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Series 7 > unit 10 > Flashcards

unit 10 Flashcards

1
Q

option

A
  • 2 party contract that conveys a right to the buyer and an obligation to the seller
  • underlying security can be stock, stock market index, foreign currency, interest rate or govt bond - anything with a fluctuating value
  • called derivative security bc their value is derived for the value of the underlying instrument
  • typically each contract represents 100 shares of the underlying stock (mini options are 10 shares)
  • 3 specifications: underlying instrument, price, expiration
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2
Q

terms of the option contact

A
  • standardized by the Options Clearing Corporation (OCC)
  • this allows options to be easily traded on an exchange like the CBOE
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3
Q

option price

A
  • contract specifies the strike/exercise price a which purchase or sale of the underlying security will occur
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4
Q

option expiration

A
  • all contacts have a specified life cycle
  • once contract is issued it can be bought or sold any time during its lifecycle
  • length of time can be customized between buyer and seller when the contract first trades
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5
Q

standard contracts

A
  • issued with a 9 month expirations and expire on the 3rd Friday of the expiration month at 11:59pm ET.
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6
Q

long term equity anticipation securities (LEAPS)

A
  • max 39 months
  • most trade in 30 months
  • options that have an expiration greater than 1 yr
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7
Q

calls

A
  • buy calls (long Call): a call buyer owns the right to buy 100 shares of a specific stock at the exercise/strike price before the expiration if they choose to exercise. Could also sell the option. Pays premium.
  • write calls (short call): call writer is obligated to sell 100 shares of the specific stock at the exercise/strike price if the buyer exercises the option
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8
Q

puts

A
  • buy puts (long put): buyer owns the right to sell 100 shares of a specific stock at the exercise/strike price if they choose. Can also sell the option. Pays premium.
  • Sell puts (short put): put writer has the obligation to buy 100 share of the specific stock at the exercise/strike price is the buyer exercises the option
  • Buying a put (in or out of the money) on a stock held short term (one year or less) erases the holding period until the put is disposed of. At that time, the holding period starts over.
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9
Q

Options Clearing Corporation (OCC)

A
  • SRO
  • issuer of listed options contracts
  • owned by the exchanges that trade options
  • functions are to standardize, guarantee performance of, issue option contracts
  • determines when new options contracts go on the market
  • designates strike price and expiration for new contracts
  • does not determine premiums - supply and demand does
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10
Q

OCC assignment of exercised contracts

A
  • randomly selects a firm with a short position, then assigned BD picks a client to allocate the obligation to (random, first in first out, other method that is fair and reasonable)
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11
Q

notification of allocation method

A
  • BD must inform options customers how they allocate exercise notices/assignments and any consequences
  • size of the writers position is NOT CONSIDERED FAIR AND REASONABLE
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12
Q

in the money call

A
  • a call is in the money when the market price of the underlying asset exceeds the strike price of the option
  • buyers want options to be in the money, sellers do not
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13
Q

in the money put

A
  • a put is in the money when the market price of the underlying asset is less than the strike price of the option
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14
Q

at the money

A
  • call or put is at the money when the market price of the underlying asset equals the strike price of the option
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15
Q

out of the money call

A
  • when the market price is below the strike price
  • buyer will not exercise call
  • advantage to seller who keeps premium
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16
Q

out of the money put

A
  • when the market price is above the strike price
  • buyer will not exercise call
  • advantage to seller who keeps premium
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17
Q

intrinsic value

A
  • the same as the amt a contract is in the money
  • always a positive amt or zero
  • an option that has intrinsic value at expiration will be exercised or sold by the buyer
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18
Q

time value

A
  • option has time value anytime the option’s premium exceeds its intrinsic value
  • Amt an option buyer will pay (and seller accept) above an option’s intrinsic value
  • buyers would pay more for longer time to expiration
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19
Q

time decay

A
  • time value will diminish as the expiration date approaches
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20
Q

parity

A
  • when premium equals the intrinsic value
  • options trade at parity just before the expiration date
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21
Q

buying calls

A
  • want the underlying market price of the stock to rise
  • bullish
  • speculation - only pay premium for bet stock rises (form of leverage)
  • deferring a decision - lock in purchase price until the option expires. Only commitment is the premium
  • diversifying holdings - with limited funds you can buy calls on variety of stocks
  • protection of a short position - acts like insurance policy.
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22
Q

