Chapter 5 - Option Contracts

Question 1

• this term is a legally binding contract between buyers and sellers
• the buyer of this term is called the “holder”

– the holder has the right to buy (call) or the right to sell (put) a round lot (100 shares) of the underlying security at a specified price (strike price)

• this term is valid for a specified period of time and loses all value after the expiration date
• the buyer of this term pays a premium for the right to exercise the option within a specified time period
• the seller of this term is obligated to buy or sell the security at the strike price
• the main components of this term are the underlying security, the expiration date, and the type of option and the strike price
• this term is issued with a range of expiration dates called Cycles

– there are three cycles: Jan/April/July/October; February/May/August/November; and March/June/September/December

Answer 1

Option

Question 2

• this term is the entity that standardizes options contracts so they can trade on exchanges
• this entity sets strike prices and expiration dates and is the issue and clearing agent for listed options
• it is owned by the exchanges that trade options

Answer 2

Options Clearing Corporation (OCC)

Question 3

• this term is a negotiated option that trades in the OTC market
• this term is not standardized or listed on an exchange
• this term is often used by portfolio managers to help them hedge or protect their portfolios, because these options can be custom-designed to meet the portfolio’s needs at a specific time

Answer 3

OTC Option

Question 4

• this term is a contract that gives the holder the right to purchase 100 shares of the underlying security at the strike price until expiration
• the writer of this term is subject to unlimited risk if they do not own the underlying security because they are required to buy the security at its current price and sell it to the holder at the strike price

Answer 4

Call Option

Question 5

• this term is a contract that gives the holder the right to sell 100 shares of the underlying security at the strike price until expiration
• the writer of this term has the obligation to buy 100 shares of the underlying security at the strike price until expiration

Answer 5

Put Option

Question 6

• this term is the price of the option and fluctuates with the price of the underlying security and the time remaining until expiration
• this term is not part of the option contract
• for a call option, this term tends to increase in value when the underlying stock price rises, especially as the price of the underlying stock approaches and goes through the strike price
• for a put option, this term increases in value when the underlying stock goes down in price, especially as the price of the underlying stock approaches and goes through the strike price
• this term is made up of time value and intrinsic value

– this term = Intrinsic Value + Time Value

• this term will be higher for option contracts with volatile stocks as the underlying security

– this is because volatility increases the likelihood that the stock will move enough for the option to end up in the money

• this term is also increased by rising interest rates because of opportunity cost, meaning that money could be invested elsewhere (i.e. debt instruments)
• this term typically increases as the strike price of the option contract decreases for calls & increases for puts

Answer 6

Option Premium

Question 7

• this term is an option contract classification
• this term can be exercised any time up to the cut-off time on expiration day
• domestic options on individual stocks are typically this term
• all domestic equity monthly options expire on the third Friday of the month at 11:59 pm ET
• this term is usually more expensive than European
• the seller of this term is assuming more risk because the option buyer can exercise the option at any time

Answer 7

American Style Option

Question 8

• this term is an option contract classification
• this term can only be exercised during a specific time period, usually the last trading day before expiration
• options on stock indexes are generally this term
• this term can only be exercised at expiration, which makes them less expensive

– this is because knowing exactly when the option will be exercised involves less risk for the option seller

Answer 8

European Style Option

Question 9

• this term is the process of matching a b/d with an option holder wanting exercise their option/right to buy or sell
• this process starts with the holder notifying their b/d
• the b/d then notifies the Options Clearing Corporation (OCC)
• the OCC then assigns a b/d who is short the option contracts that are being exercised and the b/d notifies a customer with a short position in those options
• the b/d is assigned at random and b/d’s can assign their customers at random, on a FIFO basis, or any other way that is “fair and reasonable”

Answer 9

Assignment

Question 10

• this term is nearly identical to conventional equity options except that this term represents 10 shares of the underlying security whereas traditional options represent 100 shares
• because this term is only for 10 shares, both the contract multiplier and premium multiplier for this term is 10
• the lower costs of this term provide a way for investors to participate in the movements of high-priced stocks

