Options

Breakeven: Calls

The breakeven point is the point at which the investor neither makes nor loses money. (strike price + premium) For the call buyer, the contract is profitable above the breakeven; for the call seller, the contract is profitable below the breakeven.

Breakeven: Puts

The breakeven point is the point at which the investor neither makes nor loses money. (strike price - premium) For the put buyer, the contract is profitable below the breakeven at expiration; for the put seller, the contract is profitable above the breakeven at expiration.

What happens when the holder sells the Option Contract Before the Expiration Date?

The holder can sell the option for its current premium; there is no purchase or sale of underlying stock in this situation. The investor has profit or loss based on the increase or decrease of the option's premium from the time the option was purchased (closing the position).

When will the holder of a put/call let the Option Expire?

The holder of a call will allow the option to expire if the market price of the stock is equal to or less than the strike price. The holder of a put will allow the option to expire if the market price of the stock is equal to or greater than the strike price.

When will the holder of a put/call exercise the Option?

The holder of a call will buy the stock at the strike price. The holder of a put will sell the stock at the strike price.

An investor buys 100 shares of RST at 53 and buys an RST 50 put for 2. The maximum gain is unlimited. Should the stock price fall below the strike price of 50 what will the investor do?

The investor will exercise the put to sell the stock for 50. The investor loses $3 per share on the stock and has spent $2 per share for the put. The total loss equals $500. The breakeven point is reached when the stock rises by the amount paid for the put; in this case, 53 + 2 = 55.

Determining a Spread Investor's Market Attitude (calls)

The market attitude of a spread investor is determined by the option that is the more costly of the two. With call spreads, the option with the lower strike price has the higher premium. It depends on if you purchased the option with the lower strike price or sold it. That is how you know if it is a debit (purchased the one with the lower strike price) or a credit (sold the one with the lower strike price).

The Options Contract

The most common type of options contracts are equity options. Each contract includes 100 shares when issued.

What is the maximum loss when buying calls?

The most the call buyer can lose is the premium paid; this happens if the market price is at or below the strike price at the option's expiration.

What is the maximum loss when buying a put option?

The premium paid. This happens if the market price is at or above the strike price at the option's expiration.

What is the maximum gain when writing calls?

The premium received. If a call is uncovered, the investor does not own the underlying stock. The maximum gain is earned when the stock price is at or below the exercise price at expiration.

Option Premiums

The price of an option contract is known as the premium. Both bid and ask prices are quoted in cents, with a minimum price interval of $.05. An option buyer will pay the ask, or offer price, and the option seller will receive the bid price. An option's premium reflects two types of values: intrinsic value, or the amount by which the option is in the money, and time value, which is the market's perceived worth of the time remaining to expiration.

Type

The two types of options are calls and puts.

The factor with the greatest influence on the premium.

The volatility of the underlying stock. A stock that is highly volatile has the potential to experience greater price movement; it has the possibility of greater profit because of high volatility.

What is the maximum gain when buying calls?

Theoretically, the potential gains available to call owners are unlimited because there is no limit on the rise in a stock's price.

Determining a Spread Investor's Market Attitude (puts)

With put spreads, it is just the opposite. The option with the higher strike price has the higher premium. So again, it depends on if you purchased the option with the higher strike price or sold it. That is how you know if it is a debit (purchased the one with the higher strike price) or a credit (sold the one with the higher strike price).

Long call

a call buyer owns the right to buy 100 shares of a specific stock at the strike price before the expiration if he chooses to exercise.

Short call

a call writer (seller) has the obligation to sell 100 shares of a specific stock at the strike price if the buyer exercises the contract.

Long put

a put buyer owns the right to sell 100 shares of a specific stock at the strike price before the expiration if he chooses to exercise.

Short put

a put writer (seller) has the obligation to buy 100 shares of a specific stock at the strike price if the buyer exercises the contract.

Credit Spread

a spread is a credit spread if the short option has a higher premium than the long option.

Sellers have _______

obligations

Buyers have ________

rights

Ratio Call Writing

selling more calls than the long stock position covers. This strategy generates additional premium income for the investor, but also entails unlimited risk because of the short uncovered calls.

What is the maximum loss of writing a put option?

strike price - premium (same as the breakeven) Occurs when the stock price drops to zero. The investor is forced to buy the worthless stock at the option's strike price. The investor's loss is reduced by the premium received.

