Chapter 4 Options 25-30 Questions Flashcards
Basics of an Option
Two party contract that conveys a right to the buyer and obligation to seller
Terms of the option contract are standardized by the options clearing corp (OCC), allows for easy trading on Chicago Board Options Exchange
Two types: puts and calls
Classes: equal to all calls of an issuer or all puts
Series- have same class, issuer, exercise price, and expiration month
Style- American style = exercise any time
European Style = exercise only on day preceding expiration
Equity options
Most common type of options
Each option includes 100 shares
(Other type of option is a mini option which is only 10 shares)
Underlying Securities of an Option
Stock Stock market index Foreign currency Interest rate Government bond
Two Parties in Option Contracts
- Buyer = Long = Holder = Owner
Pays premium to seller. The premium is a debit to their account and opens the position the buyer wants to take.
Buyers have the right to exercise (buy or sell)
- Seller = Short = Writer
Receives the premium and has a credit to open their position.
Has Obligation to buy or sell at exercise
3 specification of every option
- Underlying instrument: anything with fluctuating value
- Price: strike or exercise price in which purchase or sale will occur
- Expiration: Specified life cycle
Standard = 9 months and expire on the Saturday after the third Friday of a month at 11:59pm
Long term equity anticipation notes (LEAPS) = max expiration of 39 months, most trade at 30 months
Weekly contract = issued on Thursday and expire on a Friday of the following week. Not listed during week standards expire
Derivative Security
A security that derives value from an underlying instrument
Calls
Long call - RIGHT to buy 100 shares at the strike price
Short call - Call writer has the OBLIGATIONS to sell
Buyers are bullish cause he believes market will rise
Writers are bearish because they believe Market will fall
Puts
Long Put- RIGHT to sell 100 shares at the strike price
Short Put- OBLIGATIONS to buy 100 shares of a specific stock at the strike price
Identifying the price of a Call
Long XYZ Jan 60 call at 3
Long- This is buyers positions
XYZ- The company
Jan- Expires third week of January on Saturday and is a standard option
60- strike price
Call- Right to buy shares at strike
3- premium per share of stock
Identifying aspects of a Put price
Long XYZ Jan 60 Put at 3
Long XYZ Jan 60 Put at 3
Long- buyer of the Put
XYZ- the company
Jan- expiration on Saturday after third Friday, regular term
Put- Right to sell at the exercise price
3- premium per share
Put buyer is bearish
Put seller is bullish
Terms in reference to calls
SAME FOR BOTH SIDES JUST DIFFERENT DESIRE
In the money- The price of the stock has risen above strike, will be exercised by the buyer
At the money- market price equals the stock price. Buyers will typically not exercise
Out of money- market price lower than strike
Intrinsic value- Always a positive number, strike - market price, call with intrinsic value will be exercised
Parity- when premium equals intrinsic value
Breakeven- neither make or lose money
Terms in reference to Puts
SAME FOR BOTH SIDES
In the Money- Market price is below the strike price, good for buyer
At the Money- market and strike the same
Out of Money- Market is higher than strike, good for seller
Intrinsic Value- Difference when strike is higher than market
Parity- When intrinsic value matches premium
Breakeven- neither make or lose money after premium is included
Premiums in regards to options
Quoted in cents with minimum increment of 5 cents
Buyer pays the ask, seller receives the bid
Premium reflects the intrinsic value and time value (markets perceived worth of the time remaining)
Premium quoted on per share basis, could include a stock split or stock dividend
Factors affecting a premium
Volatility of the underlying stock, possibility of greater profit
Amount of intrinsic value
Time remaining until expiration (Time value)
Interest rates
Factor with greatest influence is the volatility of the underlying stock
Premium= intrinsic value + time value
How to find Time Value
Stock Price: 49 Strike: 4250 Exp: May Call last: 650 Put last: 090
Time value= Premium - intrinsic
Call TV = 7.60 - 6.50 = $1.10
Put TV = $0.90 - 0 = $0.90
Any premium on an out of money option is all Time value
Further time to expiration, the greater the time value of money
The cost above or below market value is not included in time value
4 strategies of buying a call
- Speculation - most common
- Deferring a Decision- postponing a financial commitment
- Diversification of holdings
- Protection of a short stock position-
4 strategies of writing calls
Bearish or neutral position on the underlying stock
- Speculation
- Increasing returns- make money on premium
- Lock in sale price- writing a call on an investment that has already appreciated
