Chapter 15 Options Terminology exercise or strike price Characteristics call option contract giving the holder the right to buy 100 shares of stock at a preset price called the Put option A contract giving the holder the right to sell 100 shares of stock at a preset price If a call option holder wishes to purchase the stock he or she will exercise the option The option holder must pay the exercise price to the option writer Exercise prices are adjusted for stock splits and stock dividends but not cash dividends The cost of an option is called the premium and it is a small percentage of the cost of the underlying asset The option buyer pays the cost the option writer receives the cost at the time of sale of the option The underlying company is not involved in the option market Options are a zero sum game Uses of options To hedge changes in stock price Change your risk and return profile Short sale constraints can be avoided with puts Long or bull strap buy two calls and one put more bullish than straddle Long or bull strip buy two puts and one call more bearish than straddle Short Strangle Sell out of the money put and call Warnings about Options Positions Options may have to move 10 15 or more in a short time period before an investor recovers the price Options are by definition short term instruments an investor can ride out bad times in spot markets but commission not in options o The limited loss feature makes options appear safer than they are o You have to compare equal investments in stocks and options to really see the higher risk of the option position Options are traded in a highly competitive market What s wrong with selling options Covered calls writing calls against stock you own o The investor never gets the occasional large stock price run up and suffers most of the loss of a big price drop Eliminates any positive skewness of stock returns o Wind up with portfolio of poorer performers Naked calls writing calls when you do not own the stock o Maximum gain is limited to call premium but unlimited loss poor strategy in volatile markets
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