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Series 7 > CHAPTER 9 - OPTIONS > Flashcards

CHAPTER 9 - OPTIONS Flashcards

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1
Q

Option Contract

A

Option - two party contract that gives a right to the buyer and obligation to seller

Terms - standardized by OCC to allow easier trading on an exchange like CBOE, Nasdaq option, and others

Underlying security may be a stock, index, currency, interest rate, or government bond

Derivatives - options are called derivates because their value is derived from the value of underlying instrument like a stock, index, or currency

Each option contract represents 100 shares of the underlying stock

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2
Q

Two Parties

A

Buyer = Long = Holder = Owner
Pays premium to seller
Debit to account of buyer to open their position
Has the right to exercise (buy or sell)

Seller = Short = Writer
Receives premium from buyer
Credit their account when they open their position
Has obligation when contract is exercised to sell or buy

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3
Q

Long Position

A

Long a call: pays premium for the right to buy the asset at the strike price

Long a put: pays premium for the right to sell the asset at the strike price

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4
Q

Short Position

A

Short a call: receives premium with the obligation to sell the asset at strike if exercised

Short a put: receives premium with obligation to buy the asset at strike if exercised

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5
Q

3 Option Specifications

A

Underlying Instrument: Anything with fluctuating value

Strike price: Exercise price stated

Expiration: Expire on a specified date and can be bought or sold at anytime during life cycle
- standard contracts have 9 month expirations and expire on 3rd Friday of expiration month at 11:59pm
- long-term equity anticipation notes (LEAPS) have a max expiration of 39 months but can be customized

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6
Q

Types of Options

A

Type: calls and puts

Class: all options of same type on same underlying security

Series: options of the same class, exercise price, and expiration month are in the same series

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7
Q

Calls

A

Long Call: call buyer owns right to buy 100 shares of a specific stock at exercise price before expiration, holder of the option can also sell the option

Short Call: call seller has obligation to sell 100 shares of a specific stock at strike if buyer exercises

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8
Q

Puts

A

Long Put: put buyer owns right to sell 100 shares of a specific stock at a exercise price before expiration or can sell the option

Short Put: put seller has obligation to buy 100 shares at the strike if buyer exercises

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9
Q

Opening and Closing Positions

A

First need to open:
Buying an option - opening purchase
Writing an option - opening sale

Closing sale is to get out of it:
- opened by buying, now sell to close

Closing purchase is also to get out of it:
- opening sale, now buy to close

gains and losses depend on premiums paid and premiums received

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10
Q

Settlement Dates

A

Settlement date is next business day
T+1

Buying an option on Tuesday, need to have the cash for it (pay for it) on Wednesday

Proof of ownership is trade confirmation and proof of payment

Stocks and bonds have certificates, options DO NOT

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11
Q

Role of OCC

A

OCC is an SRO and does the following:
- issues listed options contracts
- standardize and guarantee performance and issue of option contracts
- determines new option contracts that will be offered
- designates strike prices and expirations

DOES NOT determine option premiums
premiums determined by supply and demand

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12
Q

Assignment of exercise of options contracts

A

OCC guarantees the exercise of options contracts (if buyers choose to exercise), if seller cannot perform the OCC comes in

OCC assigns exercise notice to BD with a customer who has sold or written that option

BD assigns that exercise notice to a customer with short position

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13
Q

Who issues all listed options contracts?

A

OCC

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14
Q

Customer notifications of allocation method

A

OCC is notified by BD that customer wants to exercise

OCC randomly selects a firm with a short position and assigns it to them

BD assigns it to specific clients

Once option is exercised, contract can no longer be traded (binding and irreversible)

Assigned party (writer) must deliver within 1 business day (for a call) or buy within 1 business day (for a put)

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15
Q

Assignment Methods for OCC and BDs

A

OCC assigns to BD on a RANDOM BASIS

BDs assign to customers in:
- Random basis
- FIFO method
- Any fair or reasonable method

