Option Contracts 16% Flashcards
OCC
- Options Clearing Corp
- standardizes options contracts so they can trade on the exchange
- sets strike prices and expiration dates
- owned by the exchanges that trade optins
Holder
- buyer of the option
- right to call or sell (put)
Class of options
-consists of options of the same underlying security
Series
options of the same class that also have the same expiration date
Style
- exercise style of the option;
- American
- European
Option Writer
- has a short position in the option.
- collects premium
Expiration
- equity options expire on the Saturday following the third Friday of the month at 11:59 ET.
- The friday before expiration is the last trading day
OTC Options
- negotiated options that trade OTC
- can be custom-designed to meet a portfolio’s need at a specific time
Call option
-100 shares per call
Option Premium
-fluctuates with the price of the underlying security
European style options
-can only be exercised during a specific time period, usually the last trading day before expiration
American Style Contracts
-can be exercised anytime up to expiration
Assignment
- when option holders want to exercise, they must notify their broker/dealer, who in turn notifies the OCC
- The OCC assigns a b/d with a short position in the security
- b/d notifies a customer with a short position in those options
- random assignment, usually first in first out, or any other way that is “fair and reasonable”
LEAPS
- Long-term Equity Anticipation Participation Securities
- stock or index option with expiration dates 12 months out to 39 months
- conventional stocks are 9 months
Premium =
Intrinsic value + Time Value
Intrinsic Value
- when the price of the underlying security is higher(call)/lower(put) than the strike price
- called in the money
Parity
an option is at parity with the underlying security only when the option (premium plus strike price) = current market price
Time Value Calculation
Premium - intrinsic value
Option Cycles
- Three Cycles
- Jan/Apr/July/Oct
- Feb/May/Aug/Nov
- Mar/June/Sept/Dec
Actively Traded Options
Large Caps may have monthly and even weekly expiration dates
Trade Orders
- the CBOE is the largest options exchange
- Equity options trade 9:30ET to 4:00ET
- settle next biz day
- cannot be purchased on margin
Opening Transaction
- establishes a new options position or adds to an existing position
- opening purchase - establishes a long position in the options
- debit calls - debit to customer’s account
- debit puts - debit to customer’s account
- opening sell - establishes a short position in the options
- when you write puts and calls
- credit puts - credit to customers account
- credit calls - credit to customer accounts
Closing Transaction
- reduces or closes out an existing options position
- long position is sold
- closing purchase - option writer buys back his short option position
- closing sell - long position is sold
Notice of exercise from b/d due
5:30PM ET third friday
When are options automatically excercised?
-OCC will automatically exercise expiring options that are in the money by $0.01 or more
Debits and Credits
- Net Debit - represents a loss
- Net Credit - profit
- when you purchase an option or stock, you create a debit
- when you sell an option or stock, you create a debit
Max Loss
a call holder can only lose the premium paid
Max Gain
call holder is unlimited
Breakeven Point
The strike price and premium equal the underlying security price
Short Calls
- Uncovered calls and naked calls
- writer of the call
Maximum loss - writer short call
-unlimited as the stock price could go to infity
Max Gain - writer short call
-the premium
Breakeven Point - underwriter short call
underlying stock price is equal to the strike pice and premium received
Long Put
-holder of the put
Short Put
- Writer of the put
- uncovered puts and naked puts
- max loss is strike price - $0
Position Limits
- OCC sets the max number of contracts a rr, group, can have on:
- the same side of the market
- intended to prevent market manipulation
- prevents an excess “bet” on a specific directional move in the market
- limits increase as capitalization of the stock increases
- current max on the largest capitalized stocks is 250,000 options on the same side of the market
Exercise Limits
- restrictions to the number of options that can be exercised over:
- 5 consecutive business days
- same limit as the position limit
- LEAPS are added in determining position and exercise limits
Debit Calls
Long Calls
Debit Puts
long puts
Credit Calls
Short Calls
Market up?
Bulls
- Long Calls
- Short Puts
- Long Stock
Market down?
Bears-
- Short Calls
- Long Puts
- Short Sales
Contract Adjustment for Splits
- Adjust proportionately to the split
- if 3:2, you would end up with 1 contract of 150 shares
- if 2:1, you would end up with 2 contracts
Hedges
- used to protect investment against loss and control risk
- Long Put or Call
Protective put purchase
- you are long 100 shares
- by a put on your shares to hedge against the downside
Protect a Profit on an established long stock position
- your stock has gone up, but you don’t want to sell
- by a put to protect against the downside
Protective Call Purchase
- you are short a stock
- buy calls to protect against the upside
Protect a profit on an established short position
- sell short 100 shares
- stock goes down, think it is still going to go lower
- buy call to protect if it goes up
Covered Writes - Short Call
-provides a partial hedge and income.
-an investor writes option share for share against a stock position
-Covered Calls - investor is long in the position
-
Dividends and Calls
-the call holder will most likely exercise if it is near or on the dividend record date. especially if it is in the money
Covered Writes - Short Put
-writing puts on a short position
-
-Ratio writes
- long position - write more calls than they have stock
- long 100 ABC @ $35
- short 2 ABC $40 calls @ $1.25
- short position - writes more puts than they have short stock
- Short 100 XYZ @ $53
- Short 2 XYZ April 50 puts @ $2
Spreads (hedge strategy)
- uses long and short positions on the same type - either puts or calls - on the same underlying security.
- vertical spreads - price
- horizontal(calendar) spreads - time (to different expiration dates)
Debit Call Spread
- creates a net debit
- the call is bought with a lower strike price and the call is written with a higher strike price.
