Chapter 3- Equity Options Flashcards
Options
A form of hedging (protection) of a stock position that you already have
Call Option
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
Put options
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
Option Buyer AKA
Holder
Buyer
Long
Driver
you have the option
Option Seller AKA
Seller
Writer
Short
Passenger
you have an obligation
Identifying an option position:
Buy 1 ABC May 50 Call @ 4
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)
Aggregate exercise price
Strike price * shares being exercised = Aggregate exercise price
Assign (or assignment
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
Shares per contract
Could be different from 10 if a stock dividend was issued, or a stock split or reverse split occurred
Traditional options maximum expiration
9 Months unless there is a leap (maximum expiration of 39 months)
Cover calls
Most conservative options contracts
Uncovered (naked) calls
Most speculative options contracts. Unlimited loss potential
Position Limit applied to
Option positions that are on the same side of the market
Downside protection with options
Buy a put
Long Puts protect long stock positions
Upside protection with options
Buy a call
Done when you want to limit loses from shorting a stock
When hedging you always…
Put on an option that is opposite side of the market than the side you are with the stock
Protective put
you are long the stock and long the put
Married put
when the put purchased is at the money.
This is when the put is at the same price the stock was purchased for
Long Puts hedge
Long stocks positions
Long Calls hedge
short stock positions
Opening Purchasers
Made by a buyer- establishes or adding to a long positions (buying a call or buying a put)
Closing Sale
Made by the buyer - eliminates or reduces a long position (sell the call or sell the put that you already purchased)
Opening Sale
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)
Closing Purchase
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)
Reasons to buy a call
Participates in the upward movement of the stock price.
Unlimited upside potential
Limited loss potential
Offers leverage and diversification
Hedges a short sale
Possible actions of options
T- Transfer
E- expire
E- execute
Why would you write a call
You receive premium income when a neutral or down market is expected
Why would you write a covered call
Offers premium income with downside protection
Most conservative, good for retired person wanting to trade options
When you are a covered call writer
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
Why would you buy a put
Participate in a downward movement of stock prices
To protect a long stock position
Limited risk alternative to selling a stock short
Why would you sell a put
Make a premium in a neutral or upward market is expected
When are you a covered put writer
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
Escrow or depository Receipt VS Bank Guarantee Letter
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
Why do we want to be covered
Reduces the need for additional funds in a margin account
How to dissect an Options question
- 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
Options consideration for taxes
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
Breakeven on a call is
Exercise price + Premium = Breakeven
Call up
Breakeven on a put is
Exercise price - premium = Breakeven
Put down
Bulls and options
Bulls buy calls and sell puts
Bears and options
Bears sell calls and buy puts
Investors Buy options to
maximize profit potential
Investors sell options to
add income and increase the rate of return on their portfolio
Options Clearing Corporation (OCC)
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
Order book Official
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
Options exchange systems
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
3 important times for options trading
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
Position limits
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
Exercise limits
Investors are limited to the number of options contracts which may be exercised in any 5 consecutive business day period
American Style Options
Can exercise anytime after they are purposed
European Style Options
Can only be exercised at expiration
Class of options
All options of the same type on the same underlying stock
IBM calls= one class
IBM puts= one class
Series of Options
Options of the same class with the same expiration month and the same exercise price
OCC determines…
Strike price
Options expiration month
size and type of contract
OCC does not determine premium. That is determined by supply and demand
Reasons Options contracts are adjusted
Stock dividends
Stock splits
rights distributions
NOT ADJUSTED FOR CASH DIVIDENDS
Options Settlement
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
Assignment of Exercise Notice
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)
Opening position
A registered rep can never sell calls for a corporation against that same corporations underlying stock
Factors to consider if options are in the money
Type of option (Call or Put)
Strike price (execute price)
Market Price
Never consider the investor (long or short and premium paid)
Things that effect the value (premium) of an option
Market Price of the underlying stock
Time until the expiration of the option
Volatility of the underlying stock
Changes in interest rates
Liquidity
Spread position
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
The term spread
refers to the difference between the premiums of the two contracts
Primary use of spread
Limits risk, but also limits profit
Debit Spread
Spend more on premiums then you receive in premiums
You want to close the spread to make a profit (not exercised)
Credit Spread
Receive more from your premiums then you spent
Hoping that the options expire worthless so you keep the money in your pocket
Calendar (horizontal/time) spread
A spread with different expiration months
Vertical Spread
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
Bull Spread
Buy the option with the lower Strike price
Sell the option with the higher strike price
Bear Spread
Buy the option with the higher strike price
sell the option with the lower strike price
Diagonal Spread
A spread with different strike prices and different months
Debit Spread Max gain and lose
Max loss - If expired worthless you would lose difference in premiums
Max gain is the difference between the strike price - the difference in premium
Credit Spread max gain or lose
Max gain- difference between premiums
Max lose is difference between the strike prices - gain from premiums
Breakeven points on a debit spread
Call = Long exercise price+the net debit of premiums
Put- Long exercise price - the net debit of the premiums
Straddle
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.
