Positions which allow an investor to limit losses in exchange for limiting gains - Created with the sale and purchase of two options of the same class, but different series ^ Class: options of the same type on the same underlying security ^ Series: options of the same class, same expiration, and same strike price - Spreads may be either bullish or bearish and either debit or credit

Options Flashcards by Barrett Cooper

Options Overview: The Owner

The Owner

Buyer
^ Long the option
^ Pays the premium
^ Acquires a right/control

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Options Overview: The Writer

The Writer

Seller
^ Short the option
^ Receives the premium
^ Assumes an obligation

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Buy 1 ABC June 50 Call at 5

Pay $500 for the right to buy 100 shares of ABC at $50/Share up until the third Friday of June.

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When are Calls in the money and out of the money?

Calls:
^ In the money if the market price is above strike
price
^ Out of the money if the stock is below the strike
price

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When are Puts in the money and out of the money?

Puts:
^ In the money if the market price is below the strike
price
^ Out of the money if the market price is above the
strike price

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Phone Analogy for when an option is in the money

You call someone and they can put down the receiver.

Call up
Put down

If the call is above the strike price, in the money
If the put is below the strike price, in the money

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Intrinsic Value

The concept of INtrinsic value is tied to options that are IN-the-money

Intrinsic value is the amount by which an option is in-the-money

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An option’s premium

Premium = Intrinsic Value + Time Value

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Time Value is based on

Time left until expiration

Market volatility

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The OCC and Options Trading

The options clearing corporation:

Eliminates counter party risk by acting as the third
party in all option transactions
^ Acts as the buyer for all sellers and the seller for
all buyers
Deals directly with B/Ds, not customers

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Four Key Concepts for Basic Options

Strategy
a. For option BUYERS, remember the phrase
“CALL UP and PUT DOWN”
i. Buyers of Calls are BULLISH
ii. Buyers of Puts are BEARISH
b. Sellers are the opposite (Sellers of Calls are
BEARISH and Sellers of Puts are BULLISH)
Breakeven
a. To find the stock price (value) at which an
investor will breakeven, remember the
phrase “CALL UP and PUT DOWN”
i. For Calls, strike price + premium (CALL
UP)
ii. For Puts, strike price - premium (PUT
DOWN)
Maximum Gain
a. For SELLERS of options, the PREMIUM
received represents the MAXIMUM GAIN
b. For BUYERS of Calls, the maximum gain is
UNLIMITED (since a stock’s rise is
unlimited)
c. For BUYERS of PUTS, the maximum gain is
realized if the stock falls to zero (i.e., strike
price - premium * 100 shares)
Maximum Loss
a. For BUYERs of options, the PREMIUM paid
represents the MAXIMUM LOSS
b. For SELLERS of Calls, the maximum loss is
UNLIMITED (since a stock’s rise is
unlimited)
c. For SELLERS of Puts, the maximum loss is
realized if the stock falls to zero (i.e., strike
price - premium * 100 shares)

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Random Questions:

- Market price above strike price 
- Premium - intrinsic value 
- Increase in the number of contracts, but the 
      shares in the contract stay the same 
- Required document when opening an options 
      account 
- Strike price + premium
    - Strike price - premium

- Market price above strike price
	○ CALLS in-the-money and PUTS out-of- 
           money  
- Premium - intrinsic value 
	○ Time value
- Increase in the number of contracts, but the 
  shares in the contract stay the same
	○ Even split adjustment  
- Required document when opening an options 
  account 
        ○ Options disclosure document 
- Strike price + premium
        ○ Breakeven for long and short calls
- Strike price - premium 
	○ Breakeven for long and short puts

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Straddles and Combinations

Created by either:
^ Buying both a call and a put on the same underlying
security. Or,
^ Selling both a call and a put on the same underlying
security

Strategy:
^ Long straddle or combination: VOLATILITY
^ Short straddle or combination: STABILITY

Straddle:
^ Same expiration months and strike prices

Combination:
^ Different expiration months and/or strike prices

If an investor has one option component and adds another to create a multiple option position, he is considered to have legged into the position.

