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Series 7- Passed with 83% > Chapter 4 Options 25-30 Questions > Flashcards

Chapter 4 Options 25-30 Questions Flashcards

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1
Q

Basics of an Option

A

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

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2
Q

Equity options

A

Most common type of options

Each option includes 100 shares

(Other type of option is a mini option which is only 10 shares)

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3
Q

Underlying Securities of an Option

A 
Stock
Stock market index
Foreign currency
Interest rate
Government bond
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4
Q

Two Parties in Option Contracts

A
  1. 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)

  1. Seller = Short = Writer

Receives the premium and has a credit to open their position.

Has Obligation to buy or sell at exercise

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5
Q

3 specification of every option

A
  1. Underlying instrument: anything with fluctuating value
  2. Price: strike or exercise price in which purchase or sale will occur
  3. 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

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6
Q

Derivative Security

A

A security that derives value from an underlying instrument

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7
Q

Calls

A

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

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8
Q

Puts

A

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

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9
Q

Identifying the price of a Call

A

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

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10
Q

Identifying aspects of a Put price

Long XYZ Jan 60 Put at 3

A

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

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11
Q

Terms in reference to calls

SAME FOR BOTH SIDES JUST DIFFERENT DESIRE

A

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

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12
Q

Terms in reference to Puts

SAME FOR BOTH SIDES

A

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

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13
Q

Premiums in regards to options

A

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

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14
Q

Factors affecting a premium

A

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

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15
Q

How to find Time Value

Stock Price: 49
Strike: 4250
Exp: May
Call last: 650
Put last: 090
A

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

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16
Q

4 strategies of buying a call

A
  1. Speculation - most common
  2. Deferring a Decision- postponing a financial commitment
  3. Diversification of holdings
  4. Protection of a short stock position-
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17
Q

4 strategies of writing calls

A

Bearish or neutral position on the underlying stock

  1. Speculation
  2. Increasing returns- make money on premium
  3. Lock in sale price- writing a call on an investment that has already appreciated
  4. Protection of a long position

A naked call has unlimited liability and is uncovered by another position

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18
Q

3 strategies of put buying

A

Bearish on underlying stock

  1. Speculation of downward stock movement
  2. Deferring a decision to sell
  3. Protection of a Long Stock Position- makes more sense than writing a call

Max gain is the strike price - premium

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19
Q

3 strategies of writing put

A

Bullish or neutral towards stocks

  1. Speculation
  2. Increase returns- if market keeps climbing, put writers would keep the premium
  3. 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
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20
Q

Choices at expiration

A
  1. Exercise the option- either buy with the call or sell with the Put
  2. Let the option expire
  3. Sell the option contract before expiration- profit or loss comes from movement in premium (called closing the position)
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21
Q

Debit vs credit

A

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

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22
Q

Exercise of an option

A

Options are exercised if they are in the Money

Exercise of listed equity options settle regular way: 3 business days

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23
Q

Closing Transactions

A

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

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24
Q

Hedging positions

A

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

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25
Q

Covered call writing

A

Selling calls when holding a long stock position

Reduced upside potential of investment because of the stock climbs, you will have to sell

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26
Q

Protecting a long stock with a long Put

A

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

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27
Q

Protecting long stock with a short call

A

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

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28
Q

Protecting a short position with a long call

A

Sells short 100 shares at 58
Buys call at 60 for 3

Max gain 5500

Max loss is 500

Breakeven is 55

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29
Q

Cover short stock by writing a short Put

A

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

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30
Q

Cashless Collar

A

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

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31
Q

Ratio Call writing

A

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

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32
Q

What is a spread?

