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FFO Options 4: How The Option Markets Are Quoted

FFO Options 4: How The Option Markets Are Quoted. Dr. Scott Brown Stock Options. Options Symbol . An option symbol is a code by which  options  are identified on a futures exchange. Ex. XDLQ2 Although the letters may appear random, there is actually an organized structure to each symbol.

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FFO Options 4: How The Option Markets Are Quoted

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  1. FFO Options 4: How The Option Markets Are Quoted Dr. Scott Brown Stock Options

  2. Options Symbol • An option symbol is a code by which options are identified on a futures exchange. • Ex. XDLQ2 • Although the letters may appear random, there is actually an organized structure to each symbol. • It is a backup to ensure you enter the correct option order. • This is one of the three most common mistakes for both retailers and brokers. • Incorrect symbol, Wrong quantity, Wrong Action

  3. Incorrect Symbols Are Costly • You have to pay an extra commission to correct it (remove and replace) • You can incur a Loss • You may miss out favorable movements

  4. Symbol StructureXXXMS XXX – the root symbol M – Month S – Strike Price

  5. The Root symbol • Is a code that identifies the underlying code and can be any length form one to three letters. • Stocks listed on an exchange will have the same root symbol as the ticker symbol, although it may be different from splits, mergers, acquisitions and special dividends. • Ex. IBM, GE • For the NASDAQ trade stocks (with 4 letters ticker) will be reduced to three letters, including an ending “Q” to designate NASDAQ. • Ex. Dell – DLQ MSFT – MSQ

  6. The Month Symbol • The month symbol depends on the type of the option, a call or put. • For call options: the first twelve letters of the alphabet represent the 12 months • For puts: Letters M to X (letters 14 to 23 of the alphabet) are use to represents the months.

  7. Options Strike Price Symbol • Each letter from A to T represents $5 strike intervals. • Because there is a wide range of potential strike prices and a limited number of letters, each letter represents more than one strike price. • Once $100 is reached (letter T) a new root symbol is created and we are required to start back at A. • In addition letters U trough Z are reserved for $2.50 strike intervals.

  8. Options Strike Price Symbol

  9. Other Considerations … • If any option you are holding goes through a symbol change, it will automatically change in your account. • You must always check the symbol before trading, nothing ensures that the root will remains the same. There are companies that use different roots based on the range in which is the strike price • The MS of the symbol tells three important things: • The month, the strike price and the option type

  10. Option Expiration Cycles • Because option strategies require making modifications during the life of a trade, you need to know in what months the options will expire. • Originally all options stocks were randomly assigned to one of three cycles: • 1st Cycle: January; 2nd Cycle: February and 3rd Cycle March • Once a stock is assigned to a particular cycle, it does not change.

  11. The Cycles • Options under Cycle 1 would have expirations matching the first month of each quarter. • The Cycle 2 Stocks only have options expiration to the middle month of each quarter. • And the Cycle 3 have expiration for the end month of each quarter.

  12. New Rules Create Short-Term Contracts

  13. New Rules • To ensure that there would always be short-term options, the CEOB decide to change the rules. • Under the new rules, there would still be four option expiration months listed: The first two months of the quarter are always the two near months (the current and the following month, also called the serial months), but for the two farther-out months, the rules use the original cycles.

  14. Let’s see how it works … Let's say it is the beginning of January, and we are looking at a stock assigned to the January cycle. Under the newer rules, there is always the current month plus the following month available, so January and February will be available. Because four months must trade, the next two months from the original cycle would be April and July. So, the stock will have options available in January, February, April and July. 

  15. Let’s see how it works … (Cont.) • What happens when January expires? February is already trading, so that simply becomes the near-month contract. Because the first two months must trade options, March will begin to trade on the first trading day after the January expiration date. So the four months now available are February, March, April and July. 

  16. Let’s see how it works … (Cont.) What happens when February expires? Once the February options expire, March becomes the current contract. The following month, April, is already trading. But with March, April and July contracts trading, that's only three expiration months, and we need four. So, we go back to the original cycle and add October because it is the next month in the January cycle after July. So the March, April, July and October options will now be available.

  17. Some Highlights … • This pattern continues regardless of which cycle we’re on. • The serial months (current and following) must always be made available. No matter the cycle of stock, it will have the serial months available. • The remaining two months will be from the corresponding quarterly cycle.

