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PFE, Chapter 23: Introduction to options page 25

• If an October 2001 Cisco put option with exercise price $10 (the right to sell a share

of Cisco in October for $10) is worth $0.10, then the right to sell a share of Cisco for

$12.50 should be worth more. And so it is.

The graph and the table show what appear to be a few exceptions to this rule. For

example, the Cisco put with X = $60 traded for less than the put with X = $55. If you see this

kind of behavior it almost always has to do with the fact that the options in question are

infrequently traded. In the example given here, the $65 and $60 calls only traded several times

during the day in question. The result is that the option prices given in the table refer to options

traded on Cisco stock at different times and with different prices. (Notice that one of the

options—the October put with exercise price $65—didn’t trade at all.)

Property 3: When the stock price goes up, call option prices go up and put option

prices go down

The reason for this behavior is obvious, if you think of an option as a bet: Suppose you

buy a Cisco X=20 October 2001 call option. We can view this option as a bet that Cisco’s stock

price in October will be above $20. The probability of your winning this bet is higher if Cisco’s

current stock price is higher, and hence so is the call option’s price. Thus, for example, if you’re

willing to pay $1.80 for the X=20 October call when Cisco’s current stock price is $19.26, you

would be willing to pay more for the same call when Cisco’s stock price is $22.

The logic for puts is the same, though the result is opposite: The higher the stock price,

the lower the put option price.

PFE, Chapter 23: Introduction to options page 26

23.5. Writing options, shorting stock

Our discussion thus far has been from the point of view of the option purchaser. For

example in Section 23.2 we derived the profit pattern from buying a Cisco 20 call for $1.35 on 7

August 2001 and waiting until the call maturity on 21 September 2001. Similarly in Section 23.3

we looked at the profit from buying a Cisco 20 put.

There’s another side to this story: When you buy a call, someone else sells the call. In

the jargon of options markets, the call seller is writing a call.

Call buyer: On 7 August 2001 buys, for $1.35, the right to buy one share of Cisco stock

for $20 on or before 21 September 2001.

Call writer: On 7 August 2001 sells, for $1.35, the obligation to sell one share of Cisco

stock for $20—as per demand of the call option buyer—on or before 21 September.

Here’s the way the call writer’s profit pattern looks:

PFE, Chapter 23: Introduction to options page 27

CALL OPTION CASH FLOW PATTERN--the call writer

7-Aug-01 21-Sep-01

Receives: $1.35 If Cisco's stock price > $20

( denote this by S

> 20 ),

the call will be exercised.

The call writer has to sell

one share of Cisco stock

for $20.

Call writer's loss

: S

- $20

If Cisco's stock price <

$20,

( denote this by S

< 20 ),

the call will not be exercised.

Call writer's loss

: 0

In principle, the call buyer has the

right to buy Cisco stock for $20 on

any date before 21 September. In

actual fact, the call buyer will only

want to exercise the call

option at its terminal date (see next

chapter).

Figure 23.9. The cash flows from writing a Cisco call option on 7 August 2001 for $1.35 and

possibly having it exercised against the writer on 21 September 2001. The option has exercise

price X = $20.

Here’s the profit graph from writing a call option:

PFE, Chapter 23: Introduction to options page 28

ABCDEFGHIJK

Call price, 7 August 2001 1.35

Call exercise price, X 20

: Market price

of Cisco,

21 September 2001

Will call

buyer exercise

the call?

Dollar

profit/loss

0no1.35

5no1.35

10 no 1.35

16 no 1.35

18 no 1.35

20 no 1.35

21 yes 0.35

22 yes -0.65

25 yes -3.65

28 yes -6.65

30 yes -8.65

32 yes -10.65

34 yes -12.65

Technical note: The data series graphed above

are

non-contiguous

in the spreadsheet (they're

column A and column C). For how to do this: see

Chapter 26.

PROFIT FROM WRITING A CISCO CALL

Bought for $1.35 on 7Aug01; Exercise price: X=$20

Exercise date: 21Sep01

Call Writer: Dollar Profit/Loss on Cisco

Call Option

-15

-13

-11

-9

-7

-5

-3

-1

0 5 10 15 20 25 30 35

: Cisco stock price on 21Sep01

Profit = Call price - max(S

-20,0)

=IF(A18>$B$3,"yes","no")

=$B$2-IF(A18>$B$3,A18-$B$3,0)

Writing puts

There’s a similar story for puts:

Put buyer: On 7 August 2001 buys, for $2.00, the right to sell one share of Cisco stock

for $20 on or before 21 September 2001.

