Unit 1: Intro to Options

Question 1

American Style

Answer 1

Contracts exercisable any time until expiration

Question 2

European Style

Answer 2

Contracts exercisable only at expiration

Question 3

3 ways to get out of a long option position

Answer 3

1) exercise option 2) let option expire 3) sell option contract to another party before expiration

Question 4

OCC (Options Clearing Corporation)

Answer 4

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

Question 5

Exercise Price

Answer 5

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).

Question 6

Position limits

Answer 6

OCC publishes daily position limits

Question 7

Exercise limits

Answer 7

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

Question 8

When determining position limits

Answer 8

long calls are aggregated with short puts (bullish)

short calls are aggregated with long puts (bearish)

Question 9

Listed equity options cease trading

Answer 9

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.

Question 10

Holders can no longer exercise their options

Answer 10

5:30 ET on the 3rd Friday of the expiration month

Question 11

Optons Expire

Answer 11

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

Question 12

Automatic Exercise

Answer 12

In the absense of instruction, OCC will autmatically exercise in-the-money contracts (1 cent or more)

Question 13

Assignment of exercise

Answer 13

Assigned party must deliver or buy stock within 3 business days; OCC randomly assigns firm to exercise (either random or FIFO)

Question 14

Long-term equity options

Answer 14

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

Question 15

CALLS - in the money

Answer 15

market price exceeds strike price (buyers want to be in the money, sellers do not); not necessarily breakeven or profitable

Question 16

CALLS - at the money

Answer 16

market price equals strike price (attractive for sellers)

Question 17

CALLS - out of the money

Answer 17

market price is lower than strike price (most attractive for sellers)

Question 18

Intrinsic value

Answer 18

the in-the-money amount; contracts with intrinsic value will be exercised

Question 19

CALLS - breakeven

Answer 19

strike price + premium

Question 20

PUTS - in the money

Answer 20

market price is below strike price (buyers want to be in the money, sellers do not); not necessarily breakeven or profitable

Question 21

PUTS - at the money

Answer 21

market price equals strike price (attractive for sellers)

Question 22

PUTS - out of the money

Answer 22

market price is above strike price (most attractive for sellers)

Question 23

PUTS - breakeven

Answer 23

strike price - premium

Question 24

Time Value

Answer 24

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

Question 25

Parity

Answer 25

If no time remains, time value is zero; all remaining value is instrinsic value

Question 26

Rising interest rates

Answer 26

result in higher call premiums and lower put premiums (financing equities through margin too expensive with higher rates)

Question 27

High dividend rate

Answer 27

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)

Question 28

Common objectives for call buyers

Answer 28

1) Speculative Profit 2) Deferring a decision 3) Diversifying holdings

Question 29

Common objectives for call writers

Answer 29

1) Increasing yield 2) Locking in a sale price

Question 30

Common objectives for put buyers

Answer 30

1) Speculating on a decline in a stock’s value 2) deferring a decision

Question 31

Common objectives for put writers

Answer 31

1) yield 2) buying stock below its current price

Question 32

Long Calls (MG, ML, BE)

Answer 32

Max gain - Unlimited
Max loss - Premium
Breakeven - Strike Price + Premium

Question 33

Short Calls (MG, ML, BE)

Answer 33

Max gain - Premium
Max loss - Unlimited
Breakeven - Strike Price + Premium

Question 34

Long Puts (MG, ML, BE)

Answer 34

Max gain - Strike Price - Premium
Max loss - Premium
Breakeven - Strike Price - Premium

Question 35

Short Puts (MG, ML, BE)

Answer 35

Max gain - Premium
Max loss - Strike Price - Premium
Breakeven - Strike Price - Premium