Equity Options Flashcards

Question

Trading rotations

Answer 1

Upon the opening of the market, as soon as the stock opens, each class of options will open sequentially from the earliest Expiration month with the lowest exercise price out to the highest. Rotations are also done at the close of the market. Only public market and limit orders participate in the opening rotation 1. The order book official (OBO) - for CBOE listed option is an employee of the exchange who handles the public limit order book. They may only except public orders and may not trade for themselves. Their job is to see that public orders at given prices are executed before any orders from the floor at the same or better price. 2. The market maker; Market makers are traders on the CBOE floor who trade for their own accounts, at their own risk. Market maker orders never have priority over public orders at the same price on the OBO‘s book

Answer 2

1. CBOE Hybrid: Trading engine that blends the trading floor technology with an electronic trading platform 2. CBOE OSS- Order support system which electronically; A. Routes orders directly to the options trading post B. Send notice of the execution directly to the broker-dealers office bypassing the communication center on the floor off the exchange

Answer 3

CEASE TRADING 4:00pm ET on the third Friday of the expiration month. 1. If trading in a security is halted, trading in the options is also halted. 2. If traded in an option is halted, customers may still exercise. EXERCISE CUT OFF TIME 5:30pm ET On the third Friday of the expiration month EXPIRATION 8:59pm PT, 10:59pm CT, 11:59pm ET on the third Friday of the expiration month (previously the Saturday following the third Friday off the expiration month)

Answer 4

POSITION LIMITS The OCC as established the maximum number of option contracts that investors can maintain in their account at any one time on equity options when the options are in the same stock and on the same side of the market position limits generally apply to institutions and hedge funds. ** Long calls & short puts = same side of the market (Bullish)** ** Long calls & shorts calls = same site of the market (Bearish) EXERCISE LIMITS Investors are also limited to the number of listed option contract which may be exercised within any consecutive 5 business day.

Answer 5

A. OPTION STYLES: 1. American style options - Can be exercised anytime after they are purchased. 2. European style options - Can only be exercised at expiration. (Hedging) ``` B. CLASS OF OPTIONS All options of the same type of the same underline stock make up a class of options Eg. All IBM calls =one class All IBM puts = another class ``` C. SERIES OF OPTION All options of the same class with the same expiration month and same exercise price. Eg. All IBM Oct 90 calls ``` D. OPTION CYCLES All options have at least 4 expiration month but only 3 months trade at any one time. There are three cycles. These represent the cycle of months in which option contracts expire. The cycle months are: 1. January April July October (JAJO) 2. February May August November (FMAN) 3. March June September December (MJSD) ``` E. Standardize terms established by the OCC include the strike prices, option expiration month, size and type of contracts *** premiums are not established by the OCC. Premiums are determined by supply and demand in the market*** F. EXERCISE STRIKE PRICES The exercise prices that become available for trade are determined by the price of the underline security on exchanges in an auction market and not by the OCC. ``` G. OPEN CONTRACT TERM ADJUSTMENTS The number of shares in a listed option contract or the number of option contract is adjusted when the number of shares an investor will own in the stock changes. Examples include: 1. Stock dividends 2. Stock splits 3. Stock distributions ``` *** listed options are NOT adjusted for a cash dividends**

Answer 6

H. ADJUSTMENT TO OPTIONS WHEN THERE IS A STOCK SPLIT OR SCTOCK DIVIDEND - When a stock splits are stocked dividend occurs, the option will be adjusted to reflect the change in the number of shares the option represents. When there’s a stock split it will also change the strike price of the option. Eg. An investor is long 1 ABC Aug 50 call when ABC splits 2:1. On the ex-date the investor would be? 2/1 x 100/1 = 200 shares which will create 2 options 100 shares x 50= $5000 divided by 200 shares=$25 new strike price. Long 2 ABC Aug 25S after split STOCK DIVIDEND EXAMPLE Long 1ABC Dec 60 Calls @6 when ABC declares a 50% stock dividend. How many shares will the option represent after the stock dividend? 1 contract = 100 shares 100 shares x .50= 50 additional shares 50 shares added to original 100 shares= 150 share value per contract. Stock price=$6000 (60x100) divided by 150 shares = $40 new strike price Long 1 ABC Dec 40 Call covering 150 shares I. EX-DIVIDEND The exercise date of the option determines who will be the owner off the stock. 1. If a call exercise notice is filed with the OCC prior to the ex-date, the buyer (long) is entitled to the dividend, because the buyer will then on the stock. 2. If a put exercise notice is filed with the OCC prior to the ex-date the assigned put writer is entitled to the dividend, because a rideable then on the stock

Answer 7

1. Customer to clearing member (broker-dealer) When an option is bought or sold, settlement is the next business day after trade date. 2. Under regulation T, liquidation will not occur until the 4th business day after trade date. 3. Clearing member to OCC Settlement by the firm to the OCC is the next business day after trade date. 4. Exercise Settles 2 business days from the time the OCC receives the exercise notice. 1-2 applies to customer. Reg T is only for customer. 3 - when the broker-dealer required to pay.

