Series 7, Chapter 3 - Equity Options

Front 1

An option is...

Back 1

An option is a right that a seller gives to a buyer, in exchange for a premium, for a limited amount of time.

An option is "a side bet"

The buyer always is in the driver's seat and has the choice.

The seller is in the passenger seat and is obligated to go wherever the driver goes

Front 2

Call Option

Back 2

A call option gives the buyer the right to purchase or "call" 100 shares of the underlying stock from the seller.

A call option also obligates the seller to sell 100 shares of the underlying stock to the buyer

Front 3

Put Option

Back 3

A put option gives the buyer a right to put 100 shares of the underlying stock to the seller.

A put option also obligates the seller (writer) to buy 100 shares of the underlying stock from the buyer.

Front 4

Options- 2 sets of 3 Terms

Back 4

THESE TERMS ARE INTERCHANGEABLE WHEN YOU ARE DEALING W OPTIONS

BUYER / HOLDER / LONG

SELLER / WRITER / SHORT*

*Short doesn't mean borrow. Short simply means SELLING when dealing w options.

Front 5

An investor Buys 1 ABC May 50 Call @ 4

Back 5

Buys - Action
1 - # of contracts
ABC - symbol

(symbol will usually match the underlying security)

May - Month option expires

50 - Strike or Exercise price

Call - Type (Call or Put)

@4 - Premium you pay to buy the option

Front 6

Exercise or Strike Price

Back 6

The guaranteed or set price at which the holder of an option can buy (call) or sell (put) the underlying stock.

Front 7

Shares Per Contract (Option)

Back 7

One standardized option contract represents 100 shares of common stock. It can be more than 100 if there is a stock dividend or split, but assume 100 unless told otherwise.

Front 8

Duration of Option Contracts

Back 8

A standard or traditional option has a maximum expiration of 9 months from the time it is created.

Front 9

Premium (Options)

Back 9

Premium - the price at which an option contract trades. The premium is paid by the buyer of the option and received by the seller.

A premium quoted @ 4 means the buyer pays $4.00 for each common share. Since Standardized options are lots of 100. 4 x 100 = 400. The buyer would pay $400.

Front 10

Under the Options Positions Limit Rule...

Back 10

The investor is only allowed to have so many options contracts in their account at the same time IF the options contracts are on the same side of the market.

Any question about options positions limit rules - think same side of market.

Front 11

Basic Facts of the Home Base Chart
(Fill in the blank)

Back 11

1. Buyers of options are always the DRIVERS. - exercise

2. Sellers of options are always the PASSENGERS - obligated.

3. Only SELLERS/PASSENGERS of options have to be worried about being covered or uncovered.

4. A SHORT COVERED CALL is the most conservative options position.

5. A SHORT NAKED CALL is the most speculative options position. - loss potential is unlimited.

6. An investor seeking INCOME or an INCREASED RATE OF RETURN - will always be a WRITER of options contracts

7. An investor seeking MAXIMUM profit or MAXIMUM protection is always the buyer of the option.

Front 12

Put options have both profit and loss potentials that are

Back 12

Limited

Front 13

Hedging

Back 13

"Protecting"

You put a hedge on the opposite side of the market as your original position

TO LIMIT YOUR RISK

Front 14

The Two Sides of the Market Are

Back 14

Bull / Bear

Bull - long call / short put

Bear - short call / long put

Front 15

How to Hedge

Back 15

Long puts hedge long stock positions

Long calls hedge short stock positions

Investors don't sell options to hedge. Hedging requires driving

Front 16

Reasons you may want to buy a call

Back 16

1. Allows the investor to participate in the UPWARD movement of a stock's price.
2. Unlimited upside profit potential.
3. Limited loss potential.
4. Diversification - can buy many options for the price of one stock.
5. Secures a future price in today's market.
6. Hedges a short sale.

Front 17

Possible Actions of the buyer of a call.

Back 17

Exercise and buy the stock

Sell the option and close the position

Let the option expire and lose the premium

Front 18

Opening Purchase

Back 18

First transaction an investor makes

Front 19

Close the position

Back 19

Getting rid of the option in the open market.

