Options & Warrants

tamer hamed 4:00:00 AM
Types and Characteristics of Derivative Securities
Derivative securities are contracts that derive their value from some other thing, known as the underlying instrument. Derivatives include warrants, options, futures, and forwards. The underlying instruments whose value drives the derivatives' value could be common stock or stock indexes, interest rates, or agricultural commodities such as corn and soy beans.

Options
A guy steps into a tavern. He sits down at the last open stool and slaps a stack of twenties on the bar, just loud enough to get the bartender's attention. The bartender looks up from the pitcher of pale ale she's pouring.
"Just a second," she says, afraid to take her eyes off the thick head of foam forming at the top.
"No hurry," the guy says, although it's clear he's not in the mood to wait.
Bartender finally comes up and takes his order. Bourbon and Pepsi. Not Coke—Coke's for losers. He wants Pepsi with his bourbon, okay?
The bartender shrugs and mutters something as she mixes his drink. Three guys sitting to his right take the bait.
"You don't like Coke, huh, buddy?" says the dark-haired guy in the wrinkled white shirt.
"Nope," the guy says. "Don't like the drink, don't like the stock."
"What, you're a trader?" the blond guy with big shoulders says, wiping foam from his mustache.
"Just a guy who says Coke is headed where it belongs—in the toilet."
The three friends laugh and mutter among themselves for a while, not quite within earshot of the big guy badmouthing Coca-Cola.
"That's a bold statement," the dark-haired guy says. "My dad drove a route for Coke twenty years by the way."
"Good for him," the guy says. "Used to be a decent company—that's history, though. I say Coke is a dog, and I'll bet anybody at this bar it won't go above twenty-five bucks a share the rest of the year."
He says the last part loud enough to get everyone's attention. Even the jukebox seems to quiet down at this point.
"Oh yeah?" someone shouts from a corner booth. "I'll take that bet." "Me, too!" someone yells from over by the pool tables.
Pretty soon the guy has over a dozen happy hour customers standing in line to bet that Coca-Cola common stock will, without a doubt, rise above $25 a share at some point between today (March 1) and the rest of the year.
The guy breaks out a stack of cocktail napkins and on each one he writes the following:
Anyone who thinks Coca-Cola common stock will rise above $25 a share has to pay $300. Guy ends up collecting $300 from 15 different customers, walking out with $4,500 in premiums.
What's his risk as he steps onto the rainy sidewalk outside?
Unlimited. See, no matter how high Coca-Cola common stock goes between today and the 3rd Friday of December, this guy would have to sell it to any holder of the cocktail napkin for $25 a share. Theoretically, his risk is unlimited, since there's no limit to how much he'd have to pay to get the stock.
What if the stock never makes it above $25 in the next 9 months? That's his best possible outcome. If it never makes it above $25, no one will ever call him to buy the stock for $25. In short, he'll walk away with the $4,500 in premiums, laughing at all the suckers at the bar who bet the wrong way.