What is the maximum gain when buying a put option?

strike price - premium paid (same as the breakeven) A stock's price can fall no lower than zero.

Basic Options Chart

■ Buyers are on the left side; sellers are on the right. ■ The arrow identifies the investor's market attitude. Up arrows represent bullish investors; down arrows represent bearish investors. ■ The information in the parentheses identifies what occurs at the exercise of the option. ■ The solid horizontal line represents the strike price (SP). The dashed horizontal lines represent the breakevens. For calls, the breakeven is strike price plus premium, long or short, and for puts, the breakeven is strike price minus premium, long or short. ■ Calls are above the horizontal line because they are in the money when the market price is above the strike price, long or short (CALL UP). ■ Puts are below the horizontal line because they are in the money when the market price is below the strike price, long or short (PUT DOWN).

Three Specifications of an Options Contract

■ Underlying instrument: anything with fluctuating value can be the underlying instrument of an option contract. ■ Price: the contract specifies a strike or exercise price at which purchase or sale of the underlying security will occur. ■ Expiration: all contracts have a specified life cycle and expire on a specified date. Once a contract is issued, it can be bought or sold any time during its life cycle.

The Four Basic Options Transactions

■ buying calls; ■ writing calls; ■ buying puts; and ■ writing puts.

Factors Affecting Premium

■ volatility; ■ amount of intrinsic value; ■ time remaining until expiration; and ■ interest rates.

minimum price interval of option contract

$0.05

T-Chart example: An investor with no other positions buys 1 DWQ May 75 call at 6.50. The investor exercises the call when the stock is trading at 77 and immediately sells the stock in the market. What is the investor's profit or loss?

($7,500 + $650) - $7,700 ($450.00) loss

mini-option contracts can be comprised of only _______ shares

10 (Therefore mini-option contract premium of 2 represents only $20.)

Standard Contracts are comprised of ______ shares.

100 (e.g. 2 premium = $200)

Bullish call

A call buyer is a bullish investor because he wants the market to rise. The call is exercised only if the market price rises.

At the Money (Call)

A call is at the money when the market price equals the strike price. A buyer will not exercise contracts that are at the money at expiration. Sellers want at the money contracts at expiration; buyers do not. Sellers then keep the premium without obligations to perform.

In the Money (Call)

A call is in the money when the market price exceeds the strike price. A buyer will exercise calls that are in the money at expiration. Buyers want options to be in the money; sellers do not.

Out of the Money (Call)

A call is out of the money when the market price is lower than the strike price. A buyer will not exercise calls that are out of the money at expiration. Sellers want contracts to be out of the money; buyers do not. Sellers then keep the premium without obligations to perform.

Bearish call

A call writer is a bearish investor because he wants the market to fall. The contract is not exercised if the market price falls below the strike price.

Diagonal Spread

A diagonal spread is one in which the options differ in both time and price. On an options report, a line connecting these two positions would appear as a diagonal. Example of a diagonal spread: Long RST Jan 55 call for 6 Short RST Nov 60 call for 3

Bearish put

A put buyer is a bearish investor because he wants the market to fall. The put is exercised only if the market price falls below the strike price.

An XYZ Jan 50 put is trading for a premium of 5. The current market value of XYZ stock is 55. What is the time value and intrinsic value of the premium?

A put has intrinsic value when the market price of the stock is below the strike price. In this example, that market price is up, so this option has no intrinsic value. The premium of 5 is all time value. intrinsic value = 0, time value = 5.

At the Money (Put)

A put is at the money when the market price equals the strike price. A buyer will not exercise contracts that are at the money at expiration. Sellers want at the money contracts; buyers do not.

In the Money (Put)

A put is in the money when the market price is lower than the strike price. A buyer will exercise puts that are in the money at expiration. Buyers want in‑the-money contracts; sellers do not.

Out of the Money (Put)

A put is out of the money when the market price is higher than the strike price. A buyer will not exercise puts that are out of the money at expiration. Sellers want out of the money contracts; buyers do not.

Bullish put

A put writer is a bullish investor because he wants the market to rise or remain unchanged. The contract is not exercised if the market price rises above the strike price.

Debit Spread

A spread is a debit spread if the long option has a higher premium than the short option.

Spread

A spread is the simultaneous purchase of one option and sale of another option of the same class. ■ A call spread is a long call and a short call. ■ A put spread is a long put and a short put.