selling/writing/shorting calls

A
  • want the underlying market price of the stock to fall or stay the same
  • bearish or neutral
  • income strategy - looking to keep premium
  • speculations - often naked calls
  • locking in a sales price
  • protecting a long position - premium collected provides limited downside protection
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23
Q

covered call

A
  • when investor owns the # of shares covered by the option contract
  • can have actual stock or convertible security or with a long long call with the same or lower strike price with expiration no sooner than the short call
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24
Q

uncovered/naked call

A
  • when investor writes call without owning the stock or related assets that would enable the investor to deliver the stock should the option be exercised.
  • OCC will need cash deposit to ensure there are funds to buy the stock to deliver
  • unlimited potential risk of loss
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25
Q

ratio call writing

A
  • selling more call than the long position covers
  • generates additional premium
  • unlimited risk
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26
Q

long put options

A
  • bearish
  • investor can profit from a decrease in a stock’s price while investing a relatively small amt of money
  • speculation - lower risk than selling a stock short
  • deferring a decision - lock in sales price until expiration
  • protection of a long stock position - insurance policy against the stock declining in price
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27
Q

covered puts

A
  • to cover a put, one can take a short position in the stock underlying the short put or a cash covered put
  • obligation of the put writer is to pay the exercise price - need money
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28
Q

short puts

A
  • bullish or neutra
  • speculation
  • increasing returns
  • buying stock below its current price
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29
Q

open interest

A
  • put call ratio
  • number of option contracts oustanding
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30
Q

put call ratio

A
  • reflects current open interest
  • gauge investor sentiment

= #traded put options/# of traded call options

  • the higher the ratio, the more bearish investors are
  • could be contrarian indicator
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31
Q

spread

A
  • simultaneous purchase of one option and sale of another option of the same class
  • call spread: long call, short call
  • put spread: long put, short put
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32
Q

price/vertical spread

A
  • different strike prices but same expiration date
  • most common spread
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33
Q

time/calendar/horizontal spread

A
  • different expiration dates but same strike price
  • for investors who do not expect price volatility
  • hope to profit from the different rates at which the time values of the 2 options expire
  • out looks is neutral
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34
Q

diagonal spread

A
  • different expiration date and strike price
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35
Q

bull spread

A
  • when investor buys the option with the LOW strike price and sells the option with HIGH strike price
  • bulls buy low and sell high
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36
Q

bear spread

A
  • when investor buys the option with the HIGH strike price and sells the option with LOW strike price
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37
Q

debt spread

A
  • if the LONG option has a HIGHER premium than the short option
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38
Q

credit spread

A
  • if the SHORT option has a HIGHER premium than the long option
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39
Q

debt call spread

A
  • bullish
  • reduce the cost of a long option position
  • reward potential is limited
  • investor profit if option is exercised.
  • want net debt spreads to widen

debt = widen = exercise (when you begin to widen, you need to exercise)

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40
Q

credit call spread

A
  • bearish
  • reduce risk of a short option position
  • investor profits when option expires
  • want net credit spreads to narrow

credit = narrow = expire (when you become too narrow, you may expire)

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41
Q

debt put spread

A
  • bearish
  • used by investors to reduce the cost of a long position
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42
Q

credit put spread

A
  • bullish
  • reduce the risk of a short position
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43
Q

market attitude

A
  • determined by the which option costs the most (higher premium)
  • calls (lower strike price has the higher premium
    - debt if investor bough the option with lower strike price (bullish)
    • credit if the investor sold the option with the lower strike price (bearish)
  • puts (higher strike price has the higher premium)
    - debt if the investor bought the option with higher strike price (bearish)
    - credit if the investor sold the option with higher strike price (bullish)
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44
Q

straddle

A
  • call and put with same strike price and exercise date
  • can be long or short
  • used to speculate on price movement
45
Q

long straddle

A
  • when investor expects volatility in price but not sure what direction
  • BUYING a call and a put with the SAME strike price and expiration
46
Q

short stradde

A
  • when investor doesn’t expect much price movement
  • SELLING a call and a put with the SAME strike price and expiration
  • max profit is the 2 premiums
  • max loss is unlimited
47
Q

combination

A
  • call and put with different strike prices and expirations
  • cheaper to establish than long straddles if both options are out of the money
48
Q

collar

A
  • used to proceed unrealized gain on a long stock position
  • protect profit and limit upside potential
49
Q

cashless collar

A
  • where premium received on the short call is the same amt or higher than the premium paid for the long put
50
Q

index options

A
  • allow investors to profit from the movements of markets or market segments and hedge against market swings
51
Q

broad-based indexes

A

-track the movement of the entire market - S&P 100 (OEX)
- S&P 500 (SPX)
- major market index (MMI) - mimics dow jones industrial average