  18. LEAPS (Long Term Equity Anticipation Securities)

  19. LEAPS • LEAPS are long-term options • When options first started trading, there were available up to nine months, but with LEAPS we can find options nearly three years forward. • There will be more than four contracts listed at any given time. • LEAPS usually trade with a January expiration date. If a stock does have LEAPS, then new LEAPS are issued in May, June or July depending on the cycle to which the stock is assigned. • The premiums for LEAPs are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.

  20. How do Options Cycle works with the addition of LEAPS? • If a stock trades LEAPS, the new LEAPS will be issued sometime between May and July. • Let’s explain it with an example… • It’s currently July ‘05 and Intel has the following months trading: July, August, October, January‘06, January‘07, and January’08 • At this point Jan’07 and Jan’08 are LEAPS contracts. The Jan’06 are considered a quarterly contract. • When July expires, September will be added • We will then have August, September, October, and January’06 providing four months of regular contracts. • When August expires, , we will have only three months providing regular contracts, therefore the next January Cycle month will be added, which is April.

  21. How do Options Cycle works with the addition of LEAPS? (Cont.) • This process continues and eventually the date become May’06. The January’06 options will have been expired, and are no longer listed. • When May options expire, there will be only three contracts months (June, July, and October). • This is where we have to add another January contract since it is the next January cycle month. It is at this point where the January’09 contract will be rolled out. • At the same time the January’07 contract will lose their LEAPS designation because they have les than nine months to expiration. • The root symbol to show that it is no longer a LEAPS option, this will happens in May, June or July. • This process is called melding (when LEAPS options become regular options).

  22. Which Cycle is My Stock On?

  23. Which Cycle is My Stock On? • Before you can find out when a particular month will be added to the list you will need to: • Know in which cycle your stock is trade • How? If we have the months that the option has being traded, we know that the first two months are the serial months, so we must look at the third or fourth month (when the 3rd month is January, because all stocks that have LEAPS options will have them listed in January). Then we have to see to which cycle the months belong.

  24. Double, Triple and Quadruple Witching • These are days when multiple derivative products expire on the same day. • If a stock futures, stock index options, and stock options, all expire the same day, that’s a Triple Witching day. • Typically stocks futures expire on the last month of each quarter (Mar, Jun, Sept, Dec) , so triple witching occur only on these months. • Double Witching occur when any two of the three assets expire the same day. • Quadruple Witching occurs when single-stock future expire on the same day as well.

  25. Contract Size (The Multiplier) • Contract Size: • First start trading options is “generally” 100-share lots. • Referred as “The Multiplier” since is the amount we need to multiply the option premium by to find the total cost of the contract. • Ex.: if a call option is asking $3, you pay $3*100= $300 (plus Commisions). • Its also the amount we must multiply to find the total cost of the contract: • Ex: if you exercise a $30 call, you pay $30*100= $3,000 & receive 100 shares of stock.

  26. Contract Size (The Multiplier) • Changes in Contract Size: • Most common event are stock splits. • They generally occur when the price of a stock is perceived to be too high, and the company splits the stock to bring the price down. • It’s considered a dividend paid in shares rather than cash. • Three types of stock splits • Whole Number Split • Fractional Split • Reverse Split

  27. Contract Size (The Multiplier) • Whole Number Split: • You always end up with multiple 100-share lots after the split. The most popular is 2:1. • Ex.: ABC stock is trading for $180 per share. The company thinks is too expensive and announces 2:1 Stock split. If you own 100 shares of ABC prior to the split: • You will own 200 shares (100 shares * {2/1} = 200 shares). • Price of the stock will fall to $90 ($180 per shares/2 = $90 per share). • You will be in the same position, $18,000 worth of ABC stock.

  28. Contract Size (The Multiplier) • Fractional Split: • Any stock split were the second number is greater than 1 creates a fractional split, such as 3:2. • Ex.: Recall the last example and now assume the stock split is 3:2. The split ratio is 3/2= 1.5. If you had 100 shares prior to the split: • You’d have 150 shares (100 shares * {3/2 = 1.5} = 150 shares). • The price of the stock would fall too $120 ($180 per share/ {3/2 = 1.5} = $120 per share). • You will still be in the same position, $18,000 worth of stock.