A

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

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33
Q

3 types of spreads

A
  1. Price Spread (vertical spread)- different strike prices but same expiration date. Most common on series 7.
  2. Time spread (calendar or horizontal spreads)- different expiration, same strike price
  3. 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

34
Q

Debit Call Spread

A

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

35
Q

Debit vs credit spreads

A

Debit = Widen = exercise

Credit = narrow = expire

To find break even
Call spreads= net premium + lower strike
Put spreads= higher strike - net premium

36
Q

Credit Call Spread

A

Reduce risk of a short option, investor establishing is bearish

BE is short position + net premium

Profit when option expires

37
Q

Debit Put spread

A

Reduce cost of long Put position

Establishing a debit is bearish

Want the options to be exercised

38
Q

Credit Put spread

A

Reduce risk of short Put position

Potential reward is reduced

Establishing a credit is bulliss (want market to rise so neither is exercised

39
Q

Market Attitude of the Spread Investor

A

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

40
Q

Bear vs bull

A

Buy low bull

Buy high bear

41
Q

Rules for determining
Widen or shrink
Bull or Bear
Higher premium

A
  1. Widen or shrink- If you are a debit customer paying the higher premium you want it to widen.
  2. Bull is lower strike price in both option spreads
  3. 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

42
Q

Straddle

A

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

43
Q

Long Straddle

A

Expecting substantial volatility in stock price, but uncertain of which movement

Max gain is always unlimited

44
Q

Short straddles

A

Expect very little change in the market price

Collect two premiums for selling

Want the market price to stay within the breakeven points

45
Q

Combination

A

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

46
Q

Nonequity options

A

The underlying security is not a stock, so it has different contract size and delivery

47
Q

Index options

A

Based on 3 different types of indexes:

  1. Broad-based- entire market, include S&P 100 (OEX), 500 and the Major Market Index (XMI)
  2. Narrow based index- Movement of market segments in a specific industry
  3. Index with particular focus- example is the VIX which measures volatility (high reading is not bullish or bearish, measures fear of volatility)
48
Q

Index option features

A

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

49
Q

Systematic Risk

A

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 (

50
Q

Weekly Index Options

A

All weeklies are European exercise, meaning they are exercised on expiration date

51
Q

Beta

A

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

52
Q

Interest rate options

A

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

53
Q

Foreign Currency options

A

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

54
Q

Foreign Currency Option Features

A

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

55
Q

Standard features of option trading

A

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

56
Q

Option Trading Personnel

A
  1. 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)
  2. Market Makers- registered to trade for own account.
  3. Floor Broker- Firms rep on the floor of an exchange. Execute on behalf of customers and firm.
  4. Order Routing System- used to route customer orders directly to trading post
57
Q

Option Clearing Corporation

A

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

58
Q

Member firm compliance and supervision

A

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

59
Q

Options Contract Adjustments for Stock Splits and Dividends

A

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

60
Q

Open vs Closing

A

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

61
Q

Open Interest

A

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

62
Q

Types of market manipulation

A

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

63
Q

When should the customer receive the OCC disclosure document?

A

When the account is approved by the Registered Options principal or before

64
Q

Tax reporting for Expired options

A

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

65
Q

Close out tax consequences

A

Cap gain or loss equal to price differences on basis of how long it was held

66
Q

Tax situation if exercised

A

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

67
Q

Stock holding period

A

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

68
Q

Married Put

A

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.

69
Q

Short straddle

A

Carries unlimited loss potential

70
Q

Summary of Option types

A

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

71
Q

Options settle when

A

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

72
Q

Exercising options

A

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

73
Q

Designated primary market maker

A

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

74
Q

What would affect the holding period of a security if it has been held less than 12 months

A

Buy a Put

Sell a Put

Removes the risk

75
Q

Covering puts

A

Must buy at the same strike or higher to cover a short Put

76
Q

Options expire at

A

11:59 pm on the third Friday

77
Q

Options questions on taxation of gains

A

Only referring to regular options unless specifying leaps

78
Q

Ratio Call writers

A

Assume unlimited loss potential in a rising market

While have a limited maximum gain

79
Q

Marking an order ticket during a sale of long and short positions

A

Would mark the ticket with the net long position and the remaining shares would be short

80
Q

To find short market value at maitenance

A

Divide the credit balance by 1.3

Series 7- Passed with 83% (19 decks)

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