52
Q

narrow-based indexes

A
  • track the movement of market segments in a specific industry
53
Q

volatility market index (VIX)

A
  • idea measures the implied volatility of the S&P 500 options traded on the CBOE.
  • designed to reflect investor expectations of market volatility over the next 30 days
  • fear gauge /index
  • measure of the expectation (fear) that the market will be volatile
  • expectation of greater volatility generally translate into higher premiums for options contracts
  • VIX rise when put option buying increases (a contrarian signal)
  • VIX decreases when more calls than puts are being bought
54
Q

premium multiplier

A
  • $100
  • option’s cost = premium x $100
  • total dollar value of the index = strike price x $100
55
Q

trading

A
  • settle on next business day (t+1)
  • broad index base options stop trading at 4:15pm ET
  • narrow based index options stop trading at 4:00pm ET
56
Q

exercise

A
  • settles in cash
  • cash equal to the intrinsic value need to be delivered on next business day (T+1)
  • computed on the basis of the closing value of the index on the day the option is exercised
57
Q

settlement price

A
  • settlement price is base on the closing value of the index on the day of exercise
58
Q

expiration date

A
  • expires on the third Friday of the expiration month
59
Q

portfolio insurance

A
  • using index puts to hedge portfolio risk
60
Q

systemic risk

A
  • potential for a security to decrease in value, winning to its inherent tendency to move together with all securities of the same type.
  • diversification and investment strategy cannot eliminate this risk
61
Q

interest rate (yield based) options

A
  • interest rate options are yield base - they have a direct relationship to movements in interest rates
  • these options are based on yields of T-bills, T-notes and T-bonds
  • allow investors to bet on movement of interest rates (not prices)
  • 1 point = $100 (multiplier)
  • settlement is next business day in cash
  • if PM thinks rates will fall, they will buy puts or write calls.
  • if PM thinks rates will rise, they buy calls and write puts
62
Q

foreign currency options (FCOs)

A
  • allows investors to speculate on the performance of currencies other than the USD or to protect against fluctuating currency exchange rates against USD
  • available for trading on US listed exchanges: AUD, GBP, CAD, Swiss franc, Euro, Yen
  • all have contract size of 10,000 units except the Yen which is 1mm
  • importers and exporters use to hedge FX risk
  • settled in USD on the next business day
63
Q

FCO strike price

A
  • quoted in US cents, except Yen which is 1/100th of a cent
64
Q

FCO premium

A
  • quoted in cents per unit
  • 1 point of premium = $100
  • total premium of contract = premium x # of units
65
Q

FCO trading

A
  • primarily traded on the Nasdaq OMX PHLX (philly stock exchange)
  • 9:30am to 4pm ET
66
Q

FCO expiration date

A
  • expire on the third Friday of the expiration months
67
Q

breakeven

A
  • point at which investor neither makes or loses money
  • with spreads, breakeven is a number between the two strike prices
68
Q

call options - breakeven

A

call breakeven = strike price + premium

Call UP

  • profitable for call buyer above breakeven
  • profitable for call seller below breakeven
  • to find breakeven on call spread: add the net premium to the lower strike price
69
Q

put options breakeven

A

put breakeven = strike price - premium

Put DOWN

  • profitable for put buyer below breakeven
  • profitable for put seller above breakeven
  • to find breakeven on put spread: subtract the net premium to the higher strike price
70
Q

long call max gain

A
  • unlimited
71
Q

long call max loss

A
  • risk 100% of premium paid
72
Q

short call max gain

A
  • limited to premium received
73
Q

short call max loss

A
  • unlimited
74
Q

long puts max gain

A

strike price - premium

75
Q

long put max loss

A

premium paid

76
Q

short put max gain

A

premium

77
Q

short put max loss

A

strike price - premium

78
Q

debt spread

A
  • investor wants the difference between the premiums to widen
79
Q

credit spread

A
  • investor wants the difference between the premiums to narrow
80
Q

debt call spread

A

-max gain = strike price spread - debit paid
- max loss = debit

81
Q

debt put spread

A
  • max gain = difference between the two prices - net premium (debt)
  • max loss = net premium (debt)
82
Q

credit call spread

A
  • bearish investors sell calls and call spreads
  • max gain = net premium
  • max loss = difference between the strike prices - the net premium
  • breakeven = lower strike price + net premium
83
Q

credit put spread

A
  • bullish investors sell puts and put spreads
  • max gain = net premium
  • max loss is the difference between the strike prices - the net premium
  • breakeven = lower strike price - net premium
84
Q

closing position

A
  • can sell a long position (closing sale)
  • or buy back the short position (closing purchase)
85
Q

long stock, long put (protective put)