  29. Contract Size (The Multiplier) • Reverse Split: • In this case, a company with a very low stock price may vote for a reverse split to lift the price of the stock in hopes of being recognized as a viable investment. • In certain cases, this is done to meet listing requirements so that the stock be traded on a nationally recognized exchange. • Ex.: Recall the last example and now assume the split is 1:3. The split ratio is 1/3 = .33. If you had 100 shares prior to the split: • You’d have 33 shares (100 shares * 0.33 = 33 shares). • The price would rise too $545.45 ($180 per share/0.33 = $545.45) • You’d still be in the same position, $18,000 worth of ABC stock.

  30. Contract Size (The Multiplier) • Effect on you're option contracts: • Ex.: Assume you own 20 XYZ $10 calls trading for $1 and the company announces 1:5 reverse split. The split ratio is 1/5 = .20. • The number of contracts you own is 4 (20 contracts*0.2 = 4 contracts). • Strike price increased too $50 ($10 per share/0.20 = $50 per share). • Price of the option rises to $5 ($1/0.2 = $5).

  31. Contract Size (The Multiplier) • Effect on you’re option contracts (cont.): • Original position: • Contract price is $2,000 = $1*20 contracts*100 shares per contract. • Exercise value is $20,000 = $10*20contracts*100 shares per contract. • After Split Position: • Contract Price is $2,000 = $5*4 contracts*100 shares per contract. • Exercise value is $20,000 = $50*4 contracts*100 shares per contract. • There’s no change in position, only the distribution of the investment.

  32. Contract Adjustments for Special Dividends • Many stocks pay dividends on a quarterly basis. • Ex.: If a stock pays $0.80 dividend and you own 100 shares, you’ll receive $8 per year in you’re brokerage account. • Stock price is always reduced by the amount of the dividend on the date the dividend is paid, which is known as the ex-date. • Regular paid dividends do not affect options. • Special paid dividends reduce all call and put strikes by the same amount. • Ex.: If Microsoft announces a $3 dividend and you own a $30 call or put, the strike price will be reduced to $27.

  33. Contract Adjustments for Special Dividends • The Intrinsic value of the stock doesn't change. • Ex.: Recall the last example and assume that the stock trades for $35. • Intrinsic value of the option is $5 ($35-$30). • After $3 dividend is paid: • Stock price is $32 ($35-$3). • Strike price is $27 ($30-$3). • Intrinsic value still remains $5 ($32-$27).

  34. Open Interest • Options Clearing Corporation (OCC) must account for the total number of outstanding contracts. • The reason is because an option is created between two traders on opposite ends of an agreement. • OCC need to know if a trader is entering a contract or exiting. • Enter or increase position (buy to open/sell to open) Vs. Exiting or reducing position (sell to close/buy to close).

  35. Open Interest • Open interest keeps track of how many open contracts there are for a specific option. • You must count either all long positions or all short positions to get the number of outstanding contracts. • Whenever both traders are entering “opening” transactions, then the open interest will increase. • Whenever both traders are exiting “closing” transactions, then the open interest will decrease. • If one trader is entering and the other closing, then open interest remains unchanged.

  36. Open Interest • Open interest is used as a liquidity guide. • Ex.: NDX is trading around 1,550 contracts for the $1550 call trading for $108. The open interest is 1,578. • 1,578*$108 per share*100 shares = $17,000,000 represented in this option.

  37. Call Options • Early Exercise: • American Style option can be exercised at any time prior to expiration. • For many traders, the exercise restrictions on European options are considered as negative features. • It is never advantageous to exercise a call option early, with the exception of the investors that want to collect upcoming dividends on stock.

  38. Call Options • Early Exercise on a Non- Dividend Paying Stock: • Ex.: Investor#1 buys a stock for $50, and Invetor#2 buys a $50 call for $2. If the stock is trading for $60 at expiration: • Invetor#1 gains $10 ($60-$50) • Investor#2 gains $8 ($60-$52) • If the stock rises price, both profit dollar for dollar from the stock. • If the stock price drops, the option holder only loses $2 while the stock holder loses dollar for dollar for the drop.

