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Chapter 13 Stock options.

WHAT ARE THEY?

An option is a contract that is bought and sold--it gives the buyer and holder a right (but not a requirement) to force the seller of the contract to complete a certain transaction. The transaction is generally for a certain amount of goods (i.e., shares of an underlying stock) at a specified price at a certain point in time when the contract is set to expire (or for some contracts, anytime in the specified period of time before the contract expires). Options are a form of derivative instrument--so named because their value is a derivative of the price of the underlying stock (or other property) that they are associated with.

A call option is a contract that gives the holder the right to purchase a specified number of shares of common stock at a fixed price for a stated period of time. For example, an investor who anticipated an increase in the price of ABC stock could purchase a call option for 100 shares instead of the stock itself. The call option might have a term of nine months and would have a fixed exercise price. At any time during the period of the contract, the holder could exercise his option and purchase 100 shares of the stock at the stated price regardless of how high the actual price of ABC had risen.

A put option is a contract that gives the holder the right to sell a specified number of shares of common stock at a set price for a given period of time. For example, if an individual owned 100 shares of ABC and expected the price of the stock to decline, he could purchase a put option giving him the right to sell his shares at a stated price any time during the term of the option contract regardless of the actual market price of ABC stock (the benefit being that, if the market price in fact rose instead of declining, the individual would still own the stock).

Most investors typically think of either buying or selling the stock itself. But, since both puts and calls are property, these may be bought or sold independently of the underlying stock. Investors may buy or sell either (or both) of these contracts depending upon their own investment strategies. For instance, Charlee Leimberg expects ABC to increase in value and therefore buys a call that gives her the right to purchase 100 shares of the stock at a fixed price, say $65, for the next six months. Assume that the current market price of ABC is $62 per share. The cost of her call option might be $2 per share, or $200 for the contract ($2/share x 100 share bundle).

If the market price of ABC stock were to jump to $70 per share, the value of her call would also increase. The minimum value of the contract would be $500 (the difference between the market price of $70 and her exercise price of $65 times the 100 shares associated with the contract). The value of her contract could actually be higher than $500 if the contract still had a significant amount of time until the expiration date. That is because investors might anticipate further appreciation in the value of the stock, which in turn would be reflected in the price of the call option.

Charlee's sister, Lara, might have an entirely different opinion about the price of ABC stock. If she expects the price to decline, she may decide to sell a call on 100 shares of the stock. This means that Lara would be on the "other side" of her sister's transaction--she would receive $200 in return for agreeing to sell 100 shares of the stock at a price of $65 per share any time during the next six months. If the price of ABC remains below $65 per share, Charlee will let her option to buy the stock expire (since it would not behoove her to utilize the option to purchase the stock at $65/share from Lara when she could purchase it outright in the market for less), and the right that she never used will have cost her $200. Lara, on the other hand, will have a profit of $200 from the transaction and will not have to deliver the stock.

Put options work as a natural opposite to call options. An investor would buy a put if he expected a stock's price to decline. The put would give him the right to sell at a fixed price higher than the actual market price of the stock. If John Mullen expects ABC to decline from its current price of $62 per share, he could purchase a put option that would give him the right to sell the stock at a price of $60. If the share price were to fall to $58, he could exercise his option and receive $60 per share instead of the lower market price.

The seller of a put contract expects the market price of the stock to remain stable or to increase. John's associate, Mike Dunleavy, feels that the price of ABC will not go below $60 per share and offers to sell a put at that price for $1 per share. If he is correct, then the option will not be exercised, he will not have to purchase the stock, and he will have a profit of $100. If the stock's price does decline, the option will be exercised, and Mike will have to purchase the stock for $60 per share even though the actual market price may be significantly less--he might pay $60/share (as required by the put option) for a stock that might only be valued in the open market for $55/ share. However, his "loss" of $500 (100 shares x $5/share of "excess" purchase price above the current market value) will be offset by the $100 premium he received for selling (also called writing) the contract.

WHEN IS THE USE OF THIS TOOL INDICATED?

1. When investors wish to speculate on a movement in the stock market--either up, down, to stay within a certain range, or to move outside a certain range--without actually buying or selling stocks themselves.

