(5) Option Contracts
Round Lot
- 100 shares
Equity Option Contracts
- 100 shares of the underlying stock so you multiply the premium by 100 to get the total premium for the option
XYZ splits 2:1. One XYZ Nov 40 call contract becomes
- 2 XYZ Nov 20 calls. The contracts size remains 100 shares of the underlying security
XYZ splits 4:1. One XYZ Nov 40 call contract becomes
- 4 XYZ Nov 10 calls. The contract size remains 100 shares of the underlying security
Class
- A class of options consists of options of the same type on the same underlying security
ABC June 30 call at $1.50
- ABC is the underlying security - June is the expiration month - call is the type of option - 30 is the strike price - the premium is $1.50 -If you purchase one ABC June 30 call at $1.50, you pay $150 for the right to buy 100 shares of ABC for $30 a share until June expiration. If you write one ABC June 30 call at $1.50, you collect $150 and you are obligated to sell 100 shares of ABC for $30 a share until June expiration
At The Money
- An option is at the money when the market price of the underlying security is the same as the option strike price - The option premium is made up entirely of time value - the option has no intrinsic value
"T" account
- Debits represent dollars paid out of the account, and are recorded on the left - ex. purchasing an option of stock - Credits represent dollars received into the account, and are recorded on the right - ex. selling an option or stock
American Style Options
- Equity options - can be exercised any time up to expiration. The option holder has the right to exercise - monthly options expire on the third Friday of the month at 11:59 p.m. ET
Calculating Time Value and Intrinsic Value (Calls)
- First, determine if the call is "in the money" or "out of the money." - If the option is "out of the money", it has no intrinsic value and the premium is all time value. - If the option is "in the money", subtract the strike price from the market price of the underlying security and the result is the intrinsic value
Calculating Time Value and Intrinsic Value (Puts)
- First, determine if the put is "in the money" or "out of the money." - If the option is "out of the money", it has no intrinsic value and the premium is all time value. - If it is "in the money", subtract the market price of the underlying security from the strike price and the result is the intrinsic value (the amount the put is "in the money").
Expiration Dates of Options
- Jan/April/July/Oct = 1/4/7/10 - Feb/May/Aug/Nov = 2/5/8/11 - Mar/June/Sept/Dec = 3/6/9/12 - actively traded options on large cap stocks may have monthly and even weekly expiration dates in the near term months
Bullish
- Long calls and short puts are on the same side of the market because they are both bullish positions, therefore they are added together to determine position limits - long calls and short puts may also be referred to as debit calls and credit puts - Market UP, BULLS, Long Calls, Short Puts, Long Stock
Bearish
- Long puts and short calls are on the same side of the market because they are both bearish positions, therefore they are added together to determine position limits - may be referred to as debit puts and credit calls - Market DOWN, BEARS, Short Calls, Long Puts, Short Sales
Series
- Options of the same class that also have the same expiration date
Option Holder
- The buyer of an option - has the right to buy (call option) or the right to sell (put option) a round lot (100 shares) of the underlying security at a specified price, known as the "strike" or "exercise" price - has a long position in options. The option holder pays the premium (price) and has the right to exercise the option
Style
- The exercise style of the option: American or European
Write one LMN May 50 call @ $7.50 Buy one LMN May 60 call @ $1.50 max. gain, max. loss, breakeven
- The investor receives a net premium of $6 for the spread; $7.50 for writing the May 50 call less the $1.50 premium paid for the May 60 call - max. gain: premium received, which is realized at May expiration if LMN is below 50 and both calls expire - max. loss: the strike price interval of the spread less the premium received. For this position, the maximum loss is $400; 10 - $6 = $4 X 100 = $400 - breakeven: equal to the lower strike plus the premium received for the spread. In this example, the breakeven is $50 + $6 = $56. The investor loses money above $56 and makes money below $56
Type
- There are two types of options contracts: puts and calls
Protective Call Purchase
- You can protect a short stock position by purchasing calls on your short stock
Calculating Profit and Loss on Hedged Positions:
- You can use debits and credits to calculate profits and losses on hedged positions
Long Call
- a buyer or holder of a long call has the right to buy 100 shares of the underlying security at the strike price up to the expiration date of the option - max. loss: premium - max. gain: unlimited - breakeven point: strike price + premium
Selling an option that expires results in...