Long Straddle
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
Short Straddle
Sell a call and sell a put
Used if you think the value of the stock is going to remain fairly stable
The short call in a straddle is always assumed to be
uncovered which means it represents unlimited loss potential on the short straddle
Combinations
Is a straddle which has different exercise prices and/or different expiration dates
When are straddles profitable
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
Taxation of Options
Always considered capital gains or capital loses
NEVER ordinary income or ordinary loss
Since maximum life is 9 months it is always short term
Taxation of stock when buying a Put option
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
Taxation of stock when selling a covered call option
Treat the premium as short term capital gain and maintain the original cost basis
Options and holding periods
For tax purposes the holding period on stock purchased when an option is exercised begins the day after the option is executed
Margin needed for writing an uncovered equity option
% of the market value of the stock + the premium for the option
Stock index options settle in
Cash, not stock
Index options are used to
Hedge a diversified portfolio from systematic (market) risk or to anticipate market moves
Broad vs Narrow based index
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
The VIX (volatility Index Options)
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
Index Option contract sizes
1 option for an index is worth $100 instead of 100 stocks
Index options premiums
Same as other options. A purchase of 6 with still mean a total purchase price of $600
Index option American style option settlement
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
Gross Settlement (Cash settlement)
The profit or loss from in index options contract before the premiums are taken into consideration
European style option settlement exercise
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
Features of index options
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
Retail automatic Execution System (RAES)
Executes market and limit orders up to 50 contracts for public customers in OEX options and many equity options
Index Flex options
Allows for customizable exercise price, style, and expiration date
Interest rate or yield based options
Used by bond portfolio managers to protect against movements in interest rates
Yield based calls are purchased when…
you think interest rates are going to rise
Yield based puts are purchased when…
you think interest rates are going to decline
Settlement of interest rate options is in…
Cash not treasury security
Yield based options settlement is …
European style and usually the 3rd friday of the expiration month
Foreign currency options
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
Foreign option settlement value
The settlement value is determined by the spot price of the foreign currency at 12:00 noon the day before expiration date
Expiration and cycle
The expiration cycle is quarterly, March, June, September and December
Expiration date is the 3rd Friday of the expiration month
Currency options strike price decimal move
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
When to use currency options
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
Foreign Currency movements and the US dollar
Generally accepted that the foreign currency will move inversely to the US dollar
What happens to puts and calls when value of foreign currency changes
In foreign currency increase…
Calls go up
Puts go down
If foreign currency decreases
Calls go down
Puts go up
Forex Market
Trading of foreign currency
Trades 24 hours a day opening sunday night at 5pm eastern and closing friday night at 5pm eastern
US dollar index
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
LEAPs options
Long-term Equity Anticipation Securities
Follows most of the rules of other options except they go out as far as 39 months
LEAPs and using margin
LEAPs options with more then 9 months to expiration can be purchased on margin and the margin requirement is 75% of the value
Rules to approve public customers for options transaction
-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
Re approval of options trading
Must be done when customers investment objectives change
Uncovered option writing in a customer account requires
approval by a registered options principal (ROP)
Options account agreement
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
Suitability for options and public customers
no more than 15-20% of a persons investment assets should be committed for the purchase of options
Verification of background information
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
Order of action when opening new options account
-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
Types of Options Accounts
Cash accounts
Margin Accounts
Portfolio Margin Accounts
Trust Accounts
Discretionary Accounts
Cash Options accounts
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
Margin Account
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
Portfolio Margin Account
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
Trust Accounts
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
Discretionary account
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
Options Disclosure Document (ODD or “characteristics and Risks of standardized options”)
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
Customer confirmation must include
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
Customer Complaints
Must keep a separate central file for all written options complaints for a period of 4 years
Advertising and sales lit requires
Pre approval from an ROP before distribution, except for institutional customers
Correspondence Approval
Is only needed if you are sending it to more than 25 customers in a 30 day period
Communication from Broker dealer before the ODD had been delivered
Must be limited to general descriptions
Must contain contact information
must not contain recommendations
may include advertising designs and devices
Options communications record retention
Must be retained for 3 years