Size of writer position is NOT FAIR

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16
Q

Delivery After Exercise

A

Upon exercise of option, the parties are required to make settlement

Writer must either deliver or buy the stock within 2 business days from notification of exercise (same as T+1)

Settlement date for equity options is next business day or T+1

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17
Q

Intrinsic Value

A

In the money -
Call: CMV - Strike
Put: Strike - CMV

At the money -
Call and Put: Strike = CMV

Out of the money -
negative number
Call: Strike > CMV
Put: CMV > Strike

Intrinsic Value: amount a contract is in the money (CAN NEVER BE LESS THAN 0)

Options that have intrinsic value at expiration will be exercised

Intrinsic value is the same for buyers and sellers, buyers want intrinsic value, sellers do not

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18
Q

Time Value

A

At expiration the time value is 0

More time = more value

Premium = time value + intrinsic value

Time value = premium - IV

Time decay - value of option diminishes as it approaches its expiration date

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19
Q

Trading at Parity

A

Parity:
Premium = IV

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20
Q

If customer buys 100 shares of stock and writes 1 out of the money call against the long position, what is the breakeven point?

A

Cost of stock purchased less premium

100 * $50 = $5,000

Call premium = $100

$5,000 - $100 = $4,900 is the breakeven

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21
Q

Single Option Strategies

A

Buying Calls
Writing Calls
Buying Puts
Writing Puts

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22
Q

Reasons to buy a call

A

Speculation - Pay premium for the upside potential

Deferring a decision - Can buy a call and lock in a price allowing you to make a decision later for just the premium

Diversifying holdings - Can buy variety of stocks

Protection of Short Stock Position - insurance against rising prices

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23
Q

Short Call option strategies

A

Covered calls - own the stock and write a call option
can cover by either owning the stock, buying a call at a lower strike, or by a security convertible

Uncovered - write a call without owning the stock, naked short (unlimited loss potential)

Increasing returns - premiums add to the income

Speculation - profit if stock goes down

Locking in sale price - if you have a unrealized profit you can write a call to lock it

Protection of long position - limited downsize prevention from premium

Ratio call writing - selling more calls than long stock positions cover, generates income but has unlimited risk