- a credit, which is a capital gain
Horizontal or Calendar Spread
- a difference in the expiration date as opposed to the strike prices
Hedge
- a general term that refers to strategies that investors use to protect their investments against loss and control risk - Equity options can be used to hedge stock positions
A purchased option that expires results in...
- a net debit, which is a capital loss
Long-Term Equity Anticipation Participation Securities (LEAPS)
- added to put and call positions in determining position limits and exercise limits - stock or index options with expiration dates out to 39 months - capital gains and losses resulting from a 12-month or shorter holding period are classified as short-term
ABC splits 3:2. The ABC June 60 call becomes
- an ABC June 40 call with a contract size of 150 shares of the underlying security - to calculate the total premium, multiply the premium X 150 shares
Protective Put Purchase
- an investor can protect a long stock position by purchasing puts on the stock that they own
Parity
- an option is at parity with the underlying stock when the option premium has intrinsic value ONLY - Just before expiration, options that are in the money may trade at parity; however, usually option premiums have some time value - ex. XYZ stock is $62.50, and the XYZ Jan 50 call is $12.50
Spread
- an options strategy that uses long and short options of the same type - either puts or calls - on the same underlying security - vertical (price) spreads - horizontal (time) spreads
Options exist because
- any given security, there is always an investor who is bullish and one who is bearish - they give both "bulls" and "bears" a way to potentially profit from these anticipated changes in value - Listed options have a liquid secondary market - the buyer is able to leverage investment dollars by buying control of stock for a relatively small premium, resulting in greater profits on the same investment dollars - Investors also use options to hedge their stock positions - Investors can also use options to increase income by writing options against their stock positions
When call holders exercise their options, they will...
- buy stock at the strike price and the writer must sell the stock at the strike price
Strike Price Intervals for Equity Options
- can be 1, 2.50, 5, or 10 points apart
European Style Options
- can only be exercised during a specific time period, usually the last trading day before expiration
Long LEAPS
- can result in long-term capital gain or losses - occur when LEAPS are held for a period greater than 12 months
Closing Transaction
- closes out or reduces an existing options position - can be buy orders or sell orders
Time Value of an Option
- determined by how much time there is until the expiration date - The more time there is until expiration, the more time value in the option; the less time until expiration, the less time value - it "erodes" the closer it is to the expiration date - Options are wasting assets
Position Limit Rules
- developed to prevent investors from putting an excessive "bet" on a specific directional move in the market price of a security
Opening Purchase Order
- establishes a long position in the options (puts or calls)
Opening Transaction
- establishes a new options position or adds to an existing position - can be buy or sell orders
Opening Sell Order
- establishes a short position in the options - When you write puts and calls, your order is an opening sell
Strike Price
- exercise price - The price at which an option can be exercised
Option Writer
- has a short position in options - sells a put or call that they don't own - in other words, they are short the put or call - collects the premium (price) and has the obligation to buy or sell the underlying security if it is exercised
Conventional Options
- have a 9-month life - always result in short-term capital gains or losses if the option expires or the position in closed - Capital gains and losses resulting from a 12-month or shorter holding period are classified as short term
Ratio Write
- in the case of long stock: is when investors writes more calls than they have stock - For example: Long 100 DEF @ 38 and Short 2 DEF April 40 calls @ $2. The investor receives more premium ($400 instead of $200) but is exposed to unlimited risk on the short call - in the case of short stock: an investor writes more puts than they have short stock - For example: Short 100 DEF @ $38 and short 2 DEF April $35 puts @ $1.50. The investor collects premium of $300 instead of $150 but has more downside risk
Put Premiums
- increase in value when the underlying stock goes down in price, especially as the price of the underlying stock approaches and goes through the strike price
Long Calls
