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Series 7 > Chapter 3- Equity Options > Flashcards

Chapter 3- Equity Options Flashcards

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Series 7 Top-off Exam flashcards
1
Q

Options

A

A form of hedging (protection) of a stock position that you already have

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2
Q

Call Option

A

Gives the buyer the right to buy 100 shares of the underlying stock at a set price for a limited time
(call up)
seller- obligates the seller to sell 100 shares of the underlying stock at a set price for a limited time

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3
Q

Put options

A

Gives the buyer the right to sell 100 shares of the underlying stock at a set price for a limited time
(put down)
seller- obligates the seller to buy 100 shares of the underlying stock at a set price for a limited time

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4
Q

Option Buyer AKA

A

Holder
Buyer
Long
Driver

you have the option

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5
Q

Option Seller AKA

A

Seller
Writer
Short
Passenger

you have an obligation

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6
Q

Identifying an option position:
Buy 1 ABC May 50 Call @ 4

A

Buy- is the action
1- is the number of contracts (1 contract = 100 shares)
ABC- is the ticker symbol of the company
May- the expiration month. Options expire on the 3rd Friday and 11:59 of the month
50- is the strike (exercise) price
Call- is the type of option
4- is the premium per share (*100 =400 total value)

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7
Q

Aggregate exercise price

A

Strike price * shares being exercised = Aggregate exercise price

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8
Q

Assign (or assignment

A

When the buyer of an option contact decides to exercise the option the exercise will be assigned to a random seller of the same contract

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9
Q

Shares per contract

A

Could be different from 10 if a stock dividend was issued, or a stock split or reverse split occurred

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10
Q

Traditional options maximum expiration

A

9 Months unless there is a leap (maximum expiration of 39 months)

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11
Q

Cover calls

A

Most conservative options contracts

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12
Q

Uncovered (naked) calls

A

Most speculative options contracts. Unlimited loss potential

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13
Q

Position Limit applied to

A

Option positions that are on the same side of the market

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14
Q

Downside protection with options

A

Buy a put
Long Puts protect long stock positions

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15
Q

Upside protection with options

A

Buy a call
Done when you want to limit loses from shorting a stock

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16
Q

When hedging you always…

A

Put on an option that is opposite side of the market than the side you are with the stock

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17
Q

Protective put

A

you are long the stock and long the put

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18
Q

Married put

A

when the put purchased is at the money.
This is when the put is at the same price the stock was purchased for

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19
Q

Long Puts hedge

A

Long stocks positions

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20
Q

Long Calls hedge

A

short stock positions

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21
Q

Opening Purchasers

A

Made by a buyer- establishes or adding to a long positions (buying a call or buying a put)

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22
Q

Closing Sale

A

Made by the buyer - eliminates or reduces a long position (sell the call or sell the put that you already purchased)

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23
Q

Opening Sale

A

Made by the seller - Establishing or adding to a short position. Must be marked as covered or uncovered (sell a call or sell a put)

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24
Q

Closing Purchase

A

Made by the seller - eliminating or reducing a short position (buy a call or buying a put that is identical to the one that you originally sold)

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25
Q

Reasons to buy a call

A

Participates in the upward movement of the stock price.
Unlimited upside potential
Limited loss potential
Offers leverage and diversification
Hedges a short sale

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26
Q

Possible actions of options

A

T- Transfer
E- expire
E- execute

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27
Q

Why would you write a call

A

You receive premium income when a neutral or down market is expected

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28
Q

Why would you write a covered call

A

Offers premium income with downside protection
Most conservative, good for retired person wanting to trade options

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29
Q

When you are a covered call writer

A

Own the underlying stock
obtained an escrow or depository Receipt
Was long a call with equal or lower exercise price (if the Long has a Lower Strike price and expires after the call that was sold)
Owned a convertible Bonds, convertible preferred stock or a warrant as long as they can be immediately convertible and do not expire before the call

