Unit 4 Flashcards
Options
In the Money
Keep in mind this is how much the option is above or below the strike price
INTRINSIC VALUE
It does not need to be covering the premium
Calls in money
When the market price is above the SP, Long or Short
Puts in money
When the the market price is below the SP, long or short
Option premium reflects two types of values
Intrinsic and Time
Intrinsic value
The amount by which the option is in the money
Time value
Market’s perceived worth of time remaining to expiration
Options Quotes
Quoted on a per share basis
Factors affecting premium
Volatility
Amount of intrinsic
time remaining until expiration
Interest rates
Greatest influence is volatility of underlying stock
Calculation of Premium
Intrinsic Value + Time Value
Reasons to buy calls
Speculation
Deferring a decision
diversifying holdings
protection of short position
Buy call speculation
Less investment
Investor can speculate on upward price by only paying premium
Buy call Decision deferr
Investor can buy a call on a stock and lock in purchase price until the option expires
Buy call diversify holdings
Cheap way to diversify portfolio
Buy call protect short stock
Option acts as insurance against rising price of stock
Buy call maximum gain
Unlimited
Buy call maximum loss
Premium paid
Reasons to sell call
Speculation
Increasing returns
Locking in sale price
Protection of long position
Sell call speculation
Additional income can be earned by keeping premiums
Sell call locking in sale price
If an investor has an unrealized profit in a stock and wants to sell, a written call can lock in the profit
Sell call protection of long position
limts downside to the extend of the premium received
Sell call maximum gain
Premium received
Sell call maximum loss
Unlimited
Exercise contract regular way (timing)
T+2
Closing transaction
If the investor sold, the option is closed by buying the option
How to hedge long stock position
Select a bearish option with either
LONG PUT OR SHORT CALL
How to hedge a short stock position
Select a bullish option with either:
SHORT PUT OR LONG CALL
“Best Buy”
Remember the best position is to buy an option
If question asks for partial protection, or how investor can IMPROVE rate of return…
Select short option position
generates premium income to improve rate of return
NOTE : RISK IS REDUCED BY PREMIUM RECEIVED
Covered call writing
Selling calls when holding a long stock position.
Partial protection that generates income and reduces potential upside
Protective Put
Long Stock, Long Put
Investor buys:
100 shares of RST at 53 and buys RST 50 put for 2
Maximum gain is unlimited (upside potential)
Downside is $500 (premium of 2 + 3 lost on long stock)
Breakeven $55/share ($53 + 2)
Covered Call
Long stock, short call
Investor buys:
100 shares of RST at 53 and writes 1 RST 55 call for 2
Maximum gain: $400 (owner of call will exercise at $57/share so $57-$53 = $4/share)
Maximum loss: $5,100 (if stock goes to 0, total cost was $5,300-$200 premium earned)
Break even = $51/share ($5,300 - $200)
Ratio call writing
Involves selling more calls than the long stock position covers.
Generates additional premium income
HAS UNLIMITED RISK WITH SHORE UNCOVERED CALLS
Short Stock Long Call
Investor :
SELLS 100 shares of RST at $58 and buys RST $60 call for 3
Maximum gain: $5,500 ($58 - $3 premium)
Maximum loss: $500 ($3 paid for premium + $2 on short)
Break even: $55/share
Short Stock, Short Put
Investor:
SELLS 100 at $55 and writes RST $55 put at $2.50
Maximum gain: $250
Maximum loss: Unlimited
Break even: $57.5/share
REMEMBER WHEN YOU WRITE YOU RECEIVED PREMIUM!!!!
Collar
Hedge downside risk on long position of stock for no out of pocket cash
Investor is long 100 shares of XYZ at 50
Buys a 45 put at 3
Sells a 44 call for 3
Cashless collar
Spreads
Simultaneous purchase of one option and sale of another option of SAME CLASS
Call Spread
long call and short call
Put Spread
long put and short put
Price spread (vertical spread)
One that has a different SP but same expiration date
Time spread (calendar spread)
includes option contracts with DIFFERENT EXPIRATION DATES.