- investors who are long calls are bullish on the underlying stock, which means the investor wants the price of the underlying stock to go up - a bullish position
Options
- legally binding contracts between buyers and sellers - has a definite start and expiration date
Call Holder
- long calls - pays premium - right to buy - DOES NOT receive dividends on the underlying security or have voting rights
Put Holder
- long puts - pays premium - right to sell
Puts
- lose value when the underlying stock rises in price - has intrinsic value when the price of the underlying security is lower than the strike price of the put
An investor purchases 100 shares of LMN at $43 and writes one LMN Sept $45 calls @ $2.25 max. gain, max. loss, breakeven
- max. gain: $425. The investor purchased stock at 43. If it rises above 45, the investor is assigned on the short call and has to sell the stock at $45 for a gain of $200. The premium of $225 was received for writing the call; $225 + 200 = $425 - max. loss: $4,075. If LMN goes to zero, then the investor loses the $4,300 paid for the stock less the $225 premium received for writing the call; $4,300 - $225 = $4,075 - breakeven: = price paid for the stock - premium received for the call; $40.75 ($43 - $2.25 = $40.75). Below $40.75, the investor loses money, thus writing the call provides only a partial hedge on the downside risk of the stock
An investor sells short 100 shares of ABC at $72 and writes one ABC June 70 put @ $3.35 max. gain, max. loss, breakeven
- max. gain: $535. If ABC falls below $70, the investor is exercised on the short put and has to buy stock at $70 for a $200 profit plus the $335 premium received for writing the put; $200 + $335 = $535 - max. loss: unlimited because the investor is short stock - breakeven: = short sale price of the stock + premium received for writing the put; $75.35 ($72 + $3.35 = $75.35). If the stock rises above $75.35 the investor loses money and the potential loss is unlimited, thus writing the put provides only a partial hedge on the upside risk of the stock
You sell short 100 shares of XYZ stock at $62 and purchase one Sept $65 call for $1.80. max. gain, max. loss, breakeven
- max. gain: $6,020. If XYZ goes to zero, you make $6,200 on the short stock and you lose the $180 premium paid for the call. $6,200 - $180 = $6,020 - max. loss: $480. You sold XYZ short at $62. You own a call that gives you the right to purchase stock at $65. If XYZ rises above $65 a share, you could exercise the call and buy XYZ at $65 for a $300 loss. You would also lose the $180 premium you paid for the call - breakeven: price of the stock = short sale price for the stock - premium paid for the call. The breakeven point for this example is $62 - $1.80 = $60.20. You make money on this position if the stock falls below $60.20
Short 100 XYZ @ $53 Short 2 XYZ April 50 puts @ $2 max. gain, max. loss, breakeven
- max. gain: $700. At expiration, if the market price of XYZ is $50, the investor makes $300 on the stock and keeps the $400 premium for the two short puts - max. loss: unlimited because the investor is short stock - breakeven: $57 on the upside ($53 + the premium received). Above $57, the investor loses money on the short stock. Below $49, the investor loses on the uncovered short put, $53 - $4 (premium received) = $49
Long 100 ABC @ $35 Short 2 ABC $40 calls @ $1.25 max. gain, max. loss, breakeven
- max. gain: $750, if the stock is $40 at expiration. The investor will keep the $250 premium for the 2 short calls, and make $500 on the stock - max. loss: unlimited because there is an uncovered short call - breakeven: $35 - $2.50 = $32.50 on the downside. Above $32.50, the investor makes money until the stock reaches $40 ($35 + $5 (premium received) = $40), and then starts losing on the uncovered short call
You buy 100 shares of ABC stock for $41 a share and purchase an ABC June 40 put @ $2.50 max. gain, max. loss, breakeven
- max. gain: unlimited, because you own long stock - max. loss: $350. You paid $41 for the stock and you own a put that gives you the right to sell stock at $40. If ABC drops below $40, you could exercise the put and sell your stock at $40, for $100 loss and you would also lose the $250 premium you paid for the put - breakeven: when the price of the stock = price paid for the stock + premium paid for the put. The breakeven point for this example is $41 + $2.50 = $43.50. You make money on this position if the stock rises above $43.50 and you lose if the stock is below it
Buy one ABC Jan 30 calls @ $2.25 Write one ABC Jan 35 calls @ $1 max. loss, max. gain, breakeven
