Options Flashcards
This deck focuses on the options market, including option strategies and calculations.
What are the three possible tax consequences of options trading?
- The option can expire, in which case the premium is lost
- The option can be sold, possibly creating a capital gain or capital loss
- The option is exercised and the investor takes delivery of stock
What must be received by the customer before the first options trade can be accepted?
Options Disclosure Document
Within how long after the account opening must the signed options agreement be returned by the customer?
15 Days
What are the basics of equity options?
An option gives the owner the right, but not the obligation, to buy or sell 100 shares of the underlying security at some price, at some point in the future.
The price is called the strike, the right to buy is a “call,” and the right to sell is a “put”. Investor can both be long or short both calls and puts.
What are the reasons an investor would buy a call option?
- Because they are bullish on the stock and think the price will increase
- It is less expensive than buying the underlying shares (the investor is paying the premium rather than the cost of actually purchasing the stock)
- To hedge a short stock position
What is the meaning of an options contract that states:
Buy 2 XYZ Oct 40 Calls @ 3
- Buy means the investor is taking a long position in the contract and thus they will have the right to do something
- 2 reflects the number of contracts. Standard options contracts have 100 shares per contract. Thus in this example, 2 contracts each worth 100 shares for a total of 200 shares in this particular example
- XYZ is the security the investor is speculating on
- Oct is the expiration month. Most options contracts are issued with a 9 month expiration
- 40 is the strike price, which is where the investor has the right to exercise the contract
- Call is the class, which gives the investor the right to buy the stock at the strike price
- @3 is the premium, which is the cost of the contract. In this case, for the right to buy XYZ at $40 per share, the investor is paying a cost of $3 per share x 100 shares per contract x 2 contracts ($600 in total in this example)
What does being short one IBM July 30 Call mean?
The investor has an obligation to sell IBM stock at $30 if the option is exercised by the buyer between now and the expiration date of July
Under what circumstances would an investor exercise a Jan 30 IBM call?
If the shares are trading above 30 at the time the option expires, the investor would want to take advantage of their right to buy the shares at 30.
How much will investors pay in for a contract trading at a premium of $1.50 per share?
Option contracts typically represent 100 shares per contract. Therefore, the premium of $1.50 per share is multiplied by 100 to arrive at the cost of $150 for the contract.
Under what circumstances would you want to exercise a Jan 30 IBM put?
A put gives the owner the right to sell 100 shares of IBM stock at $30 per share. This investor would want to exercise their option if the shares were trading lower than 30 in order to sell the stock for more than it is actually worth.
When do options expire?
Options expire on the third Friday of the month.
What is the difference between a buyer and a seller of an option?
-
Buyers of options
- They are owners and open long positions (buying a call or buying a put)
- Buyers have a right to do something
- Pay a premium for that right
-
Sellers of options
- They are writers and open short positions (selling a call or selling a put)
- Sellers have an obligation to do something
- Receive a premium for that obligation
What are the four single options positions?
- Buy a put - a right to sell stock
- Sell a put - an obligation to buy stock
- Buy a call - a right to buy stock
- Sell a call - an obligation to sell stock
What are the attitudes of the four single options positions?
- Buy Put - Bearish View
- Sell Put - Bullish View
- Buy Call - Bullish View
- Sell Call - Bearish View
What does in-the-money refer to?
In-the-money means that the option is exercisable by the buyer of the option. Calls are in-the-money when the market value is above the strike price and puts are in-the-money when the market value of the stock is below the strike price.
At expiration, do buyers and sellers of options want the option to be “at”, “in” or “out” of the money?
- Sellers want to collect the premium and have the option remain unexercised - this means they want out-of-the-money options at expiration
- Buyers want to have in-the-money options at expiration so they exercise there option
Knowing if an option is in or out of the money is important, but knowing by how much is even more important. What is this called?
The amount of money by which the option is in-the-money is called its intrinsic value. For example, if a call option has a strike price of $50 and the stock is trading at $60, the intrinsic value would be the in-the-money amount of $10. Remember, calls are in-the-money when the market value is above the strike price. If an option is out-of-the-money, then intrinsic value is zero (it cannot be negative).
