Chapter 3- Equity Options Flashcards
The “Driver” in an option transaction is…
The person that buys the option (has the right to exercise or not)
The “Passenger” in an option translation is…
The person selling the option (they must do what the buyer of the option wants)
What could a bullish investor do instead of buying stock??
Buy a call
What could a bearish investor do instead of selling a stock short?
Buy a put
What is the most money at risk when buying an option?
The premium paid for the contract
What does a call option give the buyer the right to do?
The right to purchase 100 shares from the seller for a limited period of time at a set price
What does a call option obligate the seller to do?
To sell 100 shares to the buyer at the set price for the same period of time they had to buy
What does a put option give the buyer the right to do?
The right to sell 100 shares to the seller at a set price for a limited period of time
What does a put option obligate the seller to do?
To buy 100 shares from the buyer at a set price for the same period of time they had to sell
Whenever you are the ____ an option you are the driver, you are the ____ of a ____ position
Buyer
Holder
Long
Whenever you are the ___ an option you are the passenger, and you are the ___ of a ____ position.
Seller
Writer
Short
Short An Option means…
(Versus)
Shorting Stock which is
Selling an option
(Versus)
Borrowing stock to sell and replace at a lower price
Exercise/Strike Price
The set price at which the holder of an option can buy or sell the underlying stock
Aggregate Exercise Price
The exercise/strike price of an option contract multiplied by the number of units (generally 100 shares) of the underlying security covered by the option
Assign/Assignment in regards to option contracts is..
When the buyer of an option decides to “exercise” the option. That exercise will be “assigned” to a seller of the same option contract
A standard option has a maximum expiration of….
9 months…from the time it is created
Leap Option
A long term option with a max expiration date of 39 months
Option Premium is…
Who pays and receives it?
How is the premium quoted?
The price the option contract trades
Paid by the buyer and received by the seller
Premiums are quoted per share
Short Calls (read and understand) (short covered vs short uncovered or naked)
- What is the most conservative option position possible?
- What is the most speculative option position possible?
- A short covered call is the most conservative option position possible
- A short uncovered/naked call is the most speculative option position possible - the loss potential is unlimited
Option Position Limits are applied to??
Option Positions on the same side of the market
Go through home base chart
Go through home base chart
Income or increased rate of return tells you to be the what of an option contract?
The writer/seller/ passenger
Maximum profit or maximum protection always tells you to be the what of an option contract?
Buyer/Holder/ Driver
What words will the exam use instead of hedging?
Protect or Protecting
Hedging is..
Protecting a stock position you already have (long stock or short stock)
When hedging you always put on an option position that’s on the ____ of the market than the side you are on with stock
Opposite Side
Hedging limits your risk by…
Putting you on both sides of the market
The best downside protection with options is a _____. Needed when the investor is _____.
Long Put
Long The Stock
Being long the stock and long a put is also called a…
Protective Put
The best upside protection with options is a ______. Needed when the investor is ______.
Long Call
Short the stock
Long Puts (bearish) protect or hedge _____ positions
Long Stock
Long Calls (bullish) protect or hedge _____ positions.
Short Stock
Investors generally want _____ to hedge
Long Options
PROTECT =
Putting on an option position that’s on the opposite side of the market than the investors stock position
Opening Purchase
Establishing or adding to a long position
Buying a call or buying a put
Closing Sale
Eliminating or reducing a long position
Selling a call or selling a put
Opening Sale
What must order tickets be marked?
Establishing or adding to a short position (order tickets just be marked “covered or uncovered”)
Closing Purchase
Eliminating or reducing a short position
Buy a call or buy a put
Close never means ____ it means oh do the opposite of whatever you did to open the position
Exercise
When buying a call as an opening purchase investors will do one of the following… (3 things, driver)
- Exercise the option and buy the stock
- Close the position by selling the option contract to another investor
- Let the option expire and lose the premium
Covered Call Writing
Offers premium income with downside protection and is the most conservative option position possible
You can be a covered call writer if….
