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A Misunderstood Derivative

By William H. Mears; CPA, JD

By David E. Marcinko MBBS DPM MBA

An option is either the right to buy or sell an asset, or the obligation to buy or sell an asset. Options are derivative instruments; i.e., they derive their value from the performance of the asset upon which they are based—the underlying asset or security. This can be a stock, an equity index, a futures contract, or a Treasury security. Types of options include:

1. Equity options
2. Stock index options
3. Interest rate options
4. Foreign currency options

Multiple Terms and Definitions

• A call option contract gives the physician-investor or buyer the right, but not the obligation, to buy a stock at a specified price, subject to an expiration date.
• The put option contract gives the buyer the right, but not the obligation, to sell a stock at a specific price, subject to an expiration date.
• The right to buy or sell the underlying security is purchased for a price called the premium.
• The right to buy or sell the underlying security occurs only for a period of time and at a specific price.
• The time period of an option is called the duration.
• The day that the option ends is the expiration.
• The price at which the option can be exercised is called the strike price.
• Therefore, the right to buy or sell a security under an option contract exists only for a specific period and ceases to exist at the expiration of the option period.
• The seller of an option, the individual who has received consideration for granting to another a right, is obligated to perform under the option contract.
• The seller of a call option, also called the writer, has sold the right to buy that stock.
• The seller of a call option is obligated to sell the stock to the call option owner if the option is exercised.
• The seller of a put option is obligated to buy the stock from the put option buyer if the option is exercised.

Option Components

Listed options are traded on an exchange and are packaged and available on stock markets and indexes with various durations at various strike prices.

Over-the-counter options are options that do not trade on an established exchange but are contractual arrangements between two parties.

Because these options are not prepackaged, they can be custom tailored as to strike price, expiration date, and manner of settlement, that is, cash settlement or settlement by delivery of stock.

All listed and over-the-counter options have an expiration date.

American-style options can be exercised at any point in time prior to expiration.

A European-style option creates the right or obligation only at the expiration of a term of an option.

When physician investors purchase or sell an option, they are interested in the cost of that option or the income generated by the sale of that option.

The option premium—the cost of the option—is comprised of the intrinsic value of the option plus its time value.

The intrinsic value of the option is the option’s in-the-money amount.

Options that are out-of-the-money are priced on the basis of time value only.

Option Market Price

The major factors that affect the market price of an option are:

• The price of the underlying asset
• The strike price of the option
• The time remaining until the option expires
• The prevailing interest rates
• The expected volatility of the underlying asset

These factors work in the following manner:

1 As the price of an underlying asset increases, the call price goes up and the put price goes down.

2. As the strike price of the option increases, the call price goes down and the put price goes up.

3. As the time to expiration goes out, the call price goes up and the put price goes up.

4. As the risk-free rate of return on money goes up, the call price goes up and the put price goes down.

5. As the volatility in the underlying stock increases, the call price goes up and the put price goes up.

6. As the dividend payout rate of the underlying asset increases, the call price decreases and the put price increases.

When a physician-investor purchases an option, the underlying asset will have a market value. The investor may purchase a call option, which is available for exercise at the same market value (an at-the-money option), at an under-the-market price (in-the-money), or with an exercise price that is over the market value (in-the-money). The exercise price of these options is the strike price.

Option Volatility

The volatility of the underlying asset will also play a significant role in the pricing of an option. The more volatile a stock is, the more likely it is that its performance will be unpredictable and that the strike price will be reached or exceeded and, therefore, that the option will have value. Options on volatile stocks will have a higher premium.

Options contracts, once purchased or sold on an opening trade, can either be (1) traded on a closing trade or allowed to expire worthless or (2) exercised. If an option contract is traded, it will be treated like any other security that is traded. The contract will have proceeds of sale, a cost basis, and a holding period.

All options have a fixed expiration date. All listed equity options, regardless of their particular cycle, expire at 11:59 p.m. Eastern Standard Time on the Saturday following the third Friday of the expiration month. The option actually does not expire until Saturday, but customers must act by 5:30 p.m. on the Friday prior to the expiration date. As an option approaches its expiration date, it diminishes in value.

Agreements

Options also allow individuals to act on the basis of a predetermined contractual agreement, regardless of market conditions for a specific period. Therefore, as the option approaches its expiration date, the option diminishes in value. It is during the early part of an option’s life that it is most valuable proportionately.

Option Contracts

An option contract will always trade in sizes of 100 shares. The description of an option contract will always contain the name of the underlying security first. The name of the security will be followed by the expiration month, the exercise price, the type of option, and the premium; for example, 1 XYZ MAR 5 call 2.

At maturity, a call option will have a value that will be the greater of zero or the strike price minus the strike price. At maturity, a put option will have a value of the greater of zero or the strike price minus the stock price.

If an option contract is allowed to expire worthless, it will be treated for tax purposes like any other security that has either no proceeds or cost basis. In either case, one leg of the trade will be zero. The position will either be closed in its entirety at a gain or be closed in its entirety at a loss.

If an option is exercised, the buyer of the contract decides that the contract will be exercised. After the exercise, the buyer of a call will own the underlying asset, and the buyer of a put will sell the underlying asset. If an option is exercised, the seller of the option is always obligated to act under the options contract.

Conclusion

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Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

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Filed under: Alternative Investments, Investing, Portfolio Management |