Home  |  Get Started  |  Download  |  Advertise  |  Donate  |  Contact Us
Chapter 1. Option Trading Explained

It is strange that option trading, which has been in existence as long as the business of stock options has never been fully explained, except in leaflet form. As far as I can learn after searching through libraries and college reference books, no complete book has ever been written explaining all of the uses and facets of the business. I have written numerous articles about options, including one for and at the request of the Encyclopedia Britannica, and the present edition contains that explanation of the uses of options. But in this book I propose to give the history of options and the various uses of the Put option contract, the Call option, and their variations and combinations such as the Spread, Strip, Straddle, and Strap. Now I will say simply that a Put option is an option to sell (or "Put") at a specific price within a specified time limit. A Call option is an option to buy (or "Call for") at a specified price within a specified time. These will be thoroughly explained shortly, as will Spreads and Straddles. I will show by example just how they can be used in market operations—their speculative uses and their protective or insurance features. I will show that the main advantage in the buying of options is the feature of limited loss and unlimited possible profit. I will also show who "makes" options and why, and the advantages accruing to those who write or make these contracts. Any disadvantages will also be pointed out, because there can be disadvantages if certain age-old principles are ignored.

When I read a book on a special subject, I am curious about how qualified the writer is to handle the subject; I suppose the reader might want to know my qualifications for writing this book, so here goes.

I started in the option trading in 1919—that's forty-three years ago—and today mine is the largest stock-option business in the United States, if not the world. My firm, Filer, Schmidt & Co., has dealt in nothing but options— "Options Exclusively"—for all these years. Options are not just a department of the firm. In 1932, when the Securities Act was being drawn up, the original attitude of the lawmakers was, ". . . not knowing the difference between good options and bad options, for the matter of convenience we strike them all out." At that point the entire option business was threatened, and by appointment of the Put and Call Brokers and Dealers Association, Inc., I had the privilege of appearing before a committee of the House of Representatives and the committee of finance of the Senate to defend the usefulness and economic value of our business in the securities market. Subsequently, the Securities and Exchange Commission was formed, and the option business was allowed to function "if not in contravention of rules set down by the SEC." In all these years the SEC has not found it necessary to lay down any rules to govern the business of Put and Call options.

Almost all of the option business in this country is done by some twenty-five members of the Put and Call Brokers and Dealers Association, Inc. This association forms rules for the conduct of the business, polices the affairs of its members, arbitrates any differences between its members or between its members and the public, and reports each week to the Securities and Exchange Commission a list of option trades made by the members of the association. While the options traded through our members run into millions of shares annually, there is rarely a matter which comes before our Board of Arbitration, and seldom is an error made in making a trade.

During my forty-three years in option trading, I have lectured to trainees of stock-exchange houses as well as to representatives of stock-exchange firms from coast to coast, also to groups of professors of finance from various colleges and universities who visit New York each spring. I have lectured on the subject of stock options for a number of colleges and universities, and it has been my pleasure to have lectured for a number of years to the class in finance of the University of Vermont, which each year visits Wall Street for a six-week course of instruction in various phases of finance. I have also studied the option business in London, Paris, Amsterdam, and Switzerland, after which we patterned the option business as we operate it today in this country. Option business was done in Europe long before any of our exchanges was organized.

Of course, during the years of World War II, there was no trading on the European exchanges, for they were then closed. However, since the end of the war there has been trading on such exchanges where currency is free (for instance, in Switzerland), and today we do considerable option business between New York and Switzerland. It might be of interest to the reader to know that on the London Exchange, where option trading had been discontinued since the war even though securities, as such, were  traded,   the  members  voted  overwhelmingly  for options, and actual trading was resumed in October, 1958. London options, however, are different from American contracts in many respects, the two important differences being that options can be traded only between members— not the public—and London options cannot be "done," as they term it, for periods over seven account periods (approximately ninety days). In the United States we do a large part of our option business in six-month options and, occasionally, trade in contracts for one year. And our contracts can be bought or sold by members of an exchange or the public.

Option trading was used in Holland about three hundred years ago in the boom of tulip bulbs. A grower engaging to deliver a shipment of tulip bulbs and concerned over the safe arrival of his shipment, would, for a small sum, acquire an option from another grower on a like amount of bulbs at the current price. If for some reason the boat carrying his cargo did not arrive at its destination and the shipment of tulip bulbs was lost, through his option he could reacquire the tulips of the other grower and thereby be able to make good on his contract to deliver without having to pay the possibly much higher price prevailing at the time of delivery.

Although his insurance could cover the value of the original shipment, it could not protect him against a much higher replacement cost. His option gave him the needed insurance against a price increase or costly breach of contract.

Options are used daily in real estate transactions, and such use is explained here in an attempt to draw a parallel, as near as possible, between options on stocks and options on real estate.

A builder wants to buy a large plot of ground in order to build an office building or an apartment house. On this plot of ground there are a number of small buildings which he plans to demolish so that he can erect his building—but only if he can acquire the entire plot of ground. To buy some of the buildings only to find out that he cannot purchase all, would prevent the erection of the complete project and would be costly and risky. So for a relatively small sum the builder tries to acquire an option on each building, and having acquired such options he can buy all of the properties through these options and commence the building project. If, however, the company is unable to obtain options on all of the property, it can abandon its plans and its loss would be limited to the cost of the options acquired.

