Chapter 12 Flashcards
Buyer/Owner/Holder of an options contract
The party that is long the options contract. The buyer pays the up-front premium, and then receives the right to exercise the contract. If the option expires worthless, the premium paid represents the buyer’s maximum loss.
Seller/Writer of an options contract
The party that is short the options contract. The seller receives the premium from the buyer, and assumes the obligation to exercise the contract in the future. If the option expires worthless, the premium received is the seller’s maximum gain.
Classes of an option
Options are deemed to be of the same class if they’re tied to the same underlying asset and the same type.
Ex: All call options on JPM are of the same class, while put options on JPM are a different class.
Series of an option
All the options of the same class, with the same expiration date, and the same exercise price.
Covered vs unconvered options
Covered options= when the seller already owns the underlying
Unconvered/naked= When the seller of the option does not own the underlying.
- Uncovered call writing is far more dangerous than covered writing and may only be executed in a margin account.
True or false: The premium of an option is a fixed amount?
False, the premium on an option varies as the market price of the underlying changes.
Option premium
The option premium is made up of two components: intrinsic value and time value.
The intrinsic value measures how much the option is currently in-the-money. If the option is out-of-the-money, there is NO intrinsic value.
Time value is based on the underlying asset’s expected volatility and time until expiration.
Intrinsic value is good for buyers but bad for sellers.
- Generally. the longer the time until expiration, the greater its time value. The time value will diminish w/ the passage of time and will be zero at expiration.
- During the days leading up to an option’s expiration, an in-the-money option will be trading very close to its intrinsic value.
True or false: Intrinsic value means there will be profitability?
False.
Ex: Investor A paid a premium of 2 for XYZ 30. Now XYZ is trading at 31. Although the option is in-the-money by 1, it’s still unprofitable since there was a premium of 2.
Breakeven point
The price that an option must trade for an option holder to neither make nor lose money.
How do even stock splits affect options contracts?
Any split by 1 (ex: 2-1, 3-1, etc.) is an even split. When a corporation engages in an even stock split, the adjustments made are an increase in the # of option contracts an investor owns and a decrease in the strike price.
Ex: Investor A owns 1 XYZ 30 call. The stock is split 2-1. Now, investor A owns 2 XYZ 15 calls w/ each contract stil representing the same amount of shares. In the original contract, if investor A owned 100 shares, (100 shares $30 * 1 contract) = $3k. Now, investor A still owns 100 shares (100 shares * $15 * 2 contracts) = $3k.
* The only time the # of contracts changes is if the corporation executes an even split.
How do odd stock splits affect options contracts?
The adjustments made are an increase in # of shares and a decrease in the exercise price.
Ex: Investor A owns 1 XYZ 30 call representing 100 shares. The stock is split 3-2. Now, investor A owns 1 XYZ 20 ($30 * 2/3) call representing 150 shares. Originally, investor A owned (100 shares * $30 * 1 contract) = $3k. Now, investor A owns (150 shares * $20 * 1 contract) = $3k.
How do reverse stock splits affect options contracts?
Reverse splits are treated similarly to odd stock splits.
Ex: Investor A owns 1 XYZ 30 call representing 100 shares. If the stock is split 1-5, investor A now owns 1 XYZ 150 representing 20 shares.
How do stock dividends affect options contracts?
Options contacts are adjusted for stock dividends on the ex-dividend date. They are treated like an odd stock split.
Ex: Investor A owns 1 XYZ 30 call representing 100 shares. If the company announces a 25% stock dividend, investor A now owns 1 XYZ ($3000 ÷ 125)= 24 representing 125 shares).
True or false: An owner of a call option who calls the stock after the ex-dividend date will get the cash dividend?
False, if they call before the ex-dividend date, they will have the right to the dividend.
The Options Clearing Corporation (OCC)
Listed options are issued and guarenteed by the OCC. The OCC is regulated by the SEC and is proportionately owned by the exchanges around the world that list options. The OCC acts as a 3rd party in options deals and mitigates counterparty risk. When people buy options, their BD must settle the trade within one business day.
The OCC clears trades and guarentees that buyers will be able to exercise their rights in the event of a market deficiency, thus removing the counterparty risk.
True or false: The OCC establishes position and exercise limits on securities?