Put writer: On 7 August 2001 sells, for $2.00, the obligation to buy one share of Cisco

stock for $20—as per demand of the put option buyer—on or before 21 September.

Here’s the way the call writer’s profit pattern looks:

PFE, Chapter 23: Introduction to options page 29

PUT OPTION CASH FLOW PATTERN--the put writer

7-Aug-01 21-Sep-01

Receives: $2.00 If Cisco's stock price < $20

( denote this by S

< 20 ),

the put will be exercised.

The put writer has to buy

one share of Cisco stock

for $20.

Put writer's loss

: $20 - S

If Cisco's stock price > $20,

( denote this by S

> 20 ),

the put will not be exercised.

Put writer's loss

: 0

In principle, the put buyer has the

right to sell Cisco stock for $20 on

any date before 21 September. In

actual fact, she will only rarely want to

exercise the put option before its

terminal date (see Chapter 21).

Figure 23.10. The cash flows from writing a Cisco put option on 7 August 2001 for $2.00 and

possibly having it exercised against the writer on 21 September 2001. The option has exercise

price X = $20.

Here’s a graph of the profit pattern from writing a put:

ABCDEFGHIJK

Put price, 7 August 2001 2

Put exercise price, X 20

: Market price

of Cisco,

21 September 2001

Will put

buyer exercise

the put?

Dollar

profit/loss

to put writer

0yes-18

5yes-13

10 yes -8

16 yes -2

18 yes 0

20 no 2

21 no 2

22 no 2

25 no 2

28 no 2

30 no 2

32 no 2

34 no 2

Technical note: The data series graphed above

are non-contiguous in the spreadsheet (they're

column A and column C). For how to do this: see

Chapter 26.

PROFIT FROM WRITING A CISCO PUT

Bought for $2.00 on 7Aug01; Exercise price: X=$20

Exercise date: 21Sep01

Put Writer: Dollar Profit/Loss on Cisco

Put Option

-18

-13

-8

-3

0 5 10 15 20 25 30 35

: Cisco stock price on 21Sep01

=IF(A18<$B$3,"yes","no")

=$B$2-IF(A17<$B$3,$B$3-A18,0)

Profit = Put price - max(20-S

,0)

PFE, Chapter 23: Introduction to options page 30

Short-selling a stock

Short-selling a stock (“shorting”) is the stock equivalent of writing an option. Here’s

how shorting a stock compares to buying a stock:

Stock buyer: On 7 August 2001 buys one share of Cisco stock, for $19.26. When you

sell the stock—call the date T—you’ll get the stock price S

. Of course you will have

also earned any dividends that Cisco will have paid up to and including date T.

Ignoring

the time value of money, your profit from buying the stock is:

19.26

S Cisco dividends

−

Stock shorter: On 7 August 2001 contacts his broker and borrows one share of Cisco

stock, which he then sells, thus receiving $19.26. At some future date T, the short-seller

of the stock will purchase a share of Cisco on the open market, paying the then-current

market price S

. If along the way Cisco has paid any dividends, the short-seller will be

obliged to pay these dividends to the person he’s borrowed the stock from. His total

profit will be:

(

)

19.26

S Cisco dividends−+

[For more information, see the sidebar from the Motley Fool, one of our favorite websites.]

In the option chapters in this book, we will generally assume that stocks don’t pay any

dividends between the time you buy them and the time you sell them. This means that the profit

from buying or shorting a stock can be represented as follows:

Not something you’re like to have to worry about: Cisco has never paid a dividend!

PFE, Chapter 23: Introduction to options page 31

ABCDEFGHIJK

Cisco stock price, 7 August 2001 19.26

: Market price

of Cisco,

21 September 2001

Stock buyer's

profit

Stock shorter's

profit

0.00 -19.26 19.26

5.00 -14.26 14.26

10.00 -9.26 9.26

16.00 -3.26 3.26

18.00 -1.26 1.26

19.26 0 0

21.00 1.74 -1.74

22.00 2.74 -2.74

25.00 5.74 -5.74

28.00 8.74 -8.74

30.00 10.74 -10.74

32.00 12.74 -12.74

34.00 14.74 -14.74

PROFIT FROM BUYING OR SHORTING CISCO STOCK

Market price on 7 August 2001: $19.26

Assumption: Position liquidated on 21 September 2001

=A17-$B$2

=$B$2-A17

Profit/Loss from Buying or Shorting Cisco Stock

-25

-20

-15

-10

-5

0 5 10 15 20 25 30 35

: Cisco price on 21Sep01

Profit/loss

Stock buyer's

profit

Stock shorter's

profit

Terminology Note

A long position in a stock involves buying the stock on a particular date and possibly

selling the stock on a later date. When you have a long position in a stock, you can choose to

hold on to the stock forever (in this case you will collect the dividends that the stock pays).

