Options, the fiscal instruments that feed on Wall Street excitement, are booming. Volatility in the stock market is always good for the options business. The surge in stock prices in the last weeks has been steep enough to make options traders smile broadly.
The daily volume of options contracts traded on the nation’s five options exchanges has begun to pierce the one million level regularly, and the daily average so far this month, 980, 000, is the highest monthly rate in a year. It is also among the highest monthly levels since the options market peaked– and crashed– in 1987.
Trading volume is merely a measure of activity, but exchange officials say the dollar value of options bought and sold and the number of contracts outstanding are up, too. The reason, for anyone with a calculator, is obvious: rising stock prices make options profitable more quickly while during the same time providing the opportunity to establish new contracts.
The S&P 500 Index has bounced back from its healthy 6% sell-off and is again within spitting distance of its all-time high. And while the automotive industry’s recovery cannot be underestimated, shares of former blue-chip and Big Three automaker General Motors (NYSE: GM) are struggling, down 11% year to date. I think the stock’s current pullback represents an excellent opportunity to participate in the continued recovery of the American auto industry. After being booted from the Dow 30 back in 2009 …
In a bull market, more options can turn to gold, and the odds are greater that an investor can pick ones that do. As any options trader knows, an investor need pay only a small quantity of cash for a stock option. This is the law– but not an obligation– to buy or sell a stock by a particular time at a particular price, also referred to as the strike price. A call option rises in value if the underlying stock goes up; a put option gains if the stock declines.
Mr. Roth cited a simple example: On Dec. 27, when U.S. Surgical was selling for $109.50 A share, a call option set to expire in late January cost only $2. By Jan. 9, when the stock had soared to $131.00, Up 20 percent, the option was selling for $17, up 750 percent. A $2, 000 investment on Dec. 27, if sold on Jan. 9, would have returned $17, 000. The option, with a $115 strike price, dropped to $12.50 As the stock drifted to $127 by Friday’s close.
Of course, if U.S. Surgical shares had failed to rise, the option would have fallen in value and have been worthless by the expiration date.
But for the uninitiate, the real danger in this market lies with investors who dare to ‘write’ an option, guaranteeing to buy or sell an underlying stock at a preset price, especially in circumstances in which they don’t already own the stock. For them, a sharp, unexpected swing in the market can be fatal.
Take, for example, an investor who chose to write $2, 000 worth of call options on U.S. Surgical on Dec. 27– expecting the stock to fall– for an easy initial profit of $2, 000. The investor would have to come forward with 1, 000 shares of the stock. If the investor didn’t previously own the shares, by Jan. 9 the cost is said to have been $131, 000; after the investor sold the shares for $115, 000, the net loss would be $14, 000.
Many investors use options in complex arrangements, typically to hedge against sudden swings in the market. But the current surge was marked by the buying of options on specific stocks, reversing, at least temporarily, a trend of recent years toward buying options on stock indexes, like the Standard & Poor’s index of 100 stocks.
Where stock options and index options have traded at about equal volume over the past year, options on individual stocks have outpaced index options by about 6 to 4 since the last week in December, according to figures compiled by the Options Clearing Corporation in Chicago.
Many of those options are straightforward call orders on a specific stock, said Joseph Stefanelli, senior vice-president of the American Stock Exchange.
The options boom comes at a time of general expansion in the industry. The number of options issues traded on American exchanges has grown to 914 from 789 a year ago. Mr. Roth said much of the new issues had joined because the Securities and Exchange Commission eased the listing standards for options, effective Oct. 21.
For an option on a stock to be included on an exchange, the required minimum number of shareholders in the stock is now 2, 000, instead of 6, 000, and the minimum closing market price in the stock over the past three months is $7.50, instead of $10.
At the same time, the S.E.C. Has phased out rules over the past year that had limited particular stock options to a listing on a single exchange. Multiple listings, exchange officials said, spurred competition between the trading posts, making them more efficient.
