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Series 7 > Chapter 4 - Options > Flashcards

Chapter 4 - Options Flashcards

1
Q

What is an options contract?

A

A two party contract with a right for a buyer (able to buy the underlying security) and an obligation to the seller (must sell to the buyer of the underlying security).

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2
Q

What are the two styles of options? Explain both.

A
  • American and European.
  • An American option can be exercised any time before the expiration date. A European option can only be exercised the day before expiration. Most options are American style.
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3
Q

When buying options on stock how many shares of the underlying stock will you be purchasing if you exercise your option assuming you buy 1 contract? 10 contracts?

A

100 shares, 1000 shares

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4
Q

What does it mean when you are long a call? long a put? short a call? short a put?

A

1) long call = right to buy
2) long put = right to sell
3) short call = obligation to sell/fulfill
4) short put = obligation to buy/fulfill

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5
Q

Long XYZ Jan 60 call for 3. How much is the premium?

A

3 or $300 (3*100)

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6
Q

Buyers of calls are _______ on the market while their counterparts are_______. Buyers of puts are ________ on the market while their counterparts are _________.

A
  • Bullish
  • Bearish
  • Bearish
  • Bullish
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7
Q

For Calls describe when an option is “in the money”, “at the money”, and “out of the money”. If you were long the option when would you exercise your contract?

A
  • ITM - market price > exercise price
  • ATM - market price = exercise price
  • OTM - market price < exercise price
  • The only time you exercise your option is when you are “in the money”
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8
Q

What is intrinsic value for a call option? What if the option is “at or out of the money” does it have intrinsic value?

A
  • Intrinsic value = Market price - Strike price

- Options that are at or out the money have an intrinsic value of 0, there can never be a negative intrinsic value.

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9
Q

What is the break-even for a call option?

A

Break-even = Strike price + Premium

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10
Q

For Puts describe when an option is “in the money”, “at the money”, and “out of the money”. If you were long the option when would you exercise your contract?

A
  • ITM - market price < exercise price
  • ATM - market price = exercise price
  • OTM - market price > exercise price
  • The only time you exercise your option is when you are “in the money”
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11
Q

What is intrinsic value for a put option? What if the option is “at or out of the money” does it have intrinsic value?

A
  • Intrinsic value = Strike price - Market price

- Options that are at or out the money have an intrinsic value of 0, there can never be a negative intrinsic value.

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12
Q

What is the break-even for a put option?

A

Break-even = Strike price - Premium

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13
Q

What is the premium on an options contract? What is it composed of?

A
  • The premium is the price paid (or received) for the options contract. The buyer pays the ask/offer price and the seller receives the bid price.
  • Premium = Intrinsic Value + Time Value
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14
Q

What are the 3 choices a buyer of an options contract has when nearing the expiration date?

A
  • Exercise the option
  • Let the option expire
  • Sell the contract, or close
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15
Q

If an investor is long or short on a stock how can they hedge their position?

A

If an investor is long on a stock then they may buy a put to hedge against a drop in price for full protection or short a call for partial protection. If an investor is short on a stock they may buy a call to hedge against a rise in price for full protection or short a put for partial protection.

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16
Q

What is covered call writing?

A

Selling calls while having a long stock position. This offers partial protection for the investor and is usually used to generate a better return when stock is trading flat.

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17
Q

An investor buys 100 shares of RST at 53 and buys an RST 50 put for 2. What is the maximum loss, gain, and break even for the investor?

A
  • Maximum loss = 3 + 2 = $500
  • Maximum gain = unlimited
  • Break-even = 53 + 2 = $55
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18
Q

An investor buys 100 shares of RST at 53 and writes a RST 55 call at 2. What is the maximum loss, gain and break-even for the investor?

A
  • Maximum loss = Stock falls to 0, 2 - 53 = $5100
  • Maximum gain = 2 + 2 = $400
  • Break-even = 53 - 2 = $51
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19
Q

An investor sells short 100 shares of RST at 58 and buys a RST 60 call at 3. What is the maximum loss, gain and break-even for the investor?