A short position in a stock involves selling borrowed stock on a particular date and

buying the stock on a later date in order to give the shares back to the stock lender. Buying the

stock in order to return the shares to the lender is called closing out the short position. When you

have a short position in a stock you must close out the position at some future date.

PFE, Chapter 23: Introduction to options page 32

The Fool FAQ : Shorting Stocks

Many times on the Fool boards I've seen references to `selling a stock short' or `taking a short

position.' Will someone tell me plainly what shorting is?

An investor who sells stock short borrows shares from a brokerage house and sells them to another buyer.

Proceeds from the sale go into the shorter's account. He must buy those shares back (cover) at some point in time

and return them to the lender.

Thus, if you sell short 1000 shares of Gardner's Gondolas at $20 a share, your account gets credited with $20,000.

If the boats start sinking---since David Gardner, founder and CEO of VENI, knows nothing about their design---and

the stock follows suit, tumbling to new lows, then you will start thinking about "covering" your short there for a

very nice profit. Here's the record of transactions if the stock falls to $8.

Borrowed and Sold Short 1000 shares at $20: +$20,000

Bought back and returned 1000 shares at $8: -$8,000

Profit: + $12,000

But what happens if as the stock is falling, Tom Gardner, boatsmen extraordinaire, takes over the company at his

brother's behest, and the holes and leaks are covered. As the stock begins to takes off, from $14 to $19 to $26 to

$37, you finally decide that you'd better swallow hard and close out the transaction. You do so, buying back shares

of TOMY (new ticker symbol) at $37.

Here's the record of transaction:

Borrowed and sold short 1000 shares at $20: +$20,000

Bought back and returned 1000 shares at $37: -$37,000

Loss: -$17,000

Ouch. So you see, in the second scenario, when I, your nemesis, took over the company, you lost $17,000...which

you'll have to come up with. There's the danger....you have to be able to buy back the shares that you initially

borrowed and sold. Whether the price is higher or lower, you're going to need to buy back the shares at some point

in time.

To learn more about short selling, try reading the following books: "Tools of the Bear: How Any Investor Can Make

Money When Stocks Go Down" - Charles J. Caes; "Financial Shenanigans: How To Detect Accounting Gimmicks &

Fraud" - Howard M. Shilit; "When Stocks Crash Nicely: The Finer Art of Short Selling" - Kathry F. Staley; "Selling

Short: Risks, Rewards and Strategies for Short Selling Stocks, Options and Futures" - Joseph A. Walker. None of

these are perfect in their coverage of short selling but each has its strengths.

Shorting, unlike puts, seems to have an unlimited downside potential, correct? That is, hypothetically,

the stock can rise to infinity. Puts, besides the time limit, have a limited downside. Why then, for a

short term short, would anyone short instead of purchasing puts?

Theoretically, yes. In reality, no. Because in our number system we count upwards and don't stop, we opine that

because numbers go on forever, so can a stock price. But when we think about this objectively, it seems kind of

silly, no? Obviously a stock price, which at SOME point reflects actual value in a business, cannot go on to infinity.

Yes, puts do have a limited downside. However, options have an expiration date, which means that they are "time-

wasting assets". They also have a "strike price" which means that you need to pick a price and then have the stock

below it on expiration date. Finally, you have to pay a premium for an option and if you are not "in the money"

more than the premium, by expiration day, you still lose. So, with options, not only do you have to be worried

about the direction of the stock, you need to be correct about the magnitude of the move and the time in which it

will happen. And even then, even if you successfully manage all 3 of these things, you can still lose money if you

don't cover the premium. Not very Foolish. With shorting, you only really need to be concerned about direction. As

for limiting liability, you can do that yourself by putting in a buy stop at a price where the loss is "too much" for

you.