True. The OCC limits the amount of options an investor can hold on a single security. The maximum limit is reviewed by the OCC every six months. The OCC also sets exercise limits that represent the maximum amount of options that may be exercised on a single security within 5 consecutive business days.
- Investors CANNOT get around position limits by buying calls and selling puts or vice versa.
Long-Term Equity Anticipation Securities (LEAPS)
Equity options w/ expirations of up to 39 months that operate in the same manner as listed equity options. LEAPS lose their time value at a slower pace than normal options, offer LT portection against unfavorable market movements, and provide LT opporunities.
Liquidating (trading) an option
An alternative to exercising an option. This is where an investor executes an opposite transaction on the same option contract. The difference between what is bought vs what is received is the net profit or loss.
True or false: American style exercise is common w/ index and currency options, while European style exericse is common w/ equity options?
False, all equity options use American style exercise, while Euro style exericse is more prevalent w/ index and currency options.
True or false: W/ a long call option, for every $1 that the underlying stock price increases, the option’s intrinsic value increases by $1 and thereby the theoretical max. gain is unlimited?
True
True or false, naked call writers have a maximum potential loss of the premium?
False, they have an unlimited potential loss.
- For exam purposes, unless specified in a question, it should be assumed that the writer of an option is uncovered.
True or false: The breakeven point is the same for both the owner and the writer?
True
Differences between shorting a stock and buying puts
- Time limit: There’s no time limits on shorts, while buyers of puts have the expiration date.
- Potential loss, as long as the put owner is covered, there loss is maxed out at the premium, whereas a short seller has an unlimited potential loss.
True or false: On any options contract, the profit and loss potential for the buyer will always be the opposite for the seller?
True
Straddles
The purchase of both a call and a put or the sale of both a call and put. Long straddle is when an invester buys both options, whereas a short straddle is the opposite. Each individual option is referred to as the leg of the straddle. Long straddles are used when an investor thinks there will be a large movement in the price of a security but isn’t sure which way. Short straddles are used when the writer expects stability.
Long straddles have an unlimited potential gain if the market price rises.
- To find the BE point for a straddle, add the strike price +/- total premium.
- A long straddle can only be profitable if the movement in the underlying stock exceeds the combined premium. For example, if the premium on the call is 2 and the premium on the put is 3, the total premium is 5. The underlying’s market price would need to rise above 5 + the strike price or fall 5 below the stirke price to become profitable.
Combinations
A straddle position w/ contracts that have different exercise prices and/or different expiration months.
Spreads
Simultaneously buying and selling two calls or two puts on the same underlying security. These option positions allow investors to accept a limited gain for having a limit loss.
- W/ spreads, investors are receiving a premium for the option being sold and paying a premium for the option being bought. This is referred to as a net premium.
How to remember straddles vs spreads
Straddles: Same actions, different option (ex: Buy a call and buy a put)
Spreads: Different actions, same option (ex: Buy a call, sell a call)
Price spread/Vertical spread/Dollar spread
When the two options of the spread have the same expiration month, but different strike prices.
- These are the only type of spreads that Series 7 expects a deep understanding.
Time spread/Horizontal spread/Calendar spread/Date spread
When the two options of the spread have the same strike price, but different expiration months.
Diagonal spread
When the two options of the spread have different srike prices and different expiration months.
How to analyze a spread
- Identify the dominant leg (the option that has the largest premium)
- Identify whether the investor is a buyer or seller (Whether the dominant leg is long or short will determine this)
- Is it a debit or credit spread
- Does the investor want the spread between the premiums to widen or narrow? (Buyers need the spread to widen, whereas sellers need it to narrow)
- Which strike price is used to determine the breakeven point?
- Is the investor bullish or bearish on the underlying? (This is determined by looking at the dominant leg and what it’s trying to achieve)
- What’s the maximum gain?
- What’s the maximum loss?
- The concept of the widening or narrowing of the difference between the premiums relates to calculating an investor’s gain or loss if the options are subsequently closed out.
Debit vs credit spread
Debit spread= When more money is paid out than taken in (ex: When the investor buys an option w/ a higher premium than the option they sell)
Credit spread= When more money is taken in than paid out (ex: When the investor sells an option w/ a higher premium than the option that’s bought)
How to identify the breakeven point of a spread?
First, identify the dominant leg. Then, add the net premium to the strike price of the dominant leg if the buy leg is dominant or subtract the net premium from the strike price if the sell leg is dominant.