What two components make up the premium of an option?
Premium = Time value + Intrinsic Value
- Intrinsic value is the in-the-money amount of the option
- Time value reflects the amount of time remaining until expiration
How does an investor calculate the breakeven point of a call option?
Add the premium to the strike price.
If you buy 1 Jan 30 IBM call at $2.25, the breakeven is $32.25. At that market value, the investor’s gain on the option is offset by the loss on the premium. Remember, CALL UP
What is the breakeven for a customer who has sold 1 Feb IBM 30 calls at $2.45?
$32.45
Add the premium to the strike price.
If you buy 1 Jan 30 IBM call at $2.45, the breakeven is $32.45. At that market value, the investor’s loss on the option is offset by the gain on the premium. Remember, CALL UP
Which direction do owners of calls or puts want the stock price to be in comparison to breakeven?
The owners of a call will spend premium on the call so they want the stock to trade above the breakeven price. For puts the opposite is true. For owners of puts they want the stock to trade below the breakeven.
What are the basic styles of option expiration?
American and European
- American style can be exercised at any time prior to expiration
- European style can be exercised only at expiration
What does it mean to close an options position?
Closing an options position, means that the investor is liquidating position. If they initially bought an option, they will now sell it to close their position. If they initially sold an option, they will now buy it back to close their position.
What purpose does the Options Clearing Corporation serve?
The OCC issues and guarantees all options contracts. In doing so, they ensure the financials of the contract, which protects against default risk.
How does the OCC handle option exercises?
The OCC randomly assigns exercise notices to clearing firms, who then pass the notice along to a broker dealer, who then assigns to the customer in theory on a random basis.
Do options carry a prospectus?
No
But they do carry the Options Clearing Corporation options disclosure document, which includes information about the risks of options trading.
What is the maturity of an options contract?
Most options are set up by the OCC to expire nine months after issuance. Some contracts, known as LEAPs options, have an expiration of longer than nine months.
How does the OCC limit the risk of the options market for investors?
Position Limits
Position limits refer to the maximum number of contracts an investor can have on each side of the market (bull versus bear). These are set for each individual security.
What specific set of documentation is required to be provided to an investor prior to opening an options account?
Options clearing corporation disclosure document
This details the basics of options trading and outlines the risks.
Who must approve all new option accounts before a customer starts trading?
Someone who has passed the series 4 - a registered options principal - must approve the account before trading can begin.
What information does the broker use to determine suitability for options trading?
Financial information provided by the client to determine if they can withstand the volatility of options trading, including the potential total loss of the investment.
Within what time frame must an options investor return signed documents to the dealer after opening the account?
15 days
Broker dealer must have signed documents returned 15 days after opening the account. If not returned - the customer will not be allowed to open any new options positions.
How are Options Taxed?
Gains or losses trading common options fall under regular capital gains tax rules. There are no income distributions from option contracts.
How are options premiums taxed if the option expires?
The premium is taxed as a capital gain (for the writer) and a capital loss (for the buyer) in the month of expiration.
How are long term options contracts like LEAPs taxed?
The buyer and holder of an options contract will report long term gains or losses on LEAPs, but the seller of LEAPs will always report taxable short term capital gain.
How are option exercises taxed?
- The actual event of exercising does not create a taxable event but rather the premium paid for the option is used to adjust the cost basis of the underlying stock.
- The taxes will then be based on that new cost, and whether the investor holds stock for under or over a year.
For example, a investor buys an option for $3.00 with a strike of 50. When exercised, that stock will have a cost basis of $53, and if sold for $60 in under one year it will be a $7 short term capital gain.
How is the open interest of a contract calculated?
This is the trade count of the options that are outstanding. If one buyer and one seller exchange six contracts, the open interest goes up by six.
What component of an options contract is market driven rather than being set by the OCC?
All components of an options contract are standardized other than the option premium.
What is the main motivation for selling options?
