SMB CAPITAL OPTIONS TRAINING PROGRAM

1. SMB CAPITAL OPTIONS TRAINING PROGRAM

2. SESSION TWO Fundamental Options Concepts

3. Options are contracts • The seller (or writer) has an obligation and the buyer has a right. • Example: When you buy one American-style IBM , January 2011, 150 call, you have the right to buy 100 shares of IBM at a price of $150 per share anytime between the purchase date and the third Friday in January 2011. • If you are the seller of that call you have that same obligation.

4. American Style vs. European Style Options • Long American Style Options: Can be exercised at any time before expiration. • Long European Style Options: Are not exercised until expiration. • It can be assumed that we are only dealing with American Style Options in this course.

5. Equity Options • 1 Long Equity Call Option : the right to buy 100 shares of a stock at the strike price on or before expiration. • 1 Short Equity Call Option: the obligation to sell 100 shares of a stock at the strike price on or before expiration if the owner so desires. • 1 Long Equity Put Option: the right to sell 100 shares of a stock at the strike price on or before expiration. • 1 Short Equity Put Option: the obligation to buy 100 shares of stock at the strike price on or before expiration if the owner so desires.

6. Index Options • 1 Long Index Call or Put Option: Entitles the owner of an in the money call or put to receive cash equal to the difference between the strike price and the market price times 100 upon settlement. • 1 Short Index Call or Put: Obligates the seller of an in the money call or put to pay cash equal to the difference between the strike price and the market price times 100 upon settlement.

7. Equity Options at Expiration • Long Calls: OCC assigns stock to your account and withdraws strike price automatically for in the money options* • Short Calls: OCC removes stock from your account (or renders you short that stock) and gives you cash at strike price automatically for in the money options* • Long Puts: OCC automatically removes stock from your account (or renders you short that stock) and replaces it with cash at strike price for in the money options* • Short Puts: OCC automatically puts stock into your account and takes cash out at strike price for in the money options* • *Note: If your account is inadequately funded for this transaction your broker will rapidly reverse this position.

8. Index options at expiration • Long calls (OCC places cash into your account for in the money calls ) • Short calls ( OCC takes cash out of your account for in the money calls) • Long puts (OCC places cash into your account automatically for in the money puts) • Short puts (OCC takes cash out of your account automatically for in the money puts)

9. However………. • Most of the time we will not allow options to expire. • We will close the options through reversal transactions for risk management purposes the vast majority of the time.

10. The Options Chain

11. At the money, in the money, out of the money • ATM option (at-the-money): market price is almost exactly the strike price of the option. • ITM option (in-the-money): market price is above the strike price for a call, below the strike price for a put. • OTM option (out-of-the-money): market price is below the strike price for a call and above the strike price for a put.

12. Extrinsic and Intrinsic Values • Calls: Market Price Minus Strike Price=Intrinsic value of option. Any price beyond that is Extrinsic Value (a/k/a juice, fluff, time premium). Example: NFLX trading at 182.00. NFLX 170 Jan 2011 call trading at 25.95. Intrinsic value=12.00. Extrinsic value=13.95. • Put: Strike Price Minus Market Price=Intrinsic value of option. Any price beyond that Extrinsic Value. Example NFLX trading at 182. NFLX 200 Jan 2011 put trading at 30.45. Intrinsic value=18, extrinsic value=12.45

13. Option Values • OTM options ONLY have extrinsic value. • ATM options (exactly) ONLY have extrinsic value. • ITM options have BOTH intrinsic and extrinsic value. • At expiration all options have only their intrinsic value as there is no risk left—the final values of the options have been determined.

14. Monthlies, Quarterlies, Weeklies • Monthly Options: Generally expire on the third Friday of each month. These are the most popular and commonly traded options. • Quarterly Options: Available only at this time for Indices and ETFs and expire on the final day of each quarter. • Weekly options are listed on most Thursdays or Fridays expiring on the Friday 7 or 8 days later (no weeklies available expiring on third Friday of each month—that would be duplicative).

15. Buy options or sell them? • Options are a wasting asset as the extrinsic value of all options becomes zero by expiration week. • Income options trading is based upon SELLING OPTIONS and then benefitting from the price deterioration that takes place when the options extrinsic value evaporates over time. • Session 3 begins to delve into how this works.

16. Homework • Use your website of choice (Yahoo Finance for example). Pull up the options chain for each stock in the Dow Jones Industrial Average for the month following the current month. • For each stock, populate an X/L spreadsheet with the price of one ITM, ATM and OTM call and the price of one ITM, ATM and OTM put and then enter the amount of intrinsic and extrinsic premium embedded in each option. • Which option of the three consistently has the most extrinsic premium (OTM,ATM,ITM)? Why?