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Uncertain of the direction in which ABC stock is going to move, an investor:

Buys 1 ABC Jun 40 Call at 3
Buys 1 ABC Jun 40 Put at 2

Breakeven points:
Strategy:
Max gain:
Max loss:

The total (combined) premium is 5

Breakeven Points:
^ 40 + 5 = 45 and,
^ 40 - 5 = 35

Strategy:
  ^ Volatility
Maximum Gain:
  ^ Unlimited 
Maximum Gain:
  ^ $500 Premium

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Believing that ABC’s stock price will remain flat, an investor:

Sells 1 ABC Jun 40 Call at 3
Sells 1 ABC Jun 40 Put at 2

Breakeven points:
Strategy:
Max gain:
Max loss:

The total (combined) premium is 5

Breakeven Points:
^ 40 + 5 = 45 and,
^ 40 - 5 = 35

Strategy:
  ^ Stability
Maximum Gain:
  ^ $500 Premium 
Maximum Gain:
  ^ Unlimited

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Spreads

Positions which allow an investor to limit losses in exchange for limiting gains

Created with the sale and purchase of two options of
the same class, but different series^ Class: options of the same type on the same
underlying security
^ Series: options of the same class, same expiration,
and same strike price
Spreads may be either bullish or bearish and either
debit or credit

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Different types of Spreads

The difference in the series is what identifies them

- Price/Dollar/Vertical Spread 
  ^ Buy 1 ABC Jun 40 Call
  ^ Sell 1 ABC Jun 50 Call
- Time/Calendar/Horizontal Spread 
  ^ Buy 1 XYZ Dec 40 Call
  ^ Sell 1 XYZ Sep 40 Call
- Diagonal Spread 
  ^ Buy 1 DEF Sep 40 Put
  ^ Sell 1 DEF Mar 30 Put

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An investor who is moderately bullish on XYZ stock, but wants to minimize the cost of establishing the position, does the following:

Buys 1 XYZ Feb 80 Call at 3
Sells 1 XYZ Feb 90 Call at 1

Spread Rules:
Net Premium:
Buyer or Seller:
Debit or Credit:
Widen or Narrow:
Breakeven:
Bull or Bear:
Max Gain:
Max Loss:

Spread Rules: The breakeven must be between the
strikes
The max gain PLUS the max loss will equal
the difference in the strike prices
Net Premium: $200
Buyer or Seller: Buyer
Debit or Credit: Debit (we are paying out the premium)
Widen or Narrow: Widen
^ Just memorize: Debit = Widen, Credit = Narrow
(5 Letters) (6 Letters)
Breakeven: 80 + 2 = 82
Bull or Bear: Bullish
Max Gain: $800
Max Loss: $200 Net Premium

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An investor who is moderately bullish on XYZ stock, but wants to minimize the risk of a short position, does the following:

Sells 1 ELG Nov 95 Put at 8
Buys 1 ELG Nov 80 Put at 1

Spread Rules:
Net Premium:
Buyer or Seller:
Debit or Credit:
Widen or Narrow:
Breakeven:
Bull or Bear:
Max Gain:
Max Loss:

Spread Rules: The breakeven must be between the 
                         strikes 
                         The max gain PLUS the max loss will equal 
                         the difference in the strike prices 
Net Premium: $700
Buyer or Seller: Seller
Debit or Credit: Credit
Widen or Narrow: Narrow 
Breakeven: 95 - 7 = 88
Bull or Bear: Bull
Max Gain: $700
Max Loss: $800

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Spreads - Bull/Bear, Debit/Credit, Widen/Narrow?