Front 20

Reasons you may want to write a call

Back 20

1. Receive the premium income.

Front 21

3 ways to be a covered call writer

Back 21

1. Own the underlying stock

2. Obtain an ESCROW or DEPOSITORY RECEIPT

Front 22

ESCROW or DEPOSITORY RECEIPT

Back 22

At the bank in trust - this receipt will be delivered upon exercise if the other party exercises

1 & 2 both physically have the stock.

3. Long a call with equal or lower exercise price and short call expires before or at the same time as the long call

Front 23

Profit Loss Potential Table

Back 23

Front 24

Covered Call Reminder

Back 24

Front 25

Investors write options want to be covered because?

Back 25

Writing options covered avoids the margin requirements of writing uncovered.

Front 26

Possible Actions for an investor who sells a call as the opening sale

Back 26

1. The option will be exercised.
2. Buy the option and close the position
3. The option will expire unexercised and keep the premium

The call writer hopes for #3

Front 27

Reasons for buying a put:

Back 27

1. Bearish move, when the price drops, investor can buy the shares on the open market and sell the shares at the higher exercise price.

2. To protect or hedge a long position

3. Limited risk alternative to selling the stock short. The investor has smaller capital commitment, with the same or greater profit potential.

Front 28

Possible actions for buying a put.

Back 28

1. Exercise the option and sell the stock

2. Close the position - selling the option to another investor

3. Let the option expire and lose the premium

Front 29

Reasons for writing a put

Back 29

1. Premium Income
- improves rate of

Front 30

Three ways you can be a covered put writer

Back 30

1. Have money on deposit that is equal to the exercise price

2. Obtain a bank guarantee letter.
Both 1 & 2 - you HAVE the money

3. Be long a put with equal or greater exercise price.

Front 31

Why do investors want to be covered put writers?

Back 31

Avoid the margin requirements when writing uncovered.

Front 32

Possible actions when an investor sells a put as an opening sale

Back 32

1. Option will be exercised and the investor will buy the stock

2. Writer will buy the option to offset and close the position.

3. The option expires and the investor keeps the premium.

#3 is the most desirable outcome.

Front 33

When answering Options Calc Questions

Back 33

Treat every calc question like a frog. Identify a piece, label it, set it aside.

Rules:
1) Always keep your premiums separate from your stock transactions (use a t chart - premiums on the left, stock transactions on the right)

2. Label anything you buy with a: "B_-"

3. Label anything with an "S_+"

4. Only focus on action/transaction words: BUY/LONG/PURCHASE, SELL/SHORT/WRITE, EXERCISE!

stop reading and write something!

5. CROSS OUT THE WORDS: "when the price of the stock is"

Front 34

When answering Options Calc Questions (2)

Back 34

1) When you see "close" a position, either buy back the option or sell off the option you have.

2) Options are classified as "capital assets" All gains and losses will be short term CAPITAL gains or losses.

Front 35

When dissecting questions, we generally look for overall profit or loss. What twist can the test makers put on a question, and how do we handle it?

Back 35

The test makers could ask "per share" gain or loss or even break even.

To find these answers, divide by a hundred.

Front 36

Saying for Options

Back 36

Call Up.
Put Down.

Front 37

BREAK EVEN FORMULA FOR A CALL

Back 37

Exercise Price + Premium

=

Breakeven on a call

Regardless of who is seller or buyer

Front 38

BREAK EVEN FORMULA FOR A PUT

Back 38

Exercise Price - Premium

=

Breakeven on a put

Regardless of who is seller or buyer

Front 39

The OCC

Back 39

The Options Clearing Corporation.

It is the issuer, clearing agency, AND guarantor of all listed options in the U.S.

This means investors do not trade options directly with other investors, but instead buy and sell them from the OCC.

Every listed Option in the US goes through the OCC.

1. It operates under the jurisdiction of the Securities and Exchange Commission (SEC)

2. Is owned and run by its member exchanges which are the US exchanges that trade options (aka SROs - Self Regulatory Organizations)

Front 40

The OCC Member Exchanges include:

Back 40

1. CBOE - Chicago Board Options Exchange
2. Philadelphia Stock Exchange
3. Boston Stock Exchange
4. American Stock Exchange
5. NYSE Euronext
6. International Securities Exchange
7. NASDAQ

Option trades ARE NOT REPORTED on the consolidated tape (ticker tape) - really the only part of this slide I NEED to know.