Option

A two-party contract that conveys a right to the buyer and an obligation to the seller. The terms of option contracts are standardized by the Options Clearing Corporation (OCC), which allows options to be traded easily on an exchange such as the Chicago Board Options Exchange (CBOE). The underlying security for which an option contract is created may be a stock, stock market index, foreign currency, interest rate, or government bond.

Class

All calls of one issuer, or all puts of one issuer, are classes of options.

Series

All options of one issuer with the same class, exercise price, and expiration month are in the same series (e.g., all XYZ Jan 40 calls).

Time spread (calendar spread)

Also known as a horizontal spread. It includes option contracts with different expiration dates but the same strike prices. Investors who establish these do not expect great stock price volatility; instead they hope to profit from the different rates at which the time values of the two option premiums erode. Time spreads are called horizontal spreads because expiration months are arranged horizontally on options reports. Example of a time spread/calendar spread: Long RST Nov 60 call for 3 Short RST Jan 60 call for 5

Parity: Calls

An option is at parity when the premium equals intrinsic value. e.g. An ABC June 60 call trading at 2 when ABC is at 62 is at parity.

What is the maximum loss when writing calls?

An uncovered call (or naked call) writer's maximum loss is unlimited because the writer could be forced to buy the stock at a potentially unlimited price, if the option is exercised against him, for delivery at the strike price.

What is the maximum gain of writing a put option?

An uncovered put (naked put) writer's maximum gain is the premium received. The maximum gain is earned when the stock price is at or above the exercise price at expiration.

Long 100 XYZ shares at 62 Long 1 XYZ 60 put at 3 What is the most the customer can lose on these positions? A. $300 B. $500 C. $1,000 D. Unlimited

B. The customer has protected his stock position from downside loss by purchasing the put. If the market falls, the put will be exercised, allowing the customer to sell his stock at the option strike price of 60. Therefore, the most the customer can lose is $200 on the stock position (62 - 60), plus the premium paid for the option ($200 + $300 = $500).

A customer with no other positions sells 1 MTN Jul 80 call for 10 and buys 100 shares of MTN stock for $85 per share. If the customer enters into a closing purchase for $10 for the MTN Jul call and sells 100 shares of MTN stock for $88 per share, he would realize A. a $300 loss B. a $300 profit C. a $800 loss D. a $800 profit

B. a $300 profit

In April, a customer purchases 1 TCB Jul 85 call for 5 and purchases 1 TCB Jul 90 put for 8. TCB stock is trading at 87. If TCB stays at 87 and both options are sold for their intrinsic value, the customer will realize A. a $500 profit B. an $800 loss C. a $1,000 profit D. an $1,100 profit

B. an $800 loss

Buyers vs Writers

Buyers of options call the shots; they choose to exercise or not to exercise. That is why buyers pay premiums. The writer is at the mercy of the buyer's decision. Writers are only exercised against; they do not have the opportunity to choose to exercise. ■ The buyer wants the contract to be exercised. He wins, and the seller loses at exercise. ■ The seller wants the contract to expire. The seller wins at expiration because he gets to keep the premium. No purchase or sale of stock is required.

Style

Call or put buyers can exercise a contract any time before expiration if the contract is an American-style option. European-style options can be exercised on expiration day only. Nearly all equity options are American style. Foreign currency options may be either American style or European style.

CAL

Call spreads: Add the net premium to the Lower strike price.

Credit Call Spread

Credit call spreads are created by investors to reduce the risk of a short option position. Again, there is a trade-off; the potential reward of the investor is reduced. The investor who establishes a credit call spread is bearish.

Credit Put Spread

Credit put spreads are created by investors to reduce the risk of a short put position. Again, there is a trade-off: the potential reward of the investor is reduced. The investor who establishes a credit put spread is bullish.

A customer holds the following positions: Long 100 XYZ shares at 62 Long 1 XYZ 60 put at 3 The customer breaks even if XYZ trades at A. 57 B. 59 C. 63 D. 65

D. The customer must recover the cost of the premium paid to be at the breakeven. Since this is a long stock position, the market must advance 3 points for this to occur. Therefore, the breakeven of this hedged position is found by adding the premium of the option to the price of the stock (62 + 3 = 65).