- bullish
- the spread increases or “widens” in value as the rises to and goes through the strike price call of the short call
- max gain realized if both calls are exercised
Credit Call Spread
- net credit, receiving a premium
- writes a call with the lower strike price and sells a call with a higher strike price
- bearish
Debit Put Spread
- creates a net debit
- buys a put with a higher strike price and sells one with a lower strike price
- bearish
- spread widens as the price falls through the lower strike price put
Credit Put Spread
- net credit position
- write put at higher strike, buy put at lower strike
Ratio Spreads
- vertical spreads where the investor writes extra out of the money options
- Buy 1 ABC June 40 call @ $2
- Write 2 ABC June 45 call @ $.75
- creates an uncovered call which leaves downside risk
- the reverse for puts
Horizontal/Calendar Spreads strategy
-investor believes there will be very little volatility on the underlying stock in the near term
Straddles
- a call and a put on the same underlying security with the same strike price and expiration date
- investor buying believes there will be volatility
- writer believes there will be little or no volatility
Long Straddle
- max gain unlimited
- max loss is premium paid
Short Straddle
- max gain is premium received
- max loss is unlimited (short call)
Combinations Strategy
-like a straddle except the calls and puts have different strike prices
CBOE’s OSS
- Order Support System
- automated execution system that allows member firms to transmit option orders directly to the trading post
CBOE OBO
- Order Book Official
- keeps track of public limit orders and oversees the opening and closing of the trading day.
- cannot trade for his own account
How does the CBOE regulate how options are traded?
-each options series goes through an opening rotation.
-open series - defined as all options of one issuer within the same
class (calls or puts)
-OBO opens trading by calling for Bids and Asks for each series
-once all series have gone through the trading rotation will all options series be available for open trading.
-same for closing rotation, at market close
Reporting (options rules)
member firms have to report to the exchange about anyone that has 200 or more option contracts on the same side of the market
Customer Accounts
- First must be approved by a registered options principal (ROP)
- Second, activity must be approved by a ROP
- ROP is a principal who is qualified and registered to supervise options activity
To open an options account what must occur (order matters)
- New account form completed
- Customer loan agreement and margin agreement must be fully executed unless the customer is only buying options
- Options Disclosure document must be provided prior to the ROP approving the account;
- The customer must return the signed options account agreement to the brokerage firm within 15 days of the new account approval. However, if the customer is late signing the option agreement and sending it back, only closing transactions may occur
-Option Disclosure Document, prepared by the OCC
-details the risks involved in trading options
-must be signed and returned within 15 days of receipt(customer
free look period)
-verify net worth, annual income,
Customer Communications
- Option advertising must be approved by the ROP and filed with the SRO at least 10 days prior to us.
- Option sales literature is much more specific than advertising, requires a copy of the OCC disclosure
Tax Treatment of Options
- OCC publishes a brochure called “Taxes and Investing”
- Options - capital assets subject to capital gains tax treatment
- Long - treated depending on timeframe
- cost basis of exercised call holder, is the exercise price plus premium
- Short/Write - short term regardless
Nonequity Options
- behaves just like equity options
1. Index Options
2. Debt/Yield Options
3. Foreign Currency Options
Index Options - Cash Settlement
-Settle in cash and not securities
OEX
- S&P 100
- most widely used index for options
Trading hours for broad-based indices options
9:30 - 4:15
Trading hours for industry specific indices
9:30 - 4ET
Triple Witching
four times a year, in March, June, September, and December, three types of options expire on the same day and generally associated with volatility.
- stock
- index
- futures
Are there position limits on broad-based index options?
no
Portfolio Insurance
- A strategy where investors buy index puts to insure stock portfolios against market downturns and to protect unrealized gains
- small and mid cap stocks - buy puts on Russell 200
- diversified portfolio of large cap stocks, S&P 500
How to calculate how many puts to ensure a portfolio
- Take the Portfolio value and divide by (index value * contract multiplier)
- use beta as a multiplier to buy more puts
Debt/Yield Options
- debt (bonds) trades on price
- yield trades on underlying yield and settle in cash
Cash Settled
- actual physical delivery is not required
- cash is sent in the amount of the difference between the option strike price and the current value of the security at exercise date
Debt Options
Contract Sizes
-T-Notes and T-Bonds is $100,000 (100 bonds or notes with $1,000
face value
-Points are $1,000 and a premium of 2.10 = $1,000*(2+(10/32))
-T-Bills is $1,000,000, 100 tbills with $10,000 face
-Premiums are quoted as a percentage of $2500 (t bill points)
Yield Based Options
- underlying value is the interest rate multiplied by 10
- strike prices are based on interest rates, so a 55 = 5.5% yield
- ex: TNX 45.00 call @ $3, at expiration, interest rates are 5.5%, so the call is exercised and received the value of 10 points, 10 * 100 = $1,000
Foreign Currency Options
- the option is always foreign currency
- quoted in US Cents.
- move the decimal two places left when calculating premium and strike price
- Normally trade on the Philadelphia Stock Exchange
- 9:30 to 4PM
- Contract size of 10,000, except for yen, it is 1 million
- Exercise - Euro Style
- Saturday following the third friday of the expiration month
- Exporters buy Puts, Importers buy Calls - EPIC
Spot Price
Term for the current market value of the foreign currency
Diagonal Spread
combines a horizontal and vertical spread
Synthetic Option
Long call and short put option on the same stock at the same time