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24
Q

2 strategies that have unlimited loss potential

A

short sale

writing uncovered call

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25
Long Put Strategies
speculation - profit from downward price only paying premium Deferring a decision - lock in sale price before expiration Protection of a long stock position - insurance or heding
26
Short put options
covered - short position already held, need to deposit cash into writers accounts ensures money will be there uncovered - just the short put Speculation - profit if stock price stays above strike by earning premium Increasing returns - source of income in the premium Buying stock below its current price - helps offset stock price if obligated to buy
27
Open Interest
Number of contracts outstanding, higher the open interest the more liquid the option is Interest begin to decline and expiration approaches
28
Put-Call Ratio
current open interest in trading of put option to call options Used as a gauge of consumer sentiment and can be calculated across indices Traded put options / Traded call options Higher the ratio, more bearish people are Lower the ratio, more bullish people are
29
Breakevens
Breakeven point is where investor neither makes or loses money BE for Call options = CMV + Premium BE for Put options = CMV - Premium
30
Spreads
Call spreads: one long call and one short call BE = net credit or debit + lower strike Put spreads: one long put and one short put BE = net credit or debit - higher strike Highest gain is difference between strikes Highest loss is difference between strikes BE is ALWAYS in between strikes
31
Straddles
Long straddle - want stock price to move up or down more than premium Short straddle - want stock price to stay within premiums BE = strike - both premiums paid OR strike + both premiums paid
32
Index Options
same as single stock options Sometimes can get more from the options by trading rather than exercising because there is still time value
33
Max Gains and Losses
Long Calls Max Gain - unlimited Max Loss - premium Short Calls Max Gain - premium Max Loss - unlimited Long Puts Max Gain - BE Max Loss - premium Short Puts Max Gain - premium Max Loss - BE
34
Investor buys 100 shares of CDL at $50, two months later it is selling for $48 when he writes 1 call at $45 for $4 premium If the option is called what is the max loss?
$100 BE = $5000 - $400 = $4,600 No matter how high it goes you would get $4,500 plus $400 of premium = $4,900 max loss would be $100
35
Debit Spreads
Debit Call Spread: - max gain is premium spread - max loss is debit Credit Call Spread: - max gain is net premium - max loss is strike difference - net premium Debit Put Spread: - max gain is lower strike - net premium - max loss is net premium Credit Put Spread: - max gain is net premium - max loss is difference in strike - premium
36
Straddles and Combos
Max gain of long straddle is unlimited Max loss is premium max gain of short straddle is premium max loss is unlimited
37
Long Stock Long Put
BE = current price + premium Total loss if dropping = CMV - strike + premium
38
Long Stock Short Call
BE = stock price - premium received Max loss = stock price - premium
39
Short stock long call
BE = current price - premium Total loss = cmv - strike + premium
40
Short stock short put
covered put
41
Most protection in hedging positions
Get call price very similar to shorting price
42
Price or Vertical Spread
Different strike prices but same expiration most common
43
Time or Calendar Spread
AKA horizontal spread different expirations dates but same strike prices hope to profit from stability
44
Diagonal Spread
differs in both time and price
45
Bull and Bear Spreads
Bulls always buy low and sell high
46
Debit and Credit Spreads
Debit if higher outflow than inflow Credit if higher inflow than outflow
47
Debit Call Spreads
Bullish investors use these to reduce the cost of a long option position but that limits the reward
48
Spread Question Help
Debit = widen = exercise (when you begin to widen you need to exercise) Credit = narrow = expire (when you get too narrow you may expire)
49
Credit Call Spreads
Reduce the risk of a short option position of a bear spread
50
Debit Put Spreads
Reduce the cost of a long put being bearish want spread to widen
51
Credit Put Spreads
Bullish use these to reduce risk of short position
52
Determining a Spread Investor's Market Attitude Bear or Bull
Attitude is determined by which option is more costly of the two Higher premium is where they are going Lower strike for calls and higher strike for puts
53
Strategies combining puts and calls
Straddles Combos Collars
54
Spreads
Those combine one type of options (2 calls or 2 puts)
55
Straddle
Call and a put with the same strike price and expiration Long straddles expect volatility in either direction Short straddles expect no movement and capitalize on the premiums (sell call and put with same strike and expiration)
56
Combination
Call and put with different strikes, expirations, or both Similar to straddles but people use them as a cheaper alternative
57
Collar
Used to protect unrealized gains in a long stock position cashless collar is where premium received on short call is same amount or higher than premium for long put
58
Three main types of non-equity options
Index Interest Rate Foreign Currency
59
Index Options
Broad based index tracks major index movement like S&P 100, 500, Dow Jones Narrow based index tracks market segments like tech