4 ways
- You own the underlying stock (and it’s in my account)
- Obtained an escrow or depository receipt from the bank saying they have the stock (own the stock and it’s at the bank)
- Was “long” a call with an equal or lower exercise price (and the short call must expire at the same time or before the long)
- Owned convertible bonds, preferred stock, or warrants provided they are immediately convertible or exchangeable for common stock and do not expired before the short calls
Uncovered Call Writing is
The most speculative position in options trading (investor receives premium income but has unlimited loss potential)
Investors who write options want to be covered to avoid ____ requirements when writing uncovered options
The margin
When an investor sells a call as an opening sale, one of the following will occur
- The option will be exercised and the investor will sell the stock
- The writer will buy the option to close the position
- The option will expire unexercised and the writer keeps the premium (c is what you want to happen)
When an investor buys a put as an opening purchase they will do one of the following…
- Exercise the option and sell the stock
- Close the position by selling the option to another investor
- Let the option expire unexercised and they lose the premium paid
Put writers are covered if they (4 ways)
- Have funds equal to the aggregate exercise price on deposit
- Obtain a bank guarantee letter from an approved bank stating the bank will guarantee the investor the money they need if the option is exercised
- Are short an equal amount of the stock they would be obligated to buy
- Are long a put with an equal or greater exercise price and the short put must expire at the same time or before the long
Crows Call and you PUT your money in the bank (what does that help remember)
You use esCROW for short calls and you use a BANK guarantee for short puts
Uncovered Put writing offers the investor _____ loss potential (strike price less the premium)
Investors should ____ sell/write uncovered puts in a ___ market
Limited
Not/Bear
When an investor sells a put as an opening sale one of three things will end up happening…
- The option will be exercised and the investor will buy the stock
- The writer will buy the option to close the position
- The option will expire unexercised and the writer keeps the premium (what you want to happen)
The Action or Transaction words are?
Ignore what statement?
Buy
Sell
Exercise
Close
“When the price of the stock is”
Per option calculation dissection rules label everything you buy with a ___ and everything you sell with a ___
B-
S+
Options are classified as _____ therefore all gains and losses will be short term _____ or ____
They are never treated as?
Capital Assets
Short Term Capital gains or Capital losses
Ordinary Income or loss
The Breakeven formula for a call (buying or selling) Is
CALL UP….PUT DOWN
Exercise Price + Premium = Breakeven on a call
The Breakeven formula on a put (buying or selling) is
CALL UP…..PUT DOWN
Exercise Price - Premium = Breakeven on a Put
Investors generally ____ options when they are looking for Maximum profit potential
Buy
Investors generally ____ options when they are looking for income to increase the rate of return on their portfolio
Sell
OCC stands for and is?
Option Clearing Corporation
The issuer, clearing agency, and guarantor of all listed options in the US
OCC operates under the jurisdiction of the ____
SEC
OCC is owned and ran by?
Also known as?
It’s member exchanges which are the US exchanges which trade options
These exchanges are also known as Self Regulatory Organizations (SROs)
Option trades take place on the floor of the exchanges but ____ reported on the _____
Are not
Consolidated tape (ticker tape)
Quotes on option premiums have two prices called?
The Bid and The Ask
The “Bid” is
The lower price, the price an investor would receive if they sell an option
The “Ask” is
The higher price, the price the investor would pay if they buy an option
The difference between the bid and ask is called…
The spread on a quote
The trading of options will not open until the trading of stocks open… why?
Options are a derivative market based on the stocks
Trading Rotations occur when?
Who participates in the opening rotation?
Upon the opening of the market and upon the closing of the market
Only public market and limit orders
Order Book Official (OBO) for CBOE options is?
The employee who handles the public limit order book. They oversee that public orders at given prices are executed before any orders from the floor at the same price or better
May not trade for themselves
Market Makers are?
And they ___ have priority over public orders at the same price on the OBOs book
(Market makers used to be used so that investors had someone on the other side of their order)
Traders on the CBOE floor who trade for their own accounts at their own risk
Never
CBOE Hybrid
Trading engine that blends the trading floor technology with an electric trading platform
CBOE OSS (Order Support System) which electronically…
Routes orders directly to the options trading post
Sends notice of the execution directly to the broker dealers office bypassing the communication center on the floor of the exchange
Cease Trading Time is…
4 PM Eastern Time on the 3rd Friday of the expiration month
If trading in a security is halted, trading in the options is halted. If trading is halted, customers may still exercise.
Exercise Cut Off Time is
5:30 PM Eastern time on the third Friday of the expiration month
Expiration of the contract occurs..
11:59 PM eastern on the third Friday of the expiration month (10:59 central, 8:59 Pacific)
Position Limits general apply to (two entities)
And are put into place by the?
Institutions and Hedge funds
OCC
Investors are limited to the number of listed option contracts which may be exercised within any consecutive ____ business day period
5
American Style Options can be exercised?