- max. loss: net premium paid; $2.25 - $1 = $1.25 X 100 = $125. The maximum loss is realized at expiration if ABC stock is $30 or lower, in which case both calls expire worthless and the investor loses the entire premium - max. gain: the strike price interval of the spread minus the premium paid. The maximum gain for this position is $375. At January expiration, if ABC is trading above $35, the investor will exercise the ABC Jan 30 call and be assigned on the ABC Jan 35 call. So the stock is purchased at $30 and sold at $35 for a $500 profit - $125, the premium paid for the spread = $375 - breakeven: = lower strike + net premium paid for the spread. In this example, the breakeven is $30 + $1.25 = $31.25. The investor loses money below $31.25 and makes money above it
Protective put and calls provide
- more protection than covered writes which give you a partial hedge and income
Out of The Money
- option has no intrinsic value - the option premium is made up entirely of time value - Call: The price of the underlying security is lower than the strike price of the call - Put: The price of the underlying security is higher than the strike price of the put
Early Exercise
- option holders want to exercise their options prior to expiration
Being Assigned
- or assignment or receiving notice of exercise - the OCC assigns a broker/dealer who is short the option contracts that are being exercised, and the broker/dealer notifies a customer with a short position in those options - the OCC assigns broker/dealers at random and broker/dealers can assign their customers at random, on a first in - first out basis, or any other way that is "fair and reasonable
OTC Options
- over-the-counter positions are negotiated options that trade in the OTC market - they are not standardized or listed on an exchange - often used by portfolio managers to help them hedge or protect their portfolios, because these options can be custom-designed to meet the portfolio's needs at a specific time
Covered Write
- provides a stock investor with a partial hedge and income - To establish a covered write, an investor writes options share for share against a stock position and collects the premium - An investor who is long stock establishes a covered write by writing calls on a stock position
Equity Mini-Options
- represent 10 shares of the underlying security whereas traditional options represent 100 shares - both the contract multiplier and premium multiplier for mini-options is 10 - provide a way for investors to participate in the movements of high-priced stocks while buying even just a few shares of a single traditional option can be very expensive
Call Option
- right to buy - a contract that gives the call holder the right to purchase 100 shares of the underlying security, at the strike price until expiration
Put Option
- right to sell - a contract that gives the put holder the right to sell 100 shares of the underlying security, at the strike price until expiration
Exercise Limits
- same as position limits - restrictions on the number of options contracts on the same side of the market that can be exercised over 5 consecutive business days
When put holders exercise their options, they will...
- sell stock at the strike price and the writer must buy the stock at the strike price
Call Writer
- short calls - receives premium - obligation to sell - has the obligation to sell 100 shares of the underlying security at the strike price, until expiration - receives the premium (price) - does not own the underlying security that they are obligated to sell, the investor would have an unlimited loss potential, because the investor would be required to buy the security at its current price and sell it to the call holder at the strike price
Put Writer
- short puts - receives premium - obligation to buy - has the obligation to buy 100 shares of the underlying security at the strike price, until expiration
Options Clearing Corp (OCC)
- standardizes options contracts so they can trade on exchanges - sets strike prices and expiration dates and is the issuer and clearing agent for listed options - owned by the exchanges that trade options - sets position limits for listed options
Call Premiums
- tend to increase in value when the underlying stock price rises, especially as the price of the underlying stock approaches and goes through the strike price
Long Put
- the holder of a long put has the right to sell 100 shares of the underlying security at the strike price before the expiration date of the option -Investors buy puts if they think the price of the underlying security is going lower - a bearish position - max. loss: premium - max. gain: strike price = premium paid - breakeven point: strike price - premium
Vertical Call or Price Spread
- the investor buys one call and sells another call with a different strike price
For calls on the same underlying security with the same expiration date... (call strike price vs premium, put strike price vs premium)
- the lower the call strike price, the higher the premium - the higher the put strike price, the higher the premium
Credit Call Spread