– buying even just a few shares of a single traditional option can be very expensive

Answer 10

Equity Mini-Options

Question 11

• this term are stock or index options with expiration dates out to 39 months
• this term can result in long-term capital gains or losses when it is “long”

– this occurs when the term is held for a period greater than 12 months

Answer 11

Long-Term Anticipation Security (LEAP)

Question 12

• this term is a component of the premium for option contracts
• this term is determined by how much time there is until expiration date
• the more time there is until expiration, the more of this term there is in the option (and vice versa)
• this term “erodes” the closer it is to the expiration date
• this term is the portion of the option’s premium that is based on the amount of time remaining until the expiration date of the option contract
• in an “in-the-money” option contract, this term is equal to the difference between the premium and the intrinsic value

– this term = [ premium - intrinsic value ]

• far dated options have more of this term than near dated options, because there is more time for the underlying stock to move enough to make the option contract increase in value
• for call options on stocks with dividends:

– the option will most likely be exercised early near or on the record date because the call holder wants receive the dividend

— this assumes that the dividend is greater than this term

Answer 12

Time Value

Question 13

• this term is a component of the premium for option contracts
• a call has this term when the price of the underlying security is higher than the strike price of the call option

– this term for call options = [ price of underlying security - strike price ]

• a put option has this term when the price of the underlying security is lower than the strike price of the put

– this term for put options = [ strike price - price of underlying security ]

• it does not matter whether the investor is long or short for the option to have this term

Answer 13

Intrinsic Value

Question 14

• this term pertains to the Intrinsic Value of an option contract
• when an option is classified as this term, it has intrinsic value
• options are exercised only when they are classified as this term
• a call option is classified as this term when the price of the underlying security is higher than the strike price of the call option
• a put option is classified as this term when the price of the underlying security is lower than the strike price of the put
• an option can be classified as this term regardless of if the investor is short or long the underlying security

Answer 14

In The Money

Question 15

• this term pertains to the intrinsic value of an option contract
• an option is classified as this term when the market price of the underlying security is the same as the option strike price
• the premium of this classification of option is made up entirely of Time Value
• this classification of option contract has no Intrinsic Value

Answer 15

At The Money

Question 16

• an option is at this term with the underlying stock when the option premium has Intrinsic Value only
• just before expiration, options that are in-the-money may trade at this term

Answer 16

Parity

Question 17

• this term is the largest options exchange
• equity options trade from 9:30 until 4 ET
• option trades settle next business day and option premiums must be paid in full

Answer 17

Chicago Board Options Exchange (CBOE)

Question 18

• this term establishes a new options position or adds to an existing position
• this term can be buy or sell orders

– a purchase order for this term establishes a long position in the options

– a sell order for this term establishes a short position in the options

Answer 18

Opening Transaction

Question 19

• this term closes out or reduces an existing options position
• this term can be buy or sell orders

– a sell results in the long position being sold

– a buy results in option writer buying back the short options position

Answer 19

Closing Transaction

Question 20

• this occurs for equity option contracts at 11:59 pm ET on the third Friday of the expiration month
• options stop trading at 4 pm ET on the third Friday of the month this occurs
• the OCC must receive notice of exercise from b/d’s on Friday no later than 5:30 pm ET

– b/d’s have their own deadlines to receive notice of exercise from their customers that are earlier than the OCC deadline

• when this term is set to occur for options in-the-money by $0.01 or more, the OCC will automatically exercise the options

Answer 20

Expiration

Question 21

• this term is a classification of an option contract
• this term grants an investor the right to buy 100 shares of the underlying security at the strike price up to expiration date of the option
• investors buy this term if they think the price of the underlying security is going higher

– this is a bullish strategy because the price/premium of the option will tend to increase as the price of the underlying stock increases

• the maximum loss of this term for the holder is the premium paid
• the maximum gain is unlimited because there is no limit to how high the price of the underlying stock can rise
• the breakeven point occurs when the price of the underlying security is equal to the strike price plus the premium paid for the option

