ow Option Orders Originate
Before going into the further explanation and application of options
- specifically about trade call option - it might be
interesting to explain how orders for options originate and are executed.
An interested party—perhaps in Detroit—will ask his stockbroker
to ascertain on what terms a Call option can be had on a certain stock
for, let us say, 90 days for the purpose of trade call option. The stockbroker
will find this out through his New York office, which in turn gets in
touch with an option-dealer for the terms on which a Call option can be
had on that particular issue. The option-dealer might quote the contract
at a nominal price of $400. This quotation is sent back to the customer
in Detroit, and if the quotation meets with his approval, an order will
be given to the option-dealer to "buy Call on 100 XYZ at market for
90 days for $400." On receipt of such an order, the option-dealer
will get in touch with his clients who might be interested in selling
such a contract, and when he has been successful in negotiating the trade,
he will report to the stock-exchange firm from whom he received the order:
"Sold you Call 100 XYZ at 70 for 90 days for $400 expires October
24." The Call option contract is then delivered to the stock-exchange
firm which gave the order and the latter will pay for the contract from
the customer's account and hold the contract, subject to instructions
by the customer before expiration as to whether or not the option should
be exercised. (The cost of federal and state tax will be added to the
cost of a Call option. There is no tax required on a Put option.)
Explanation of Chart
A look at the accompanying chart of U.S. Steel common shows that it broke from 72 in the second week of July, 1957, to 48¼ by the third week in December of the same year. From 48¼ it rose in almost a straight move to just under 100 in January, 1959.
In the examples that I use as illustration, people might say that I am using only favorable ones. I am using not only examples of options that were profitable to the buyer but also those where the buyer of the option was wrong and lost his premium money. Some of the examples are taken right from the records and are options that were actually sold at the time and at the price mentioned.
On July 23, 1957, when U.S. Steel was selling at 70½, 6-month-and-10-day Puts were sold at 70 ½ for $475 per 100-share Put. The Puts expired on February 3, 1958, and on that date the stock sold at 56. The Put contracts could have been closed out on that date with a profit of $1,450, less the cost of the option and commissions for buying and selling the stock. Of course, during the life of the option, the stock sold for as little as 48¼. Had the holder of the option seen fit to close out his option in mid-December, he could have bought stock at 49 and exercised his option before expiration, showing a profit of $2,150. Even if the man's judgment of the market had been wrong—but it wasn't—his loss would have been limited to the cost of the Put option.
If someone had been farsighted enough to buy Calls on U.S. Steel in mid-April,
1958, when steel was selling at 56, his profit could have been enormous.
On April 16, 1958, Calls were sold at 57 5/8, expiring in 6 months and
10 days (October 27, 1958), for $450 per 100-share Call. On October 27
the stock sold at 87, and if the owner had chosen trade call option on
that date, the profit would have been $2,937.50, less the cost of the
option and stock-exchange commissions for buying and selling the stock.
The owner of such a Call does not necessarily have to sell the stock after
he Calls it—he may see fit to Call it and carry the stock, looking
for a higher price at which to sell it. Of course, in calling the stock
and carrying it, he will be required to margin the stock properly with
his stock-exchange house.
If the customer wishes to have the option exercised and it happens to be a Call on XYZ at 70, his instructions to his stockbroker will read: "Exercise Call on 100 XYZ at 70 expiring October 24 and sell stock at market;" or if he wishes to exercise his Call contract and carry the stock in his account his instructions should read: "Exercise Call on 100 XYZ at 70 expiring [date] and carry stock in my account."
Of course, if he chooses to carry the stock, he will be obliged to margin it according to stock-exchange requirements. If he exercises the Call and at the same time sells the stock, he will be required to deposit only 25 percent margin or $1000, whichever is greater.
It might be of interest at this time to explain that the option-dealer does not operate on a commission basis, but his profit is made in the difference between what he pays for an option and what he receives for it. An option-dealer having an order to buy an option for $500 will probably bid $450 to the maker of the option, which he is going to sell for $500, and therefore make about $50 on the transaction. It may be possible sometimes to buy the option for a lesser amount, and in that case the option-dealer's profit will be larger. Conversely, the broker may not be able to buy the option for less than $475 in order to fill his order, and therefore his profit would be $25. So much for the various uses of the Put contract.
ses of the Call Option Contract
A Call option is a contract, paid for when it is purchased, which gives the holder the right to buy, at his option, a specified number of shares of a stated stock at a fixed price, on or before a fixed date. The option money is the amount paid for the option contract. Should the option be exercised, it is not applied against the purchase price of the stock. If you pay $500 for a Call on XYZ at 70 and you exercise the Call, you pay 70 for the stock, less any dividends or rights that belong to the contract.
he Use of a Call Contract for Speculation
A man thinks that a stock, now selling in the market at 50, is going
to have a substantial rise. He buys a Call option on 100 shares at 50,
good for 90 days, for $350 plus tax. The federal and state tax departments
demand that tax stamps be affixed to Call options (but not to Puts). This
tax, paid for by the buyer of the option at the time he buys it, is the
same amount that would be paid by a seller on a sale of the stock at the
Call price. The maximum is $12 per 100 shares and is fixed according to
the dollar value of the stock involved. When the trader buys the Call
option at 50, good for 90 days, for $350, this amount is the most he can
lose, no matter what happens to the stock. If the trader is correct in
his judgment and the stock rises to, let us say, 70, before his Call contract
expires, he buys the stock by exercising his Call and chooses trade call
option in the market at 70. His profit is $2,000 less the cost of the
Call contract, and his account shows:
||Bought call 100 XYZ at 50 for
|| $ 350
||Bought 100 shares at 50 thru Call
||Sold 100 shares at 70
The transaction shows a profit of almost 500 per cent of the $350 at risk.
In making such a trade, when the stock is Called and sold on the same day, the holder of the Call contract will be required to deposit margin of 25 percent of the sale price—70—with his stock-exchange broker until the trade clears on the fourth business day following the trade.
Please remember that not only does the cost of the option constitute the
total risk to the holder, but the choice of exercising the option also
belongs to the holder of the contract and he will exercise his option
only if it is to his advantage to do so. The seller or maker of the contract
has no choice—he must live up to the terms of the contract at the
option of the holder of the contract. In this way, the terms of the relationship
are binding while finances are redistributed according to market fluctuations
as long as trade call option remains viable.