A
  • Maximum loss = 3 + 2 = $500
  • Maximum gain = 58 - 3 = $5500
  • Break-even = 58 - 3 = $55
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20
Q

An investor sells short 100 shares of RST at 55 and writes a RST 55 put at 2.50. What is the maximum loss, gain and break-even for the investor?

A
  • Maximum loss = Unlimited
  • Maximum gain = 2.50, $250
  • Break-even = 55 + 2.50 = $57.50
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21
Q

What is a collar?

A

An investor can hedge downside risk on a long position on a stock with no out of pocket cash.

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22
Q

An investor is long 100 shares of RST at 50, they buy a RST 45 put at 3 and sell a RST 55 call at 3. What is the net cost, maximum loss and gain?

A
  • Net cost = 3 - 3 = $0
  • Maximum loss = 45 - 50 = $500
  • Maximum gain = 55 - 50 = $500
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23
Q

What is a spread?

A

The simultaneous purchase and sale of an option.

24
Q

What is a call spread? put spread?

A

Call spread = long call + short call

Put spread = long put + short put

25
Q

What is a price spread or vertical spread? Give an example.

A
  • A spread that has different strike prices but the same expiration month. These are the most common spreads.
  • Long RST Nov 50 call at 7 and Short RST Nov 60 call at 3
26
Q

What is a time spread or calendar spread? Give an example.

A
  • A spread that has different expirations but the same strike price.
  • Long RST Nov 60 call at 3 and Short RST Jan 60 call at 5
27
Q

What is a diagonal spread? Give an example.

A
  • A diagonal spread has different expirations and different strike prices.
  • Long RST Jan 55 call at 6 and Short RST Aug 60 call at 5
28
Q

What is a debit spread? credit spread?

A

The net cost once an investor has simultaneously bought and sold an option. On the t-chart if the purchase of the option outweighs the proceeds from the sale then it is debit. If the proceeds of the sale outweigh the purchase then it is a credit.

29
Q

Why would an investor use a debit call spread strategy?

A

A debit call spread is used to reduce cost on a long position since the investor is bullish. The investor also gains partial insurance if the stock falls which once again offsets cost.

30
Q

An investor buys 1 RST November 55 call for 6 and sells 1 RST November 60 call for 3. What is the investors maximum gain, loss, and break-even.

A

Determine if it is a debit/credit spread. -6 + 3 = -3, Debit Spread.

  • Maximum gain = 5 - 3 = 2, or $200
  • Maximum loss = Debit Spread = -$300
  • Break-even = 55 60, 55 + 3 = 58
31
Q

For bullish spread investors what do they want to see happen with the spreads?

A

Widen, exercise becomes more likely

32
Q

For bearish spread investors what do they want to see happen with spreads?

A

Narrow, exercise is less likely

33
Q

To calculate the break-even for call spreads and put spreads what do you need to know and how do you calculate them?

A
  • The net premium and the strike prices
  • Call spreads break-even = Lower Strike + Net Premium
  • Put spread break-even = Higher Strike - Net Premium
34
Q

For quick reference, how do you calculate max gain and loss on spreads?

A
  • Determine if it is a net debit/credit, if it’s a net debit then its max loss. For max gain subtract net debit from the difference in strike prices.
  • Max gain + Max loss = Difference in Strikes
35
Q

Why would an investor use a credit call spread?

A

It reduces the risk of the short option and they are bearish.

36
Q

Why would an investor use a debit put spread?

A

It reduces the cost of the long put position and they are bearish.

37
Q

Buy 1 RST November 55 put at 6 and sell 1 RST November 50 put at 3. What is the maximum gain, loss, and break-even?

A
  • Maximum gain = 2, $200
  • Maximum loss = -3, -$300
  • Break-even = 50 55, 55 - 3 = 52
38
Q

Why would an investor us a credit put spread?

A

It reduces the risk of the put position and they are bullish.

39
Q

What is a straddle?

A

A call and put with the same strike and expiration month.