Answer 21

Long Call Option

Question 22

• this term is a classification of an option contract that is referred to as Uncovered Calls or Naked Calls
• the seller or writer of this term has the obligation to sell 100 shares of the underlying security at the strike price before the expiration date
• an investor will write this term when the investor thinks the price of the underlying security is going lower or remaining the same

– this is a bearish to neutral strategy

• the maximum loss for this term is unlimited because in theory the upside potential of the underlying security is unlimited
• the maximum gain is the premium received
• the breakeven point occurs when the price of the underlying stock is equal to the strike price + premium received

– the breakeven point is the same for the holder and the writer of this term

Answer 22

Short Call Option

Question 23

• this term is a classification of an option contract that is referred to as an Uncovered Put or Naked Put
• the writer of this term has an obligation to buy 100 shares of the underlying security at the strike price up to the expiration date
• an investor will write this term when they think the underlying security is going higher or remaining the same

– this is a bullish to neutral strategy

• investors also write this term when they think that the underlying stock will have little to no price movement

– if correct, they make money as the Time Value in the option premium decays as it gets closer to expiration

• the maximum gain for writing this term is the premium received
• the maximum loss for writing this term is the strike price minus the premium received

– the writer incurs max loss if the stock is at 0 at expiration

• the breakeven point occurs when the price of the underlying security is equal to the strike price minus the premium received

Answer 23

Short Put Option

Question 24

• this term refers to the maximum number of option contracts that an individual, a registered representative managing discretionary accounts, or a group of individuals acting together can have on the same side of the market
• this term is set by the Options Clearing Corp (OCC) for listed options
• this term was developed to prevent investors from putting an excessive “bet” on a specific directional move in the market price of a security

– it was also developed to prevent market manipulation

• this term is subject to change and is not the same for all option classes
• this term will be higher for actively traded large cap stocks and lower for small cap stocks
• this term for large cap stocks is currently 250,000 option contracts on the same side of the market

Answer 24

Position Limit

Question 25

• this term is a restriction on the number of option contracts on the same side of the market that can be exercised over 5 consecutive business days
• this term for large cap stocks is currently 250,000 option contracts

– this term shares the same limit values as Position Limits

Answer 25

Exercise Limits

Question 26

• this term is an investment strategy that investors use to protect their investments against loss and to control risk
• this term is used to reduce risk associated with an investment by using a second investment to offset a potential loss on the first
• for example, an investor can protect a long stock position by purchasing puts on the stock that they own

– this is referred to as a Protective Put Purchase

Answer 26

Hedging

Question 27

• this term provides a stock investor with a partial hedge and income
• this term is established when an investor writes options share-for-share against a stock position and collects premium
• an investor who is long stock establishes this term by writing calls on the position

– writing calls provides income to the investor (premium received from call) and creates a partial downside hedge, but limits the investor’s potential profit on the stock

Answer 27

Covered Write

Question 28

• this term, in the case of long stock, is when an investors write more calls than they have stock

– the investor receives more premium but has unlimited risk on the short call

• this term, in the case of short stock, is when an investor writes more puts than they have short stock

– the investor collects more premium but has more downside risk

Answer 28

Ratio Write

Question 29

• this term is an options strategy that uses long and short positions of the same type (either puts or calls) on the same underlying security
• this term can be classified as Vertical (Price) or Horizontal (Time)

Answer 29

Spread

Question 30

• this term is a type of Vertical (Price) Spread

– Vertical means that the investor buys one call and sells another call with a different strike price

• Debit means that the investor is establishing the spread for a net debit

– in other words, money is being paid to establish the spread

• to establish this term, an investor buys a call with a lower strike price and writes a call with a higher strike price
• this term has less risk than owning a call
• writing this term with the higher strike price offsets some of the premium paid for the lower strike price but it also limits the potential gain because it obligates the writer to sell stock at strike price
• this term is a bullish position because the investor wants the underlying security to go higher
• the spread increases in value (or “widens”) as the stock rises to and goes through the strike price of the short call
• maximum gain is realized if both calls are exercised
• max loss is the net premium paid
• max gain is the strike price interval of the spread minus the premium paid
• breakeven point is equal to the lower strike plus the net premium paid for the spread