Investors sell options in order to generate income in the form of the premium received.
For sellers of call options, what are the maximum gain and loss amounts?
When an investor sells a call option, they have an obligation to sell the stock at the strike price. No matter how high the price of the stock increases, the investor will have an obligation to buy the stock in the market and then sell it at the strike. Because there is no maximum on how high the stock can go, the maximum loss in unlimited.
Whenever an investor sells an option, if the option moves out-of-the-money the buyer will not exercise and therefore the option will expire and the investor will get to keep the premium received.
What type of account is required before an investor can sell naked calls or puts?
Naked options require a margin account be set up for the customer prior to trading.
Does covered call writing require the use of a margin account?
No
In a covered call, because the investor already owns the stock or a stock equivalent and can use those shares to make delivery if the call is exercised against them, the customer is not required to deposit any margin or collateral.
In what type of trading environment will writing options benefit the seller?
If markets are very volatile, the option seller is at risk for the stock price to vary widely and trade in the money. This means for the option seller, the best market environment is for the market to be stable and the option will “decay” over time and the seller gets to keep the option premium.
What is a covered put?
A covered put means that the investor has enough cash in the account to buy the stock if the option is exercised and they are forced to buy the stock at the strike price. To cover a put, the writer of a put can:
- Deposit cash equal to the strike price
- Short the underlying stock (this will generate cash)
- Buy a put option with a higher strike price and same expiration or same strike price but later expiration
In what type of option strategy is an investor buying calls and puts at the same strike price and same expiration?
A long straddle
What are the costs of an long straddle?
In a long straddle, an investor buys call and buys puts together and therefore must pay premiums on both options. To profit, the investor needs enough volatility up or down to offset the combined premiums that were paid.
If an investor buys:
- 1 Feb IBM 30 Call at 2.45
- 1 Feb IBM 30 Put at 3.00
- Stock is currently trading at 30
What are the breakevens?
For a straddle, there are two breakevens - both CALL UP and PUT DOWN using the combined premiums (in this case $5.45). Therefore, on the calls, the breakeven is $35.45 and on the puts it is $24.55.
What component of an options contract is market driven rather than being set by the OCC?
All components of an options contract are standardized other than the option premium.
What is the main motivation for selling options?
Investors sell options in order to generate income in the form of the premium received.
For sellers of call options, what are the maximum gain and loss amounts?
When an investor sells a call option, they have an obligation to sell the stock at the strike price. No matter how high the price of the stock increases, the investor will have an obligation to buy the stock in the market and then sell it at the strike. Because there is no maximum on how high the stock can go, the maximum loss in unlimited.
Whenever an investor sells an option, if the option moves out-of-the-money the buyer will not exercise and therefore the option will expire and the investor will get to keep the premium received.
What type of account is required before an investor can sell naked calls or puts?
Naked options require a margin account be set up for the customer prior to trading.
Does covered call writing require the use of a margin account?
No
In a covered call, because the investor already owns the stock or a stock equivalent and can use those shares to make delivery if the call is exercised against them, the customer is not required to deposit any margin or collateral.
In what type of trading environment will writing options benefit the seller?
If markets are very volatile, the option seller is at risk for the stock price to vary widely and trade in the money. This means for the option seller, the best market environment is for the market to be stable and the option will “decay” over time and the seller gets to keep the option premium.
What is a covered put?
A covered put means that the investor has enough cash in the account to buy the stock if the option is exercised and they are forced to buy the stock at the strike price. To cover a put, the writer of a put can:
- Deposit cash equal to the strike price
- Short the underlying stock (this will generate cash)
- Buy a put option with a higher strike price and same expiration or same strike price but later expiration
In what type of option strategy is an investor buying calls and puts at the same strike price and same expiration?
A long straddle
What are the costs of an long straddle?
In a long straddle, an investor buys call and buys puts together and therefore must pay premiums on both options. To profit, the investor needs enough volatility up or down to offset the combined premiums that were paid.