2. When an investor wishes to create a leveraged situation in his investment portfolio. In this case the leverage comes about due to the fixed price at which either a put or a call contract is exercised. This price, referred to as the exercise price or strike price, does not change during the life of the contract regardless of the movements in the price of the underlying stock.

Example: Assume a stock is currently selling for $60 per share. A call option is available on that same stock and has an exercise price of $55 per share. The option alone will sell for at least the $5 per share difference between the stock price and the exercise price (and possibly for more). If the price of the underlying stock were to double to $120 per share, the investor who merely purchased the stock would have a gain of 100% (($120 - $60)/ $60 = 100%). If the stock did increase to $120 per share, the value of the option would increase to at least $65 per share ($120 - $55 = $65)--however, the original purchase price of the option was only $5! This is an increase of 1300% (($65 / $5 = 1300%), a return that is 1200% higher than that earned with the purchase of the stock.

3. When an investor has limited funds but still wishes to speculate with some of his investments. Puts and calls are generally traded at small fractions of the price of their underlying stocks. For example, if IBM Corp. stock were selling at $70 per share, a call option to purchase 100 IBM shares at an exercise price of $70 might trade for $200 to $300, whereas the purchase of 100 IBM shares at $70 per share would be $7,000.

4. When an investor wishes to generate additional income from a stock portfolio without initially selling any of the positions. By selling call options on shares in his portfolio to speculators, the writer of these options can receive a fee or "premium" for taking part in the contract. For instance, Lara Leimberg, in the example above, received $200 for selling a call contract, and if the call option wasn't exercised, she would still be able to keep her underlying stock as well. Note, however, that if the stock price does rise such that the call option is exercised, the call writer will be required to provide stock to the option buyer at the specified strike price.

5. When an investor desires to "hedge" a stock or his entire portfolio against unexpected declines or other unfavorable moves in the price of the stock. John Mullen, in the example above, was protecting himself against a substantial decline in the value of his ABC shares by buying a put contract. The option guaranteed him a right to sell his stock at a minimum price of $60 per share, which might turn out to be much higher than the actual stock price in the event of a decline (thus hedging and preserving his account against the decline).

ADVANTAGES

1. The fixed exercise price of these option contracts creates a leverage factor that may be advantageous to the investor. For example, if a common stock were to double in value, a 100% increase, the value of a call option on the same stock might increase as much as 500% or more.

2. Option trading requires a relatively small investment on the part of the investor.

3. Income earned from the sale of either put or call contracts is paid to the investor immediately no matter what the term of the contract may be.

4. An investor can substantially hedge the risk of most or all of her potential portfolio losses without actually selling the underlying stock positions until desired.

DISADVANTAGES

1. Leverage operates in both directions, and a decline (rise) in the price of a stock will typically result in a much larger percentage loss for the buyer of a call (put) option. For example, if stock purchased at $60 per share were to drop to $30, the result is a 50% decline in market value. If an investor purchased an option to buy the stock at $55 per share when the market price was $60 per share, the call would have been worth at least $5 per share. But, when the stock drops to $30 per share, the value of the option will become almost nil--a 100% loss!

2. Both puts and calls have a relatively short life span--typically not more than nine months. In recent years, a new form of options have become available called LEAPS (Long-term Equity Antici Pation Securities)--these long-term options generally have terms extending as far as 2 years and 9 months from issue. In either case, options are sometimes referred to as "wasting assets" because they will be of no value after a particular point in time, the expiration date--unless the stock price does in fact move (or not move) as desired.

3. Call options, though they enable the holder to purchase shares of common stock, have neither voting rights nor are they entitled to receive any dividends declared and paid during the term of the option. Even though the life of an option is relatively short (no more than nine months) this lack of income can be an important (and/or costly) disadvantage.

TAX IMPLICATIONS

1. Options generally are classified as capital assets for tax purposes (1), though they are subject to some special rules because of their unique nature. See the discussion of capital gains and losses in Chapter 43, "Taxation of Investment Vehicles."

2. Investors who buy call options will have a capital gain or loss if the option is sold in a "closing" transaction. Gain or loss is calculated by subtracting the sale price of the option from the purchase price (including any brokerage fees included in either transaction). (2) Because exchange-traded call options are issued for a term of only nine months, any capital gain or loss will be short-term.