- Protection of a long position
A naked call has unlimited liability and is uncovered by another position
3 strategies of put buying
Bearish on underlying stock
- Speculation of downward stock movement
- Deferring a decision to sell
- Protection of a Long Stock Position- makes more sense than writing a call
Max gain is the strike price - premium
3 strategies of writing put
Bullish or neutral towards stocks
- Speculation
- Increase returns- if market keeps climbing, put writers would keep the premium
- Buying stock below its current price- if the price drops and a option is exercised, you may be able to pay a lower price for the stock
Ex. Current price 39, Put was issued for 40 with premium of 3. You’d buy due to exercise for 39 but only pay 37 after premium
Choices at expiration
- Exercise the option- either buy with the call or sell with the Put
- Let the option expire
- Sell the option contract before expiration- profit or loss comes from movement in premium (called closing the position)
Debit vs credit
Debit- money paid out is a debit to the investors account
Buying a Put or a call is a debit
Credit- money received by the investor
Selling a Put or a Call will result in a credit
Exercise of an option
Options are exercised if they are in the Money
Exercise of listed equity options settle regular way: 3 business days
Closing Transactions
If you initially bought a Call or put, you can close by selling it
If you initially sold an option, you can close by buying that option back.
Always the opposite
Hedging positions
Long stock positions can hedge by: buying a Put or, to a limited degree, selling a Call
Short stock position can be hedged by: buying a Call or selling a Put to some degree
Best way to protect a position is by buying an option
Covered call writing
Selling calls when holding a long stock position
Reduced upside potential of investment because of the stock climbs, you will have to sell
Protecting a long stock with a long Put
Buys RST at 53, and a Put of RST 50 for 2
Max gain unlimited- 200
Max loss is 500
Break even would be 55
Protecting long stock with a short call
Buy 100 shares of RST at 53
Write a call at 55 for 2
Max gain is 400
Max loss is 5100
Limits upside while not protecting downside
Protecting a short position with a long call
Sells short 100 shares at 58
Buys call at 60 for 3
Max gain 5500
Max loss is 500
Breakeven is 55
Cover short stock by writing a short Put
Sells 100 shares at 55
Writes Put at 55 for 2.50
Max gain 250
Max loss is unlimited minus 250
Breakeven is 57.50
Cashless Collar
Buys 100 shares at 50
Buys a Put at 45 for 3
Sells a Call at 55 for 3
Max loss 500
Max gain 500
Eliminates major downside risk, but also kills upside
Ratio Call writing
Selling more calls than your long position covers
Buy 100 shares at 55
Sell a call at 60 for 3
Sell a call at 59 for 4
Max gain 1100
Max loss unlimited
No effect between 59-60
What is a spread?
Simultaneously buy one option and sale of another option of the same class
Ex. Long call and a short call
Must be a long and a short
Cannot be two longs or two shorts
3 types of spreads
- Price Spread (vertical spread)- different strike prices but same expiration date. Most common on series 7.
- Time spread (calendar or horizontal spreads)- different expiration, same strike price
- Diagonal Spread- differ in both time and price
Categorized as a debit or credit spread: if the short position has the higher premium then it’s a credit spread
Debit Call Spread
Used to reduce cost of a long position, bullish
Buy 55 call for 6
Sell 60 call for 3
Max gain 200
Max loss 300
Breakeven: To find its the net premium added to lower strike
Investor profits if both exercise
Debit vs credit spreads
Debit = Widen = exercise
Credit = narrow = expire
To find break even
Call spreads= net premium + lower strike
Put spreads= higher strike - net premium
Credit Call Spread
Reduce risk of a short option, investor establishing is bearish
BE is short position + net premium
Profit when option expires
Debit Put spread
Reduce cost of long Put position
Establishing a debit is bearish
Want the options to be exercised
Credit Put spread
Reduce risk of short Put position
Potential reward is reduced
Establishing a credit is bulliss (want market to rise so neither is exercised
Market Attitude of the Spread Investor
If you are the buyer of a call at the lower strike and higher premium, you are bullish
If you are buyer of a Call with Higher strike price and lower premium, you are bear
Buyer ofPut with higher strike, and lower premium Bull
Buyer of Put with lower strike and higher premium, Bear
Buying lower strike you are the bull, buying higher you are bear
Bear vs bull
Buy low bull
Buy high bear
Rules for determining
Widen or shrink
Bull or Bear
Higher premium
- Widen or shrink- If you are a debit customer paying the higher premium you want it to widen.