Now the common question in anybody’s mind would be :’ How do we value a stock option? ‘ The Answer is very simple: the value of an option (though theoretical) is calculated on the basis of various propagandas and conditions. The models are developed by people known as quantitative analysts. Such models try to forecast how the value of an option changes with respect to changing conditions. Thus, the risks coupled with conceding, possessing, or trading options may be quantized and handled with a greater degree of accuracy, maybe, than is usually the case with other types of investment. The options that are traded at an exchange make up a vital category of options which have homogeneous indenture tones and are being addressed on public exchanges, enabling trading between self-regulating parties. Over-the-counter options are dealt with between private parties and often billion dollar conglomerates that have taken part in split dealings and defrayal measures with each other.
Mr. Bickford noted that trading volume in 1991 was well below the 1987 levels, in part because the market traded at a relatively narrow range for the majority of the year. In October 1987, when the stock market crashed, some investors who had been writing put options– betting that prices wouldn’t fall– were wiped out. Many others, who had been purchasing call options, lost all they had invested. The popularity of the options market declined markedly.
The five exchanges that handle options are the Chicago Board Options Exchange and the American, Pacific, Philadelphia and New York Stock Exchanges. But a large portion of the options business isn’t traded in the standardized setting of the exchanges, but over-the-counter, typically in bigger quantities and dollar values.
Companies that grant stock options to employees refer to such grants as Compensatory Stock Options. These are broken down into two categories: Incentive Stock Options (‘ISO’, the purpose of this article) and Nonqualified Stock Options. Most employees receive incentive stock options. Nonqualified stock options are usually earmarked for senior executives or non-employees that the company feels are critical to the direction of the company’s business.
When the employee exercises the stock option (purchases the stock) there’s no regular income taxation. However, there may be an alternative minimum tax on the surplus of the fair market value of the stock on the exercise date over the employee’s exercise price (discounted purchase price of the stock).
When the employee exercises the stock option (purchases the stock) and subsequently sells the stock there is taxation. Here is where ISO taxation gets complicated. When you buy your company stock (exercise the stock option) and sell the company stock the taxable amount is determined based on when you sold the stock. You can purchase the company stock (exercise the ISO) and sell the stock during the same year (called a disqualified disposition) or you can buy the company stock and sell the stock in a subsequent year. When you sell the company stock in a subsequent year the regular tax treatment depends upon how long you held the stock and how long you held the stock options.
Short-Term Capital Gain Income is equivalent to the excess of the sales proceeds, relating to the sale of the company stock over the fair market value of the firm stock on the exercise date (date of purchase).
Buy company stock in one year and sell it in the following year. If you hold the stock for longer than twelve months (and you held the ISO for more than two years), then the gap between the sales price and the exercise price is a long term capital gain which is punishable by a maximum 15% federal tax rate. If you hold the stock for twelve months or below the tax calculation is the same thing as if you had bought and sold the stock during the same year (W-2 income and possibly short-term capital gain income).
ISO Example: Stan Smith is an employee of Savurlife Pharmaceutical Inc. and is given ISOs on January 1, 2004 that entitle him to purchase (exercise) 100 shares of Savurlife at $1, 000 (exercise price) on January 2, 2006 (exercise date/purchase date). The fair market value on January 2, 2006 is $3, 000. If Stan doesn’t sell the stock in 2006, then $2, 000 ($3, 000 less $1, 000) will be issued as part of alternative minimum tax in 2006, but not submitted to any regular income tax in 2006. If Stan sells the stock in 2006 for $3, 000 then the $2, 000 will be processed as W-2 wages in 2006. If Stan sells the stock on January 3, 2007 (one year and one day after purchase and ISO held more than two years) for $3, 000 then the $2, 000 gain will be seen as a long-term capital gain and taxed at no greater than the maximum capital gains federal tax rate of 15%.
The new year is usually a busy time for traders who shape such large, customized options deals, because money managers are eager to lock in yearly gains and reposition their portfolios for the new year. Add to that a soaring market. You get a recipe for a great deal of business.
The options business is likely to remain hampered by what traders call misperceptions and lack of knowledge despite the spurt in activity.