3. No gain or loss is realized upon the exercise of a call option. A capital gain or loss is realized only when the stock acquired through exercise of the call is sold. (3) The cost of the call is added to the purchase price of the stock in computing the gain or loss for tax purposes. The holding period is measured from the day after the call option is exercised, not from the date the call was purchased. (4)

4. Investors who write calls or purchase put options and then close out their positions by repurchasing them will recognize any capital gain upon the closing. However, since dispositions involving options are subject to the wash sale rule, loss on the sale of a call option within 30 days before or after the date of purchase of substantially identical stocks or securities may not be recognized. Instead, such a loss will generally increase the basis of the replacement stock or securities. It is important to note that an option to acquire or sell an underlying stock, and the underlying stock itself, are considered substantially identical property for the purposes of the wash sale rules. (5) If the option expires unexercised, the investor will realize a short-term capital gain.

5. An investor who writes a call option that is exercised will realize a capital gain or loss upon exercise. The capital gain or loss is actually realized on the underlying stock that must be sold/delivered to the call option buyer--the premium the investor received for writing the call is added to the selling price of the stock in calculating the amount of capital gain or loss. (6)

6. Exercising a put option constitutes a sale of the stock and is a taxable event. The cost of the put is subtracted from the selling price of the stock in computing capital gain or loss for tax purposes. The date of exercise of the put option is treated as the sale date of the stock. (7)

7. Investors who write puts and repurchase their put obligations will realize a short-term capital gain or loss on the closing. If the option expires unexercised, the investor will realize a short-term capital gain, because exchange-traded call options are issued for a term of only nine months.

8. When a put option is exercised, the writer is required to purchase the stock put to him. However, this is not treated as a taxable event for the writer of the put contract. Instead, the put writer deducts the premium received for writing the put from the purchase price of the stock. (8) The holding period for the stock is measured from the date of exercise of the put. (9)

9. The tax consequences of many options structures become more complicated when multiple options are held at once, and/or including positions in the underlying stock. See Chapter 41, "Hedging Option Strategies," for further tax consequences of more complex options strategies.

ALTERNATIVES

1. Stock purchase warrants have many of the same features as call options. They enable the owner of the warrant to purchase a certain number of shares of stock at a fixed price for a given period of time. The original term of the warrant is generally much longer than a put or call option, frequently lasting for several years. However, warrants are offered by corporations and are frequently issued in connection with the sale of other securities such as bonds or preferred stock. Some warrants are listed on the organized securities exchanges, but the majority are traded in the over-the-counter market. The fixed exercise price of warrants creates the same type of leverage provided by options. Additional information on stock warrants can be found in Chapter 12, "Warrants and Rights."

2. Stock "rights" are another form of option that enables existing shareholders to purchase new stock being issued by a corporation. Generally one right is issued for each share of stock an investor owns, and the rights entitle the stockholder to purchase additional shares at a stated price (or often fractional shares--sometimes it will take multiple rights to purchase a single share of stock). Rights have an extremely short life span and generally must be exercised within a month or so of the new stock offering. Additional information on stock rights can be found in Chapter 12, "Warrants and Rights."

WHERE AND HOW DO I GET IT?

Put and call stock options are traded on several organized exchanges, most of which are related to stock exchanges. The first exchange to be organized especially for trading of options was the Chicago Board Options Exchange (CBOE), which began operating in April, 1973. The CBOE was an extension of the Chicago Board of Trade that had a long history of trading options on agricultural commodities. Since 1973, trading in puts and calls has extended to the American Stock Exchange, the Pacific Coast Stock Exchange, the Philadelphia Stock Exchange, and the New York Stock Exchange. Several firms operate as market-makers at the various exchanges to help maintain liquidity and fair pricing for all traded options. Options traded through all of these exchanges are ultimately issued and maintained by the Options Clearing Corporation (OCC). Today these options may be traded on more than 1,500 different underlying stocks.

The formal organization of options contracts has brought tremendous popularity to the options markets because of the fact that all exchange-traded options contracts are standardized (i.e., all based upon the same terms). This allows all buyers and sellers to know exactly what they are receiving in the options contract (aside from their possibly differing beliefs about the underlying stock), which makes the contracts easier to evaluate, and far more liquid.

