Lesson 6: Options
Call Option: 1 FB 170 Call at 8
-Buyer has the right to buy shares (100 shares) at 170 -Seller has the obligation sell shares at $170 -Strike Price = $170, Premium = $8 Buyer will never exercise call option when Market Value is below contract strike price MV < Strike = Out of the Money (contract won't be exercised) MV > Strike = IN THE MONEY Breakeven = $178 (both buyer and seller won't have profit/loss) Call UP
Put Option: 1 FB 170 put at 10
-buyer has the right to sell shares at $170 (put options are confusing because you are BUYING in order to sell at lower price) -Seller has the obligation to buy shares at $170 Out of the money = MV > Strike In-the-Money = MV < Strike Breakeven at $160 There are puts when they are "in-the-money" but still not profitable Puts are exercised when market is going down. PUT DOWN
Which Option Position would satisfy the below investor's goal? 1.) Very Bullish on stock 2.) Earn income if a stock appreciates 3.) Earn income if owned stock stays flat 4.) believe a stock will decline with certainty 5.) Earn Income with a high degree of risk
1.) Very Bullish on stock = = Long Call, would enjoy upside appreciation locking in strike price 2.) Earn income if a stock appreciates = short put, will generate premium income when sell contract, as stock goes up. when you see "earn income" usually means sell 3.) Earn income if owned stock stays flat = Covered Call 4.) believe a stock will decline with certainty = Long Put 5.) Earn Income with a high degree of risk = Short Call
Put Strategies: 1 FB 170 Put at 10 1.) When is this option contract in-the-money 2.) When is this option contract profitable for the owner? 3.) Would the owner exercise the contract at $164? 4.) When is this contract profitable for the writer? 5.) What is the contract's breakeven point? 6.) What does the option cost the buyer (earn the seller)?
1.) When is this option contract in-the-money -when FB < $170 2.) When is this option contract profitable for the owner? -When FB < $160 3.) Would the owner exercise the contract at $164? -Yes -Exercise = $4 loss -Expire = $10 loss 4.) When is this contract profitable for the writer? -when FB > $160 5.) What is the contract's breakeven point? -$160 for buyer & seller 6.) What does the option cost the buyer (earn the seller)? -$1,000.... 10 x 100 shares
The 1 FB 170 Call at 8 1.) When is this option contract in-the-money 2.) When is this option contract profitable for the owner? 3.) Would the owner exercise the contract at $175? 4.) When is this contract profitable for the writer? 5.) What is the contract's breakeven point? 6.) Who breaks even at that price? (buyer, seller, or both)
1.) When is this option contract in-the-money? -when FB MV > $170 2.) When is this option contract profitable for the owner? -When FB MV > $178 3.) Would the owner exercise the contract at $175? -Yes... -Exercise = $3 loss -Expire = $8 Loss 4.) When is this contract profitable for the writer? -When FB MV < $178 5.) What is the contract's breakeven point? -When FB MV = $178 6.) Who breaks even at that price? (buyer, seller, or both) -BOTH
How many shares are purchased and sold upon exercise?
100 shares per contract (the premium represents 100 shares)
An investor writes 2 STP Jan 50 puts for 3 when STP is trading for 49. What is the investor's breakeven on the position? A) 46 B) 53 C) 47 D) 56
47 The breakeven for a long or short put is the strike price minus the premium.
An investor purchases 100 shares of XYZ stock at 72 and later buys 1 XYZ 69 put for 2.50 to protect the stock position. When the market price of ABC is 68. What is the investor's breakeven on the combined purchase? A) 70.5 B) 74.5 C) 65.5 D) 66.5
74.5 When an investor buys a put to protect a stock purchase, the investor will breakeven when the stock price is equal to the cost of the stock plus the put premium. 72 + 2.50 = $74.50.
Arrange the dates below in the order in which they occur, first to last, in a typical cash dividend payment process for a regular way transaction. I. Ex-dividend date II. Record date III. Declaration date IV. Payable date A) III, I, II, IV B) II, III, I, IV C) III, I, IV, II D) I, II, III, IV
A) III, I, II, IV The process of cash dividend payment typically takes place over approximately a three week period. They must first be declared, and they will be paid on the payable date, which is the last date in the process. They are paid to persons who own the stock on the date of record. In order to own the stock on date of record, an investor must buy the stock before the ex-date (regular way settlement requires 2 business days), which is 1 business day before the record date.
Howard buys listed options with an expiration date that is more than two years in the future. What is this type of option called? A) LEAP B) LOMOS C) LIFER D) LIZRD
A) LEAP Long-term equity anticipation securities (LEAPs) are listed options with long-term expirations, of up to three years from the time of issuance. This is different from standard option contracts, which have an expiration of nine months.
