The Business Master (3rd Edition)/The Business Master (3rd Edition).iso/files/finacial/finasst/asst2.chp

Text File | 1992-09-24 | 13.6 KB | 366 lines

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#T15,4,STOCK OPTIONS - PUTS & CALLS
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~C~IFUNDAMENTALS OF STOCK OPTIONS~N

Options are contracts related to the ~W~Ifuture~N purchase or sale of stock.
Option contracts are always written for 100 share lots of stock only.  Each
option contract is written for a specific stock issue (~W~Ithe underlying stock~N),
and may be either a ~W~ICALL~N or a ~W~IPUT.~N
#D3


A ~W~ICALL~N is a contractural right to BUY 100 shares of stock at a specified
price (~W~Ithe strike price~N) on or before a specified expiry date of the
contract.
#D2

A ~W~IPUT~N is a contractual right to SELL 100 shares of stock at the strike
price on or before the specified expiry date of the contract.
#D2


As an investor, you may be either the buyer or the seller--of either a put or
a call option.  If you are the buyer of either option, you buy the contractual
right to exercise the option.  If you are the seller, you sell that contract-
ual right.
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Actually, as the buyer of an option, exercise of your contractural right is
only one of the three choices you have:
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[1] ~C~IExercise the Option:~N
When an option owner exercises his/her option right, 100 shares of the under-
lying stock will be traded ~W~Iat the strike price~N.  (A call option will be exer-
cised when the current market value of the underlying stock is greater than
the strike price; a put option will be exercised when the current market value
of the underlying stock is less than the strike price).
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[2] ~C~ICancel the Options Contract:~N
Neither the buyer (nor the seller) of a stock option is REQUIRED to wait until
the option expiry date, (nor until the market price crosses the strike price
to act.  Either party may effectively cancel his participation in the contract
at any time by respectively buying or selling, an offseting option in the same
stock--at whatever option price prevails at that time.
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[3] ~C~IAllow the Options Contract to Expire:~N
The buyer may elect to take no action and simply allow the contract expire.
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As an individual investor, there are five basic strategies you may use in
dealing in the stock options market--~W~Itwo as a buyer, three as a seller.~N
#D2

Two Buyer Strategies:

[1] ~C~IBUYING CALLS:~N
Buying a call gives you the right to PURCHASE 100 shares of the underlying
stock.  That right increases in value (up to expiry date) if the market
value of the stock becomes greater than the strike price of the option.
#D4

Actually, many buyers never intend to exercise the option right.  If the
market value of the stock rises, so does the value of the option.  If that
occurs, the option itself can simply be sold at a profit.  Profits might be
quite high--100% or more, and in quite short time periods--but risks are high
as well.
#D4

If the market value of the stock falls, the value of the option will also
progressively decrease.  In this circumstance, many buyers sell the option
at a reduced price prior to expiry date in order to limit their losses on
the option venture.
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[2] ~C~IBUYING PUTS:~N
Buying a put gives you the right to SELL 100 shares of the underlying stock.
at a specified price.  If the value of the stock falls below that price, the
value of the put option will correspondingly rise.
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If that occurs, you may elect to continue to hold the option--anticipating
further losses in the stock price (gains in the option value) before expiry,
or you may elect to simply sell the put option itself at a profit.
#D3


However, if the stock price moves upward, or tends to stay in a narrow range,
the put option will progressively  lose value and eventually become worth-
less  --- possibly even before its expiry date.
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And Three Seller Strategies:
#D1

[3] ~C~ISELLING CALLS:~N
There are two variations of this strategy--one involves the greatest degree
of risk in options trading; the other involves the least risk in options
trading.  The two variations are (a) selling "uncovered" or "naked" calls,
and (b) selling "covered" calls.  (The seller of an uncovered call does not
actually own the shares of the underlying stock; the seller of a covered call
doe own those shares).
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   (a) ~C~ISelling Uncovered Calls:~N
       The seller of an uncovered call option grants the buyer the right to
       purchase 100 shares of the underlying stock at the strike price at any
       time up to and including the option expiry date.
#D3