- The lower the stirke price of the call, the higher its premium.
- The lower the strike price of the put, the lower its premium.
True or false: Investors can realize an unlimited gain on a spread?
False, the maximum gain/loss on a spread is limited. For example, an investor may have the right but not the obligation to buy at $40 w/ the call they purchased but if they also sold a put at $45 then they are forced to sell at $45. Therefore, there max. gain is capped.
- The maximum loss on a spread is the net premium paid.
Analyzation example:
Sell 1 XYZ October 65 Put at 7
Buy 1 XYZ October 55 Put at 1
- The sell leg is the dominant leg
- Since the sell leg is the dominant leg, the investor is a seller.
- It’s a credit spread since the 7 received from the premium from selling the put is greater than the 1 received from buying the call.
- Since the investor is a net seller, they want the spread to narrow.
- BE Point = 65 (since the investor is a seller) - (7 - 1) = 59.
- Bullish, the sell leg is dominant and the investor is selling puts.
- The net premium
- Difference between strike prices = (65 - 55) = 10 ; Net premium spread = (7 - 1) = 6. Max. loss = (10 - 6) = 4.
Butterfly spreads
Two spreads that are established simultaneously. One is a bullish spread and the other is a bearish spread. The resulting position is neutral, and allows the investor to profit if the underlying price is neutral.
Butterfly stocks are established at a net debit position and have two breakeven points. The max. gain occurs if the underlying is at the middle strike price at expiration. Some profit will be earned if the underlying’s price remains between the two breakeven points. If the underlying’s price rises above or falls below the breakeven points, the losses are limited to a specific amount.
Protective put
Long underlying + Long put. This is essentially an insurance policy against the possible decline in the underlying’s price.
Ex: Investor A buys 100 shares of Stock A at $91/share, and also buys a put w/ an exercise price of $90 at a $2 premium. If the stock drops to $80/share, investor A’s loss is less than if they didn’t own the stock- ($91 * 100 = $9.1k spent on Stock A + $200 premium = $9.3k out). ($90 exercise price * 100 shares = $9k). The investor’s loss is $300.
Remember, the hedges have an expiration date.
Breakeven, Max. Gain, and Max. Loss of a Protective Put
Ex: Investor A buys 100 shares of Stock A at $91/share, and also buys a put w/ an exercise price of $90 at a $2 premium. The breakeven is $91 (cost of the underlying) + $2 (premium) = $93.
Max. Gain = unlimited since the stock could rise forever.
Max. Loss = $300 as described in the flashcard above.
True or false: In addition to hedging, puts can be used to protect profit?
True. If investor A buys Stock A at $91, and in 3 months the stock rises to $100/share, investor A can buy puts to lock in that price at $100/share.
Protective call
Short underlying + Long call. This is a form of insurance that protects against a rise in the underlying’s price.
Breakeven, Max. Gain, and Max. Loss of a Protective Call
Ex: Investor A shorts 100 shares of Stock A at $48/share, and also buys a call w/ an exercise price of $50 at a $3 premium.
Breakeven = $48 (cost of the underlying) - $3 (premium) = $45.
Max. Gain = (if the stock falls to 0, the gain on the stock is $48 * 100 = $4.8k) - $300 premium = $4.5k.
Max. Loss: (($50 - $48) * 100 shares = $200) + $300 premium = $500
Covered call
Long underlying + Short call. This allows investors to increase the return on the portfolios and also provides a partial hedge against the underlying’s falling price. Covered calls are good for investors who are mildly bullish on the underlying.
Ex: Investor A purchases 100 shares of Stock A at $30/share and writes a Stock A call w/ an exercise price of $35 and a premium of $1. If the stock stays in between $30-$34, investor A profits. If the stock falls below $30, the premium received from writing the call will offset some of the loss.
- A covered call writer sacrifices the future upside potential of the stock for the immediate receipt of the premium.
Breakeven, Max. Gain, and Max. Loss of a Covered Call
Ex: Investor A purchases 100 shares of Stock A at $30/share and writes a Stock A call w/ an exercise price of $35 and a premium of $1.
Breakeven point: $30 - $1 = $29. (As long as the stock stays at or above $29, the investor will breakeven).
Max. Gain: ($3.5k (received when the investor is obligated to sell stock A to the call owner) + $100 (premium) - $3k (to initially purchase the stock)) = $600 gain.