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30
Q

Why would you buy a put

A

Participate in a downward movement of stock prices
To protect a long stock position
Limited risk alternative to selling a stock short

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31
Q

Why would you sell a put

A

Make a premium in a neutral or upward market is expected

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32
Q

When are you a covered put writer

A

Have funds on deposit
Bank guarantee letter
short an equal amount of the stock
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

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33
Q

Escrow or depository Receipt VS Bank Guarantee Letter

A

Escrow (depository) receipt are used for covering call. Crows CALL
Bank Guarantee Letters are used to cover a put. You PUT money in a bank

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34
Q

Why do we want to be covered

A

Reduces the need for additional funds in a margin account

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35
Q

How to dissect an Options question

A
  1. Set up a T chart and separate premiums and stock transactions
    Label anything bought with a “B-“
    Label anything sold with an “S+”
    Look and work with action/transaction words
    ignore “when the price of the stock is” unless it is connected with an action
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36
Q

Options consideration for taxes

A

Options are considered capital asset so they are taxed as a short term capital gain. But they are never treated as ordinary income or ordinary losses

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37
Q

Breakeven on a call is

A

Exercise price + Premium = Breakeven
Call up

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38
Q

Breakeven on a put is

A

Exercise price - premium = Breakeven
Put down

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39
Q

Bulls and options

A

Bulls buy calls and sell puts

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40
Q

Bears and options

A

Bears sell calls and buy puts

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41
Q

Investors Buy options to

A

maximize profit potential

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42
Q

Investors sell options to

A

add income and increase the rate of return on their portfolio

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43
Q

Options Clearing Corporation (OCC)

A

Issuer, clearing agency, and guarantor of all listed options in the US
Owned and run by member exchanges
it is a self-regulatory organizations (SRO)
Take place on the floor of the exchanges but are not reported to the ticker (consolidated) tapes

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44
Q

Order book Official

A

Is an employee for the CBOE (Chicago board options exchange) who handles public limit order books
May only accept limit orders and may not trade for themselves

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45
Q

Options exchange systems

A

CBOE has a hybrid systems, both by person and electronically
The electronic system is known as the Order Support System (OSS)
OSS routes orders directly to the options trading post and sends notice of the execution directly to the broker dealer

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46
Q

3 important times for options trading

A

Cease tradings is a 4pm eastern time on the 3rd Friday of the month
If tradings is halted on the stock then trading of them option is also halted but it can still be executed
Exercise cut off time is 5:30pm eastern on the 3rd Friday of the month
Expiration occurs at 11:59pm eastern time on the 3rd Friday of the expiration month

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47
Q

Position limits

A

There is a limit to the number of options contracts an investor can hold at a time that are on a single side of the market.
Long Calls and short puts are on the bullish side
short calls and long puts are on the bearish side of the market

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48
Q

Exercise limits

A

Investors are limited to the number of options contracts which may be exercised in any 5 consecutive business day period

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49
Q

American Style Options

A

Can exercise anytime after they are purposed

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50
Q

European Style Options

A

Can only be exercised at expiration

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51
Q

Class of options

A

All options of the same type on the same underlying stock
IBM calls= one class
IBM puts= one class

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52
Q

Series of Options

A

Options of the same class with the same expiration month and the same exercise price

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53
Q

OCC determines…

A

Strike price
Options expiration month
size and type of contract

OCC does not determine premium. That is determined by supply and demand

54
Q

Reasons Options contracts are adjusted

A

Stock dividends
Stock splits
rights distributions

NOT ADJUSTED FOR CASH DIVIDENDS

55
Q

Options Settlement

A

CUSTOMERS
Customer to clearing member (broker dealer) - T+1
Regulation T liquidations doesn’t occur until 4th day after trade T+4
BROKER DEALER
Between B/D to OCC is the next business day after trade date (NO reg T grace period for the broker dealer)
Exercise - settles 2 business days (T+2) from the time OCC receives the exercise notice on the option