  39. Call Options • Exercising a Call to Collect a Dividend: • Designed to offset a loss and not for a financial gain. • Ex.: Assume that a stock is trading for $50 and pays $1 dividend. You own a $40 call that is trading at parity for $10. The day the dividend is paid, the stock value decreases by $1. If you exercise the call: • $10 of unrealized gain, while lose $1 of stock price. • You get dividend of $1. • Therefore you now have $9 of unrealized gain and $1 of realized gain.

  40. Put Options • With put options, if the stock is sufficiently in the money, it doesn’t make sense to exercise early. • The difference with the call option, with a put option you're trying to get rid of a risky asset and receiving cash. • If you delay the exercise of the put, you only lose the interest you could have earned on the cash.

  41. Mechanics of Exercising a Call to Collect Dividends • If an investor wishes to collect the dividend on a stock, he must exercise the call to gain control of it. • He must be a stockholder before the record date to be eligible to receive the dividend. • Investor must focus to exercise the call option before the ex-date to assure to buy the stock with the dividend. If an investor buy on or after the ex-date, he buys the stock without the dividend.

  42. WhyIsThere So MuchConfusion In Practice? • For investors, to figure out who gets the dividend is not as easy as it seems. Many times they get confused and are unable to find the appropriate date the stock must be buy in order to receive the dividend payment. The reason for this confusion is due to three dates associated with the dividend announcement: • Record date • Payable date • Ex-date

  43. WhyIsThere So MuchConfusion In Practice? (cont) • Corporations usually only publicize the record date and payable date. • The record date is the only date that matters to the company. Before making the dividend payment, the company looks at a list of names of the stock owners as of the record date and pay the dividends to them. • The payable date is when the payment is actually made, which may be a week or more after the record date.

  44. WhyIsThere So MuchConfusion In Practice? (cont) • In order to be the owner of record, the stock transaction must be settled by the record date. There is currently a three-business-day settlement period (trade date plus three business day). For example, if you buy a stock on Monday it will be settle on Thursday. • Suppose that the record date is on March 10, if you want to own the stock by that date, you need to make your purchase on March 7 or before. If you buy the stock on March 8 or later you will not be the owner as of the record date (you will not receive the dividend payment).

  45. Why Is There So Much Confusion In Practice? (cont) • All the confusion has to do with the timing of the settlement period. Many investors think they just need to buy the stocks on or before the record date in order to collect the dividend. The truth is they have to make the purchase three business days before the record date. • The ex-date is an artificial creation of brokerage firms to mathematically figure out the purchase date that makes you owner by the record date. If the company announces a March 10 record date, the ex-date would be March 8. If you buy the stock on March 8 or later, you will not be the owner of the stock by the record date ( won’t receive the next dividend payment)

  46. Why Is There So Much Confusion In Practice? (cont) • After understanding the stock settlement process, adding call options to the figure is not complicated. If you own a call option and wish to exercise it in order to collect the dividend, you must exercise the call the day before the ex-date.

  47. Does It Really Matters If The Stock Holders Get The Dividend? • Mathematically, there is no difference if stockholders get the dividend or not. The reason there is not mathematical difference is that the stock price is reduced by the amount of the dividend on the ex-date. • For instance, if an investor buy one share of stock for $100 before the ex-date and collect a dividend payment of $2, on the ex-date the stock will decline to $98 and the total value of his account will remain the same: $98 + $ 2= $100.

  48. Rules Violation: Selling Dividends • Many brokers take advantage of investors by touting an immediate return on your money by purchasing stock just before the ex-date. A broker may call saying if you purchase a stock for $100, you will receive a 2% return on your money the very next day. By now you should know this is not true. • For tax reasons, buying the stock just to get the dividend is not a good idea. When an investor buys on share of stock for $100, he is paying with after-tax dollars, he doesn’t owe tax on the $100. However, if you buy the stock before the ex-date you will owe taxes on the dividend payment.

  49. Rules Violation: Selling Dividends (cont.) • For these reasons the NASD (National Association Of Security Dealers) prohibits brokers of selling you stocks exclusively for the reason of collecting the dividend.

  50. Types of Options Orders • To understand the many terms associated with placing orders is crucial, particularly in today’s market when most people make trades online and there is no interaction with a broker. Making the Trade • There are five basics pieces of information you must specify when you are buying or selling options: • Action (buy or sell) • Quantity (number of contracts) • Symbol • Price • Time

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