What are the three possible tax consequences of options trading?
- The option can expire, in which case the premium is lost
- The option can be sold, possibly creating a capital gain or capital loss
- The option is exercised and the investor takes delivery of stock
What must be received by the customer before the first options trade can be accepted?
Options Disclosure Document
Within how long after the account opening must the signed options agreement be returned by the customer?
What are the basics of equity options?
An option gives the owner the right, but not the obligation, to buy or sell 100 shares of the underlying security at some price, at some point in the future.
The price is called the strike, the right to buy is a "call," and the right to sell is a "put". Investor can both be long or short both calls and puts.
What are the reasons an investor would buy a call option?
- Because they are bullish on the stock and think the price will increase
- It is less expensive than buying the underlying shares (the investor is paying the premium rather than the cost of actually purchasing the stock)
- To hedge a short stock position
What is the meaning of an options contract that states:
Buy 2 XYZ Oct 40 Calls @ 3
Buy means the investor is taking a long position in the contract and thus they will have the right to do something
2 reflects the number of contracts. Standard options contracts have 100 shares per contract. Thus in this example, 2 contracts each worth 100 shares for a total of 200 shares in this particular example
XYZ is the security the investor is speculating on
Oct is the expiration month. Most options contracts are issued with a 9 month expiration
40 is the strike price, which is where the investor has the right to exercise the contract
Call is the class, which gives the investor the right to buy the stock at the strike price
@3 is the premium, which is the cost of the contract. In this case, for the right to buy XYZ at $40 per share, the investor is paying a cost of $3 per share x 100 shares per contract x 2 contracts ($600 in total in this example)
What does being short one IBM July 30 Call mean?
The investor has an obligation to sell IBM stock at $30 if the option is exercised by the buyer between now and the expiration date of July
Under what circumstances would an investor exercise a Jan 30 IBM call?
If the shares are trading above 30 at the time the option expires, the investor would want to take advantage of their right to buy the shares at 30.
How much will investors pay in for a contract trading at a premium of $1.50 per share?
Option contracts typically represent 100 shares per contract. Therefore, the premium of $1.50 per share is multiplied by 100 to arrive at the cost of $150 for the contract.
Under what circumstances would you want to exercise a Jan 30 IBM put?
A put gives the owner the right to sell 100 shares of IBM stock at $30 per share. This investor would want to exercise their option if the shares were trading lower than 30 in order to sell the stock for more than it is actually worth.
When do options expire?
Options expire on the third Friday of the month.
What is the difference between a buyer and a seller of an option?
Buyers of options
- They are owners and open long positions (buying a call or buying a put)
- Buyers have a right to do something
- Pay a premium for that right
Sellers of options
- They are writers and open short positions (selling a call or selling a put)
- Sellers have an obligation to do something
- Receive a premium for that obligation
What are the four single options positions?
- Buy a put - a right to sell stock
- Sell a put - an obligation to buy stock
- Buy a call - a right to buy stock
- Sell a call - an obligation to sell stock
What are the attitudes of the four single options positions?
- Buy Put - Bearish View
- Sell Put - Bullish View
- Buy Call - Bullish View
- Sell Call - Bearish View
What does in-the-money refer to?
In-the-money means that the option is exercisable by the buyer of the option. Calls are in-the-money when the market value is above the strike price and puts are in-the-money when the market value of the stock is below the strike price.
At expiration, do buyers and sellers of options want the option to be "at", "in" or "out" of the money?
- Sellers want to collect the premium and have the option remain unexercised - this means they want out-of-the-money options at expiration
- Buyers want to have in-the-money options at expiration so they exercise there option
Knowing if an option is in or out of the money is important, but knowing by how much is even more important. What is this called?
The amount of money by which the option is in-the-money is called its intrinsic value. For example, if a call option has a strike price of $50 and the stock is trading at $60, the intrinsic value would be the in-the-money amount of $10. Remember, calls are in-the-money when the market value is above the strike price. If an option is out-of-the-money, then intrinsic value is zero (it cannot be negative).
What two components make up the premium of an option?
Premium = Time value + Intrinsic Value
- Intrinsic value is the in-the-money amount of the option
- Time value reflects the amount of time remaining until expiration
How does an investor calculate the breakeven point of a call option?
Add the premium to the strike price.
If you buy 1 Jan 30 IBM call at $2.25, the breakeven is $32.25. At that market value, the investor's gain on the option is offset by the loss on the premium. Remember, CALL UP
What is the breakeven for a customer who has sold 1 Feb IBM 30 calls at $2.45?
Add the premium to the strike price.
If you buy 1 Jan 30 IBM call at $2.45, the breakeven is $32.45. At that market value, the investor's loss on the option is offset by the gain on the premium. Remember, CALL UP
Which direction do owners of calls or puts want the stock price to be in comparison to breakeven?
The owners of a call will spend premium on the call so they want the stock to trade above the breakeven price. For puts the opposite is true. For owners of puts they want the stock to trade below the breakeven.
What are the basic styles of option expiration?
American and European
- American style can be exercised at any time prior to expiration
- European style can be exercised only at expiration
What does it mean to close an options position?
Closing an options position, means that the investor is liquidating position. If they initially bought an option, they will now sell it to close their position. If they initially sold an option, they will not buy it back to close their position.
What purpose does the Options Clearing Corporation serve?
The OCC issues and guarantees all options contracts. In doing so, they ensure the financials of the contract, which protects against default risk.
How does the OCC handle option exercises?
The OCC randomly assigns exercise notices to clearing firms, who then pass the notice along to a broker dealer, who then assigns to the customer in theory on a random basis.
Do options carry a prospectus?
But they do carry the Options Clearing Corporation options disclosure document, which includes information about the risks of options trading.
What is the maturity of an options contract?
Most options are set up by the OCC to expire nine months after issuance. Some contracts, known as LEAPs options, have an expiration of longer than nine months.
How does the OCC limit the risk of the options market for investors?
Position limits refer to the maximum number of contracts an investor can have on each side of the market (bull versus bear). These are set for each individual security.
What specific set of documentation is required to be provided to an investor prior to opening an options account?
Options clearing corporation disclosure document
This details the basics of options trading and outlines the risks.
Who must approve all new option accounts before a customer starts trading?
Someone who has passed the series 4 - a registered options principal - must approve the account before trading can begin.