60
VIX
Measures implied volatility of S&P500 index options that trade on CBOE Reflect expectations of investors over market volatility over next 30 days, often referred to as a fear gauge VIX rises with more puts and falls with more calls
61
Index Option Features
Premium multiplier - use a multiplier of $100 to calculate options cost and options strike is multiplied by $100 to determine total dollar value of index Trading - settle on the next business day or T+1 Exercise - settles in cash rather than deliver of security and requires cash to be delivered T+1, writer of option delivers cash equal to intrinsic value of option to buyer, if option is in the money by 5 points then the owner can exercise and receive $500 from assigned seller Settlement price - settlement price is based on closing value of the index on the day of exercise, not value at time of trading Expiration Dates - expires third Friday of every month
62
Will you make more money closing a position rather than exercising?
YES, still has time value
63
Index Options Strategy
Portfolio insurance - hedge strategy Still subject to systematic risk
64
Interest Rate (Yield Based) Options
Interest rate options are yield based (have direct relationship to movements in interest rates) Based on yields of T-Bills, notes, and bonds strike price of 35 cents = yield of 3.5% each point is worth $100 Contract multiplier of $100 settlement is next business day in cash
65
Foreign Currency Options (FCOs)
Allow investors to speculate on performance of currencies other than US dollar or protect against fluctuating currency rates Features: cash settled in USD Contract sizes - small enough for retail investors Every currency has contract sizes of 10,000 expect for Japanese Yen, which is $1M Strike prices are quotes in US cents, Japanese Yen is quoted in 1/100 of a cent Premiums - quotes in cents per unit 2.5 = .025 Trading - 9:30-4:00 Expiration - third Friday of the month Settlement - next business day in cash Strategies - want the currency that you are buying from to NOT increase, so if it is increasing you want long calls
66
EPIC Rule
US exports buy puts Importers buy calls IPEC if flipped for international
67
Tax Treatment of Options
3 ways that you can handle an option Expiration Close Exercise
68
Expiration
Buyer loses premium and seller profits Buyer reports capital loss and seller reports capital gain in amount of premium LEAPS writers must report short-term capital gains at expiration LEAPS buyers report LT gain or losses if held for more than 12 months
69
Closing out
capital gain or loss equal to any price difference based on the premium that is either gained or lost
70
Exercise
EXERCISE ALONE DOES NOT CREATE A TAXABLE EVENT Exercise does not generate cap gain or loss until subsequent purchase or sale of stock occurs if long call is exercised, you buy the stock and basis includes premium and strike price long put will result in taxable event
71
Stock holding periods
options are not allowed to postpone sale of stock to generate LTCG, if holding period of a stock is 12 months or less before purchase of a put, gain will be ST
72
Married put
customer buys stock and put on that stock, it is married cost basis is adjusted upward by premium
73
Wash Sale Rule
30 days before or after
74
Tax Events
Expiration Buy call - capital loss Sell call - capital gain Buy put - capital loss Sell put - capital gain Exercised Buy call: (strike + premium = cost basis) Sell call: (strike + premium = sales proceeds) Buy put: (strike - premium = sales proceeds) Sell put: (strike - premium = basis)
75
New account formation
Customer must complete new account form and BD must seek the following info: - investment objectives - employment status - income - net worth - liquid net worth - marital status and dependents - legal age also includes: - investment experience - financial info - date of options disclosure document was given - type of transactions approved - retail or institutional - signature of RR - signature of ROP
76
Written approval by ROP
ROP must review and approve the account in writing before or at the initial trade once the new account form is completed Trading can take place while waiting for approval
77
When is the ODD disclosure document needed?
No later than at the time account is approved for options trading
78
Investment strategies and different levels of approval
may be 4 or 5 levels on what an investor can trade in options for uncovered calls or puts approval, need written procedures covering specific criteria approving it, minimum equity requirement, and requirement to provide special written document describing risk involved
79
Verification by customer
within 15 days of approval, firm must obtain from customer a signed written agreement that they will follow the rules if not received within 15 days, can only place closing trades If OCC revised the ODD, all existing accounts need the ODD no later than by the date the customer's next option transaction confirmation is delivered
80
Options Account Opening
Customer wants to trade options RR determines suitability OCC ODD is provided at or before account opening Option account is approved by ROP First trade may take place Option contracts are sold or bought Signed option agreement within 15 days Closing transactions only if not returned
81
Options contract adjustments
Adjustments are required for stock splits, reverse stock splits, stock dividends, and rights offerings but NOT cash dividends