What is short interest? Does it have anything to do with short attention spans?

PFE, Chapter 23: Introduction to options page 33

Pardon? Short interest? Oh yes! Ahem, short interest is simply the total number of shares of a company that have

been sold short. The Fool believes that the best shorts are those with low short interest. They present the

maximum chance for price depreciation as few short sales have occurred, driving down the price. Also, low short

interest stocks are less susceptible to short squeezes (see below). Short interest figures are available towards the

end of each month in financial publications like Barron's and the Investor's Business Daily.

The significance of short interest is relative. If a company has 100 million shares outstanding and trades 6 million

shares a day, a short interest of 3 million shares is probably not significant (depending on how many shares are

closely held). But a short interest of 3 million for a company with 10 million shares outstanding trading only

100,000 shares a day is quite high.

I've heard the term 'days to cover' thrown around quite a bit. Does 'days to cover' have anything to do

with short interest?

Yes, it does! Days to cover is a function of how many shares of a particular company have been sold short. It is

calculated by dividing the number of shares sold short by the average daily trading volume.

Look at Ichabod's Noggins

http://quote.yahoo.com/quotes?SYMBOLS=HEAD&detailed=t(Nasdaq:HEAD). One million shares of

this issue have been sold short (we can find this number, called the short interest, in such publications as Barrons

and the IBD). It has an average trading volume of 25,000. The days to cover is 1,000,000/25,000, or 40 days.

When you short a stock, you want the days to cover to be low, say around 7 days or so. This will make the shares

less subject to a short squeeze, the nightmare of shorters in which someone starts buying up the shares and

driving up the share price. This induces shorters to buy back their shares, which also drives up the price! A short

days to cover means the short interest can be eliminated quickly, preventing a short squeeze from working very

well.

Also, a lengthy days to cover means that many people have already sold short the stock, making a further decline

less likely.

What effect does a large short coverage have (generally) on the stock`s price? Generally, heavy buying

increases the price while selling decreases it. Assuming the stocks price has been steady, or climbing,

and many shorters attempt to cover their losses, how will this affect the price?

What you are referring to, in investment parlance, is a "short squeeze." When a number of short sellers all try to

"cover" their short at the same time, that does indeed drive the stock up.

Our approach when shorting is therefore to avoid in general stocks that already have a fairly hefty amount of

existing short sales. We try to set ourselves up so we'll never get squeezed.

I'll point out that short squeezes can be the result of better than expected earnings or some other fundamental

aspects of a company's operation. They can also be the result of direct manipulation. That is, profit-seeking

individuals with large amounts of cash at their disposal can look on a large short position in a stock as an invitation

to start buying, driving up the share prices, thus forcing short-sellers to cover. This in turn drives up the price, and

before you know it, the share price has soared!

OK, I understand the potential benefits and risks of shorting, except for one thing. If the stock I've

shorted pays a dividend, am I liable for that dividend?

Yes. If you are short as of the ex-dividend date, you are liable to pay the dividend to the person whose shares you

have borrowed to make your short sale. I must say, however, that if you are correct in your judgment to sell the

issue short, your profits achieved thereby will certainly outweigh the small dollar amount of the dividend payout.

What happens if the stock I've shorted splits?

MF Swagman replies:

Let's say we're speaking of a two-for-one split. In that case, all that happens is that you must cover your short

position with twice as many shares as you opened it. If you shorted 100 shares, you must cover with 200. Don't

forget, though, that the magnitude of your investment hasn't changed, for while you now have twice as many

shares, each one is only worth half as much as before! So, while your original cost basis for the 100 shares may

have $36, now, with 200 shares, it is only $18.

PFE, Chapter 23: Introduction to options page 34

This is a very foolish question, I'm sure, but if I sell short I am essentially borrowing the shares from

someone else through my broker. Assuming that the lender does NOT need the shares prematurely,

what determines how long I can stay short? (pun intended) How long do I have before I am forced to

cover my position? Is there any regulation? Is it simply dependent on when/if the broker needs them?

Could I possibly stay short for an indefinite period?

As far as I know, there is no pre-determined limit to how long you can keep your short position open. Technically,

you could be forced to cover at any time, but typically, having the shares you have borrowed called back is

unusual. At least so state all the Schwab representatives of whom I have asked this question.

Source: The Motley Fool website, http://www.fool.com/FoolFAQ/FoolFAQ0033.htm