56
Q

Assignment of Exercise Notice

A

The firm to be assigned on a random basis
Firm determines the client on either:
random basis
FIFO
or any other approved method by the exchange
(it can not be because of the size of the clients position)

57
Q

Opening position

A

A registered rep can never sell calls for a corporation against that same corporations underlying stock

58
Q

Factors to consider if options are in the money

A

Type of option (Call or Put)
Strike price (execute price)
Market Price

Never consider the investor (long or short and premium paid)

59
Q

Things that effect the value (premium) of an option

A

Market Price of the underlying stock
Time until the expiration of the option
Volatility of the underlying stock
Changes in interest rates
Liquidity

60
Q

Spread position

A

It is a long and a short position in either 2 call contracts or 2 put contracts
Different expiration months and/or different strike prices
Buy and sell a call- call spread
Buy and sell a put - put spread

61
Q

The term spread

A

refers to the difference between the premiums of the two contracts

62
Q

Primary use of spread

A

Limits risk, but also limits profit

63
Q

Debit Spread

A

Spend more on premiums then you receive in premiums
You want to close the spread to make a profit (not exercised)

64
Q

Credit Spread

A

Receive more from your premiums then you spent

Hoping that the options expire worthless so you keep the money in your pocket

65
Q

Calendar (horizontal/time) spread

A

A spread with different expiration months

66
Q

Vertical Spread

A

Is a spread that has different strike prices
The spread is either bull or bearish
Always listed as a vertical bull spread or vertical bear spread, never just a vertical spread

67
Q

Bull Spread

A

Buy the option with the lower Strike price
Sell the option with the higher strike price

68
Q

Bear Spread

A

Buy the option with the higher strike price
sell the option with the lower strike price

69
Q

Diagonal Spread

A

A spread with different strike prices and different months

70
Q

Debit Spread Max gain and lose

A

Max loss - If expired worthless you would lose difference in premiums
Max gain is the difference between the strike price - the difference in premium

71
Q

Credit Spread max gain or lose

A

Max gain- difference between premiums
Max lose is difference between the strike prices - gain from premiums

72
Q

Breakeven points on a debit spread

A

Call = Long exercise price+the net debit of premiums

Put- Long exercise price - the net debit of the premiums

73
Q

Straddle

A

equal number of puts and calls, both long or both short on the same stock with the same expiration month and exercise price
either 2 buys or to sells.

74
Q

Long Straddle

A

Buy a call and buy a put

Use it if you think there will be a major change in the market price of a stock but you don’t know which direction it will go

75
Q

Short Straddle

A

Sell a call and sell a put

Used if you think the value of the stock is going to remain fairly stable

76
Q

The short call in a straddle is always assumed to be

A

uncovered which means it represents unlimited loss potential on the short straddle

77
Q

Combinations

A

Is a straddle which has different exercise prices and/or different expiration dates

78
Q

When are straddles profitable

A

If you have a short straddle or combination then you are profitable inside of the break even points
If you have a long straddle or combination you are profitable outside of the breakeven points

79
Q

Taxation of Options

A

Always considered capital gains or capital loses
NEVER ordinary income or ordinary loss
Since maximum life is 9 months it is always short term

80
Q

Taxation of stock when buying a Put option

A

The IRS views this as you sold the stock, have to pay tax on it, and now have to start a new holding period at the end of the put contract

81
Q

Taxation of stock when selling a covered call option

A

Treat the premium as short term capital gain and maintain the original cost basis

82
Q

Options and holding periods

A

For tax purposes the holding period on stock purchased when an option is exercised begins the day after the option is executed

83
Q

Margin needed for writing an uncovered equity option

A

% of the market value of the stock + the premium for the option

84
Q

Stock index options settle in

A

Cash, not stock

85
Q

Index options are used to

A

Hedge a diversified portfolio from systematic (market) risk or to anticipate market moves