Answer 30

Debit Call Spread

Question 31

• this term is a type of Vertical (Price) Spread
• credit means that the investor is establishing the spread for a net credit (receiving the premium)
• to establish this term, an investor writes the call with the lower strike price and purchases the call with the higher strike price

– because the investor is writing the more expensive call, a net premium is received for the spread

– purchasing the higher strike price reduces the investor’s potential loss because the long call can be exercised, which means the stock can be purchased at the strike price

• this term is a bearish position
• the spread loses value (or “narrows”) as the price of the underlying stock falls to or below the lower strike price
• the investor realizes maximum gain at expiration if both calls expire and he keeps the premium received
• max gain is the premium received
• max loss is the strike price interval of the spread less the premium received
• breakeven point on the stock is equal to the lower strike price plus the premium received for the spread

Answer 31

Credit Call Spread

Question 32

• this term is a type of Vertical (Price) Spread
• to establish this term, the investor buys a put with a higher strike and sells a put with a lower strike price

– selling the lower strike price put offsets some of the premium paid for the higher strike price put, but also limits potential gain

• this is a bearish position
• the spread increases in value or “widens” as the underlying stock falls to and goes through the lower strike price put and the probability of exercise increases
• maximum gain is realized at expiration if both puts are exercised
• max loss is the premium paid
• max gain is the difference between the strike prices minus the net debit
• breakeven point is equal to the higher strike less the net premium paid for the spread

Answer 32

Debit Put Spread

Question 33

• this term is a type of Vertical (Price) Spread
• this term is established when an investor writes a put with a higher strike price and purchases a put with a lower strike price

– purchasing the lower strike price put reduces the investor’s potential loss because the long put an be exercised and the stock can be sold at the strike price

– the cost of the long put also reduces the premium received so the potential profit is ultimately reduced

• this term is a bullish position
• the spread loses value or “narrows” as the price of the underlying stock rises to or goes through the higher strike price put
• the investor realized maximum gain at expiration if both puts are out-of-the-money and expire worthless
• max gain is the premium received
• max loss is the strike price interval of the spread less the premium received
• breakeven point is equal to the higher strike less the premium received for the spread

Answer 33

Credit Put Spread

Question 34

• this term is a Vertical (Price) Spread where the investor writes extra out-of-the-money options

– for calls, this term exposes the investor to unlimited upside risk from the uncovered call

– for puts, this term exposes the investor to downside risk (strike price - premium received) on the uncovered put

Answer 34

Ratio Spread

Question 35

• this term is referred to as a Price Spread
• this term has the same expiration date but different strike prices
• this term can be established with either calls or puts
• this term reduces some of the risks associated with buying and writing puts and calls but also reduces the profit potential
• this term can be established for a debit or credit

Answer 35

Vertical Spread

Question 36

• this term is also referred to as a Calendar Spread
• this term is an options strategy wherein an investor writes a near term option and buys a far dated option of the same type, with the same strike price on the same underlying security
• the investor who purchases this term believes that there will be very little volatility on the underlying stock in the near term

– if correct, the short near term option will lose value at a faster rate than the long far dated option, especially during the month leading up to expiration

Answer 36

Horizontal Spread

Question 37

• this term is a call and a put on the same underlying security with the same strike price and the same expiration date
• the investor buying/writing this term is speculating on the volatility of the underlying security

– the buyer of this term expects the underlying security to make a substantial move, but is not sure if the move will be up or down

– the seller of this term expects little or no volatility in the movement of the underlying security

— if correct, the seller makes money because the option premiums will gradually go down in value because of the decline in volatility and the erosion of the time value

• this term has two breakeven points, one for the downside and one for the upside

– the upside breakeven point is an indicator of when the investor would breakeven by exercising the call option

– the downside breakeven point is an indicator of when the investor would breakeven by exercising the put option