Buy an XYZ Nov 90 Call
Sell an XYZ Nov 80 Call

Write an ABC Mar 35 Put
Buy an ABC Mar 40 Put

Short a JMK Oct 75 Call
Long a JMK Dec 75 Call

Buy an XYZ Nov 90 Call
Sell an XYZ Nov 80 Call
(Bearish, Credit, Narrow)
- For CALL spreads, the dominant leg is always 
  determined by the LOWER strike

Write an ABC Mar 35 Put
Buy an ABC Mar 40 Put
(Bearish, Debit, Widen)
- For PUT spreads, the dominant leg is always 
  determined by the HIGHER strike

Short a JMK Oct 75 Call
Long a JMK Dec 75 Call
(Debit, Widen)

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Butterfly Spreads

What insect has a short body, but two long wings?

A combination of two spreads - one is a debit and one is a credit
^ Can be created with either calls or puts

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Main thing to know about Butterfly Spreads

The maximum gain is at the middle strike price

Different purposes for utilizing options

Speculation
- Options can be purchased or sold to generate a
profit
- In this case, the investor has no existing position
in the underlying security
○ Long Calls and Short Puts are bullish
○ Long Puts and Short Calls are bearish

Hedging
- To hedge (protect) an existing stock position, an
investor could BUY an option
○ Long Puts may be used to protect the
downside risk of a long stock position
○ Long Calls may be used to protect the
upside risk of a short stock position

Generate Income
- To generate income on an existing stock
position, an investor could SELL an option
○ Short Calls may generate income on long
stock positions
o Short Puts may generate income on short
stock positions

If you’re Long stock position and you want to protect it:

If you’re Long stock position and you want to generate income:

If you’re Short stock position and you want to protect it:

If you’re Short stock and you want to generate income:

If you’re Long stock position and you want to protect it:
- Buy a Put

If you’re Long stock position and you want to generate income:
- Sell the Call

If you’re Short stock position and you want to protect it:
- Buy a Call

If you’re Short stock and you want to generate income:
- Sell the Put

Covered and Uncovered Positions

* Uncovered options are done in margin accounts, not cash accounts* * Covered options can be done in margin or cash accounts* Covered call is when you own the underlying stock Uncovered call is when you do not own the underlying stock

Stock and Option Positions - To protect (or hedge) stock in a volatile market: - To generate income in a stable market:

- To protect (or hedge) stock in a volatile market: ○ Long Stock + Long Put ^ If the stock decreases, the value gained on the put can offset the loss on the stock ○ Short Stock + Long Call ^ If the stock increases, the value gained on the call can offset the loss on the stock - To generate income in a stable market: ○ Long Stock + Short Call (Covered Call) OR, ○ Short Stock + Short Put (Covered Put) ^ For both positions, if the stock remains stable, the options will expire and the premiums will be retained ^ However, for the Covered Put, the upside risk is unlimited

If the test asks, "You're short stock - how do you protect it"?

The better option is buying the Call. - You can Short a covered put, but if the stock rises - you'll only get the premium from selling the put. Because you're short stock, you have unlimited upside risk if the stock rises.

Ratio Call Writing

A position that consists of a long stock position, but more calls written than the number of shares owned. If you write more calls than shares that you own, it will have unlimited risk

Index Options

Provide the opportunity to speculate on, or hedge against, the movement of the market, rather than the movement of a specific stock Broad-based Index: ^ Reflects performance of the entire market Narrow-based Index: ^ Reflects performance of a particular sector

Volatility Index (VIX) Options

The VIX is a barometer of investor sentiment and expected market volatility ^ Based on the S&P 500 index options

How would you use the VIX

When does volatility tend to increase? - When the market drops abruptly If an investor believes the S&P 500 Index will fall in value, an investor may: - Buy VIX Calls

World Currency Options

Proved the opportunity to speculate on, or hedge against, the movement of exchange rates on foreign currencies compared to the U.S. dollar There's no options on the U.S dollar - it just compares them to the U.S. dollar

Buying a foreign currency put

You are a U.S. exporter and will be paid in a foreign currency. You will have to convert the foreign currency to the U.S. dollar when you receive the payment. Your fear is that the value of the foreign currency will drop, so you buy a put to hedge against that risk.