Answer 8

1. OCC to Clearing Member (broker-dealer) - firm to be assigned is determined on a “Random Basis” 2. Clearing Members to Client Customer to be assigned is determined on a: A. Random basis B. FIFO - first on, first out or oldest shortest position C. Any other method approved by the exchange *** Exercise notices are NOT assigned based on the largest short position *** L. As an opening transaction a registered representative can never sell calls for a corporation (issuer) against the corporation’s own underlying stock,

Answer 9

1. On a Call occurs when the market price of the stock is greater than the exercise price of the option Eg 1 ABC June 80 Call ABC @ 84. 2. On a Put occurs when the market price of the stock is less than the exercise price of the option Eg. 1 ABC June 40 Put ABC @35

Answer 10

Occurs when the market price is the same as the exercise price. Eg 1 ABC June 50 call ABC @50

Answer 11

1. On a Call occurs when the market price of the stock is less than the exercise price of the option Eg 1 ABC June 45 Call ABC @40 2. On a Put occurs when the market price of the stock is greater than the exercise price of the option Eg 1 ABC June 60 Put ABC @40 ***Do NOT consider premiums or long or short*** ***For “in-the-money” remember CALL UP & PUT DOWN*** Important note: An option investor is NEVER “in-the-money” or “out the money” Only option contracts are considered in the money or out the money. Premiums are not considered when determining “in-the-money” or “out-the-money” status of an option

Answer 12

1. The Intrinsic Value of an option is the in-the-money amount of the option. 2. The Time Value is the amount of premium which exceeds the intrinsic value 3. Options are referred to as “wasting assets” because their time value declines the closer you get to the expiration date. The premium of an option is directly related to what the intrinsic value of the option is; the more the option is “in-the-money” the higher the premium will be, 1. The premium value of an option will move dollar for dollar with the price of the underlining stock when the option is “in-the-money “ All the below affect the price of premium of an option 1. Market price of the underlying stock 2. Time until expiration of the option 3. Volatility of the underlying stock 4. Changes in the interest rate 5. Liquidity

Answer 13

Long-term Equity Anticipation Security (LEAPS) Long-term options on stock and stock indexes. These options gives investors the same privilege as a short-term options but have added benefit of the longer-term expiration. B. Contract value of LEAPS * Equity LEAPS = 100 shares of underlying stock. * Index LEAPS = $100 times the value of the underlying index settled in cash. C. Premium Quotations For both stock and stock index leaps one point in premium = $100 D. LEAPS Maturity/expirations : 1. Equity LEAPS: most are 3+ years (39 months) from the time they are listed. 2. Index LEAPS : most expire up to 3+ years (39 months) from the time they are listed. 3. Both expire on the third Friday of the expiration month. E. Exercise Style; 1. Equity and OEX (S&P 100) LEAPS have American exercise style, which means the option maybe exercised anytime up to expiration. 2. SPX (S&P 500) LEAPS have European exercise style, which means the options may only be exercised at expiration date. F. Exercise settlement: 1. Equity LEAPS will settle in the underlying stock on the second business day following exercise date. 2. Index LEAPS will settle in cash the next business day following exercise date. G. Position limits on ALL equity options (short & long term) are aggregated (added together) on the same underlying stock. H. Buying OEX LEAPS Puts would provide a hedge for a large portfolio of large-cap equity securities I. LEAPS option with more than nine months expiration can purchased on margin. The margin requirement is 75% of the premium value.

Answer 14

Index options are options that mirrors a specific index, such as the S&P 500. Because these options mirror an index they settle in cash , no securities are exchanged when an exercise takes place. Assuming an exercise takes place: A. Buyers of index options (both calls and puts) will receive cash that is equal to the difference between the market price at the close of trading for the index and the exercise price on the contract. B. Sellers of Index options (both calls and puts) will owe cash that is equal to the difference between the market price of the close at trading for the index and the exercise price on the contract. C. Index options that are in-the-money by $0.01 or more are automatically exercised at expiration unless alternate instructions are received from the buyer of the contract

Answer 15

Options that are based on market volatility. These options contracts normally have an “inverse” or opposite relationship to the market. A. When the market is going up and doing well. Volatility is normally low. B. When the market is going down and doing poorly, volatility is normally higher. C. An investor would: 1. Buy VIX Calls if the investor anticipated high levels of volatility and an overall decrease in the market prices of stocks. 2. Buy VIX Puts if the investor anticipated low levels of volatility and an overall increase in the market prices stocks. 3. Investors who wish to hedge long stocks positions in an index often purchase VIX call options as a hedge for their long stock positions.

Answer 16

Are options based upon exchange rates between the currency of two countries. Investor would: A. Buy calls on a foreign currency if they want to hedge against declining values of U.S currency B. Buy puts on a foreign currency if they wanted to hedge against rising values of U.S currency C. Options are not available on U.S currency within U.S Securities Markets.

Answer 17

Are options traded “off” of the floor of an exchange, as opposed to being “listed” and traded on the floor of an exchange. OTC Options: A. Have a direct link between buyer and seller. B. Generally, do not have a secondary market C. Are not standardized like listed options when it comes to contract size, strike price and expiration date.