Front 41

Quotes on option premiums - the premium quote on an option has two prices

Back 41

"BID" - is the price they would receive if they SELL AN OPTION and is always lower

"ASK" - is the price they would PAY if they BUY AN OPTION and it's always higher

Bid 3.25 Ask 3.40

The difference in the Bid and Ask is called the spread.

Front 42

Trading Rotations

Back 42

As soon as the stock opens each class of options will open sequentially from earliest expiration month with the lowest exercise price out to to the highest.

The options won't open if the stock doesn't open.

Only PUBLIC MARKET AND LIMIT orders participate in the OPENING ROTATION

Front 43

Order Book Official (OBO)

Back 43

OBO for CBOE listed options is an employee of the exchange that handles the PUBLIC limit order book
(A specialist on a stock exchange works for themselves. The OBO is an EMPLOYEE)

- May not trade for themselves. May only accept public orders

-OBO's job is to see public orders at given prices are executed before orders from the floor at same or better price

Front 44

Market-Makers

Back 44

Traders on CBOE floor who trade for own accounts, at own risk. NEVER have priority over public orders at the same price on OBO's Book

Front 45

CBOE Hybrid

Back 45

Trading engine blending the trading floor technology with an electronic trading platform
-CBOE OSS - Order Support System which electronically:
a: routes orders directly to the options trading post
b: electronically sends notice of the execution directly to the broker/dealers office, bypassing the communication center

Front 46

Three Times Relating to Options

Back 46

Cease Trading - 4:02 PM Eastern on the business day prior to expiration (mostly Fridays)
- if trading in a security is halted, trading in the options is also halted
-IF TRADING IN AN OPTION IS HALTED, CUSTOMERS CAN STILL EXERCISE

Exercise cut off time - 5:30 pm eastern time on the business day prior to expiration

Expiration - 11:59 eastern on the SATURDAY following the THIRD Friday of the expiration month

Front 47

Position Limits

Back 47

- the OCC has established max number of option contracts an investor can maintain at any time when options are on the same stock and "same side of the market"

Reportable limits generally only apply to institutions and hedge funds because the limit usually starts around 3,000

Investors are also limited to number of listed option contracts which may be exercised within any consecutive 5 business day period

Front 48

American Style Options

Back 48

American Style Options can be exercised Anytime

Think Letter A - American/Anytime

Front 49

European Style Options

Back 49

Can only be exercised at Expiration

Think letter E -
European/Expiration

Front 50

Classes of Options

Back 50

All options of the same type on the same underlying stock

I.E. ALL IBM CALLS is one class

and ALL IBM PUTS is another class

Front 51

Series of Option

Back 51

All options of the same class WITH the same expiration month and the same exercise price.

I.E.
ALL IBM OCT 90 CALLS is one series

ALL IBM OCT 85 CALLS is another series

Front 52

Option Cycles

Back 52

Three common option cycles.

They have four months in each cycle. But options only trade for the current three months out of the four.

Option cycles:

JAJO - January April July Oct
FMAN - Feb May Aug Nov
MJSD - Mar June Sept Dec

Example - if we look at the first cycle, and we are early in January, we will only see Jan, April, and July quoted. When January's options expire on the Saturday following the third Friday, we'll see only April, July, Oct quoted.

Count 9 months from the expired month to figure out which month is opening.

Example....February closes on the Saturday after the third Friday. Which Month will open on Monday? Since Feb is the second month, you add nine and get the 11th month - November.

Front 53

Standardized terms established by the OCC

Back 53

Strike prices, option expiration months, and type

PREMIUMS ARE NOT ESTABLISHED BY THE OCC - supply and demand dictate premiums.

Front 54

Strike / Exercise Prices

Back 54

Exercise prices are set in intervals based on the underlying stock.

If the underlying stock is:

$0.01 - $24.99, the interval is 2.5 points

$25 - $199.99, the interval is 5 points

$200+, the interval is 10 points

Front 55

Option Term Adjustments

Back 55

Listed options are adjusted for:

Stock dividends
Splits
Rights Distributions

Front 56

Adjusting Option Contracts for Splits

Back 56

Client buys 1 ABC 50 call @ 5

2:1 split.
2/1 x share amount
(1 contract = 100 shares)
2/1 x 100 = 200

We never have fractions of option contracts.

This would produce 2 full option contracts at 100 shares a piece, but we need to adjust the strike price.