Max. Loss= ($3k (to initially purchase the stock) - $100 premium received) = $2.9k
Collar
Writing a covered call while simulatenously purchasing a protective put. This is intended to reduce the risk of holding the underlying and lock in a sale price.
Ex: Investor A creates the following collar on Stock A
Long 100 shares of Stock A at $62/share
Long 1 Stock A May 60 put
Short 1 Stock A May 65 call
W/ this, if Stock A’s price declines, investor A can put the stock at $60/share, thereby limiting the loss. However, if the price rises above $65/shares, then investor A will be obligated to sell Stock A to the option buyer.
- Collars are generally created w/ out-of-the-money options.
- The # of contracts for the put and the call must be the same but the exercise price can be different.
Zero cost collar/Costless collar
When the premium received on the sale of the call is >= the premium paid on the purchase of the protective put creating no out-of-pocket expense to the investor.
Ratio writing
An aggressive option strategy that invovles a long stock position w/ an unequal # of calls written against it.
Ex: Investor A buys 100 shares of Stock A at $78/share and sells 2 Stock A October 80 calls for a total premium of 8.
In this case, 1 of the call contracts is covered by the stock A that investor A owns but the 2nd call contract is uncovered.
Covered put
Short underlying + Short put. This allows the investor to increase returns, while hedging the short position. Covered put writers are considered mildly bearish for the ST prospects of the stock.
Breakeven, Max. Gain, and Max. Loss of a Covered Put
Ex: Investor A shorts 100 shares of Stock A at $35/share and writes a 1 Stock A October 30 put at a premium of 3.
Breakeven= ($35 + 3 premium) = 38 BE point
Max. Gain= ($35/share - $30/share (when the put would be exercised) * 100) = $500 + $300 premium = $800
Max. Loss= Unlimited
True or false: All listed equity options use European style exercise, while some non-equity options use American style exercise?
False, All listed equity options use American style exercise, while some non-equity options use European style exercise?
Broad-based index vs narrow-based index
Broad-based index: Composed of a group of stocks that reflect the performance of an entire market.
Narrow-based index: Measures the performance of a particular market segment or industry group.
What 2 specific risks can index options alleviate:
- The risk associated w/ the specific industry in which a corporation operates (narrow-based indexes can help w/ this)
- The risk associated w/ how a specific firm will react to trends in the overall stock market (broad-based indexes can help w/ this)
True or false: If an index option is exercised, there is physical settlement?
False, if index options are exercise, they are cash settled. The cash received is the difference between the strike price and the closing value of the index on the day the option is exercised.
- If an index option is exercised during the day and ultimately closes out-of-the-money, the buyer may experience a loss due to being required to pay the writer the out-of-the-money amount.
Expiration date for VIX options
VIX options do not have set expiration dates like other options. VIX options expire on the Wednesday that’s 30 days prior to the 3rd Friday of the following calendar month.
- The VIX typically moves inversely to the S&P 500.
Foreign currency options
Allow investors to speculate on or hedge against changes in exchange rates.
Interbank Market
The market where purchases and sales of foreign currencies occur between commercial banks. The market where foreign exchange rates are established.
The Interbank market is decentralized and unregulated.
- The Interbank Market has unlimited trading hours.
Spot transactions
Transactions set for immediate delivery. These settle within 2 days after the trade date.
- The Fed disseminates spot rates on a daily basis.
Forward transactions
Transactions agreed upon now but to be done at some point in the future. These settle in more than 2 days after the trade.
Factors that affect a country’s FX spot rate
- Demand for a country’s raw products
- The country’s balance of payments
- The wealth of a country’s population
- The level of foreign investment by the country
- Government monetary and fiscal policy
- Direct government intervention
- Prevailing interest rates
- Geopolitical factors
Foreign currency options
Allow investors to take positions based on the value of a foreign currency in comparison to the dollar. These contracts are USD settled, which means there’s no delivery or receipt of foreign currency. The contracts are quoted in terms of the dollars required to purchase one unit of the foreign currency.
If an investor trades foreign currency call options, the contract becomes in-the-money if the foreign currency strengthens in relation to the dollar. The opposite is true for put options.
Foreign currency options use European style exercise
- Foreign currency options are issued and guarenteed by the OCC.