Buying a foreign currency call

You are a U.S. importer and will pay the foreign country with their currency. Your fear is that the foreign currency will go up and cost you more when you have to obtain the currency upon delivery of the imports. So, you buy a call to hedge the risk against your fear.

Interbank Market

This is where currency spot prices are established. The Interbank Market: ^ Has unlimited trading hours (spot trades) ^ Is unregulated and decentralized Currency options trade on philly market

World Currency Option Multiplier

$100

Yield-Based Option Strategies

Preferred stock and bond prices and yields are inversely related: ^ When anticipating a fall in bond prices, an investor expects a rise in bond yields ^ When anticipating a rise in bond prices, an investor expects a fall in bond yields

If an investor believes: Yields will decrease, they should If an investor believes: Yields will increase, they should

If an investor believes: Yields will decrease, they should ^ Buy yield-based puts or ^ Sell yield-based puts If an investor believes: Yields will increase, they should ^ Buy yield-based calls or ^ Sell yield-based puts

Option Taxation: - Expire Worthless - Liquidated, Offset, Closed-Out - Exercised

Option Taxation: - Expire Worthless ^ Capital gain for the seller, capital loss for the buyer ^ Generally S/T gain/loss ^ Unless, if a LEAPS is purchased and held for more than one year - Liquidated, Offset, Closed-Out ^ Usually S/T gain/loss (compare premiums, difference is gain or loss) ^ Unless if you purchase and held a LEAPS for more than a year - Exercised ^ The option premium will not generate a gain or loss ^ To calculate the cost basis or sales proceeds: * Of an exercised call, the premium is added to the strike price (i.e., CALL UP) * Of an exercised put, the premium is subtracted from the strike price (i.e., PUT DOWN)

An investor is long one ABC Jun 90 Call at 4. If the option is later exercised, the investor will have a basis of _________

$9400 $9000 for the stock $400 for the premium

An investor owns 100 shares of XYZ at $42 per share and sells an XYZ Dec 40 Call for 3. If the call is exercised, what are the investor's sales proceeds for tax purposes?

$4,300 The cost of the stock when the investor purchased it is irrelevant. The question is asking what the investor's sales proceeds were.

An investor is long a DEF Feb 45 Put at 3. If the option is alter exercised when DEF is at 40, the investor will have proceeds of _______

$4,200 Remember, call up - put down It's a put, so subtract the premium from the proceeds

Puts and Holding Periods: Stock Holding Periods

If a stock's long-term holding period is not yet established: ^ The purchase of a put terminates the holding period for the stock ^ The holding period begins anew only after the put expires or is closed out If a stock's long-term holding period is already established, a put purchase does not change it (it remains long-term)

Puts and Holding Periods: Married Put

A put purchased on the same day that stock is purchased ^ The holding period for the stock starts on the purchase date ^ The premium paid becomes part of the stock's basis, even after expiration

A straddle involves

Buying or selling both a call and put on the same underlying security, with the same strike price, and the same expiration date

The breakeven on a straddle is found by ______________ and _______________ from the strike price

The breakeven on a straddle is found by adding the total premiums and subtracting the total premiums from the strike price

Vertical spreads have _____________, but __________

Vertical spreads have different strike prices, but the same expiration dates - and vice versa

For vertical spreads, the difference in the strike prices equals the ________________

For vertical spreads, the difference in the strike prices equals the maximum gain + maximum loss

A debit put spread is _________ and the investor wants the spread to __________

A debit put spread is bearish and the investor wants the spread to widen

Long calls are used to hedge ___________ and short calls generate income on ___________

Long calls are used to hedge short positions and short calls generate income on long positions

A VIX call will likely become valuable after the market _______

A VIX call will likely become valuable after the market falls

If an investor believes bond prices may be falling, she may want to purchase __________

If an investor believes bond prices may be falling, she may want to purchase yield-based calls

The holding period on stock and a put on the stock will run concurrently if the two are

The holding period on stock and a put on the stock will run concurrently if the two are married (bought on the same day)