We DIVIDE by the split ratio for the call price.

50 / 2/1
50/2
New strike price is $25

Front 57

Options - Ex Dividend Date

Back 57

Exercise in options date works just like a trade date in stock

Whoever ends up owning the stock the day before ex dividend date will own the stock.

Front 58

Regular Way settlement for options

Customer to Clearing Member (broker/dealer)

Back 58

Customer pays T+1
Customer pays business day after trade date.

Reg T is still T+5 for the customer
(Customer can get a T+5 Reg T trade.. The Clearing Member (brokerage) can not)

THE BROKER/DEALER TO OCC IS REQUIRED TO BE T+1

Front 59

Exercise Options

Back 59

The exercise settles 3 BUSINESS DAYS FROM THE TIME THE OCC receives the exercise notice

Front 60

Exercise Options automatic exercise

Back 60

At expiration the OCC will automatically exercise customer options which are in the money by 1 cent or more...

It used to be 3/4 point
before that 1/4 point ..... the test may ask for any of these three answers. It will be one of these.

Front 61

As an opening transaction..

Back 61

A registered rep, can never sell calls for a corporation against the corporation's own underlying stock.

Front 62

Option Contracts - In the Money?

(IN the money means it has INtrinsic value)

Back 62

Option CONTRACTS are going to be in the money, at the money, or out of the money AND SEPARATELY, investors are going to be making money, even, or losing the money. The two pieces are not interchangeable (because of premiums)

Front 63

When deciding whether an option is in the money....

(IN the money means the option has INtrinsic value)

Back 63

Never consider premiums.

Never consider long or short.

We are talking only about the option ITSELF.

Three points to consider
- Type of option (CALL/PUT)
- Strike Price
- Market Price

Front 64

In the money on a put occurs when....

Back 64

the market price is LESS than the exercise price of an option

Front 65

A call has intrinsic value if...

Back 65

the market price is GREATER than the exercise price of the option

Front 66

An option is at the money when....

Back 66

The exercise Px of the option is equal to the market price of the underlying security.

Front 67

Intrinsic Value equals...

Back 67

The amount the option is in the money.

Ex. Call with exercise price of 50. Stock is trading at 55.00

You can buy the call and exercise at 50, then sell at 55.00....

The intrinsic value is 5 points.

Front 68

Time Value is....

Back 68

the amount of premium that exceeds the intrinsic value...

Ex. Call with exercise price of 50 @ 8. Stock is trading at 55.00

You can buy the call and exercise at 50, then sell at 55.00....

The intrinsic value is 5 points. But the time value is 3 points. (premium of 8 - intrinsic value)

Time value is the cost you pay to have the option for the duration.

As you get closer to expiration date, the time value goes down because you have less time to make a decision to exercise.

Front 69

Wasting Assets

Back 69

Options are referred to as "wasting assets" because their time value declines as time moves closer to the expiration date.

Ex. An Aug option is going to be more valuable in Feb than in July because I have mroe time to let the market fluctuate and choose if I should exercise it.

Front 70

Intrinsic value is directly related to...

Back 70

the premium. The more the option is in the money, the higher the premium will be.

The premium value of an option will move dollar for dollar when the option is at the money or in the money

Front 71

What effects Pricing of Options Premiums?

Back 71

- Intrinsic value
- Interest rates
- Market price of underlying stock
- Time until expiration of the option
- Volatility of the underlying stock - greater volatility, greater premium

Front 72

With a spread, you always have to:

Back 72

- have a long (buy) and a short (sell) position at the same time.
- The long and short have to be on the same kind of option (long short/short put OR long call/short call) but with different expiration months and / or different strike prices.

Spreads put you on both sides of the market, thus limiting your risk. That's the primary use of a spread. But it also limits your profit potential.

Front 73

Calendar Spread is...

aka...

Back 73

a spread that has different expiration months

aaka - Time Spread or Horizontal Spread

Front 74

Vertical spread is...

Back 74

a spread with different striking prices.

Then decide if it is a bull or bear spread

Front 75

Use of Spreads

Back 75

Even though both options could be exercised, that action is not expected.

Investors generally intend to make or lose their money in premiums - not exercises.

Front 76

(VERTICAL) BULL SPREAD

Back 76

BL BL BL BL BL BL BL BL

BUY the option with the LOWER striking price

Front 77

Vertical Bear Spread...