Debit Call Spread

Debit call spreads are used by investors to reduce the cost of a long option position. There is, however, a trade-off, because the potential reward of the investor is also reduced. The investor who establishes a debit call spread is bullish.

Debit Put Spread

Debit put spreads are used by investors to reduce the cost of a long put position. The investor who establishes a debit put spread is bearish.

Put/Call choices at expiration

Exercise the Option Let the Option Expire Sell the Option Contract Before the Expiration Date

finding breakeven points on spreads (CAL & PSH)

For Call spreads: Add the net premium to the Lower strike price. For Put spreads: Subtract the net premium from the Higher strike price.

If you are short XYZ stock what option would provide full protection and what option would provide partial protection?

Full protection: Long Call Partial protection: Short Put

If you are long XYZ stock what option would provide full protection and what option would provide partial protection?

Full protection: Long Put Partial protection: Short Call

Intrinsic Value: Calls

Intrinsic value is the in the money amount. A call has intrinsic value when the market price is above the strike price. (market price - strike price) Always positive or zero Buyers like calls to have intrinsic value; sellers do not. A call that has intrinsic value at expiration will be exercised. e.g. XYZ 30 call with XYZ stock trading at 35. Intrinsic value (IV) of call = (stock price 35 - strike price 30 = 5 IV)

Intrinsic Value: Puts

Intrinsic value is the in the money amount. A put has intrinsic value when the market price is below the strike price. (strike price - market price) Always positive or zero Buyers like options to have intrinsic value; sellers do not. An option (call or put) that has intrinsic value at expiration will be exercised. e.g. XYZ 40 put with XYZ stock trading at 35. Intrinsic value (IV) of put = (strike price 40 - stock price 35 = 5 IV).

Types of Spreads

Investors can buy or sell 3 types of spreads: -a price (or vertical) spread -a time (or calendar) spread -a diagonal spread

Price spread (vertical spread)

Is one that has different strike prices but the same expiration date. It is called a vertical spread because strike prices on options reports are reported vertically. Example of a price spread/vertical spread: Long RST Nov 50 call for 7 Short RST Nov 60 call for 3. *The most common spread, and the one most likely to occur on the Series 7 exam, is the price spread (vertical spread), in which the two options have the same expiration date but different exercise prices.

key features of call contracts (Long XYZ Jan 60 call at 3)

Long: The investor has bought the call and has the right to exercise the contract. XYZ: The contract includes 100 shares of XYZ stock. Jan: The contract expires on the third Friday of January at 11:59 pm ET. 60: The strike price of the contract is 60. Call: The type of option is a call, and the investor has the right to buy the stock at 60 since he is long the call. 3: The premium of the contract is $3 per share. Contracts are issued with 100 shares, so the total premium is $300. The investor paid the premium to buy the call. Buyers of calls want the market price of the underlying stock to rise. The investor who owns this call hopes that the market price will rise above 60. He then has the right to buy the stock at the strike price of 60, even if the market price is higher (e.g., 80).

key features of put contracts (Long XYZ Jan 60 put at 3)

Long: The investor has bought the put and has the right to exercise the contract. XYZ The contract includes 100 shares of XYZ stock. Jan: The contract expires on the third Friday of January at 11:59 pm ET. 60: The strike price of the contract is 60. Put: The type of option is a put, and the investor has the right to sell the stock at 60 since he is long the put. 3: The premium of the contract is $3 per share. Contracts are issued with 100 shares, so the total premium is $300. The investor paid the premium to buy the put. Buyers of puts want the market price of the underlying stock to fall. The investor who owns this put hopes that the market price will fall below 60. He then has the right to sell the stock at the strike price of 60, even if the market price is lower (e.g., 40).

Options T chart

Money paid out is identified as a debit (DR) to the investor's account. Money received is a credit (CR) to the investor's account.

When are option contracts exercised?

Option contracts are exercised if they are in the money. Writers are required to fulfill their obligations as required. Exercises of listed equity options settle regular way: two business days from the exercise date.

What happens when an option contract expires? What are they worth if they are at or out of the money at expiration?

Option contracts expire worthless if they are at the money or out of the money at expiration. At expiration, the buyer of the option loses the premium paid; the seller of the option profits by the amount of the premium received.

Derivative Securities

Options are called derivative securities because their value is derived from the value of the underlying instrument, such as stock, an index, or a foreign currency.