Buying or selling puts and calls is very similar to buying or selling the underlying stocks. However, option trades must be made through a "margin account" that allows a customer to buy securities with money borrowed from a broker. Transactions are made through brokerage firms that relay the orders they receive to the trading floors of the options exchanges. Orders are carried out by the exchange and the results of the trade are reported back to the brokerage firm, which in turn notifies its customer.

To execute a transaction an investor can merely call his broker and state, "Please purchase 5 ABC April-60 call option contracts for my account." A written record of the trade automatically will be sent to the buyer or seller of the option contract confirming the transaction. This is the only evidence of the purchase or sale that the investor will receive. This is due to the fact that the option is a contract to buy or sell rather than an actual security.

Once a trade has been made, the position of the buyer or seller remains "open" until one of three events occurs:

1. The option may expire without being exercised. Expiration of an option series will "close out" all positions open at that time. This is the result frequently desired by sellers of call options who hope to keep the premium they received and to keep their shares of stock as well.

2. The option may be exercised and the underlying shares of stock will have to be transferred. For example, if a call option is exercised, the seller will have to deliver shares of stock at the exercise price to be paid by the buyer of the call.

3. The buyer or seller of the option may close out his original position. This is done simply by entering an order opposite to the first order. For instance, assume Greg Murphy had purchased a put option allowing him to sell GM stock at a price of $70 per share. Greg now wishes to close out his position and may do so by selling the exact same option contract. The two option contracts offset each other and, at that point, Greg has neither an option to buy or sell. He may have had a profit or loss on his original position. The amount of the gain or loss will depend upon the change in price of the initial option contract from the date of purchase or sale until the position is closed. For example, Greg may have paid $5 per share, or $500 in total, for the original put option. If the contract were selling for $300 when he closed out his position, he would have a loss of $200 on the transaction.

WHAT FEES OR OTHER ACQUISITION COSTS ARE INVOLVED?

Commissions on the purchase or sale of option contracts are similar to those paid on other security transactions. Brokerage firms typically charge a percentage of the value of the transaction with a minimum commission of $25 or $30. For example, a single contract trade amounting to $250 may involve a commission of $25. Ten contracts amounting to $2,500 may result in a commission of $150.

HOW DO I SELECT THE BEST OF ITS TYPE?

1. Since investors can buy or sell puts or calls (while buying, selling, or holding the underlying security) there are a great many different option strategies available at any given time. Perhaps the first decision that must be made is an estimate of whether the stock market as a whole, or any one stock, is likely to advance or decline. If the market is moving upward, investors are more likely to want to buy calls or sell put options. If the market or a stock is weak, then a strategy of buying puts or selling calls may be in order.

2. The volatility of the underlying stock has a lot to do with the movement of both put and call options. The more active a particular issue, the more likely the option will have a wide swing in price. Speculators should look for stocks that experience fairly rapid movements, either up or down, over a relatively short period of time. More conservative investors may want to concentrate on options where the underlying stock is relatively stable in price.

3. The period of time to expiration of the option should be considered before any purchase or sale is made. The longer the term of the option, the more likely the price of the stock to change significantly, and the greater the volatility of the option. Again, investors who wish to speculate will tend to prefer longer-term options, while conservative investors will prefer shorter maturities.

4. The dividends paid on the underlying stock have a significant impact on the value of an option. Option holders do not receive any dividends, which are paid only to holders of actual stock. Therefore, options on high dividend-paying stocks will tend to be less valuable than those on issues with low dividends, or none at all.

WHERE CAN I FIND OUT MORE ABOUT IT?

1. Each of the option exchanges publishes a variety of booklets dealing with the mechanics of option trading and various strategies for investors. These booklets generally are also available through most brokerage firms or on the Internet. One such publication is Characteristics and Risks of Standardized Options, published by the Options Clearing Corporation. This booklet can be viewed or downloaded at www.cboe.com.

2. Larger brokerage firms have specialists who concentrate on options and may even manage option funds for their clients. Such firms frequently publish their own reports and recommendations.