Anytime after they are purchased
European Style Options can be exercised?
Only at expiration
What are class options?
All options of the same type on the same underlying stock make up a class of options
Ex. All IBM Calls or All IBM Puts
What is a series of options?
All options of the same class with the same expiration month and same exercise price
Ex. All IBM October 19 calls
Option Cycles
All options have at least 4 expiration months but only 3 months trade at any one time (9 months and when one month in cycle closes the next one opens)
Standardized Terms established by the OCC are?
What is not established by the OCC?
Strike Prices, Option Expiration Months, size, and type of contracts
Premiums…are established by supply and demand
Exercise Prices are determined by?
The price of the underlying security on exchanges in an auction market not by the OCC
The number of shares in a listed option contract or the number of option contracts is adjusted when the number of shares an investor will own in the stock changes…examples include:
They are NOT adjusted for?
- Stock Dividends
- Stock Splits
- Rights distributions
Cash Dividends
When a stock split or stock dividend occurs, the option will be adjusted to reflect the change in the ____ the option represents
What will it change?
number of shares
The number of shares or options and the strike price
What does a stock split do to the option contract?
Ex. 2/1 split
(2/1)(100/1)= 200/1 200 shares so ___ options
It creates more option contracts
2
How do you calculate the new strike price after a stock split?
Take the value amount of the contract before the split and divide it by the amount of new shares
How do you know when to create more options or to uncreate the shares of the option? In regards to stock splits and dividends
If it can make full options for example 200 shares. 300 shares.
If it can not make full options then it’s one contract worth 150. Or 250.
To calculate strike price and additional shares you are always…
Dividing old value total by the new share or contract amount
And for additional shares you multiply what they are doing with the old amount of shares
The ______ of the option determines who will be the owner of the stock
Whoever owns the stock prior to the ex date is entitled to ____
Exercise date
The dividend
Customer to Broker Dealer option settlement is? (Customer Transaction)
The next business day after the trade (T+1)
Reg T liquidation of option occurs? (customer transaction)
the 4th business day after the trade date (T+4)
Clearing Member to OCC option settlement occurs? (Broker dealer paying the OCC)
The next business day after the trade date (T+1) (There is NO REG T grace period for the Broker dealer)
Exercise option settlement occurs? (Think OCC)
Settled 2 business days from the time the OCC receives the exercise notice (T+2 from the time they receive the notice)
How is assignment of an exercise notice handled when dealing with an OCC to Clearing Member transaction (broker dealer) (assignment of an exercise notice)
Firm to be assumed is determined in a “random basis”
How is assignment of an exercise notice handled when it involves clearing members to clients? (How is it assigned)
How are they NOT assigned?
Customer is determined on a
- Random Basis
- FIFO first in first out, or oldest short position
- Any other method approved by the exchange
Based on LARGEST short position
As an opening transaction a registered representative can ________ against the corporations own underlying stock
Never sell calls for a corporation (issuer)
A call is “in the money” or has Intrinsic Value when?
When the market price of the stock is greater than the exercise price of the option
A put is “in the money” or has Intrinsic Value when?
When the market price of the stock is less than the exercise price of the option
At the money occurs when?
The market price is the same as the exercise price
Out of the money on a call occurs when?
The market price of the stock is less than the exercise price of the option
Out of the money on a put occurs when?
The market price of the stock is greater than the exercise price of the option
Premium is ____ considered for determining if a option is in the money. Just the investors ____ and _____.
Long and short is ____ considered either
Never
Breakeven/Profit
Never
The “In the money amount” is also called the options _____
In the money by 7 points can also be said as?
Intrinsic Value
Intrinsic value = 7 points
The amount of premium that exceeds the intrinsic value is known as the?
Time value
Options are referred to as “wasting assets” because their time value _____ the closer you get to the expiration date
Declines
No such thing as a ____ intrinsic value
Negative
The more “in the money” and option is the ____ the premium will be
Higher
The premium value of an option will move _____ with the price of the underlying stock when the option is “in the money”
Dollar for dollar
All of the following items would affect the pricing of the premium on an option (5 things)
- Market Price of the underlying stocks
- Time until expiration of the option
- Volatility of the underlying stock
- Changes in interest reiterated
- Liquidity
Leaps stands for?
It is?