Cabinet or Accommodation Transactions (accommodation liquidations)

Options exchanges allow an accommodation procedure for closing out worthless options before expiration. Orders to liquidate worthless options are kept, so to speak, in a cabinet to be executed by the market maker or the electronic book. The rules are as follows. ■ The closing transaction can be placed only at a price of $1 per contract ($.01 per share); these transactions are considered limit orders. ■ All closing transactions must be handled in priority, based on time of receipt. ■ Bids and offers at $1 per contract ($.01 per share) must be submitted in writing, to be matched by the market maker or electronic book. ■ Cabinet trades are not reported to the consolidated tape system (CTS) but must be reported to the exchange at the close of business. ■ Cabinet trades can be used by both firm (proprietary) and public customer accounts to close worthless positions before expiration. Cabinet trades produce a confirmation to the customer showing a closeout for the sum of $1, which can be useful for transaction and tax records.

Options Quotes

Options premiums are quoted on a per share basis. Options contracts are issued to include 100 shares of stock, so the total premium is calculated by multiplying by 100. However, some contracts may be subject to stock splits and stock dividends and may include more than 100 shares.

debit or credit put spread? Long 1 Sept. 40 put Short 1 Sept. 30 put

Purchased the one with the higher strike price (higher premium), so this is a debit, and debit put spreads are bearish.

debit or credit call spread? Long 1 July 40 call Short 1 July 45 call

Purchased the one with the lower strike price (higher premium), so this is a debit, and debit call spreads are bullish.

PSH

Put spreads: Subtract the net premium from the Higher strike price.

Covered Call Writing

Selling calls when holding a long stock position, also known as covered call writing, is partial protection that generates income and reduces the stock's upside potential.

key features of call contracts (Short XYZ Jan 60 call at 3)

Short: The investor has sold the call and has obligations to perform if the contract is exercised. XYZ: The contract includes 100 shares of XYZ stock. Jan: The contract expires on the third Friday of January at 11:59 pm ET. If expiration occurs, the writer keeps the premium without any obligation. 60: The strike price of the contract is 60. Call: The type of option is a call, and the investor is obligated to sell the stock at 60, if exercised, because he is short the call. 3: The premium of the contract is $3 per share. Options contracts are issued with 100 shares, so the total premium is $300. Writers of calls want the market price of the underlying stock to fall or stay the same. The investor who owns this call hopes that the market price will rise or go above 60. The contract will not be exercised if the market price is at or below 60 at expiration, and the writer keeps the premium of $300 with no obligation.

key features of put contracts (Short XYZ Jan 60 put at 3)

Short: The investor has sold the put and has obligations to perform if the contract is exercised. XYZ: The contract includes 100 shares of XYZ stock. Jan: The contract expires on the third Friday of January at 11:59 pm ET. If expiration occurs, the writer keeps the premium without any obligation. 60: The strike price of the contract is 60. Put: The type of option is a put, and the investor is obligated to buy the stock at 60, if exercised, because he is short the put. 3: The premium of the contract is $3 per share. Options contracts are issued with 100 shares, so the total premium is $300. Writers of puts want the market price of the underlying stock to rise or stay the same. If the market price is at or above 60, the investor keeps the premium of $300 with no obligation because the contract will not be exercised.

debit or credit put spread? Long 1 Dec. 20 put Short 1 Dec. 25 put

Sold the one with the higher strike price (higher premium) so this is a credit, and credit put spreads are bullish.

debit or credit call spread? Long 1 Aug. 40 call Short 1 Aug. 30 call

Sold the one with the lower strike price (higher premium), so this is a credit, and credit call spreads are bearish.

Option Contact Expirations

Standard contracts are issued with nine-month expirations and expire on the third Friday of the expiration month at 11:59 pm ET. — Long-term equity anticipation securities (LEAPS) have maximum expirations up to 39 months. Though the maximum is 39 months, most trade with a 30 month life-cycle. The length of time until the contract expires is the one contract specification that can be customized between buyer and seller when the contract first trades. — Weekly contracts are issued on a Thursday and expire on the Friday of the following week. They have much lower premiums as a result of the shorter time span between the day of issue and the day they expire. New weeklies are listed each week, except the week that standardized contracts expire.

finding maximum gain and maximum loss

Start by completing a T‑chart. If the result is a net debit, the net debit equals maximum loss. Find the maximum gain by subtracting the net debit from the difference in the two strike prices of the spread.