3. Several of the major investment advisory services include information on options in their publications. Both Standard & Poor's and Value Line collect data on puts and calls although they do not make recommendations or assign a quality rating as they do with stocks and bonds.

4. For further information on options, see the Chicago Board Options Exchange at www.cboe.com.

QUESTIONS AND ANSWERS

Question--How long does an option contract last?

Answer--Option contracts can have maturities up to several months. Most exchange-traded options contracts expire on the Saturday after the third Friday of each month (although some types of options only have contracts that expire every three months). Most trading activity takes place on those options that will expire within the next two or three months. New options are introduced by the various exchanges as old options expire.

Question--Are options available for all stocks?

Answer--No, options are available on a relatively limited number of stocks. The five options exchanges trade puts and calls on about 1,500 issues, but this is only a portion of the thousands of listed stocks and the many thousands more that are traded on the over-the-counter market. Options are generally available on those issues that are widely held or that are very actively traded. The exchanges review their lists on a regular basis and add new issues from time to time.

Question--Do I have to own a particular stock before I can trade its options?

Answer--No, you may trade options--both puts and calls--without actual ownership of the underlying stock. This is referred to as trading "naked" or "uncovered" as opposed to owning the stock and being "covered." The additional risk in naked trading is the possible need to buy the stock for delivery if the option is exercised. This can be particularly expensive since double commissions are involved as well as the cost of purchasing the underlying stock.

Question--If I acquire stock by exercising a call option, what is the actual cost basis of my shares?

Answer--The cost basis of the stock for tax purposes will be the exercise price paid for the shares plus the premium paid for the call option. For example, if an investor paid $500 for a call on 100 shares of stock (i.e., $5/share), and later exercised the option at a price of $50 per share, the cost basis of the stock would be $50 + $5 = $55 per share.

Question--If I buy an option and let it expire without being exercised, is my loss on the transaction a capital loss?

Answer--Yes, if the option expires, it is treated as if it were sold on the expiration date. The premium that was paid to acquire the option is treated as a short-term capital loss.

Question--How is the premium income received by option writers taxed?

Answer--First, there is no tax due at the time the option is written and the premium is paid to the seller. For tax purposes, the premium is considered to be deferred until the transaction is completed, even though the writer actually receives the funds immediately. If the option expires without being exercised, the premium is recognized as a short-term capital gain and is included in the writer's income for the tax year in which the option expired. If the option is exercised, the writer adds the premium to the striking price to calculate the total amount received. This amount is compared with the writer's cost basis to determine whether a taxable gain or loss has been realized. Any gain or loss that results from a "closing purchase" is considered short-term capital gain or loss.

Question--What are LEAPS?

Answer--LEAPS, or Long-Term Equity AnticiPation Securities, are long-term options that generally have expiration dates up to 2 years and 9 months (issued in April and expiring in January in the 3rd subsequent year). They are available on a limited number of equities (approximately 450) and indexes (approximately 10). Fundamentally, LEAPS operate in the same manner as any other options--the primary difference is the increased utility (either for speculators or hedgers) available because of the increased term until expiration.

Question--What is the difference between an American option and a European option?

Answer--The difference between these two options types is the timing of when they can be exercised. American options can be exercised anytime between issue and expiration--this form of option is typical for most equity options traded on any of the exchanges. European options can only be exercised at (or in a short time window immediately before) expiration--these are occasionally used with some forms of cash-settled index options. Note that although there may be limitations on when they can be exercised, European options (like all options) can still be traded to close out a position at any time.

CHAPTER ENDNOTES

(1.) IRC Sec. 1234A.

(2.) Rev. Rul. 58-234, 1958-1 CB 279.

(3.) Ibid.

(4.) IRC Sec. 1223(6).

(5.) IRC Sec. 1091(a).

(6.) Rev. Rul. 58-234, 1958-1 CB 279.

(7.) Ibid.

(8.) Ibid.

(9.) IRC Sec. 1223(6).
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Title Annotation:Tools of Investment Planning
Publication:Tools & Techniques of Investment Planning, 2nd ed.
Date:Jan 1, 2006
Words:4759
Previous Article:Chapter 12 Warrants and rights.
Next Article:Chapter 14 Financial futures.
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