If an investor buys:
- 1 Feb IBM 30 Call at 2.45
- 1 Feb IBM 30 Put at 3.00
- Stock is currently trading at 30
What are the breakevens?
For a straddle, there are two breakevens - both CALL UP and PUT DOWN using the combined premiums (in this case $5.45). Therefore, on the calls, the breakeven is $35.45 and on the puts it is $24.55.
What kind of option can be used to protect a short stock position?
Buy Calls
When an investor sells short, they are speculating the price will fall. Buying calls, locks in a purchase price for the stock if it begins to rise rather than fall.
What is the maximum gain and loss on this long stock hedge?
- Own 400 shares IEO at 35
- Buy 4 IEO Jan 30 puts at 2.50
Because the investor owns the stock, their maximum gain is unlimited. No matter how high the stock goes, they will make an infinite amount on their stock and the put will expire out of the money.
Because the investor owns the stock, their risk is the price begins to fall. If that happens, their insurance policy of the put option comes into play. No matter how low the price goes, the investor can always exercise the put and sell the stock at $30. Therefore, the most the investor can lose is the $5 difference between the cost of the stock and the exercise price plus the $2.50 they paid for the put option, or a total of $7.50 per share.
What is the maximum gain and loss of this short stock hedge?
- Short 100 shares XON at $22.50
- Buy 1 XON Jun 30 call at $1.00
Because the investor is short the stock, they are speculating the price will fall. Since they are bearish, the best case scenario is the price of the stock falls down to zero. If this occurs, the investor will earn $22.50 on their short minus the $1 premium they paid for the call option, for a maximum gain of $21.50 per share. Keep in mind, as the price falls, call options will expire out-of-the-money.
Because the investor is bearish, their concern is that the price will rise. If that happens, their insurance policy of the calloption comes into play. No matter how high the price goes, the investor can always exercise the call and repurchase the stock at $30. Therefore, the most the investor can lose is the $7.50 difference between the short sale price and the exercise price plus the $1 they paid for the call option, or a total of $8.50 per share.
What are the breakevens for the below position
- Sell 1 JCP 40 Calls at $6.00
- Sell 1 JCP 40 Puts at $4.50
For a straddle, there are two breakevens - both CALL UP and PUT DOWN using the combined premiums (in this case $10.50). Therefore, on the calls, the breakeven is $50.50 and on the puts it is $29.50.
How is a combination different from a straddle?
Combinations and straddles are identical with one exception. For a straddle, the calls and puts the investor is buying or selling will have the same strike price and expiration. In contrast, for a combination the expiration and/or strike prices of the two options will be different.
What is the breakeven of the below position:
- Buys 1 Jun ARR 50 call at $2
- Buys 1 Jun ARR 55 put at $3
For a combination, there are two breakevens - both CALL UP and PUT DOWN using the combined premiums (in this case $5). Therefore, on the calls, the breakeven is $55 and on the puts it is $50.
What is the formula for breakeven calculations on both straddles and combinations either bought or sold?
The formula is always the same:
- Take the sum of the premiums.
- Add that amount to the call strike
- Subtract that amount from the put strike
That is the breakeven - it doesn’t matter if the combo or straddle is bought or sold, the calculation is the same. Remember CALL UP, PUT DOWN.
How are option spreads structured?
A spread is buying and selling calls or buying and selling puts on the same underlying stock. An example of a spread trade would be:
- Buy 1 UPS Jan 35 call at $3.45
- Sell 1 UPS Mar 45 call at $2.00
The spread itself refers to the difference in the premiums between what the investor is paying to buy one option and receiving when selling the other.
What type of spread will generate income for an investor?
Credit Spread
In a credit spread, the investor is a net seller (they are selling the more valuable position), which means they will receive net premiums.
When an investor pays out premiums for a spread position, what type of spread is it?
Debit Spread
A debit spread means the investor is the net buyer (they are buying the more valuable position) and therefore opening the position will cost them net premiums.
For a spread to have a bullish attitude, which options positions must be dominant?
In a call spread, the long call must be the dominant position in order for the spread to be bullish. Remember, long calls are bullish.
