Unit 1: Intro to Options Flashcards
American Style
Contracts exercisable any time until expiration
European Style
Contracts exercisable only at expiration
3 ways to get out of a long option position
1) exercise option 2) let option expire 3) sell option contract to another party before expiration
OCC (Options Clearing Corporation)
Issues new contracts, guarantees performance of option contracts, and acts as a clearing house for option trades (makes secondary trading possible)
Strike prices and expiration determined by OCC; market determines premiums
Exercise Price
aka Strike Price; set at intervals of $5 but can be $2.50 for lower priced securities (below $25) and $10-20 for higher priced securities (above $200)
Exercise prices are limited (10-20 points above/below current stock price).
Position limits
OCC publishes daily position limits
Exercise limits
Investors are limited on number of contracts that can be exercised within 5 consecutive business days.
Limits apply to individuals, individuals acting in concert, and RR’s acting for discretionary accounts
When determining position limits
long calls are aggregated with short puts (bullish)
short calls are aggregated with long puts (bearish)
Listed equity options cease trading
4:00 ET on the 3rd Friday of the expiration month
Narrow-based index options also stop trading at 4:00 pm ET but broad-based index options, such as the Standard & Poor’s 500 (SPX), continue to trade until 4:15 pm ET.
Holders can no longer exercise their options
5:30 ET on the 3rd Friday of the expiration month
Optons Expire
11:59 ET on the Staurday following the 3rd Friday of the expiration month
The hours between 5:30 Fri and 11:59 Sat allow for firms to clear their books of option transactions by notifying the OCC
Brokerage firms can establish earlier cutoff times to accomodate own closing procedures
Automatic Exercise
In the absense of instruction, OCC will autmatically exercise in-the-money contracts (1 cent or more)
Assignment of exercise
Assigned party must deliver or buy stock within 3 business days; OCC randomly assigns firm to exercise (either random or FIFO)
Long-term equity options
CBOEs (Chicago Board Options Exch) and LEAPs (long term equity anticipation securities; expiraions of up to 39 months for equity LEAPs and 36 months for index LEAPs
Premiums tend to greater than traditional options because long term entails greater time value
Exercise American Style
CALLS - in the money
market price exceeds strike price (buyers want to be in the money, sellers do not); not necessarily breakeven or profitable
CALLS - at the money
market price equals strike price (attractive for sellers)
CALLS - out of the money
market price is lower than strike price (most attractive for sellers)
Intrinsic value
the in-the-money amount; contracts with intrinsic value will be exercised
CALLS - breakeven
strike price + premium
PUTS - in the money
market price is below strike price (buyers want to be in the money, sellers do not); not necessarily breakeven or profitable
PUTS - at the money
market price equals strike price (attractive for sellers)
PUTS - out of the money
market price is above strike price (most attractive for sellers)
PUTS - breakeven
strike price - premium
Time Value
the market’s perceived worth of the time remaining to expiration; As the expiration date approaches, time value will diminish; on the last trading day before expiration, the option no longer has time value and premium usually equals intrinsic value
Premium - Intrinsic Value
Parity
If no time remains, time value is zero; all remaining value is instrinsic value
Rising interest rates
result in higher call premiums and lower put premiums (financing equities through margin too expensive with higher rates)
High dividend rate
results in lower call premiums and higher put premiums (better to own stock outright vs option to collect income; shorting become expensive bc seller still owes divs)
Common objectives for call buyers
1) Speculative Profit 2) Deferring a decision 3) Diversifying holdings
Common objectives for call writers
1) Increasing yield 2) Locking in a sale price
Common objectives for put buyers
1) Speculating on a decline in a stock’s value 2) deferring a decision
Common objectives for put writers
1) yield 2) buying stock below its current price
Long Calls (MG, ML, BE)
Max gain - Unlimited
Max loss - Premium
Breakeven - Strike Price + Premium
Short Calls (MG, ML, BE)
Max gain - Premium
Max loss - Unlimited
Breakeven - Strike Price + Premium
Long Puts (MG, ML, BE)
Max gain - Strike Price - Premium
Max loss - Premium
Breakeven - Strike Price - Premium
Short Puts (MG, ML, BE)
Max gain - Premium
Max loss - Strike Price - Premium
Breakeven - Strike Price - Premium