82
Functioning of Listed Options Market
Exchange traded options are listed options that are standardized OTC options are called conventional options and are not standardized Most likely tested centers for options: CBOE NYSE Nasdaq Stock Market PHLX
83
Standard Features of Options Trading and Settlement
Trade from 9:30 to 4:00 pm ET where broad based index option trade until 4:15
84
Position Limits
Limits at 250,000 contracts on the same side of the market, applies across all accounts cannot jump in with another person to get over the position limit, that is acting in concert CBOE looks for control, indicating the ability to make investment decisions for an account or influence the investment decisions made for an account - all parties to JT account have authority to act on account - a person has authority to execute transaction in an account These will be acting in concert: - individual account or a JT - individual who has discretion over an account and account itself (third party) limit applies to each side, bull and bear side
85
Exercise limits
OCC exercise limits are max number of contracts that can be exercised on same side within a period of 5 business days no more than 250,000 contracts that can be exercised on one side
86
American and European Style
American - can exercise anytime European - can exercise on the final day
87
If the net spread would never result in a profit, can a principal approve the order?
NO
88
If I buy a stock at $153 and then get a put when the option is at $149, what do I add the premium to get the BE?
$153 BE gets added (call) or subtracted (put) from the original sale price
89
If I write calls and they expire worthless, what is my tax situation?
Short term gain
90
Yield based options expire when?
Last day of trading
91
If you are holding a stock and buy a put before the stock is at the 12 month mark, what is the tax treatment?
STCG selling a call does not have the same impact
92
Customer writes 2 puts at 2 and then the contracts are closed at a premium of 4 what is the gain/loss?
Loss of $400 Bought for $400 (2*200) Sold for $800 (4*200)
93
Does the premium reduce the gain of closing a position at a higher value?
YES If selling a call you bought for 50 at 62, with a 4 premium then the gain would be 8 * 100 = $800
94
If beta is 1.2 what does that mean in terms of how many puts to buy?
That means that it is 1.2 times riskier, so buy 1.2 times the amount of puts
95
If a call option has a stock dividend, what does that do?
Number of contracts stays the same but the strike price is reduced the number of shares per contract is increased but the contract size is the same
96
If i am in the US doing business in Canada, what am i position wise in terms of their currency?
I am long the Canadian dollar I am short the US dollar Need to buy long puts against the Canadian dollar to hedge my currency risk
97
If i buy a put on a long stock position before 12 months, what is my holding period?
STCG
98
Class of options
class = same type (calls) on the same security Series = same expiration and exercise price
99
2 Feb XYZ 40 Calls at 4 bought in August 2021 expire in what year?
2022 - Feb
100
If you exercise a call, does the premium cost get added to the basis?
YES Basis is (call price * shares) + basis
101
Buy a 100 long position at $83 in Oct 2020 Sell call at 85 for 3 in April At expiration, price of stock is at 90, what is the gain/loss?
long position = $700 LTCG sell call = $300 premium - $500 call price = $200 loss total is $500 LTCG
102
Does writing a call on a long position keep it as a STCG?
NO that is only with buying a long put with a long stock as STCG
103
What is listed on a listed yield based option?
OCC guarantees performance of option contracts
104
Long 70 put @4-1/4 Short 80 put @10 what is breakeven, max gain and loss?
BE = 10-4.25 = 5.75 BE = 80-5.75 BE = 74.25 Max gain = 575 Max loss = 425
105
Net debit of .8 is a cost of what for 1 option contact?
.8 * 100 $80
106
How do writers of T-Bill options deliver exercised option contracts?
Deliver cash equal to the intrinsic value of the contract
107
What protects a short May 90 put?
A long June 95 put
108
Ratio write
writing more calls than you have actual stock
109
Imports and options
US importers buy calls on foreign currency US Exports buy puts on foreign currency
110
For bull call spread or debit spread, do you want spread to widen or narrow?
Widen and stock price to rise above BE
111
person with 300 XYZ long position and short 30 call options on XYZ if in what position?
Ratio spread WAY many more calls positions (3,000) than he has stock in the position (300)
112
Approval of new options account may occur before when
customer verifies info on new account form
113
when must exercise instruction for options come into OCC
no later than 5:30pm ET on third Friday of expiration month
114
UK company exports sweaters to US and is paid in USD what do they buy to hedge currency risk?
buy British calls long USD, short British calls so you want to buy British calls
115
US company sells stereos, and imports them from Japan what do they buy to hedge currency risk?
buy calls on the Japanese Yens
116
If on the same day a customer buys a stock for $100 and a long put for $3 and the put goes unexercised, what is the cost basis?
Basis is $103 If bought on the same day the basis is "married" together
117

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