       The seller receives the proceeds from the sale of the option.  BUT--
       if the market value of the underlying stock rises substantially, the
       seller will have to purchase those shares at the prevailing market
       price and to deliver them at the strike price--no matter how high the
       market price rises!
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   (b) ~C~ISelling Covered Calls:~N
       Selling covered call options is the most conservative (least risky) of
       the strategies in the Stock Options market.
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       The seller of a covered call option  OWNS the 100 shares of the
       underlying stock.  Thus, the shares are available (at whatever price
       the owner previously paid for them) to honor the option should it be
       exercised.
#D3

       The seller of covered call options may earn 30% or more per year, with
       a fairly consistent rate of return.  He/she will have to give up the
       occasional large return on specific stocks themselves, however, since
       unexpired options on stocks that rise substantially are INVARIABLY
       exercisedcised.
#D3

       (The mathematics of evaluating covered call sales are extensive and
       involved, and will be discussed in detail later in this guide).
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[5] ~C~ISelling Puts:~N
Selling a put gives the buyer the option to sell (TO YOU) 100 shares of the
underlying stock at the specified strike price, at any time during the con-
tract period.
#D3

As the seller of a put, you cannot cover yourself in the same way that you
can when selling a call.  You can, however, practice a form of coverage by
selling the underlying stock you may own at the same time you sell the put
option.
#D3

The risk in selling puts, as compared to selling uncovered calls, is some-
what more limited.  (Although a stock's market value may--in theory--
increase without limit, it cannot decrease below zero.  Thus, the maximum
theoretical risk in selling a put option, large as it may be, IS limited.
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The mathematical analyses of four of the five basic techniques of particip-
ating in stock options are simple enough that the power of a computer is not
needed.  We will discuss these briefly, then move on to the one method which
can benefit considerably from computer analysis.
#D3

[1] ~C~IBuying a Call:~N
Your total investment is the sum of the price of the call plus your broker's
commisssion on the transaction.  That amount is also your maximum risk.
#D3

If the market value of the underlying stock rises above the strike price, and
you both exercise your option, AND immediately resell the 100 shares, your net
profit is your selling price minus 2x the broker's commisssion (once to buy,
once to sell), minus your total investment in the option.
#D3

Your annualized rate of return on your total investment is your net profit
divided by your total investment, multiplied by 365 and divided by the number
of days elapsed between buying the option and buying/selling the stock.
#D3

~C~INOTE CAREFULLY THE LARGE INFLUENCE OF BROKER'S COMMISSIONS IN ALL THIS!~N
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[2] ~C~IBuying a Put:~N
Your total investment is the sum of the price of the put plus your broker's
commisssion on the transaction.  That amount is also your maximum risk.
#D2

If the market value of the underlying stock goes under the strike price, AND
you exercise your option, your net profit is your selling price for the stock
less the broker's commisssion to sell the stock less  your total investment.
#D3

Your annualized rate of return on your total investment is your net profit
divided by your total investment, multiplied by 365 and divided by the number
of days elapsed between buying the option and selling the stock.
#D2

~C~INOTE CAREFULLY THE LARGE INFLUENCE OF BROKER'S COMMISSIONS IN ALL THIS!~N
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[3] ~C~ISelling a Call (Uncovered):~N
Your net profit, if the buyer allows the option to expire, is the price of
the call minus your broker's commission for selling it.  Your net investment
is zero, and your annualized rate of return is infinite.
#D2


However, if the buyer exercises the option, your net loss is 100x the differ-
ence between the strike price and the price at which you have to buy the
underlying stock, plus twice the broker's stock commission-(once for buying,
once for selling)- plus the broker's commission on the sale of the option,
minus the sale price of the option.
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[4] ~C~ISelling a Put:~N
In selling a put, you sell the buyer the right to sell TO YOU 100 shares of
the underlying stock at a fixed (strike) price up to the expiry of the con-
tract.


