split, there would be standard $40 options covering 100 shares and non-standard options covering 150 shares. To distinguish between them they each have their own root symbol.

Q:

I tried to enter a limit order to buy an option for $3.15. My order was rejected due to entering an incorrect price. What was wrong with the price I entered?

A:

Premiums are quoted in minimum increments. The minimum increments for premiums below $3.00 are quoted in nickel (.05) increments. Premiums for $3.00 and above are quoted in dime (.10) increments. In reference to the question, a correct limit order price might be either $3.10 or $3.20.

Q:

Stock XYZ is trading at $26.50. Will the exchanges add a 27½ strike?

A:

Strike prices are typically added in the following increments:

- 0 - 25 strikes will be added in 2½ point intervals
- 30 - 200 strikes will be added in 5 point intervals
- 200+ strikes will be added in 10 point intervals

Quite often strike prices are adjusted due to stock splits. So, if you notice a 27½ point strike, it is generally the result of a stock split.

Q:

Lucent Technologies Inc only has option series that expire in January 2004 and January 2005. Why?

A:

Currently, exchange rules prohibit adding new series and/or strikes for securities that trade below $3.00 per share. Lucent began trading below $3.00 around June 5, 2002. The expiration months that existed at the time were June 2002, July 2002, September 2002, January 2004 and January 2005. As contracts expired, no new series were added. At some point all existing series may expire. When a security begins to trade above the $3.00 per share price, the option exchanges have the option of adding new series.

Q:

What is meant by "rolling an option"?

A:

In the options market, "rolling" is a trading event where the options trader simultaneously closes out one option position and establishes a new, similar option position, usually with a different expiration (a.k.a. "rolling out"), strike price (a.k.a. "rolling up") or both. Options traders can: "roll up" or "roll down" in strike price, or "roll out" or "roll in" to different expiration months.