© All rights reserved to Meitav Self Learning Ltd. Do not duplicate, copy, photocopy, translate, store in a database, broadcast, or record in any manner whatsoever, or through any electronic, optical, or other mechanical media, any part whatsoever of the material in this book. Commercial use of the material in this book is absolutely prohibited. INTRODUCTION Dear Reader, When you finish reading this book you be surprised to see how interesting and the simple the subject is. However, you might find the terminology difficult, and you will need to study it. But don’t worry, after looking a few times at the options table in the newspaper and the internet, the terminology will “stick” and become a part of you. In order to make the subjects understandable and to aid in their ongoing absorption, we preferred to leave out details and subjects which are somewhat unusual, some of them marginal and technical and some of them too complex. Here and there we have strayed from being totally accurate, intentionally or unintentionally. This is a book for beginners and is not designed to make you into a professional. The knowledge gained by you will enable you to improve your profitability in the capital market, both as a saver and as a lender. The improvement will be expressed in the ability to get the best out of your financial adviser at the bank. Reader Guidelines 1. In the course of reading the first pages, don’t invest too much thought and effort on subjects or details about which have not given details or details mentioned briefly, and which remain unclear. Don’t worry! We have thought of everything. The details will become clear before you reach page 49. 2. Since effort is required to absorb the terminology, we recommend reading the book a few times. 3. The drawings are for illustration and understanding, and are not there for decorative purposes, so don’t skip them. 4. Changes in trading procedures: In view of the dynamism of the capital market, the stock market changes to trading procedures from time to time. It is possible that when reading the book the trading procedures could be different from what appears in it. 5. We use the letter K instead of 000. For example: $100k is written instead of $100,000. Each time the letter K is written, read it as thousand. K – An abbreviation of Kilo (=1000). We would be happy to hear any reactions and to answer any questions relating to an understanding of the material. Enjoyable reading S. Simanovsky 3 Table of Contents Chapter 1- Options- Introduction .......................................................................6 Types of Options.......................................................................................................6 Call Options ..............................................................................................................6 Put Option ................................................................................................................7 Call Option - Characteristics ....................................................................................9 Put Options - Characteristics .................................................................................10 Option name ..........................................................................................................10 Gross Profit and Net Profit on Options ..................................................................12 Chapter 2- Buying a Call Option .......................................................................13 Buying a call Option ...............................................................................................13 Buying a Call Option - Graphic Presentation of Profit (or Loss) from the Option on Date B ....................................................................................................16 Chapter 3- Buying a Put Option ........................................................................18 Put Options.............................................................................................................18 Buying a Put Option - Graphic Presentation of Profit (or Loss) From the Option on date B .....................................................................................21 Buying Put Options - Main Characteristics ............................................................22 Chapter 4- Supplements and Terms .................................................................23 Where Options Come From ....................................................................................23 The Risk for Option Writers ....................................................................................25 Internal Value of an Option ...................................................................................26 Time Value of the Premium ....................................................................................27 Significance of the Time Value in the Premium .....................................................28 Definitions of Status of Options ............................................................................30 4 Shlomo Simanovsky Options for Beginners Chapter 5- Writing a Call Option .....................................................................31 Writing a Call Option .............................................................................................31 Freezing the Loss ....................................................................................................33 The Reasons for Writing Call Options ....................................................................34 Graphic Presentation of the Profit / Loss at Date B ...............................................36 Chapter 6- Writing a Put Option .....................................................................38 Writing a Put Option ..............................................................................................38 The Reasons for Writing a Put Option ...................................................................40 Graphical Presentation of the Profit / Loss on date B ...........................................41 Writing a Put Option - Main Characteristics ..........................................................42 Chapter 7- Options Strategy .............................................................................43 Buying a House Using a Strategy ...........................................................................45 Explanation of Terms .............................................................................................48 Selling a House Using a Strategy ...........................................................................48 5 Chapter 1 Options- Introduction Types of Options There are two types of options: 1. Call option (= buy option) 2. Put option (= sell option) Call Options A call option is a security giving its owner the right to purchase an asset, known as the “underlying asset” (for example: a house), at a price agreed upon in advance, which is known as the “strike price” (for example: $100,000). An option has a limited duration. The option contains a definition of the “underlying asset”, what the terms of purchase are and the duration of the option. We purchase the “underlying asset” from the “option writer”, who we talk about later. Buying an option is similar to buying a lottery ticket. You buy, in the expectation of making a profit. If you do not make a profit, the option becomes “garbage”. 6 Shlomo Simanovsky Options for Beginners Examples of an Underlying Asset An underlying asset can be any asset, but the most common assets are standard assets, such as: An ounce of gold, 1,000 barrels of oil, 100 “Microsoft Corp.” shares etc. There are some intangible assets also, such as share indexes, which we will deal with in more detail later on. Underlying Asset in the Example: House In order to simplify understanding of the subject, we will use an example where the “underlying asset” is a house at an imaginary vacation resort, where all the houses are of the same size and price. The prices of the houses change daily according to the number of vacationers at the resort. The more vacationers there are in town, the greater the price is and likewise, the fewer vacationers in town, the lower the price will be. Premium The price we pay for the option is known as the premium. The premium is like the price we pay for a lottery ticket. Exercising the Call option We will exercise the Call option only if we are able to buy the underlying asset at a price lower than the market price. If this is not possible, we will throw the option in the garbage. Put Option A Put option is a security giving us the right to sell an asset, known as the “underlying asset” (for example: a house), at a price agreed in advance, which is known as the “exercise price”. The option has a limited duration. The option also contains a definition of the “underlying asset”, what the terms of sale are and the duration of the option. 7 Options- Introduction Exercising the Put Option We would exercise the Put option only if we are able to sell the underlying asset at a price higher than the market price. If this cannot be done, we will throw the option away. Options Trading Most options are traded in a stock market. This means that the stock market acts as an intermediary between buyers and sellers of options. The brokerage is carried out in the stock market. The prices of the options, as we previously stated, are referred to as the “premium”, and they change during trading, according to the supply and demand, in exactly the same way as the prices of shares vary. At the start of trading you can buy a particular option for a premium of $10, and sell the option at the end of the trading day for $20. In this book, we will relate only to traded options and we will assume that the houses in the example are tradable. In other words, we can buy and sell the options on any day when trading takes place in the stock market. 8 Shlomo Simanovsky Options for Beginners Call Option - Characteristics Every option (both Put and Call) are characterized by four items of data which are known in advance, as follows: Illustration 1- Example of Call option data 1. Underlying asset: In our example, the underlying asset is the house in the vacation resort. 2. Type of option: Call. 3. Exercise price: The price which the option holder pays for the house if he decides to exercise the option. In our example, he would pay $100K for the house. The exercise price is a fixed price, which is known in advance and is not affected by the market price. 4. Expiry date: Every option has a limited duration. The expiry date stated is the last day of its life and after that date it becomes worthless. The duration of an option varies from market to market. Usually its duration is less than one year. Period of Exercise of the Option A distinction is made between two methods: 1. The American method - the option can be realized at any time up to the expiry date. 2. The European method - the option can be exercised only at the date of expiry. 9 Options- Introduction Put Options - Characteristics As previously mentioned, a Put option is an option to sell an underlying asset, for example an option to sell a house. The explanation for the four items of data in the following illustration is similar to the previous explanation about the call option. Illustration 2- Example of Put option data Option name The name of an option consists of 4 parts, which are its four pieces of data: 1. Underlyin asset 2. Type of option 3. Exercise price 4. date of expiry The name of the option is shown below and is read from left to right: Uniformity of data The data relating to options on the same “underlying asset” are usually uniform. For example, in the case of houses, the price of the houses is always in thousands of dollars and the expiry is always on the last day of the month. 10 Shlomo Simanovsky Options for Beginners Abbreviated name The uniformity of data enables us to abbreviate the name of the option. The abbreviation is based on the fact that the person trading in options will recognize the meaning of the abbreviations. the abbreviated name of the call option will be: Explanation of abbreviations H - House. C - Call. 100 - $100K. June - June 30, 2008. The abbreviated name of a Put option will be: A further abbreviation of the name: If we know for certain that the underlying asset is a house, we can dispense with the H. For example: When the options appear in the newspaper under the title “Prices of options on houses”. The abbreviated name will be: 11