- the opposite of a debit call spread - an investor writes the call with the lower strike price and purchases the call with the higher strike price - Purchasing the higher strike price call reduces the investor's potential loss because the long call can be exercised, which means the stock can be purchased at the strike price; the premium for the long call also reduces the total premium received, so it reduces his potential profit - a bearish position - loses value or "narrows" as the price of the underlying stock falls to or below the lower strike price call - maximum gain at expiration if both calls expire and he keeps the premium received
Premium
- the price of an option - isn't part of the contract - fluctuates with the price of the underlying security and the time remaining until expiration - are made up of time value and intrinsic value = intrinsic value + time value
Calculating Time Value and Intrinsic Value
- to compute how much of an option premium is time value and how much is intrinsic value, you have to determine if the option is "in the money" and by how much
Debit Call Spread
- type of vertical (price) spread - to establish a debit call spread, an investor buys a call with a lower strike price and writes a call with a higher strike price - has less risk than owning a call - the maximum loss is the premium paid and the maximum gain is unlimited - a bullish position - increases in value or "widens" as the stock rises to and goes through the strike price call of the short call, and the probability of exercise increases
Short Call
- uncovered calls or naked calls - the seller or writer of a short call has the obligation to sell 100 shares of the underlying security at the strike price before the expiration date of the option - an investor will write/short calls when the investor thinks the price of the underlying security is going lower or remaining the same, this is a bearish to neutral strategy - max. loss: unlimited - max. gain: premium - breakeven point: strike price + premium
Short Put
- uncovered puts or naked puts - the writer of a short put has the obligation to buy 100 shares of a specific stock at the strike price up to the expiration date - Investors write/short puts when they think the underlying security is going higher or remaining the same - bullish to neutral strategy - If the underlying security goes higher the put will go down in value and the put writer can purchase the put back at a lower price - If the short position is held until expiration, and the put is out of the money, it will expire and the put writer will realize maximum gain (the premium received) - max. gain: premium - max. loss: strike price = the premium received - breakeven point: strike price - premium - breakeven point is the same for the put holder and the put writer - If the underlying security continues to rise above the breakeven point,the put holder will lose and the put writer profits. - If the stock drops below the breakeven point, the put writer will lose and the put holder will profit
In The Money
- when an option has intrinsic value - a call is in the money when the price of the underlying security is higher than the strike price of the call (think "call up") - A put is in the money when the price of the underlying security is lower than the strike price of the put (think "put down") - does not matter whether the investor is long or short
Intrinsic Value
- when the price of the underlying security is higher than the strike price of the call
To hedge a stock position
- you have to establish an options position on the opposite side of the market.
Intrinsic Value (Calls) =
= market price - strike price
Time Value =
= premium - intrinsic value
Intrinsic Value (Puts) =
= strike price - market price
Claudette purchases 300 shares of ABC stock @ $24 and writes 3 ABC Jan 25 calls @ $1.75. At January expiration, ABC is $27.50. What is Claudette's profit or loss?
Debit Credit 24 1.75 25 --------- 2.75 - Claudette made a profit of $825. She purchased stock at $24; a debit. She received a premium of $1.75 for her short calls; a credit. At expiration, her short calls are exercised and she has to sell her stock at $25; a credit. $1 + $1.75 = $2.75 X 100 X 3 = $825.
Jay bought 100 shares of XYZ @ $28 and purchased one XYZ Feb 25 put for $0.88. At February expiration, XYZ is $27 and Jay closes out his entire position. What is his profit or loss?
Debit Credit 28 0.88 27 ------- 1.88 - Jay lost $188. He bought 100 shares of XYZ at $28; a debit and sold it for $27; a credit. He paid $0.88 for his long put; a debit. At expiration the put was out of the money and expired worthless. $1.88 X 100 = $188.
Maria sold short 100 shares of ABC @ $52. She bought one ABC April 55 call @ $1.40. ABC falls to $46 and Maria buys back the short stock and sells her long call for $0.32. What is her profit or loss?