Back 77

Buy the option with the higher strike price

Sell the option with the lower strike price

If you're being chased by a (non black) bear, you want to climb up HIGH in a tree. . . . . . . . . . . . . . . . . . . .

Front 78

Diagonal Spread

Back 78

A spread that has different exercise prices

AND

Different expiration months.

Front 79

Debit/Credit Spread

Back 79

If you add your premiums together, you will get a Net Debit Or Net Credit

B - Premium (Debit)
S + Premium (Credit)
------------------------
Net Credit or Debit

Front 80

Notes about Net Debit Spreads

(IMPORTANT)

Back 80

When you do a spread at a net debit, you do not want the options to expire.

We also remember that we don't anticipate exercising....

We always want debit spreads to WIDEN by more than the ORIGINAL DEBIT.

The most you can lose is the net debit of a spread. The most you can gain is the difference in
(strike prices)-original net debit

Front 81

Notes about Net Credit Spreads

Back 81

1. Maximum profit potential is the original net credit in premiums.

2. Maximum loss potential is the (difference in the two strike prices) - the net credit in premiums.

3. Credit spreads must expire or narrow to be profitable.


Or

Front 82

Calculating the Breakeven of a Debit Spread

Back 82

Call:
Breakeven mkt price =
Long exercise price + NetDebit

Put:
Breakeven mkt price =
Long exercise price - Net Debit

Front 83

Calculating the Breakeven of a Debit Spread

Back 83

Call:
Breakeven mkt price =
Long exercise price + NetDebit

Put:
Breakeven mkt price =
Long exercise price - Net Debit

Front 84

Straddle

Back 84

A call and a put together BUT THEY HAVE TO HAVE TO BE ON THE SAME STOCK, WITH THE SAME EXPIRATION MONTH, AND USE THE SAME EXERCISE PRICE.
PICKY. PICKY. PICKY.

Either a long straddle - both a long put and a long call

OR

A short straddle - a short call and a short put

Front 85

The Long Straddle

Back 85

A long call and long put

1. Establish a long straddle if you anticipate a MAJOR move in the market price, but don't know which direction it will be in.

2. The investor is trying to make money by exercising one of the options and let the other expire

3. If the options both expire, the max the investor loses is the premiums they paid.

Front 86

The Short Straddle

Back 86

A short call and short put

1. Investors establish short straddles when they expect the market to remain NEUTRAL.
- Investors make their money from the premiums on the options.

************************************The short call is assumed to be UNCOVERED. This represents unlimited loss potential to the investor
************************************

Front 87

COMBINATION

Back 87

A straddle which has different exercise prices AND/OR different expiration months.

1. Investors establish short combos when they expect the market price to remain neutral.
------they make their money on premiums.
*******Short combo assumes an UNCOVERED call and has unlimited loss potential*********

2. In a long combo - If options EXPIRE, the maximum loss potential is the amount of the premiums

Front 88

Breakeven of Straddles

Back 88

Upside B/E:
Call Strike Px + (Total of Both Premiums)

Downside B/E:
Put strike price - (total of both premiums)

Downside B/E will be less than upside B/E.

Anything outside of the B/E range will be a profit. Anything inside the B/E rang will be a loss. Anything at either of the B/E points will be............... Breakeven.

Front 89

Short Against the Box

Back 89

Happens when an investor is long and short the same amount of the same stock at the same time.

Front 90

The margin required for writing UNCOVERED equity options

Back 90

20% of the market value of the stock + the premium paid for the option

Front 91

Taxation Timeframes, Exercise

Back 91

Since the life of a standard option is 9 months, it's considered short term. Anything over a year is long term.

The holding period on stock purchased bedgins on the day that the option is exercised.

Holding period for stock is interrupted by a short sale of the stock or the purchase of a put of the same security. Meaning that if the short sale or put purchase happens after you've held the security for 6 months, it gets cut at 6 months even if you continue to hold it for another year.

Front 92

Taxation - Cost Basis

Back 92

Cost Basis of a long stock position is reduced by the premium of a short call if it expires - tax man still gets a cut of your premium

If the long stock position is acquired by the purchase of a call... you get to add the premium to your cost basis for tax purposes.

If you sell your stock by exercising a long put, the sale proceeds get taxed only on the proceeds MINUS what you paid in premium for the