As another illustration about option trading, let us suppose that Mr. Jones wants to sell a piece of property for $100,000, and Mr. Smith believes that he can sell it to Mr. White for $125,000. Mr. Smith wouldn't want to buy the property and then find that he was unable to sell to Mr. White. So for a relatively small sum he buys an option from Mr. Jones, good for 90 days, to buy the property for $100,000. If, within the 90 days Mr. Smith is successful in making the sale to Mr. White for $125,000, he then exercises his option and buys the property from Mr. Jones according to the terms of his option contract, and sells it to Mr. White. Mr. Smith has made $25,000, less the cost of his option. If, however, he had been unable to sell the property to Mr. White, Mr. Smith would have allowed his option to lapse and his loss would have been limited to the cost of the option contract.

Options are used extensively in many businesses today. A ball club has an option on a player, a movie studio on an actor or actress, and you can even choose your own option as to how you wish to have your life insurance paid to your heirs.

Webster's Dictionary gives these definitions of "option":

  1. The exercise of the power of choice.
  2. Power of choosing:  the right of choice, an alternative.
  3. A stipulated privilege of buying or selling a stated property, security or commodity at a given price within a specified time.
  4. The right of an insured person to choose the form in which payments due to him on a policy shall be made or applied.

In the case of Put and Call stock options, the choice or "option" belongs to the holder of the option contract; he can exercise his contract or not, according to his choice, and he will exercise the option at or before its expiration only if it is to his advantage to do so. The seller of the option has no choice; once he has sold the contract, he must accept stock or deliver stock according to the terms of the option and only at the option of the one who holds the contract.

Options are sometimes confused with "hedging" or "arbitraging"—they are neither; for again to use Webster's definitions:

Arbitrage—Purchasing in one market for immediate sale in another at a higher price.

Hedge—To counterbalance a sale or purchase of one security by making a purchase or sale of another.

Neither of the above-described operations can be compared to option trading. Neither the arbitrageur nor the hedger has any option; he has made two complete trades. The holder of a Put or Call option exercises his option contract only if it is to his advantage to do so. He has one side of his trade in his option contract and the other side —the buying against a Put or the selling against a Call—is done only if it is profitable to the one who holds the option contract.

Options can be used as a speculative medium with small, or relatively small, risk and with unlimited possible profit. The leverage in connection with option-trading is exceedingly attractive. In any venture, the relation of the possible profit to the possible loss is something that cannot be overlooked. The uses to which options can be put are numerous, and because the general public and even the brokerage fraternity are not well versed in the various uses of options, this book will explain in considerable detail many of the general uses and even the intricacies of option-dealing.

Colleges and universities have begun to realize that this subject, which is part of Wall Street procedure, could well be included in a course on finance. I feel that the information gained through such education will stand the students in good stead when they enter the business world, particularly the field of finance.

It is my contention that options are protective contracts—they protect either before or after a stock commitment. A man can buy an option to protect a purchase or sale already made or about to be made. He can acquire a Put contract to protect stock which he holds. He can buy a Put to protect him against unlimited loss when he buys a stock. He can buy a Put to protect a profit which he already has and doesn't want to lose. Or he can acquire a Put or a Call to protect him against a commitment which he expects to make at a later date and on which, when he makes such commitment, he does not want to take an unlimited risk. So an option is a protective device no matter when it is used.

It is not my contention that everyone must trade in options, but I do say that anyone who has an interest in securities should have a knowledge of Put and Call options because at some time or other options can play a part in one's security-trading, whether to protect a profit or possibly to recapture stock after taking a profit.

From figures recently gathered, there are about 12,000,000 stockholders in the United States. I will venture to say that of these 12,000,000 stockholders, not even 12,000 have more than a smattering of knowledge of Put and Call options, and not more than 1,200 out of the 12,000,000 could explain very much of the technical workings of the option contract. Take my word for it—to understand the workings of options is not very difficult and any effort to unravel this supposed mystery will be rewarding to the stockbroker and also to his customer.

Option trading spread into the securities business as a protective and also a speculative device. In the late nineteenth century, options in this country acquired the names of "Puts" and "Calls," and they have been dealt in in increasing numbers ever since, for those who deal in securities recognize both their protective and their speculative value.

Put-Call options can be used profitably in either a rising or a falling market, and the increasing interest in them is a result of the knowledge gained by the public of the various uses to which options can be put.

Of course a man wouldn't think of owning a home without insuring it against fire; nor would he think of not insuring his wife's jewelry and furs against loss or theft; he carries life insurance to protect his family when he dies. Yet it is strange that relatively few people understand that through Put and Call options they can protect themselves against unlimited loss in stock-holdings, or can preserve substantial "paper" profits without selling. Many of the large losses, either of invested capital or "paper" profits, sustained by traders in the bad breaks in the market that come every now and then, could have been avoided through the protection that is available through options. It has been my experience that small stock-losses do not break a man, but it is the large loss taken by the stubborn trader in a market like that of 1929, 1937, 1946, or 1957 that can wipe out a trader or leave him with little chance to recoup his losses.

Now seems to be the time when options are needed in the field of finance more than ever before because they act as a protection against excessive losses and as a safeguard for profits. It should be made known to every investor and speculator that there is a way to guard against excessive losses by limiting such losses to a specified and relatively small amount.

Are You Ready To Move Onto The Next Lesson? Click Here….

Add URL | Contact Us | Privacy Policy | Option Trading Strategies Sitemap | Resources
COPYRIGHT (C) 2005 www.optiontradingstrategies.org