Debit Credit 52 1.40 46 0.32 ------- 4.92 - Maria made a profit of $492. She shorted stock at $52; a credit, and bought it back at $46; a debit. She paid $1.40 for the long call; a debit and sold it for $0.32; a credit. $4.92 X 100 = $492.
Stock Position Hedge Partial Hedge (protective call or put) (covered write) Long stock Short stock
Stock Position Hedge Partial Hedge (protective call or put)(covered write) Long stock Long put short call Short stock Long call short put
The market price of DEF is 31. Gordon bought 5 DEF Dec 30 calls @ $3.00 and wrote 5 DEF Sept 30 calls for $1.75. At September expiration, DEF is 29 and the Sept 30 calls expire. If Gordon sells his DEF Dec 30 calls for $2, what is his profit or loss?
debit credit 1.25 2 ------- 0.75 - Gordon's profit is $375. Gordon established the spread for a net debit of $1.25 ($3 - $1.75). His short calls expired worthless and he sold his long calls for $2. So he closed the position for a $2.00 credit - $1.25 debit = $0.75 credit X 100 = $75 X 5 spreads = $375.
Sally wrote 3 XYZ Oct 50 puts @ $2.25 when XYZ was trading at a market price of $52. At expiration, XYZ is at $57. What is Sally's profit or loss?
debit credit 2.25 - Sally's opening transaction was a sell, so it is a credit of $2.25. The XYZ October $50 puts were out of the money at expiration, so they expired worthless. Sally's profit is $675. $2.25 X 100 =$225 X 3 contracts = $675.
Jerry wrote 5 XYZ Oct 50 puts @ $2.25 when XYZ was trading at a market price of $52. At October expiration, XYZ is at $45 and Jerry's puts are exercised. He immediately sold 500 shares of XYZ at $45. What is his profit or loss?
debit credit 2.25 50 ------- 45 - Jerry's opening transaction is a sell, so it is a credit of $2.25. His short puts were in the money at expiration, so they were exercised against him and had to buy 500 shares of XYZ at $50, which is a debit. He sold his stock at $45, which is a credit. Jerry lost $1,375 or net of the Debit and Credit. To calculate: 50 - (2.25 + 45) = 50 - 47.25 = $2.75 X 100 shares per contract = $275 X 5 contracts = $1,375 loss.
Adam bought one ABC June 30 call @ $2.60 when ABC stock was trading at a market price of $31. Subsequently, ABC stock rose to $38 and Adam exercised his call and sold his stock at $38. What is his profit or loss?
debit credit 2.60 30 38 -------- 5.40 - Adam bought a call, which creates a debit of $2.60. He exercised the call and bought stock at the $30 strike price; a debit of $30. He sold the stock for $38, which creates a credit of $38. The result of all the transactions is a credit of $5.40 X100, so Adam's profit is $540.
Juan thinks that ABC stock is going higher. He wants to buy 5 ABC Feb 40 calls @ $4.25, but he is worried about losing his entire investment of $2,125. To minimize his potential loss, he decides to create a call spread and writes 5 ABC Feb 50 calls @ $1.00, for a net premium of $3.25. A month later, he closes the entire position for $6. What is his profit or loss?
debit credit 3.25 6 ------- 2.75 - Juan's profit is $1,375. Juan purchased the call spread (he bought the lower strike price call) for a net premium of $3.25 ($4.25 - $1.00 = $3.25) and sold it for a net premium of $6. $6 - $3.25 = $2.75 X 100= $275 X 5 contracts = $1,375.
Adam purchased one ABC June 50 call @ $3.50. A month later he sold it for $6. What is his profit or loss?
debit credit 3.50 6 ------- 2.50 - Since Adam bought a call and paid a premium, there is a debit to the account of $3.50. When he sold the call, the account is credited $6. The result is a credit to his account of $2.50.X 100, so he had a $250 profit.
Adam writes one ABC June 50 call @ $3.50. A month later, he buys it back at $6. What is his profit or loss?
debit credit 3.50 6 ------- 2.50 - Adam's opening transaction is a sell, so it is a credit of $3.50. When Adam later purchased his short call, it created a debit of $6. The result is a debit of $2.50 X 100, so Adam lost $250.