86
Q

Broad vs Narrow based index

A

Broad- covers a wide range of industries ie S&P 10 or S&P 500
Narrow covers a narrow range of industries, made up of 9 or fewer securities

87
Q

The VIX (volatility Index Options)

A

Only European style
Expiration based on a February cycle
1 point on the VIX=$100
Automatically exercises if settlement exceeds strike price
Buying a VIX call option protects against the risk of sharply falling stock prices

88
Q

Index Option contract sizes

A

1 option for an index is worth $100 instead of 100 stocks

89
Q

Index options premiums

A

Same as other options. A purchase of 6 with still mean a total purchase price of $600

90
Q

Index option American style option settlement

A

Settlement is the difference between the exercise price of the option and the current index value AT THE CLOSE of trading on the day of exercise time $100

91
Q

Gross Settlement (Cash settlement)

A

The profit or loss from in index options contract before the premiums are taken into consideration

92
Q

European style option settlement exercise

A

Settlement is the difference between the exercise price of the option and the exercise value of the index on the expiration date (Usually a Friday) time $100

93
Q

Features of index options

A

Exercise price are set in intervals of 5
Expiration monthly
Most expire on the 3rd friday of the month
Can opening trading of the index options even if ALL underlying stocks are not yet trading

94
Q

Retail automatic Execution System (RAES)

A

Executes market and limit orders up to 50 contracts for public customers in OEX options and many equity options

95
Q

Index Flex options

A

Allows for customizable exercise price, style, and expiration date

96
Q

Interest rate or yield based options

A

Used by bond portfolio managers to protect against movements in interest rates

97
Q

Yield based calls are purchased when…

A

you think interest rates are going to rise

98
Q

Yield based puts are purchased when…

A

you think interest rates are going to decline

99
Q

Settlement of interest rate options is in…

A

Cash not treasury security

100
Q

Yield based options settlement is …

A

European style and usually the 3rd friday of the expiration month

101
Q

Foreign currency options

A

Sold on the Philadelphia stock exchange
Can not buy options on the US dollar
Settle in US dollars
Issued and guaranteed by OCC
trade during normal trading hours (9:30am-4:30om)
Always European style exercise

102
Q

Foreign option settlement value

A

The settlement value is determined by the spot price of the foreign currency at 12:00 noon the day before expiration date

103
Q

Expiration and cycle

A

The expiration cycle is quarterly, March, June, September and December
Expiration date is the 3rd Friday of the expiration month

104
Q

Currency options strike price decimal move

A

Japanese yen- move 4 places to the right
Mexican Peso, South Africa Rand and the Swedish Krona- move 3 places to the right
All others move two places to the right

105
Q

When to use currency options

A

If a US investor must make a payment in a foreign currency the investor would Buy Calls to hedge their position
If a US investor must accept payment in a foreign currency the investor would Buy Puts to hedge the position

106
Q

Foreign Currency movements and the US dollar

A

Generally accepted that the foreign currency will move inversely to the US dollar

107
Q

What happens to puts and calls when value of foreign currency changes

A

In foreign currency increase…
Calls go up
Puts go down

If foreign currency decreases
Calls go down
Puts go up

108
Q

Forex Market

A

Trading of foreign currency
Trades 24 hours a day opening sunday night at 5pm eastern and closing friday night at 5pm eastern

109
Q

US dollar index

A

Measures the US dollar against a basket of foreign currency
Maintained and published by ICE (InterContinental Exchange Inc.)
When the dollar strengthens the index goes up
When the dollar weakens the index goes down

110
Q

LEAPs options

A

Long-term Equity Anticipation Securities
Follows most of the rules of other options except they go out as far as 39 months

111
Q

LEAPs and using margin

A

LEAPs options with more then 9 months to expiration can be purchased on margin and the margin requirement is 75% of the value