Answer 37

Straddle

Question 38

• the writer of this term owns the underlying security of the call & put option contracts
• the maximum gain for the seller is unlimited because the stocks are owned
• maximum loss is the premium paid
• the downside breakeven point is the premium of the call and the put subtracted from the put strike price
• the upside breakeven point is the premium of the call and the put added to the call strike price
• an investor holding this term makes a profit if the underlying security trades above or below the breakeven points

Answer 38

Long Straddle

Question 39

• the writer of this term does not own the underlying security of the call & put option contracts, meaning that the writer is obligated to sell or buy the shares if the options are exercised
• the maximum gain for the writer is the premium received
• the maximum loss for the writer is unlimited because the writer does not own the underlying security
• the upside breakeven point is the premium of the call and the put added to the call strike price
• the downside breakeven point is the premium of the call and the put subtracted from the put strike price
• a holder of this term makes a profit if the underlying security trades in between the breakeven points

Answer 39

Short Straddle

Question 40

• this term, similar to a Straddle, is a strategy for speculating on the volatility of the underlying stock
• the calculations for the breakeven points, maximum gains, and maximum losses are calculated in the same manner as Straddles
• this term involves buying or selling a call option & put option on the same underlying security, but the option contracts have different strike prices and/or expiration months

Answer 40

Combination

Question 41

• option orders are transmitted to the trading floor via this term
• this term is an automated execution system that allows member firms to transmit option orders directly to the trading post
• when these orders are executed, this term automatically notifies the member firm of the completed transaction

Answer 41

Order Support System (OSS)

Question 42

• this term can be found at each trading post on the CBOE
• this term is an individual who keeps track of public limit orders and oversees the opening and closing of the trade day

– this term opens trading by calling for Bids and Offers for each Option Series

— this establishes an opening price for each Option Series

– each options series goes through a closing rotation overseen by this term to get closing Bids and Offers

• this term works for the exchange and cannot trade for his/her own account

Answer 42

Order Book Official (OBO)

Question 43

• this term are members of the exchange who trade for their own account
• this term will make bids and offers for options when there is a shortage of public orders

– this term literally makes markets

Answer 43

Market Makers

Question 44

• this term is defined as all options of one issuer with the same class (all calls of one issuer or all puts of one issuer are another), exercise price, and expiration month

Answer 44

Option Series

Question 45

• this term is prepared by the Options Clearing Corporation (OCC)
• this term is a document that details the risks involved in trading options
• the customer must be sent this term at or prior to account approval by the Registered Option Principal (ROP)

Answer 45

Option Disclosure Document

Question 46

• this term is given to the customer after the Option Disclosure Document
• the client has to sign and return this term within 15 days of receipt
• when the customer signs this term, they verify net worth, annual income, and that they’ve read and understood the Option Disclosure Document

– they also confirm that they understand their approved level of trading and will abide by the position limits imposed by the Exchange

Answer 46

Option Agreement

Question 47

• this term (Tax Treatment of Options) will go over how long options are to be taxed
• if puts or calls are purchased and held for more than a year, the profit/loss on the sale is treated as a long-term capital gain/loss

– if held less than a year, the gain/loss is treated as a short-term capital gain/loss

• long puts/calls that expire are treated as a sale for tax purposes

– the expiration date is considered the sale date

• exercising options is not a taxable event
• when a call holder exercises and purchases the underlying security, a new tax holding period begins the day after he/she exercises the call

– the cost basis for the stock is the strike price plus the premium paid for the put

— this is compared to the investor’s stock purchase price top determine a capital gain/loss

• if exercise causes a purchase, the option premium is added to the strike price to equal cost basis
• if exercise results in a sale, the option premium is subtracted from the strike price to compute the sale proceeds

– the sale proceeds are then compared to the investor’s original stock purchase price

Answer 47

Tax Treatment of Long Options

Question 48

• this term (Tax Treatment of Options) will go over how short options are to be taxed
• income from writing puts and calls is treated as a short-term capital gain regardless of how long the investor held the position
• it is included in income when the option position is closed, either from a closing purchase or expiration
• if a call writer is exercised, the sale proceeds equal the strike price plus the premium received

– the tax treatment of the profit/loss depends on how long the investor held the underlying security