- Bull is lower strike price in both option spreads
- High premium for Call is the bull
Higher premium for Put is the bear
Bull call debit Widen
Bull Put credit shrink
Bear call credit shrink
Beat Put debit Widen
Straddle
Composed of a Call and a Put, with the same strike price and expiration
Would probably buy in a volatile market
Sell in a non volatile
Buying both or selling both
Long Straddle
Expecting substantial volatility in stock price, but uncertain of which movement
Max gain is always unlimited
Short straddles
Expect very little change in the market price
Collect two premiums for selling
Want the market price to stay within the breakeven points
Combination
Composed of a Call and a Put with different strike prices, expiration months or both
Similar to straddle, easier to establish than long straddles
Make money if stock trades outside of breakeven in a long combo
Nonequity options
The underlying security is not a stock, so it has different contract size and delivery
Index options
Based on 3 different types of indexes:
- Broad-based- entire market, include S&P 100 (OEX), 500 and the Major Market Index (XMI)
- Narrow based index- Movement of market segments in a specific industry
- Index with particular focus- example is the VIX which measures volatility (high reading is not bullish or bearish, measures fear of volatility)
Index option features
Multiplier is still $100
Settle on next business day, broad based stop trading at 4:15, narrow at 4
Settled in cash rather than delivery of a security
Settlement price is end of market trading on day of exercise, not the settlement date
Expire on the third Friday of the expiration month
As long as there is time value, customer will make more by closing the position
Excercise Settlement value is based on closing index value on day exercise instructions are received
Systematic Risk
The risk that the market will decline
Can eliminate by buying portfolio insurance in the form of an option
To hedge a portfolio of 920,000, you would have to buy 20 Puts if strike is 460
460*20= 9,200 (
Weekly Index Options
All weeklies are European exercise, meaning they are exercised on expiration date
Beta
Measure of volatility of a stock related to volatility of market in general
1.0 is a perfect match
Ex. If a portfolio has a beta of 1.2, then you may have to buy more Puts when insuring your portfolio
Interest rate options
Yield based on strike price
Ex. A strike of 35 is 3.5% yield
Based on T-bill, Tnote, t bonds
If yield moves from 3.5 to 4.5%, the investor will make $1000 ($100 per point)
All are European style options
Foreign Currency options
Available for trading on US listed exchanges for Australian Dollar, British pound, Canadian dollar, Japanese yen, and the Euro
Speculate or protect against inflation of currency
Importers and exporters often use
Foreign Currency Option Features
Cash settled, no physical delivery
Contract sizes are usually 10,000 except the Yen which is 1,000,000
Strike prices are commonly quoted in US cents
Yen is quoted in 1/100th of a cent
One point is $100
Example: Swiss Franc with premium of 1.5 cents. Premium= 150
Traded between 9:30-4pm on Philadelphia Nasdaq
Expire third Friday
Settle on next business day when purchasing and selling and executing
Buy or sell options based on currency you are purchasing in
Exporters usually buy in regards to foreign currency except if exporting to US, where they buy on own currency
Standard features of option trading
OTC market for options is limited due to options not being standardized
Listed stock options trade from 9:30-4pm (excluding broad based which trade till 4:15)
Trades can be made until 4pm in options
Option trades are settled on the next business day. Stock delivered as a result of exercise is settled regular way (three business days)
Contracts in the Money by at least a penny are exercised automatically unless otherwise instructed. Instruction must be received by 5:30 pm on last trade day
250,000 contract max on the same side of market
Sides: long call/short put (bull side) vs short call/long Put (bear side)
Exercise limit of 250000 in 5 business day period
Option Trading Personnel
- Designated Primary Market Maker- Floor trader responsible for maintaining a two-sided market for an option. All equity options have a DPM. (Also have a eDPM)
- Market Makers- registered to trade for own account.
- Floor Broker- Firms rep on the floor of an exchange. Execute on behalf of customers and firm.