112
Q

Rules to approve public customers for options transaction

A

-Each customer must be approved by a branch manager
-Initial approve must be sent to a ROP (S-4) for approval or disapproval within 10 business days
If firm losses their ROP they can only execute “closing” transactions
If there are 3 or more ROPs in an office that loses its brnach manager then all activities but be routed to another branch manager for approval

113
Q

Re approval of options trading

A

Must be done when customers investment objectives change

114
Q

Uncovered option writing in a customer account requires

A

approval by a registered options principal (ROP)

115
Q

Options account agreement

A

Must be received by the member firm within 15 CALENDAR days from the time the account was approved for options trading.
If not only liquidating (closing or execute) transactions can be done

116
Q

Suitability for options and public customers

A

no more than 15-20% of a persons investment assets should be committed for the purchase of options

117
Q

Verification of background information

A

Must be sent to the customer within 15 calendar days
Customer must be given the change to correct or complete information
If customer does not respond firm may consider the information valid
If firm becomes aware of major changes they just send a new copy of verification within 15 days

118
Q

Order of action when opening new options account

A

-Obtain essential facts from the customer
-Provide customer with ODD at or before they are approved
-Get the approval of the Securities Sales Supervisor or Branch office Manager
-Enter the Order
-Obtain a signed options account agreement within 15 calender days
Background and financial information must be sent to the customer for verification within 15 Calendar days

119
Q

Types of Options Accounts

A

Cash accounts
Margin Accounts
Portfolio Margin Accounts
Trust Accounts
Discretionary Accounts

120
Q

Cash Options accounts

A

Customer pay in full for securities purchased
May buy calls and puts and sell covered calls and covered puts

In cash account convertible bonds and warrants CANNOT be used to cover positions

121
Q

Margin Account

A

An investor may buy calls and puts and sell covered calls and covered puts
can be executed on the same day purchased
100% of the premium is always required for standard or traditional margins. You can buy options in a margin account but you cannot buy options on margin (not including LEAPs)
Put on a spread position
Write uncovered calls and puts

122
Q

Portfolio Margin Account

A

Use quantitative models to determine margin requirements by measuring risk and the effect of hedging. Allows investors to have greater leverage on margin equity securities based on actual risk
Customers must be approved for uncovered options
Government Securities are not allowed in these accounts
Deficiencies must be met within 3 business days, if not no new orders can be placed and liquidation will occur

123
Q

Trust Accounts

A

To be approved:
organization approving must know the trust’s investment objectives
Examine the trust agreement to ensure the trustee is empowered to trade options

124
Q

Discretionary account

A

Must have prior written authorization must be on file
Another ROP then the one that approved the account must review the acceptance and maintain a record of the basis
Discretionary order tickets must be clearly identified as discretionary and approved and initialed on the day it is entered
Excessive trading is prohibited

125
Q

Options Disclosure Document (ODD or “characteristics and Risks of standardized options”)

A

ODD must be furnished at or before the time the customer’s account is approved for options transactions
If there is a change to the ODD the revised copy must be furnished not later than the time that their next trade confirmation is sent
If RR is sending an options worksheet to a customer is be preceded by or accompanying ODD

126
Q

Customer confirmation must include

A

Underlying security
Type of option
Expiration month
Exercise price
numbers of options contracts
premium
commissions
date of transactions
settlement date
whether the transaction is a purchase or sale
whether the firm acted as a principal or agent
whether the transactions was an opening or closing transaction

127
Q

Customer Complaints

A

Must keep a separate central file for all written options complaints for a period of 4 years

128
Q

Advertising and sales lit requires

A

Pre approval from an ROP before distribution, except for institutional customers

129
Q

Correspondence Approval

A

Is only needed if you are sending it to more than 25 customers in a 30 day period

130
Q

Communication from Broker dealer before the ODD had been delivered

A

Must be limited to general descriptions
Must contain contact information
must not contain recommendations
may include advertising designs and devices

131
Q

Options communications record retention

A

Must be retained for 3 years

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