A
  • protect long position
  • most often used with equity positions or index options to protect the whole portfolio
  • protects gains
  • max gain is unlimited
86
Q

long stock, short call (covered call)

A
  • protect long position
  • limited risk protection, not as much protection as a protective put
  • limits max gain
  • neutral to slightly bullish investor
  • normally done in a stable market
87
Q

short stock, long call

A
  • provides partial downside protection
88
Q

short stock, short put

A
  • offers limited protection
89
Q

option expiration

A
  • LEAPS writers must report short term capital gains even if they held the contract for more than 12 months
  • LEAPS buyers will report long term capital losses/gains if held for more than 12 months
90
Q

Long-Term Equity Anticipation Securities (LEAPS)

A

Publicly traded options contracts with expiration dates that are longer than one year

91
Q

closing out an option

A
  • Closing sales or purchases generate a capital gain or loss equal to any pay difference
92
Q

exercise an option

A

results in capital gain or loss

93
Q

married put

A
  • when on the same day, customer buys stock and buys a put option on that stock as a hedge
  • cost basis is adjusted upward by the premium paid
94
Q

new account form

A
  • needed to open options account
  • includes:
    • investment objectives
    • employment
    • est annual income
    • net worth
    • liquid net worth
    • martial status and dependents
    • legal age
  • might include:
    • investment exp
    • sources of fin and background info
    • date the options disclosure doc was provided
    • types of transactions the customer can do
    • retail or institutional
    • sig of reg rep and principal
  • Principal or branch manager must review and approve the account in writing t or before the initial trade
95
Q

levels of approvals for option accts

A
  • might need additional approvals to write options, uncovered options, ratio writing, spreads and straddles, etc
96
Q

customer option agreement

A
  • customer must returned signed copy of option agreement within 15 days of account approval
  • if not signed the firm can only permit closing transaction
97
Q

option contact adjustments

A
  • adjustments need to made for stock splits, reverse stock splits, stock dividend and rights offerings
  • no adjustment for dividends
  • adjustments to the # of shares are rounded DOWN to the next whole share
98
Q

even stock splits

A
  • new options contracts are created
  • even splits end in 1 (X:1)
99
Q

uneven (fractional) stock split

A
  • does NOT create new options contracts
  • stock dividends are treated as uneven splits - number of contracts remains the same, strike price is adjusted and the contract now covers more share
100
Q

trading options

A
  • traded most commonly on: CBOE, NYSE, Nasdaq, PHLX
101
Q

listed options

A
  • traded on an exchange
  • standardized exercise prices and expiration dates
102
Q

OTC options

A
  • called conventional options
  • not standardized
  • not much activity in secondary market bc contract terms are individually negotiated
103
Q

standard features of listed options

A
  • trade from 9:30am to 4pm ET (except for index options that trade until 4:15pm ET)
  • latest time for exercise is 5:30pm ET
  • expire on the 3rd Friday of the month at 11:59pm ET
  • settle on T+1 (stocks delivered as a result of exercise settle on T+2)
  • automatic exercise
104
Q

automatic exercise

A
  • any contracts that are at least 0.01 in the money are automatically exercised unless other instructions have been given
105
Q

position limits

A
  • 250,000 contracts on the same side of the market (bull side - long call and short puts; bear side - short calls and long puts)
  • applies to: individuals, reg reps acting for discretionary accts, and individuals acting in concert (determined by control relationship)
106
Q

exercise limits

A
  • max number of contracts that can be exercise on the same side of the market within a specified period
  • 5 consecutive BDs
107
Q

American style options

A
  • can exercised anytime before expiration
108
Q

European style options

A
  • can only be exercised on the expiration day (last day of trading)
109
Q

decay risk

A

Time decay is the loss of time value as an option nears its expiration date. At the expiration date, the time value is zero. The only value to the option is intrinsic value, if any.

Series 7 (19 decks)

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