In a put spread, the short put must be the dominant position in order for the spread to be bullish. Remember, short puts are bullish.
What is the maximum gain and maximum loss on the below spread?
- Buy 1 JPM 40 Calls at 5.50
- Sell 1 JPM 60 Calls at 1.00
For spreads, the option with the higher premium is always dominant. Therefore, because buying calls has the higher premium, this investor is bullish.
Because the investor is bullish, they want the price to increase. Theoretically, as the market value goes up, they can exericse their calls and buy the stock at 40, but keep in mind the short calls will force them to sell at 60. Therefore, the maximum gain is the $20 difference in the strike prices minus the debit of $4.50 they paid in premiums. Therefore, the maximum gain is $15.50
Because the investors are bullish, the worst case scenario is the price falls in which case both options expire and the investor will lose their debit of $4.50 per share.
For a spread to have a bearish attitude, which options positions must be dominant?
In a call spread, the short call must be the dominant position in order for the spread to be bearish. Remember, short calls are bearish.
In a put spread, the long put must be the dominant position in order for the spread to be bearish. Remember, long puts are bearish.
To create a bear spread, will an investor sell the call option with the lower strike price or higher strike price.
For calls, the lower strike price is always dominant. For puts, the higher strike price is always dominant. Therefore, for a call spread, the investor must sell the call with the lower strike price so that the bearish position is the dominent position.
What is the maximum gain in the below position?
- Buy 1 JPY June 60 call at $4.50
- Sell 1 JPY June 30 call at $8.00
In this example, short calls is the dominant position because it has the higher premium and therefore the investor is bearish. Therefore, the best case scenario is that the stock price will fall and the investor will get to keep the net credit of $3.50 per share (difference between the $8 received for the short calls and $4.50 paid for the long calls).
What type of spread has different expiration months and different strike prices?
Diagonal Spread
What types of spreads are spread out over different strike prices or spread out over different times?
- Spread positions where the options have different strike prices are called a vertical spread
- Spread positions where the options have different expirations are called calendar spreads or horizontal spreads
Of all the option strategies, which is the most risky?
The riskiest options position is selling uncovered calls. Rememeber, when an investor sells a call they have an obligation to sell the stock at the strike price. Regardless of how high the price goes, the investor will have to purchase those shares to make delivery and sell them at the strike and thus their potential for loss is unlimited as there is no limit to how high the stock can go.
For what type of spread does an investor want it to widen versus narrow?
Remember, that an investor always wants a debit spread to widen and a credit spread to narrow.
On what type of option trade must the spread widen to be profitable?
An investor always wants a debit spread to widen.
On what type of option strategy is a narrowing of the difference in option premium profitable?
An investor always wants a credit spread to narrow.
What type of option can be used to protect a long stock position?
Buy puts
If the stock begins to trade lower through the put strike, the investor can “put” or sell the stock to someone else at a higher price.
How are option collars structured?
In order to create a collar, the investor will purchase a put and sell a call on stock they already own.
What is the difference between the exercise of an equity based option versus a stock index option?
When equity based options are exercised there is a stock transaction. The investor is buying or selling the underlying shares. However, for an index option, it would not be practical for an investor to get one share of every stock on the index so instead they are exercised for cash.
What are the two general types of Index Options?
- Broad based index options will track a market or an index as a whole
- Narrow based index options will track a smaller sector or industry rather than a larger index
How are most index options used?
Risk Management
If a portfolio manager or individual investor has a well-diversified portfolio, they may want to temporarily remove the market risk by hedging with index options just like they would hedge a stock.
When are options automatically exercised by the OCC?
All options contracts that are in-the-money by at least one penny are automatically exercised by the OCC on expiration unless the customer provides alternate instructions.
What are long term options called?
LEAPS (Long Term Equity Anticipation Securities)
How long can a LEAPS’ maturity be?
LEAPs typically mature in 30 months, but can mature as long as three years after issuance. This contrasts with standard options contracts which have an expiration of 9 months.
What do yield-based options speculate on?