• if a put writer is exercised, the cost basis is established for the underlying security purchased

– this cost basis equals the strike price less the premium received

– the tax holding period for this new stock position begins the day after the purchase

Answer 48

Tax Treatment of Short Options

Question 49

• this term is classified as a non-equity option
• this term consists of the put and call options that are traded on broad-based indices like the S&P 500 and the S&P 100 (OEX) as well as narrow-based indices that track specific market sectors such as the XOI (Oil Index)
• this term allows investors to capitalize on price movements of the stock market as a whole or stock market sectors, and can be used to hedge a portfolio of stocks
• this term usually has a contract multiplier of 100

– the option strike price is multiplied by 100 to calculate the dollar value of the underlying index

• the total premium for this term can be found by multiplying the quoted premium by the contract multiplier
• this term settles in cash instead of securities (i.e. Cash Settlement)
• the holder of this term receives cash equal to the intrinsic value of the option

– the writer is required to deliver cash equal to the intrinsic value of the option by the following business day

• the exercise settlement value is based on the closing value or the opening value (depending on the index) of the underlying index on the day the option is exercised

– exercise settlement based on the opening value is referred to as AM Settlement

– exercise settlement based on the closing value is referred to as PM Settlement

• this term is typically exercised European Style, which means the options may only be exercised during a specified time period just prior to expiration
• American Style Exercise for this term means that the option may be exercised at anytime up to the exercise cut-off time on expiration day
• this term expires on the third Friday of the month for American Style and on the business day before the day that the exercise settlement is calculated for European Style
• all types of this term currently have no position limits
• however, there are reporting requirements for exchange members, regarding member firms and their customers who hold large positions in this term
• strategies involving this term are the same as for equity options, with the exception of Covered Writes

– you cannot do a Covered Write on this term

• this term is often purchased by investors and portfolio managers to insure stock portfolios against market downturns and to protect unrealized gains

Answer 49

Index Option

Question 50

• this term is a measurement of how closely the volatility of a stock, or a portfolio of stocks, follows the overall market
• this term is valued at 1 for stocks/stock portfolios that have the same volatility as the overall stock market
• if this term is valued at 0.75, then the stock/stock portfolio is 25% less volatile than the overall stock market, and vice versa
• this term is important to portfolio managers because if the beta of their portfolio is higher than the market, they need to purchase more puts to hedge their portfolio

– a portfolio with a value of 1.10 for this term needs to purchase 10% more puts

– a portfolio valued at 1.20 in this term would need to purchase 20% more puts

Answer 50

Beta

Question 51

• this term is another type of non-equity option
• this term is price-based and give the option holder the right to buy or sell bonds at the strike price
• this term is European Style

Answer 51

Bond Option

Question 52

• this term is a type of non-equity option
• this term is yield-based meaning that it is based on an underlying yield and settle in cash

– the option holder receives cash equal to the intrinsic value of the option when exercised

• this term is European Style
• this term is available on T-Bills, T-Notes, and T-Bonds
• investors use this term to speculate on the direction of interest rates and to hedge a bond portfolio against a rise in interest rates

Answer 52

Interest Rate Option

Question 53

• this term is an option contract with a bond as the underlying security
• an investor who thinks that interest rates are going higher will purchase puts and an investor who thinks that interest rates are going down will purchase calls

Answer 53

Yield Option

Question 54

• this term is also referred to as a Foreign Currency Option
• this term is an option contract on foreign currencies
• this term is never on the US dollar, even though it is quoted in US dollars
• this term usually trades on the Philadelphia Stock exchange
• the current market value of this term is referred to as the Spot Price
• the contract size for this term is usually 10,000 meaning that one contract represents 10,000 units of the foreign currency, with the exception of the Japanese Yen (one contract represents 1 million Yen)
• this term is exercised European-style meaning that they can only be exercised on the expiration date, which is the third Friday of the expiration month
• the position limit for this term is 200,000 contracts on the same side of the market
• this term goes in the opposite direction of the US dollar

Answer 54

World Currency Option