The Offering of Special Options Part 3

For many years prior to 1935, options were dealt in for periods of 2 days, 7 days, 15 days, and 30 days-rarely longer. The short-term contract is now quite obsolete-most of our current business is in contracts for 60 days, 90 days, and 6 months. The 6-month option is usually made for 6 months and 10 days to take advantage of the long-term gains provision of the tax law.

The option business is a little different from the stock-exchange business. In the latter, if you want to buy 100 shares of U.S. Steel, you place your order with a broker who, through his man on the floor of the exchange, can buy or sell the stock in a matter of minutes. A ready market will be quoted, e.g., 691/2 bid offered at 70. That means that there is a ready market where you can sell stock at 691/2 or buy stock at 70. In the over-the-counter market, if you want to buy or sell an unlisted stock such as an insurance or a bank stock, a dealer in those issues will quote you a firm market and will trade immediately. Not so in the option business-here almost all quotes are nominal and subject to being filled, and every trade must be consummated individually and by phone. It may be that when an order is placed to buy or sell an option, as many as fifty phone calls will have to be made by the option-dealer before a trade is completed. He may have to make phone calls to Detroit or Chicago or anywhere in the country. Only through an option-dealer's knowledge of the business can he quote with any accuracy the market on any issue for an option, and only through this knowledge and his contacts can he fill his orders for options with the least delay. Contracts are sometimes offered "firm" for a few minutes and, occasionally, a contract will be offered overnight. The option-dealer usually keeps a file system listing clients who have signified that they have an interest in selling options on various issues, and it is this list of possible sellers of options that the dealer contacts when he has orders to buy either Puts or Calls.

Uses of the Put Option Contract

In all of the following examples, for the sake of better understanding, I will try as much as possible to use one figure for the price of the stock and one figure for the cost of the option. Understand, please, that these prices change in actual practice. The cost of an option on a stock selling at 50 would be less than one selling at 80 and, likewise, the cost of an option for 90 days would be less than one for 6 months on the same stock. The price of an option usually depends on the price of the stock, the duration of the option, the volatility of the stock, and supply and demand for the options in question.

Buying a Put Option for Speculation

A man who thought that a stock selling in the market at 50 would decline to possibly 30 could buy a Put option. In buying an option, he should have some idea to what extent the stock might move. In inquiring what a Put option would cost, he might receive a nominal quote of, say, $350 for a Put at the market for 90 days. Most options are negotiated "at the market," which means at "the current market," when the option can be obtained by the option-dealer. Suppose that the stock is selling at 50 and the quoted price of $350 is satisfactory to you. You enter your order: "Buy a 90-day Put on 100 XYZ [the name of the stock] for $350." If you are trading through your stock-exchange broker, he will give your order to an option-dealer who will contact one of his clients who sells options on that stock and will attempt to buy the option for you. When, after this contact or several others, he has obtained the Put option for you, he reports to the stock-exchange broker who gave him the order, and he in turn reports to the customer: "Bought Put 100 XYZ at 50 expires December 30 for $350." Let us say that the man who bought the Put option, expecting a decline in the stock, was wrong, and that the stock, instead of going to 30 (as he expected), advanced to 70 and was selling there when his option expired. He would have lost the $350 that he paid for his Put option. Bear in mind that the limit of the man's loss was the cost of his Put option, or $350, no matter how high the stock rose and no matter how wrong he was, and that he would draw on the equity in his account to that extent only. Suppose, on the other hand, he had sold the stock short in the market. His loss would have been 20 points and still no knowledge as to the possible extent of loss until he covered the short sale. But in the purchase of the Put option his account would read:

Remember, too, that no trade has been made in the stock, so no stock-exchange commission has been paid. A regular stock-exchange commission is charged by your broker only if a transfer of stock is made in connection with the option.

On the other hand, suppose the man's judgment was correct and the stock declined to 30. If he had instructed his stockbroker to buy 100 shares at 30 and exercise his Put option, his account would look like this:

Sold 100 shares at 50 (through exercise of Put) $5,000

Total Receipts $5,000

Bought 100 shares in market at 30 3,000
Bought Put at 50

Cost 350

Total Cost 3,350

Profit on trade $1,650

The profit then would be almost 500 per cent of the cost of the Put contract. The profit is the difference between the cost of the stock plus the cost of the Put option and the proceeds of the Put that was exercised.

In all of these examples showing the use of options, the commission cost has been ignored. But at no time could the loss have been more than the cost of the option- $350-and any stock-exchange commissions would have been paid out of profit or out of possible recovery of part of the premium which was paid.