Exercise prices and premiums of foreign currency options
Exercise prices for the Australian dollar, British pound, Canadian dollar, Swiss franc, and euro option contracts are stated in cents per unit, while exercise prices on the Japanese yen option contracts are stated in
hundredths of a cent per unit.
For most currency options, the contract’s exercise price may be converted into U.S. terms by moving its decimal point two places to the left (e.g., a strike price of 160 for a British pound contract becomes $1.60). However, for the exercise price on a Japanese yen contract, the decimal point must
be moved four places to the left (e.g., a strike price of 98 for a Japanese yen contract becomes $.0098).
How can foreign currency options be used to hedge risk?
For investors who are long assets exposed to FX risk, buying puts can hedge the risk. If the value of the currency position decreases, the increase in value to the put will offset the decrease in value to the long.
Yield-based options
An option that is based on yields rather than price. The value of a yield-based option is the difference between the exercise price and the value of the yield. The strategy employed by the investor in a yield-based option is dependent on bond yields, NOT bond prices.
To determine the actual yield of a yield-based option, the strike price is divided by 10. For example, a 20-year 71.50 T-Bond represents a yield of 7.15%, while a 13-week T-Bill w/ a strike price of 36 represents a yield of 3.6%.
Yield-based options settle on a cash basis.
Yield-based options use European exercise style.
- Although these options may only be exercised at expiration, investors are able to close out (liquidate) their positions at any time during the life of the contract. If closed out, the profit or loss will be determined by comparing the premiums of the opening and closing transactions.
Yield-based option example
Ex: Investor A buys a July 7.5% call based on the 30-year T-bond yield for a premium of 2. At expiration, if the settlement value is 7.95%, the profit is [ ((7.95-7.5) * 1000) = $450 - $200 premium = $250 profit ]
How options that are held to expiry are taxed
If an option expires unexercised, the premium will represent either a capital gain or capital loss depending if it’s held by the owner or writer. Since most options are ST (maturity < 12 months) the capital gains are considered ST. An exception is made for the purchase of LEAPs since their expiration can be as long as 39 months.
Since the writer of uncovered options (including LEAPs if they’re uncovered) don’t actually own the asset to establish a holding period, capital gains of uncovered options are ALWAYS considered ST.
How options that are liquidated are taxed
If the options are closed out within 12 months (most are), then any capital gains are taxed as ST. For LEAPs and other options that are closed out after 12 months, they’re considered LT.
How options that are exercised are taxed
Need to determine the cost basis (total cost to acquire) for buyers of calls and sellers of puts OR the sales proceeds (total money received on delivery) for sellers of calls and buyers of puts.
For call options that’re exercised, the calculation of either basis or sales proceeds is simply the strike price + the premium.
For put options, the calculation of basis or sales proceeds is simply strike price - premium.
When an options investor is in a position to acquire stock, the IRS says the holding period begins w/ the exercise, NOT the purchase of the option. This will lead to capital gains being taxed as ST investments.
Calculating cost basis for calls/puts is the same as the breakeven point
How are covered calls taxed
For writers of the option, if the option expires unexercised, both covered and uncovered calls are taxed in the same way. The premium is a ST taxable gain and taxes are paid in the year the option expires. In this case, the cost basis is unaffected.
If a covered call is liquidated before it expires, the result is a ST gain/loss regardless of how long it was held for.
If a covered call is exercised, the stock is sold at the strike price and the investor then has a capital gain/loss.
Qualified covered calls
If covered calls have long expirations and are not deep in-the-money. Qualified covered calls qualify for LT capital gains/loss treatment when they’re exercised.
How hedging using options is taxed (Buying stock and buying puts)
- If the put is bought the same day the stock is purchased: The cost basis is the cost of the stock + cost of the option.
- Puts bought after the day the stock was bought: The two purchases are treated separately for tax purposes.
- If an investor buys shares of stock and establishes a LT holding
period, a subsequent put purchases doesn’t affect the client’s holding period in the stock. Under IRS rules, if a stock’s holding period has been established as LT it’s considered LT regardless of subsequent hedging actions.
- If the investor has owned a stock for less than one year and then buys a put on that stock, the stock’s holding period will be terminated. The holding period in the stock will not restart at day one until the put is no longer associated with the stock. To achieve a long-term holding period, a stock must be held at risk (unhedged) for longer than one year.
True or false: Option order tickets are required to be approved in advance by a registered options principal (ROP)?
False