40
Q

An investor buys 1 ABC Jan 50 call at 3 and buys 1 ABC Jan 50 put at 4. What kind of straddle is this? What is the maximum gain, loss, and break-even?

A
  • Long straddle, investor expects substantial of volatility
  • Maximum gain = Unlimited
  • Maximum loss = 3 + 4 = 7, $700
  • Break-even = 50 + 7 = 57 and 50 - 7 = 43
41
Q

An investor sells 1 ABC Jan 45 call at 4 and sells 1 ABC Jan 45 put at 5. What kind of straddle is this? What is the maximum gain, loss and break-even?

A
  • Short Straddle, investor doesn’t expect much movement
  • Maximum gain = 4 + 5 = 9
  • Maximum loss = Unlimited
  • Break-even = 45 + 9 = 54 and 45 - 9 = 36
42
Q

True or False: Calls with lower strike prices have higher premiums and puts with higher strike prices are more valuable?

A

True, both options have better chances of being in the money before expiration of the contract.

43
Q

True or False: If you buy the lower strike price you are bullish?

A
  • True
  • Buy 1 Jan 50 call and sell 1 Jan 60 call, bull spread
  • Buy 1 Jan 50 put and sell 1 Jan 60 put, bull spread
  • Opposite for bears
44
Q

What is a combination? Give an example of a long combination.

A

A call and a put with different strikes, months, or both. Similar to a straddle strategy. Buy XYZ Jan 40 call and Buy XYZ Jan 45 put.

45
Q

Why would someone use an Index option?

A

To hedge against portfolio risk. An insurance on the portfolio and helps with systematic risk.

46
Q

An investor buys an index option, 1 OEX Jan 460 call at 3.20. The index is currently at 461. What is the premium, breakeven, intrinsic value, and time value of the option?

A

Premium = 3.20 * 100 = $320
Breakeven = 460 + 3.20 = 463.20
Intrinsic = 461 - 460 = 1, $100
Time Value = $320 - $100 = $220

47
Q

A customer has a $920,000 portfolio, to hedge, he wants to buy OEX puts that are currently trading at 460. How many contracts will he need to buy in order to hedge his portfolio?

A

Each contract = 460 * 100 = $46,000

$920,000/$46,000 = 20 contracts

48
Q

If a stock has a beta of 1.2 what does that mean?

A

The stock is 20% more volatile than the current market.

49
Q

For an interest rate option, a strike of 35 is what in yield? If rates increase to 45, how much is the increase in dollars? How much is each point worth? Are these options American or European?

A

Yield = 3.5%
10pt increase = $1000
1pt = $100

50
Q

For currency options what are the sizes? What about Yen? What are strikes quoted in, and for Yen?

A

Standard currencies are in size of 10k, while Yen is 100k. Strikes are quoted in US cents and Yen is 1/100 of a cent.

51
Q

An investor holds 1 Swiss contract at 1.5. What was the cost of the option?

A

10,000 * 0.015 = $150

1pt = $100

52
Q

Importers would buy what type of option on a foreign currency, and exporters would buy what type of option on a foreign currency?

A

Importers buy calls and exporters buy puts

53
Q

If an investor has an option that is in the money at expiration and he does nothing what will happen?

A

The OCC will automatically exercise the option if it is in the money by at least 5 cents.

54
Q

Does a customer have to do anything special to trade options?

A

Yes they must be provided disclosures and get approval by the branch manager and sign an options agreement

55
Q

What happens to an option when a stock splits? If an investor has 1 ALF 60 call and there is a 2:1 split what happens? A 3:2 split?

A

Options will split along with the stock.
1 ALF 60 call (2:1) 2 ALF 30 calls
1 ALF 60 call (3:2) 1 ALF 60 call with 150 shares

56
Q

There are 3 tax consequences involved with options, what are they? Explain them.

A

1) Expiration, buyer loses premium and seller profits, capital loss for buyer and cap gain for seller
2) Closing, capital gain or loss equal to price difference
3) Exercise, no cap gain or loss until exercised. If option is exercised then strike + prem. = cost basis for a call.

Series 7 (16 decks)

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