Give investors the same privileges as short term options but have the added benefit of the _____
Long Term Equity Anticipation Securities
Long term options on stocks and on stock indexes
Longer Term Expiration
Contract Values of Leaps:
Equity Leaps represent?
Index Leaps represent?
100 shares of the underlying stock
$100 (times the glare of the underlying index settled in cash)
For both stock and stock index LEAPS one point in premium = ???
$100
Equity and Index LEAPS have expiration dates of??
And they expire on??
39 months OR 3+ Years
The 3rd Friday of the expiration month
Equity and OEX (S+P 100) LEAPS have an _____ exercise style
Meaning?
American
They can be exercised anytime
SPX (S & P 500) LEAPS have a ____ exercise style
Meaning?
European
Can only be exercised at expiration
S&P 500 LEAPS are primarily used for…
Hedging
Equity Leaps settle… (in what and when?)
In the underlying stock on the second business day following the exercise date (T+2)
Index LEAPS settle… (in what and when?)
In cash the next business day following the exercise date (T+1)
Position Limits in ALL equity options (long and short) are _____ on the same underlying stock
Meaning?
Aggregated
Added together
Buying OEX (S&P 100) LEAPS PUTS would provide a ____ for a large portfolio of large cap equity securities
Hedge
Leaps options with more than 9 months to expiration can be purchased on ____
The ___ requirement is?
Margin
75% of the premium value
Index Options are?
Cash or securities on exercise?
Options that mirror a specific index.
Because they mirror an index they settle in cash meaning no securities are exchanged when an exercise takes place
If an index option is exercised what happens to the buyer and the seller of the option?
- Buyers of the index options will receive cash that is equal to the difference between the market price at the close of trading for the index and the exercise price on the contract
- Sellers of the index options will owe cash that is equal to the difference between the market price at the close of trading for the index and the exercise price on the contract
Index options that are in the money by 1 cent or more are _____ exercised at expiration unless alternate instructions are received from the buyer of the contract
Automatically
VIX Options (CBOE Volatility Index Options) are…
How do they normally react to the market?
Options that are based on market volatility.
They normally have an “inverse” or opposite relationship to the market
You buy a VIX call when you think the market price of the stocks is gonna go ____
You buy a VIX put when you think the market price of the stocks is gonna up ____
Down (or on high volatility)
Up (or on low volatility)
When the market is going up and doing well, volatility is normally ____
When the market is going down and doing poorly, volatility is normally _____
Low
Higher
Investors who wish to hedge long stock positions in an index often purchase _____ as a hedge for their long stock positions
VIX Call Options
Foreign Currency Options are…
Options based upon exchange rates between the currencies of two countries
We always expect the value of a Foreign Currency to move in the ____ direction of the US dollar
If US dollar is strong we would expect a ____ in foreign currency values
Opposite
Decline
Investors Buy Calls on a foreign currency if they wanted to hedge against ____ values of US currency
When would you wanna buy foreign currency?
Declining
Investors Buy Puts on a foreign currency if they wanted to hedge against _____ values of US currency
When would you wanna sell foreign currency?
Rising
OTC Options are…
Options traded “off” the floor of an exchange
As opposed to being listed and traded on the floor of an exchange
OTC Options:
3 things
- Have a direct link between buyer and seller
- Generally, do not have a secondary market
- Are not standardized like listed options when it comes to contract size, strike price and expiration date
Options Disclosure Document (ODD)
Also called the “Characteristics and Risks of Standardized Options”
(Delivery Rules are)
- Customers must be furnished with a current ODD at or before the time the customers account is approved for option translations
- If there are changes to the ODD customers must be furnished with a revised ODD or supplement to the existing. Not later than the time that their next confirmation is sent
- If a registered representative wants to send an options worksheet to a customer, it must be preceded or accompanied by an ODD
If an options account is approved by a sale supervisor initially the account must be reviewed and approved or disapproved by an ROP (registered options principle) within ____ business days
10 BUSINESS
Option Account Agreement must be received by the member firm (broker dealer which is a member of FINRA) within ____ calendar days from the time the account is approved for options trading
If agreement is not returned within 15 calendar days only ____ transactions can occur
15 CALENDAR
Liquidating (Closing)
Background and financial information must be sent to the customer for verification within ____ calendar days after the account is approved for options trading
15 CALENDAR
Option account agreement states..
The customer will abide by the exchange rules and position limits
If the customer does not respond to the request for verification and/or correction, the firm may consider the information to be ____
Verified