- Order Routing System- used to route customer orders directly to trading post
Option Clearing Corporation
Determines when new options are put on market
Designates strike and expiration month
Assigns exercise notices on a random basis
Broker/Dealer that receives exercise notice can assign based on first in/first out or a fair and reasonable method
Requires the OCC Options Disclosure Document must be distributed to clients and that a customer return a signed Options agreement to customers within 15 days of opening an options account
Options account must be approved by branch manager
Can make trade after approval but may only close position if Options agreement is not signed in 15 days
Member firm compliance and supervision
Required to designate a registered Options principal (series 4) to look over customer accounts
Must also approve any distributions to clients
Past performance cannot be included in Option advertising but can be in sales literature
Options Contract Adjustments for Stock Splits and Dividends
Not adjusted for cash dividends less than 12.50 per option contract
Adjustments to share count is rounded down
New option contracts are generated when an even stock split occurs (ending in 1 ex. 3:1)
2:1 split of 1 ALF 60 becomes 2 ALF 30
Uneven receives new option symbol
3:2 split of 1 ALF 60 becomes 1 ALF 40 with 150 shares
Open vs Closing
Must designate when filling out an order ticket whether the trade is opening or closing a position
Must also designate whether a sale is covered or uncovered
If protected by another position it’s called
Open Interest
Number of contracts outstanding in an option
Higher interest, more liquid
Put Call ratio- measures current open interest in trading of Put vs call
Calculated by dividing puts over calls… the higher the more bearish
Can be used as a contrarian indicator if the ratio becomes too skewed towards bearish
Types of market manipulation
Capping- entering sell orders in order to keep a stock from rising above calls one is short of
Supporting- entering purchase orders to keep price above a put
Pegging- trying to keep price steady
Front Running- Taking an option position before entering a block order received
When should the customer receive the OCC disclosure document?
When the account is approved by the Registered Options principal or before
Tax reporting for Expired options
Buyer reports a capital loss equal to The premium on date of expiration!
LEAPS writers will report a short term capital gain if it expires without being exercised regardless of whether it went over 12 months
Close out tax consequences
Cap gain or loss equal to price differences on basis of how long it was held
Tax situation if exercised
Cost basis if you end up purchasing the stock will be increased or decreased by premium
Ex. Exercise a long call, cost basis would be strike price plus premium paid
Sale proceeds if you end up selling a stock will be increased or decreased by premium
Ex. You sell a call and it’s exercised. Your proceeds will be the strike price plus the premium you received
Exercising an option does not necessarily constitute a taxable event
Stock holding period
If a stock has been held for 11 months and the investor buys a Put to lock in a sale price, the investors return will be classified as a short term gain though the stock could be held for 20 months at time of exercise
Married Put
If you buy a Put along with a stock on the same day, the cost basis of the stock is raised to include the Put.
Short straddle
Carries unlimited loss potential
Summary of Option types
Spread- 3types: Price, Time and Diagonal
Have two of a class (Call or a Put) one bought, one sold
Price- buy Call in May at 50, sell Call in May at 60
Time- buy Call in May at 50, sell Call in June and 50
Diagonal- buy Call in May at 45, sell Call in June at 50
Straddle- composed of a Call and a Put at the same price both bought
Long- Buy call in may at 50, Buy Put in may at 50
Short- Sell call in may at 50, sell put in May at 50
Combination- Variation of a straddle either in date, or strike or both
Ex- Sell call in may at 50, Sell put in may at 55
Options settle when
Purchases of options settle on the next day
Broad based index options stop trading at 4:15pm
Narrow based index options and stock options stop trading at 4pm
Exercising options
Settlement of an equity option is regular way (3 business days) for exercise
Index options settle next business day for exercise
Buying or selling option is next business day
Designated primary market maker
Acts as an agent in maintaining the electronic order book on behalf of the CBOE and a market maker who may trade for his own account
What would affect the holding period of a security if it has been held less than 12 months
Buy a Put
Sell a Put
Removes the risk
Covering puts
Must buy at the same strike or higher to cover a short Put
Options expire at
11:59 pm on the third Friday
Options questions on taxation of gains
Only referring to regular options unless specifying leaps
Ratio Call writers
Assume unlimited loss potential in a rising market
While have a limited maximum gain
Marking an order ticket during a sale of long and short positions
Would mark the ticket with the net long position and the remaining shares would be short
To find short market value at maitenance
Divide the credit balance by 1.3
