unit 10 Flashcards
option
- 2 party contract that conveys a right to the buyer and an obligation to the seller
- underlying security can be stock, stock market index, foreign currency, interest rate or govt bond - anything with a fluctuating value
- called derivative security bc their value is derived for the value of the underlying instrument
- typically each contract represents 100 shares of the underlying stock (mini options are 10 shares)
- 3 specifications: underlying instrument, price, expiration
terms of the option contact
- standardized by the Options Clearing Corporation (OCC)
- this allows options to be easily traded on an exchange like the CBOE
option price
- contract specifies the strike/exercise price a which purchase or sale of the underlying security will occur
option expiration
- all contacts have a specified life cycle
- once contract is issued it can be bought or sold any time during its lifecycle
- length of time can be customized between buyer and seller when the contract first trades
standard contracts
- issued with a 9 month expirations and expire on the 3rd Friday of the expiration month at 11:59pm ET.
long term equity anticipation securities (LEAPS)
- max 39 months
- most trade in 30 months
- options that have an expiration greater than 1 yr
calls
- buy calls (long Call): a call buyer owns the right to buy 100 shares of a specific stock at the exercise/strike price before the expiration if they choose to exercise. Could also sell the option. Pays premium.
- write calls (short call): call writer is obligated to sell 100 shares of the specific stock at the exercise/strike price if the buyer exercises the option
puts
- buy puts (long put): buyer owns the right to sell 100 shares of a specific stock at the exercise/strike price if they choose. Can also sell the option. Pays premium.
- Sell puts (short put): put writer has the obligation to buy 100 share of the specific stock at the exercise/strike price is the buyer exercises the option
- Buying a put (in or out of the money) on a stock held short term (one year or less) erases the holding period until the put is disposed of. At that time, the holding period starts over.
Options Clearing Corporation (OCC)
- SRO
- issuer of listed options contracts
- owned by the exchanges that trade options
- functions are to standardize, guarantee performance of, issue option contracts
- determines when new options contracts go on the market
- designates strike price and expiration for new contracts
- does not determine premiums - supply and demand does
OCC assignment of exercised contracts
- randomly selects a firm with a short position, then assigned BD picks a client to allocate the obligation to (random, first in first out, other method that is fair and reasonable)
notification of allocation method
- BD must inform options customers how they allocate exercise notices/assignments and any consequences
- size of the writers position is NOT CONSIDERED FAIR AND REASONABLE
in the money call
- a call is in the money when the market price of the underlying asset exceeds the strike price of the option
- buyers want options to be in the money, sellers do not
in the money put
- a put is in the money when the market price of the underlying asset is less than the strike price of the option
at the money
- call or put is at the money when the market price of the underlying asset equals the strike price of the option
out of the money call
- when the market price is below the strike price
- buyer will not exercise call
- advantage to seller who keeps premium
out of the money put
- when the market price is above the strike price
- buyer will not exercise call
- advantage to seller who keeps premium
intrinsic value
- the same as the amt a contract is in the money
- always a positive amt or zero
- an option that has intrinsic value at expiration will be exercised or sold by the buyer
time value
- option has time value anytime the option’s premium exceeds its intrinsic value
- Amt an option buyer will pay (and seller accept) above an option’s intrinsic value
- buyers would pay more for longer time to expiration
time decay
- time value will diminish as the expiration date approaches
parity
- when premium equals the intrinsic value
- options trade at parity just before the expiration date
buying calls
- want the underlying market price of the stock to rise
- bullish
- speculation - only pay premium for bet stock rises (form of leverage)
- deferring a decision - lock in purchase price until the option expires. Only commitment is the premium
- diversifying holdings - with limited funds you can buy calls on variety of stocks
- protection of a short position - acts like insurance policy.
selling/writing/shorting calls
- want the underlying market price of the stock to fall or stay the same
- bearish or neutral
- income strategy - looking to keep premium
- speculations - often naked calls
- locking in a sales price
- protecting a long position - premium collected provides limited downside protection
covered call
- when investor owns the # of shares covered by the option contract
- can have actual stock or convertible security or with a long long call with the same or lower strike price with expiration no sooner than the short call
uncovered/naked call
- when investor writes call without owning the stock or related assets that would enable the investor to deliver the stock should the option be exercised.
- OCC will need cash deposit to ensure there are funds to buy the stock to deliver
- unlimited potential risk of loss
ratio call writing
- selling more call than the long position covers
- generates additional premium
- unlimited risk
long put options
- bearish
- investor can profit from a decrease in a stock’s price while investing a relatively small amt of money
- speculation - lower risk than selling a stock short
- deferring a decision - lock in sales price until expiration
- protection of a long stock position - insurance policy against the stock declining in price
covered puts
- to cover a put, one can take a short position in the stock underlying the short put or a cash covered put
- obligation of the put writer is to pay the exercise price - need money
short puts
- bullish or neutra
- speculation
- increasing returns
- buying stock below its current price
open interest
- put call ratio
- number of option contracts oustanding
put call ratio
- reflects current open interest
- gauge investor sentiment
= #traded put options/# of traded call options
- the higher the ratio, the more bearish investors are
- could be contrarian indicator
spread
- simultaneous purchase of one option and sale of another option of the same class
- call spread: long call, short call
- put spread: long put, short put
price/vertical spread
- different strike prices but same expiration date
- most common spread
time/calendar/horizontal spread
- different expiration dates but same strike price
- for investors who do not expect price volatility
- hope to profit from the different rates at which the time values of the 2 options expire
- out looks is neutral
diagonal spread
- different expiration date and strike price
bull spread
- when investor buys the option with the LOW strike price and sells the option with HIGH strike price
- bulls buy low and sell high
bear spread
- when investor buys the option with the HIGH strike price and sells the option with LOW strike price
debt spread
- if the LONG option has a HIGHER premium than the short option
credit spread
- if the SHORT option has a HIGHER premium than the long option
debt call spread
- bullish
- reduce the cost of a long option position
- reward potential is limited
- investor profit if option is exercised.
- want net debt spreads to widen
debt = widen = exercise (when you begin to widen, you need to exercise)
credit call spread
- bearish
- reduce risk of a short option position
- investor profits when option expires
- want net credit spreads to narrow
credit = narrow = expire (when you become too narrow, you may expire)
debt put spread
- bearish
- used by investors to reduce the cost of a long position
credit put spread
- bullish
- reduce the risk of a short position
market attitude
- determined by the which option costs the most (higher premium)
- calls (lower strike price has the higher premium
- debt if investor bough the option with lower strike price (bullish)- credit if the investor sold the option with the lower strike price (bearish)
- puts (higher strike price has the higher premium)
- debt if the investor bought the option with higher strike price (bearish)
- credit if the investor sold the option with higher strike price (bullish)