What the guy sold at the bar was a Coca-Cola Dec 25 call @3. As the writer of that option, he granted any buyer willing to pay $300 the right to buy 100 shares of Coca-Cola common stock for $25 per-share anytime between today and the end of the contract. When would the person holding that option want to use or exercise it?
Only if Coca-Cola were worth more than $25 a share. In fact, since they each paid $3 a share for this right, Coca-Cola will have to rise above $28—their breakeven point—before it ever becomes worth the trouble of exercising the call.
Either way, the guy who wrote the calls gets the $4,500 in premiums. If Coke never makes it above $25, he'll never have to lift a finger. Just smile as the calls expire on the third Friday of December. We said derivatives are a zero-sum game. If an option expires, the seller realizes his maximum gain, while the buyer realizes his maximum loss. In this case, the buyers would lose a total of $4,500, and the seller would make/ keep that amount.
Think of a call option as a bet between a buyer and a seller. The buyer says the price of something is going up. The seller disagrees. Rather than argue about it, they buy and sell call options.
The buyer pays the seller a premium. Because he pays some money, he gets the right to buy 100 shares of a stock for a set price within a stated time frame. If the buyer has the right to buy the stock, the seller has the obligation to sell the stock to the buyer at the already agreed upon price, if the buyer chooses to exercise that right.
Buyers have rights. Sellers have obligations.
The buyer pays a premium, and he receives the right to buy the underlying stock at a stated price. That price is known as the strike price or exercise price.
Calls
A "MSFT Aug 70" call gives the call buyer the right to buy MSFT common stock for $70 at any time up to the expiration date in August. If the stock goes up to $90 before expiration, the owner of the call could buy the stock for $70. If MSFT went up to $190, the call owner could buy it at the strike price of $70. So, you can prob¬ably see why call buyers make money when the underlying stock goes up in value.
Call buyers are betting the stock's market price will go above the strike price. That's why they're called "bulls." Bull = up. If you hold an Aug 70 call, that means you're "bullish" on the stock and would like to see the underlying stock go above 70. How far above?
As far as possible. The higher it goes, the more valuable your call becomes. Wouldn't you love to buy a stock priced at $190 for only $70?
That's what call buyers are hoping to do.
So, for a call, compare the strike price to the stock's market price. Whenever the underlying stock trades above the strike price of the call, the call is in-the-money. A MSFT Aug 70 call is in-the-money as soon as MSFT begins to trade above $70 a share. If MSFT were trading at $80 a share, the Aug 70 call is in-the-money by exactly $10.
Notice how we are not referring to a buyer or seller when we say a call is in-the¬ money. One problem with buying options is you might end up paying, say, $5 a share and even though the call does go in-the-money by $3 a share, you lose that difference. We'll talk about buyers' gains and losses in a minute. For now, understand that any time the market price is higher than the strike price, the call is in-the-money. Period.
The Premium
Option premiums represent the probability that a buyer could win. If the premium is cheap, it's a long shot. If the premium is expensive, things are probably already working in favor of the buyer with time left for things to get even better.
For example, if MSFT common stock now trades for $28 a share, the right to buy it next month for $40 is all but worthless, while the right to buy it for $30 has some chance of working out for the buyer and would, therefore, trade at a higher pre¬mium. The right to buy the stock for $30 through next month is also not worth as much as the right to buy it for $30 through the next three or four months, right? The premiums would show this is exactly right. For call options, the premiums rise as the strike prices drop, and as time goes out.
If today were St. Patrick's Day, a MSFT Mar 20 call is worth more than a MSFT Mar 25 call, but a MSFT May 20 call is worth more than both. Why? The right to buy MSFT for $20 is worth more than the right to pay $25, and the right to do so for two extra months is worth even more.
Exercise, Trade, Expire
Sometimes options are opened and closed; sometimes they are exercised; and some¬times they expire worthless. If the call goes in-the-money, the investor could choose to exercise it. That means he buys stock at the strike price and sells it immediately at the current market price.
The investor could also close his position by selling it. If he bought to open, he sells the option to close. If he sold to open, he buys the option back to close.
And, finally, the option could expire worthless. When that happens, the buyer loses all he paid, while the seller makes his maximum gain.
Puts
If we clipped the follow¬ing coupon from the newspaper, what would it allow us to do?
That coupon represents an IXR Oct 40 put. As the holder/owner/buyer of this put we have the right to sell IXR stock for $40.
What if IXR is only worth $2?
Great! We get to sell the stock for $40 at any time before the end of trading on Friday, October 20, even if it's worth only two bucks on the open market. In fact, even if it's worth zero, we can sell it for the $40 strike price.
That's how a put works. A put buyer gets the right to sell IXR at the strike price before the contract expires. No matter how low IXR goes, the holder of an Oct 40 put has the right to sell 100 shares of IXR for $40 each before the end of trading on the third Friday of October.
Who buys puts? Investors who think a stock is about to drop in price. Bears.
Strange as it seems, as the stock price drops below the strike price, the value of the put goes up.
Think of it like this—if a stock is now at $20, wouldn't you like to sell it to someone for $40? If you were ready to exercise the put, you could buy the stock for $20, then immediately sell it to the put writer for $40. That would involve exercising the put. As we saw with calls, though, options investors don't always exercise their options, but, rather, close the positions for their intrinsic value. If they take in more than they spend, they end up with a profit. If they spend more than they take in, they don't.
For puts, intrinsic value is the amount of money a put's strike price is above the market price, which is another way of saying the market price has fallen below the strike price. An October 40 put has how much intrinsic value when the underlying stock trades at $20?
$20. Wouldn't you love to sell something worth only $20 for $40?
Talk about putting it to someone! The owner of a put profits when he can sell higher than the market price. He needs the stock price to go down, below the strike price. That's when he profits, when the stock is losing value.
Hedging (Risk Modification Techniques)
If we buy stock, we are betting that its price is going up. If it goes down, we lose. If we sell a stock short, we are betting that the price is going down. If it goes up, we lose.
Maybe the problem with both strategies, then, is that the investor is betting all one way. What he could do, instead, is hedge his bet.
To hedge a stock position means to "bet the other way, too." The term "hedge" is based on the way people grow hedges to establish the boundaries around their property. In this case, the property is stock—with a hedge, the owner can establish the boundaries in terms of what he's willing to lose.
Let's say a stock in an investor's portfolio looks like it is about to drop. What should we tell him to do? Sell the stock? Yes, but that is a drastic measure, especially when it is also possible that the stock will rally, and we would hate to miss out if it did.
So, instead of taking a drastic measure, maybe the investor could buy an option that names a selling price for the stock. Which option gives an investor the right to sell stock at a particular price?
A put. So, if he thought one of his stocks might drop sharply, the investor could buy a put, giving him the right to sell the stock at the put's strike price, regardless of how low it goes.
It's like a homeowner's insurance policy. If you own a home, you buy insurance against fire. Doesn't mean you hope your house burns down, but, if it does burn down, you will be glad you paid the premium for the policy.
Buying puts against stock you own is a form of insurance. Insuring your downside, you might say.
A question might look like this:
Jimmy Joe purchases 100 shares of QSTX for $50 a share. Mr. Joe is bullish on QSTX for the long-term but is nervous about a possible downturn. To hedge his risk and get the best protection, which of the following strategies would you recommend?
A.    sell a call
B.    buy a call
C.    sell a put
D.    buy a put
If an investor buys stock, he is bullish, or betting the price will go up. To hedge, he'd have to take a bearish position, betting that the stock might go down. There are two "bearish" positions he can take to bet the other way or "hedge." He could sell a call, but if the test wanted you to recommend that strategy, the question would have said something about "increasing income" or "increasing yield."
And this one doesn't. This one gives you the key phrase:
"...and get the best protection..."
Whenever you see the word "protection," remember that the investor has to BUY an option. If an investor is long stock, he would buy a put for protection.
So, Mr. Jimmy Joe paid for protection in the question. If he has a put, he has the right to sell his stock for a minimum price rather than seeing how far the price drops on the secondary market. On the other hand, the question might have looked like this:
Barbara Bean purchases 100 shares of QSTX for $50 a share. Barbara is bullish on QSTX for the long-term but is afraid it may trade sideways in the short-term. To hedge her risk and increase income, which of the fol-lowing strategies would you recommend?
A.    sell a call
B.    buy a call
C.    sell a put
D.    buy a put
As we saw, we do not increase our income by buying a put. When we buy something, money comes out of our wallet. In this case, Barbara Bean must sell an option. What is the only bearish option she could sell?
A call. Call sellers are bearish. Or, bearish-neutral. If the stock goes "sideways," the call will expire in Barbara's favor.
Since Barbara already owns the stock, this would be a covered call. Let's say she bought the stock at $50, then writes a Sep 60 call at $3. If the stock goes up more than she expected, what would happen? This investor would be forced to honor her obligation to sell the stock at the strike price of $60. But, she only paid $50 for the stock, so she profits. And, she took in $3 for writing the call. So, she made $13, which represents her maximum gain.
Her maximum loss is much larger than the investor who bought the put in the preceding question. In this case the investor has not purchased a sale price for her stock. All she did was take in a premium of $3. That is the extent of her downside insurance. She paid $50 for the stock and took in $3 for the call. So, when the stock falls to $47 she has "broken even."
After that what's to prevent her from losing everything from that point down to zero? Nothing. So, $47-per-share is her maximum loss. This illustrates why buying puts is for protection of a long position, while selling covered calls is just a way to generate premiums if the investor feels the stock is likely to trade in a narrow range for the dur¬ation of the call options.
Since they sell something they eventually must buy back, short sellers hope the stock's price goes down. If an investor sells a stock short for $50, he hopes it will drop to maybe $1 or $2 a share. If the stock goes up instead, what is his risk?
Unlimited loss. Remember, he still has to buy this stock back, and he does not want to buy it back for more than he first sold it. Which option gives an investor the right to buy stock at the strike price?
Calls. So, if this investor wants protection, he buys a call. As with an insurance policy, he does not want to use the call, but it names the maximum price he must pay to re¬purchase the stock he sold short.
A test question could look like this:
An investor sells short 100 shares of ABC at $50. In order to protect against an increase in price, which of the following strategies would you recom-mend?
A.    buy a put
B.    sell a put
C.    sell a call
D.    buy a call

