Crusading and Cascading through the World of Options Trading

Step 1: What the heck are options??? Level 1: Textbook definition

“…a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties…”

This is an ok start but still not nearly broken down enough; neither to fulfill our in depth analysis nor

to change the world nor to completely grasp conceptually… let’s keep deconstructing

Level 2: An example to delve even deeper

You find a house you want to buy but you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000 (at this point you have “bought” a contract agreement that he must sell you the house for 200k at the end of three months) – in the meantime, one of two things happens:

1) You’re a lucky son of a gun and discover that the house is actually the true birthplace of Elvis! (dayum…) As a result, the market value of the house skyrockets to $1 million!!! Because the owner has already sold you the option (that contract you paid for), he is still obligated to sell you the house for $200,000. In the end, you’ll make a profit of $797,000 ($1 million - $200,000 - $3,000)

Yay for lucky you! Bet you’re glad you decided to buy that option (aka. contract) from him now!;)

2) You’re an unlucky son of a b*#% and while touring the house, you discover not only that the walls are chocked-full of asbestos (causes cancer btw), but also that the ghost of Henry VII haunts the master bedroom (kinda cool I guess); furthermore, a family of super-intelligent rats have built one hell of a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option and not the whole house yet, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.

The option could have ended up making you 797 million but Elvis was born elsewhere… sucks to suck!

Level 3: Time to take a quick step back and reflect

Ø Options in a nutshell:

1) When you buy an option, you have the right to purchase/carry out what the option outlines

that you are entitled to. BUT! You do not have to follow through with that something! You can always let the expiration date go by, at which point the option becomes worthless.

• If you choose to let it expire and not continue with the deal outlined in the option, you will GUARANTEED lose 100% of your investment (which is exactly the amount of money you used to pay for that option)

• It’s just like if you got engaged to me; you have the right and ability to marry me at some point in the future! BUT you do not have to follow through with it and marry me if you want! You’d only lose the amount of time you invested in me;)

2) An option is merely a contract that deals with some underlying asset (your favorite word!). For this reason, options are called derivatives (it derives all its value from something else). In the example, the house that would be purchased is that underlying asset. Most of the time, the underlying asset is a stock (ownership in a corporation) or an index (imaginary portfolio of securities representing a particular market or a portion of it).

Ø The nuances of option trading (the types of options available):

1) a Call – gives the holder of the option the right to buy an asset at a certain price

within a specific period of time.

• Similar to having a long position on a stock; when you buy a stock in the hopes that its value will increase over the time you have it

• Buyers of calls hope that the asset’s value (the stock that the option is a contract about) will increase substantially before the option expires – that way they can go through with the initial option agreement/contract and buy the stock!

2) a Put – gives the holder the right to sell an asset at a certain price within a specific period of time.

• Similar to having a short position on a stock; when you sell a stock with the expectation that it

will drop in value • Buyers of puts hope that the price of the asset being sold (the stock that the option is a contract

about) will fall before the option expires

v Call/Put buyers are called holders and are not obligated to buy or sell. Essentially, they have the choice whether or not to follow through on the “contract agreement” described by the option.

v Call/Put sellers are called writers and are obligated to buy or sell. This means that a seller may be required (by the buyer of the option) to follow through with his promise to buy or sell the agreed on asset.

Level 4: Now that we know options, what the heck are ATM’s?

Some essential definitions:

• Strike/exercise price – the price (agreed on in the contract) that you can buy/sell the underlying asset for at some point before the option’s expiration date - in our example, it would be the promised $200,000 price tag on the house

• Intrinsic value of option – the difference between the strike price (what you can buy the stock for according to the option’s agreement) and the underlying asset’s actual current value (what it’s actually worth at the time you buy it) – in the example it would be the difference between the $200,000 strike price and the actual $1 million value of the house at the time you buy it

• Option Premium – the price that the option is bought/sold for on the market - in the example, the $3,000 to buy the option

• Time value of an option – equal to the option premium minus the intrinsic value of the option. Investors are willing to pay a higher premium for more time since the contract will have longer to become profitable (more chance for the underlying asset to move higher in price) – the more time until the expiration of an option, the higher the time value

• Implied volatility – the estimated ability of the underlying asset to go up or down in price – the higher the volatility of the asset, the higher chance that it’s price will change and become profitable to the owner of the option (more volatility makes the option premium higher)

• Exercising an option – going through with the agreement outlined in the option agreement – in the example, buying the house for the $200,000 strike price

Ø Option acronyms: three letters that indicate the status of an option

1. OTM (out of money) option: the underlying asset’s price on the market is below

the strike price in the agreement (negative intrinsic value). If you were to exercise the option (buy the worthless house for $200,000) you would lose money. The value of the option is all extrinsic (based on time value and implied volatility). Thus, the value of this option goes lower as you near the expiration date.

2. ATM (at the money) option: the underlying asset’s price on the market is the same as the strike price in the agreement (zero intrinsic value). If you exercised the option (bought the $200,000 house for $200,000) then you would make no money, right now. However, these options still have their extrinsic value since there is still time for the underlying asset’s price to go up and make you a profit. (THIS IS THE TYPE OF OPTION THAT IS TRADED WITH THE HIGHEST FREQUENCY)

3. ITM (in the money) option: the underlying asset’s price on the market is higher than the strike price in the agreement (positive intrinsic value). If you exercised the option (bought the $1 million house for $200,000) you would be making an instant profit! On top of that, you still have the extrinsic value which could allow you to make even more profit if the price of the asset rises even higher.

Level 5: Final piece of the puzzle: what is Options Backdating?

Ø Options Backdating:

“The process of granting an option that is dated prior to the date that the company granted that option. In this way, the exercise

price of the granted option can be set at a lower price than that of the company's stock at the granting date.”

Basically, its when a company changes the strike price of a current option to make it lower than

or equal to the current asset’s market price. In our example, “backdating” would entail lowering the $200,000 strike price of the house in the option to $0 after you found out it was

worthless. This changes an OTM option to either an ATM option (if they make the strike price 0$) or an ITM option (if they made the strike price negative… bad example, but you get the

idea). It is intended to make an option that has negative intrinsic value have either no intrinsic value – ATM option – or positive intrinsic value – ITM option – and thus more favorable to a

buyer.

This tactic seems unfair and kind of like cheating right? They are adjusting the date on the option to a previous date where the asset was at a lower value so they can imbue their option with some false intrinsic value before it can even gain any…

Ø Why it happened before? o This process occurred when companies were only required to report the selling of

stock options to the SEC within two months of the date they were issued. Companies would simply wait for a period in which the company's stock price fell to a low and then moved higher within that two-month period and would then sell the option (while the stock was at a high) with the date set to when it was at its lowest point (the initial strike price would then be that low). Thus, at the time they sell the option, it already has some intrinsic value and is ITM while it should be set at an ATM price!

Ø Why it doesn’t happen anymore? o The act of options backdating has become much more difficult as companies are

now required to report the granting of options to the SEC within two business days. Thus, instead of having a two-month period worth of fluctuating from a low to a high point, they only have a two day period… not long enough for them to backdate it to a significantly lower price. This adjustment to the filing window came in with the Sarbanes-Oxley legislation.