If the buyer DOES NOT exercise that right, your net profit is the price of
the put option minus the broker's commission for selling it.  Your net in-
vestment is zero, and your annualized rate of return is onfinite.


If the buyer DOES exercise the right, your net loss is 100x the difference
between the sock's market price and the option's strike price, plus the
broker's commission for buying the stock, plus the broker's commission on
the sale of the option, minus the selling price of the option.


~C~INOTE CAREFULLY THE LARGE INFLUENCE OF BROKER'S COMMISSIONS IN ALL THIS!~N
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         ~W~IUSING THE OPTIONS MODULE TO CALCULATE A COVERED CALL SALE
                 Data for the following items is required:~N

Current Price: ~C~IThe current market price per share for the underlying stock.~N

Strike Price:  ~C~IThe specified strike price for the particular option.~N

Expiry Month:  ~C~IAll options expire on the same date in any given month. Thus,
               only the month need be stated in the contract.~N

Option Price:  ~C~IThe current price of the option (per share).~N

Broker Fees:   ~C~IThe brokerage firm's fee to buy/sell 100 shares of the under-
               lying stock, and its fee to buy/sell one option.~N

Margin Rate:   ~C~IIf you will purchase the underlying stock shares on margin,
               the cost of that borrowing is a part of your venture cost.~N

Dividends:     ~C~IThe dividends per share, if any, that will be paid during the
               life of the option.~N
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                       ~W~IA NOTE ABOUT BROKER'S FEES~N

Because sale of a covered call option involves three brokerage fees--buying
the underlying stock, selling the call option, and selling the underlying
stock when the option is exercised--in a relatively brief period of time,
brokerage costs are an important part of a covered call analysis.

Brokerage fees or commissions vary widely.  They vary from broker to broker,
by dollar value of the individual transaction, by total dollar value of your
account with the broker, etcetera.  The Options module requires that you
enter the correct data for two fees: the fee to buy or sell 100 shares of the
underlying stock, and the fee to buy or sell one option in that stock.
#D10

~W~IDEFAULT VALUES:~N
On the data entry screen, these fees are initially set to zero.  If you do
not enter other values for these fees, the program will use fees derived from
Dean Witter Reynolds schedules.  Relative rankings of options will be correct
using these default values.  However, your actual brokerage fees MUST be used
to obtain accurate yields on any individual option.
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   ~W~IThe Options module in THE FINANCIAL ASSISTANT calculates the following:
          (all yields are reported as equivalent annual rates (pct/year)~N

Yield at Current Price: ~C~Iyield if stock price does not move and you hold the
                        stock to the option's expiry date.~N

Yield at Strike Price:  ~C~Iyield if stock price rises and buyer exercises the
                        option on its expiry date.~N

Yield ex-dividends:     ~C~Iyield if the buyer exercises the option prior to any
                        dividend date (in order to capture the dividend).~N

Break-even Price:       ~C~Iif the option is not exercised, the downside selling
                        price per share at which you will just recover your
                        costs.~N

Pct Loss Protection:    ~C~Ithe percent of purchase price that the underlying
                        stock price can lose before you incur a net loss on
                        the venture.~N
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The Options module can very quickly calculate any covered call option, and a
printed record of the data and results can be obtained by simply pressing the
<Print Scn> key.
#D3


However, because a major use for such calculations is to compare a number
of options with the purpose of selecting one or more for participation, the
Options module can be used to quickly calculate all options of potential
interest, and, when all have been completed, to then display a tabular summary
of all those analyses on a single screen. A very compact printed report can
then be obtained via the <Print Scn> key.
#D5


[An example calculation is contained within the program itself. The data for
it is automatically displayed when you select the Options module.  To run the
example, DO NOT ENTER ANY DATA--just press the <ESC> key].
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