The answer is "D," buy a call. Again the word "protection" means the investor has to buy an option. If he is concerned about his purchase price, he buys a call, which gives him the right to purchase stock at a strike price. Maybe he's willing to risk having to repurchase the stock at $55 but not a penny higher. Therefore, he buys a Sep 55 call for $2. Using our T-chart, where would we plug in the numbers? If he sells the stock at $50, that's a credit to his account, so let's place $50 in the credit column. He paid $2 for the call, so that's "2" in the debit column.
Okay, where does this investor break even, then? $48. 50 in the credit column, 2 in the debit column, so 48 would make things even.
And if you prefer to analyze the position, start with step one—look at the stock position. He shorted the stock at $50, which means he wants it to go down. If he paid $2 for the option, doesn't the stock have to work his way by exactly $2 before he breaks even?
It does. So when the stock goes down to $48, this investor breaks even. Is there anything to prevent him from making everything from that point down to zero? No. So $48 is his maximum gain, too. Breakeven down to zero.
What about his maximum loss? Well, let's say disaster strikes. The stock skyrockets to $120 a share. Does he have to buy it back at that price in order to "cover his short"? No. At what price could he buy back the stock?
The strike price of $55. That was the protection he bought. And, if he exercised his call, his T-chart would show that $50 came in when he sold short, while $57 came out (when he bought the stock at $55 after buying the call at $2). That's a loss, but it's only a loss of $7, which isn't too bad considering how risky it is to sell a security short.
So if a short seller needs protection, he buys a call. It's the same thing as long stock–long a put, only upside down.
Now, let's look at the mirror image of the covered call. Say this same short seller wanted to hedge his bet while also increasing income. If he starts out bearish, he hedges with a bullish position. To increase income, he'll have to sell a position. Only bullish position he can sell is a put. So, he ends up short the stock and also short a put. In other words, he sells the stock short and also sells a put on that underlying stock. If the stock gets put to him, presumably he'll use those shares to cover his short stock position.
If he shorts the stock at $50 and sells adun 40 put @ 3, where would he break even? Well, short sellers want to see the stock go down. However, since he took in $3, he can let his stock position work against him by $3. This investor breaks even at $53.
Right? That's what selling an option does for a hedger; it offsets the potential loss by the amount of premium collected. And, your T-chart tells you that $50 came in when he sold the stock short, plus $3 that came in for selling the put. So, 53 is the breakeven point.
What's the most he can lose? Well, how high could the stock rise? Unlimited. Does he have the right to buy the stock back at a set price? No. So, his maximum loss is unlimited.
Like the covered call writer, he has also capped his "upside" or his maximum gain. His upside is down, remember. When the stock goes down to zero, does he get to buy it back at zero?
Not after writing that put option. The investor who bought the Jun 40 put is going to make him buy the stock for $40. Now the investor realizes his maximum gain. Sold the stock at $50, bought it back at $40. That's a gain of $10. He also took in $3 for writing the put. So, his maximum gain is $13. Stock price vs. Strike price + Premium.


