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Options

• Description: You can access the portfolio applets for the options trading strategies at http://www.socr.ucla.edu/htmls/app/ .

An option is a contract between two investors:

• Issuer (or seller), holder of a short position. He sells the option.

• Holder (buyer), holder of a long position. He buys the option.

Types of options:

• Call option: Gives the holder the right to buy an asset by a certain date for a certain price called exercise price with a fee. This fee it is the price of the option or premium.

• Put option: Gives the holder the right to sell an asset by a certain date for a certain price called exercise price with a fee. This fee it is the price of the put or premium.

The date specified it is called: the expiration date or maturity date. The price specified it is called the exercise price or the strike price.
There are European options (can be exercised only on the expiration date) and American options (can be exercised at any time up to the expiration date).
Stock options mechanics:

• Options are normally traded in units of 100 shares. The price of the option is on a per share basis. Therefore, if the price of an option is priced at $0.50, the total premium for that option would be \(\$50\) (\(0.50 \times 100 = \$50\)).

• Stock options are on a January, February, or March cycle. Stocks are randomly assigned in one of these three cycles. For example, IBM is on a January cycle (options can be bought on Jan, Apr, Jul, Oct).

Stock options expired on the Saturday immediately following the third Friday of the expiration month.

The call option will only be exercised if the stock price at expiration is larger than the exercise price. In this case the holder of the call will have a positive payoff. The put option will only be exercised if the stock price at expiration is lower than the exercise price. In this case the holder of the put will have a positive payoff. The two figures below shows when the holder or the seller make a positive payoff.

There is an infinite number of combinations that one can make using call and put options. Some of the combinations have special names, like straddles, strips, straps, bull spreads, bear spreads, butterfly spreads, covered call, etc. All these are shown in the SOCR Trading Options applet. Here are some snapshots:

• The materials above was partially taken from
  

Modern Portfolio Theory by Edwin J. Elton, Martin J. Gruber, Stephen J. Brown, and William N. Goetzmann, Sixth Edition, Wiley, 2003, and
Options, Futues, and Other Derivatives by John C. Hull, Sixth Edition, Pearson Prentice Hall, 2006.