Investors do not expect price volatility. Expect to profit from different rates.
Diagonal spread
Positions differ on both time and price.
Debit spread
If LONG option has higher premium than the short option
Long premium > Short premium
Credit spread
If SHORT option has higher premium that long option
Short premium > long premium
Debit call spread
Investors reduce the cost of long option position.
BULLISH POSITION
Buy 1 RST Nov 55 call for 6
Sell 1 Nov 60 call for 3
Max Gain = $200
Max Loss = $300
BE = $58
What type of spread would an investor look for premiums to widen?
Debit spread
When you begin to widen you need to exercise
Debit = Widen = Exercise
What type of spread would an investor look for premiums to narrow?
Credit spread
Credit spreads are profitable if premiums narrow and expiration occurs
credit = narrow = expire
CAL and PSH (finding break even points)
for Call Spreads; Add net premium to Lower SP
for Put Spreads: Subtract net premium from Higher SP
Maximum gain / loss calculation
T chart
IF result is net debit, net debit equals max loss
Max gain = subtract net debit from difference of two SP of spread
Credit Call Spread
Created to reduce the risk of short position.
Potential reward of the investor is reduced
BEARISH
Buy 1 RST Nov 55 call for 2
Sell 1 RST Nov 45 call for 9
Max gain = $700
Max loss = $300
BE = $52/share
Debit Put Spread
Used to reduce cost of long put position
Bearish position
Buy 1 RST Nov 55 put of 6
Sell 1 RST Nov 50 put for 3
Credit put spread
Created to reduce risk of short put position.
Potential reward for investor is reduced.
Bullish position.
Max Gain - credit spred
Net credit
Max loss - credit spred
Difference between strike price - net credit
Max gain - debit spred
Difference between strike price - net debit
Max loss - debit spread
Net debit
Market attituede
determined by the option that is more costly of the two
Call debit
if the investor PURCHASED the one with the lower SP (higher premium)
Bullish
Call credit
If the investor SOLD the one with the lower SP (higher premium)
Bearish
Put debit
Investor PURCHASED the one with the higher SP (higher premium)
Bearish
Put credit
Investor SOLD the one with the higher SP (higher premium)
Bullish
Market attitude trick
Buying Lower SP = Bull
Straddle
Call and put with the same SP and expiration month
Can be long or short and are used by investors to speculate on price movement
INVESTOR PREDICTS HIGH VOLATILITY
Long straddle
Expects substantial volatility but is uncertain where price will move.
Investor PURCHASES a call and put
Short straddle
Expects price will not change or will change very little
collects two premiums by SELLING a call and put
Max gain Long straddle
Unlimited
Max loss Long Straddle
Total premium paid
Breakevens Long straddle
Call: Strike price + both premiums
Put: Strike price - both premiums
Maxgain Short straddle
Total premium received
Max loss long straddle
Unlimited
Break evens Short straddle
Call: Strike price + both premiums
Put: Strike price - both premiums
Combinations
Includes call and put with different SPs, exirations months, or both.
Similar to straddles
Use of a combination
Cheaper to establish than long straddles if both options are out of money
Long straddle example
Long Jan 40 call and Long Jan 45 put
In money when underlying stock is OUTSIDE breakeven points
Short straddle
If investor writes both option - result is short combo
Makes money when underlying stock stays BETWEEN Breakeven points
Non-equity options
function the same as equity options except:
Different contract sizes
Different delivery and exercise standards
Options indexes
allow investors to profit from movements in markets or segments
also can hedge against market swings
Broad based indexes
reflect movement of entire market
Narrow based indexes
track movement of market segments in a specific industry which as tech or pharmaceuticals
Index option multiplier
Typically use a $100 multiplier
Index option trading
T+1
Index option exercise
Settles in cash rather than delivery of security. Settles next day.
Index option settlement price
Based on closing value of index on day of exercise.
Not value at time of exercise.