Position Limits
The customer's signature on the options agreement means he understands the risks associated with options and will follow the rules of the options exchange. For example, he won't take the electronic quotes and re-sell them on a website. He won't write calls and then flee the country whenever they go deep in-the-money. And, he will abide by any position limits that may be in place.

A position limit means that a customer, or a group of customers "acting in concert," will not try to corner the market, so to speak.

If a standardized option has a position limit of 25000, that means that an investor can have no more than 25,000 bull or bear positions in that option. If he buys 20,000 calls, there are 5,000 bull positions left. He could, therefore, buy 20,000 calls and write 5,000 puts.

I'm talking about "per class" here, meaning all MSFT calls or puts, not all MSFT Oct 30 calls, which would be a series. He could also establish 25,000 bear positions (buy puts, sell calls) on an underlying security.

exercise limits
The same numbers used for position limits are used for exercise limits. That means if the option is subject to a limit of 25,000, 25,000 represents the maximum number of open bull or bear positions a trader can have at one time on a class of options and also the maximum number of contracts he can exercise over five consecutive business days. The CBOE regularly publishes a list of position limits associated with options.

Warrants
A warrant gives the holder the right to buy the issuer's common stock for a set price regardless of how high the stock price rises on the secondary market. There are no dividends attached to a warrant. If an investor owns a warrant, all he owns is the opportunity to purchase a company's stock at a predetermined price. If a warrant lets him buy XYZ for $30 per-share as of some future date, he will benefit if the stock price rises above $30 by that date.
When issued, the exercise price stated on the warrant is above the current market price of the stock. It usually takes a long time for a stock's price to go above the price stated on the warrant, assuming that ever happens at all. But, they're good for a long time, typically somewhere between two and ten years.
Warrants are often included in a bond offering. As we saw earlier, corporations pay interest to borrow money through bonds. If they include warrants, they can "sweeten the deal" and offer investors a lower interest payment. Why would one investor take 4% when his buddy gets 6% on his bond? Doesn't the buddy make $60 a year, while the other investor only makes $40 per $1,000? Yes. But if the company's common stock rises, the buddy will be making $60 a year, while the other investor could make a profit on the common stock.
Warrants are issued by the company itself. Equity options, on the other hand, are created by options exchanges and are based on the price of various public company stocks. So, MSFT might issue warrants to certain investors, but a MSFT call or put option is not issued by Microsoft. It is issued by the options exchanges, with Microsoft's permission but not their participation.

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