Yield-based-options speculate on interest rates for treasury securities. If an investor thinks interest rates will increase, they would open up a bullish position (buy calls or sell puts) and if an investor believes that interest rates will fall, they will open up a bearish position (sell calls or buy puts). Importantly, keep in mind that investors are speculating directly on interest rates NOT prices.
For a yield based option, a strike price of 60 represents what yield?
Yield based options are valued using a multiplier of 10 x YTM. Therefore, a strike price of 60 would reflect a yield of 6.0%.
How is the payoff with yield-based options calculated?
- Recall what a “point” is in yield space - 100 basis points
- If the strikes are expressed in yield, the multiplier is still 100 so we just need to figure out how many points the option is in the money
A 45 call on rates would be a strike of 4.5% and if rates closed at 5.0% that is a difference of 50 points = 50*100 = $5,000
What do FX options speculate on?
Foreign currency options speculate on how foreign currencies will perform relative to the USD. For example, if the investor believes the USD will weaken, this means other currencies are getting stronger, so purchasing calls on the foreign is the best option.
On the test - never choose to buy options on the USD - they don’t exist.
Which of the following statements about the time value of an option are true?
I. Time value is larger if the option is far in-the-money or far out-of-the-money.
II. When the option is at-the-money, a shorter time to expiration results in a smaller time value.
III. When the option is at-the-money, a longer time to expiration results in a larger time value.
II and III
Time value refers to the amount of time remaining until expiration. A longer amount of time equates to a larger time value and vice versa.
What is the relationship between options premiums and volatility?
Increased volatility will typically increase premiums for options as with greater volatility there is more a chance that an option will move deeper into-the-money prior to expiration.
When dealing with exchange-traded options, what is not established by the exchange?
The price of the option, meaning the premium, is market driven and not established by the OCC.
The S&P 500 is at $2005 at expiration. Assuming an investor had bought a call option with a strike price of $2,100, what is the intrinsic value of the option?
Intrinsic value is the in-the-money amount of the option. Keep in mind that calls are ITM when the market value is greater than the strike price. In this example, because the market value is below the strike price, the option has no intrinsic value.
If there is expectation for extreme volatility in the market over the next few months, what is the likely effect on the option prices of calls and puts, respectively?
increase, increase
Uncertainty means more volatility, and volatility has a very strong effect on option prices. Higher volatility increases both call and put option premiums because greater volatility increases possible upside value and increases possible downside values of the underlying.
What is the minimum value of any option?
Keep in mind, whenever the question asks about the value of an option, they are referring to the premium. They premium can never be below zero. Note, it would be zero for an option that has no intrinsic value at expiration since there would be no more time value remaining.
What are the terms that refers to the relationship between the price of the underlying and the exercise price of an option?
In-the-money/out-of-the-money
An option is in-the-money when it is exercisable. Calls are in-the-money when the market value is above the strike price and puts are in-the-money when the market value is below the strike price.
An option is out-the-money when it has no intrinsic value and is not exercisable. Calls are out-of-the-money when the market value is below the strike price and puts are out-of-the-money when the market value is above the strike price.
What is the relationship between the strike price and premium?
All other factors being equal, the higher the exercise price, the lower the premium of a call and the higher the premium of a put. This is because it will require a higher hurdle for a call to be in-the-money as the price will have to move even higher, but a lower hurdle for puts to be in-the-money.
An investor holds stock in a firm and is nervous that the stock price of this firm will fall in the next year. As a result, the investor is thinking of purchasing a 9-month, 6-month, and 3-month puts.
All things being equal, which of these options is the least expensive?
The 3-month option would be least expensive as it will have the smallest time value of the three options.
Some options can be exercised only at expiration. Other options can be exercised at any time prior to expiration.
What are the terms used for options that can be exercised only at expiration and options that can be exercised at any time prior to expiration, respectively?
European option; American option
European options can be exercised only at expiration.
American options can be exercised at any time prior to expiration. Moneyness refers to the characteristic that an option has positive intrinsic value.