Index option expiration dates
Expire on third Friday of expiration month
Index option time value
Premium - Intrinsic
Index option strategy
If investor is bullish: buy calls or write puts
If investor is bearish: write calls or buy put
Portfolio insurance
portfolio manager guys a put on index to offset if market value decreases
Beta
measure of volatility of stock or portfolio related to the volatility of the market in general.
Beta of 1.0
same volatility as market in general
Beta of 1.2
20% more volatile than market in general
Interest rate options
Yield based off T-bills, notes, and bonds.
If investor is bullish and buys yield based option with SP of 35 (reflects a yield of 3.5%). If rates rose to 4.5% investor could exercise and receive CASH equal to intrinsic value
Can buy/sell puts and calls
Foreign currency options
allows investors to speculate on the performance of currencies other than USD
Provides protection against fluctuating currencies
Foreign currency settlement
Next day in USD
Foreign currency contract sizes
$10,000
$1,000,000 YEN
Foreign currency strike prices
Usually quoted in US cents
Yen is 1/100th of a cent
Foreign currency premiums
Quoted at cents per unit
FX premium example
Contract of 10,000 units is quoted with a premium of 1.5, cost of contract equals
10,000 x 0.15 or $150.
FX option expiration date
3rd friday of month
Understanding FX prices
If USD is rising - other currencies are falling
If USD is falling - other currencies are rising
If importer believes USD will fall against Swiss franc then…
Investor should buy calls on franc to lock in purchase price
Who buys FX calls who buys FX puts
Importers buy calls
Exporters buy puts
Rule of thumb - exporters buy puts on the foriegn currency
KEEP IN MIND NO OPTIONS CAN BE BOUGHT ON USD
So if British exporter is looking to hedge risk - he would buy BP call (no USD)
Listed options
Exchange traded options
Standardized strike price, expiration date etc
Listed options settlment
regular way (t+2)
Automatic exercise
if in money at least by 0.1, they are automaticall exercised
Options position limits
No more than 250,000 contracts on same side may be exercised within 5 BD
Apply to individuals , registered resp acting in discretion, and individuals acting in concert
Options exercise limits
OCC time limits for max number of contracts (on same side of market) is 5 BD
American / European contracts
American = can exercise option at any time European = only can exercise at expiration date
Where are options traded?
CBOE - Chicago board of options exchange
Designated Primary Market Maker
Floor trader responsible for maintaining two sided market for product on CBOE.
Can perform roles of market maker and/or floor broker
Options market maker
Registered with the exchange to trade for their own accounts. Must stand by and be ready to buy and sell.
Order routing systems
Computerized system used to route customer orders directly to the trading post.
Options Clearing Corporation (OCC)
Clearing agent for options contracts
Determines when new options should be offered
Designates SP and expiration month
Exercise of option through OCC
Guaranteed by OCC
BD notifies OCC, then OCC assignes exerciese notices on random basis.
BD then assign exercise notice on random basis based upon FIFO or any other type of reasonable method
OCC Options Disclosure Document
Must be provided at or before account approval.
No later than 15 days after approval, customer must return options agreement.
Options Contract Adjustments
Adjusted for splits, reverse splits, dividends and rights offerings
NOT ADJUSTED FOR
Ordinary cash dividends or distributions
Stock splits - option contracts
When occur:
Additonal options contracts are created.
After a 2:1 split 1 ALF 60 call becomes 2 ALF 30 call
Uneven split - options contract
Adjusted for uneven splits
After a 3:2 split
1 ALF 60 call will be represented by 1 ALF 40 call
Closing transaction
can be buy or sell
BD needs to disclose if it is a covered or uncovered transaction
Put - Call ratio
Reflects the current open interest in trade of put options to call options
Divide number of traded put options to number of traded call options
Higher ratio - more bearish investors have been
Note: can be contrarian, long high ratio could mean that its time to start buying
Exercise Long Call
closing purchase
Exercise Short call
closing sale
Married put
If on same day customer buys stock and buys put option, the option is MARRIED to stock