An investor makes a purchase of 100 call options on a Friday. This transaction will settle on A) Monday B) Friday C) Wednesday D) Tuesday
A) Monday
An investor writes a call to increase income to his portfolio. In establishing this position this investor has engaged in an A) Opening sale B) Closing purchase C) Opening purchase D) Closing sale
A) Opening sale
An investor sells 2 XYZ Apr 73 call for 2.50 when XYZ is trading for 72.25. In November, the contract is closed for its intrinsic value when XYZ is trading for 74. Which of the following statements is TRUE? A) The investor has a profit of $300 B) The investor has a loss of $300 C) The investor has a profit of $150 D) The investor has a loss of $150
A) The investor has a profit of $300 The 2 calls were sold for $500, and the closing purchase prior to expiration for intrinsic value cost the investor $200. Each call is in the money by $100 because the market price of the stock is more than the exercise price. Therefore, the investor generated $500 on the sale and only paid $200 to buy back the calls for a gain of $300.
In April, an investor purchases an October XYZ 75 call for premium of $700. By September the premium is $400. If the investor directs his broker to get out of the options market, which of the following statements is TRUE? A) The transaction will be a closing sale with a loss of $300 B) The transaction will be an opening sale with a gain of $300 C) The transaction will be a closing purchase with a loss of $300 D) The transaction will be an opening purchase with a loss of $300
A) The transaction will be a closing sale with a loss of $300 This investor opened a position by purchasing a call for premium of $700. A closing transaction is made to offset or cancel potential loss by selling the option at the then current premium of $400, which results in a loss of $300. The investor has chosen to close the position to limit potential loss.
Could the writer (seller) of an option contract choose to
A.) Exercise? NO B.) Let option expire? NO C. Close position (trade the contract)? YES
Could the owner (buyer) of an option contract choose to A.) Exercise? B.) Let option expire? C. Close position (trade the contract)?
A.) Exercise? YES B.) Let option expire? YES C. Close position (trade the contract)? YES
Index Options
An index option uses the value of an index (e.g, S&P 500, DJIA, Russell 2000) as the underlying asset Investment Objective: -Protect an entire portfolio -hedge with long puts -Generate Enhanced Returns -write covered calls -Speculate on the index's value -buy calls or puts Similar to Equity Options -100x multiplier -equity options are for 100 shares -Index options have a 100x multiplier Differences from Equity Options -Settle for Cash -No physical settlement -How much cash? -The difference between the strike price and index's value
An investor writes 2 Feb 45 calls for 2.25. The stock price at which the investor breaks even is A) 49.5 B) 47.25 C) 40.5 D) 42.75
B) 47.25
An investor sells short 100 shares of XYZ stock at 61 and buys 1 XYZ 65 call for 1.50 When the market price of ABC is 62. What is the investor's breakeven on the combined positions? A) 63.5 B) 59.5 C) 62.5 D) 60.5
B) 59.5 When an investor buys a call to protect a short stock position, the investor will breakeven when the stock price is equal to the price at which the stock was sold short minus the call premium paid. 61 - 1.50 = $59.50. The investor is bearish and will make money only when the short position can be bought in and price below this point because of the premium that was paid for the call.
With the market price at $67.25 at expiration, a long XYZ 65 call will A) expire B) Be automatically exercised according to OCC provisions C) Be exercised only if the holder gives exercise instruction D) Be exercised only if the counterparty to the contract has met the initial margin requirement for purchase of the stock
B) Be automatically exercised according to OCC provisions The Options Clearing Corporation has provisions for the automatic exercise of certain in-the-money options at expiration. This procedure is also referred to as "exercise by exception." Generally, the OCC will automatically exercise any expiring equity call or put in a customer account that is $0.01 or more in-the-money, and an index option that is $.01 or more in-the-money. However, the customer's broker-dealer may have a different threshold for automatic exercise which may or may not be the same as the OCC's.
A client owns a portfolio of blue chip stocks that is to fund his retirement in 10 years. Although confident that the market will continue to advance, he is concerned that a market correction of more than 10% could wipe out significant value. Which of the following strategies might benefit this investor? A) Sell index puts B) Buy index puts C) Sell index calls D) Buy index calls
B) Buy index puts By purchasing index puts the investor would earn cash in an overall market decline. This cash could offset portfolio losses and allow the investor to benefit from continued market growth from the blue chip portfolio.
Which of the following terms is most interchangeable with "listed option"? A) Customized option B) Exchange traded option C) Standardized option D) OTC option
B) Exchange traded option Listed options are puts and calls that are exchange traded. They have standardized strike prices and expiration dates which make them marketable and liquid for buyers and sellers.
When is the settlement date for physical delivery of stock when options have been exercised? A) The 5th business day after exercise B) The day of exercise C) The 2nd business day after exercise D) The 3rd business day after exercise
B) The day of exercise
Which income producing options strategy allows an investor to purchase shares at a predetermined price? A) Buy a call B) Write a put C) Buy a put D) Write a call
B) Write a put The sale of a put requires an investor to buy shares when assigned. The income is earned through the receipt of the premium.
Put Option
Buyer: Right to sell FB, pays premium Seller: Obligated to buy FB, earns premium, Bullish
An investor purchases an XYZ Apr 90 call for 2.50 when XYZ is trading for 86. Prior to expiration contract is sold for its intrinsic value when XYZ is trading for 96. Which of the following statements is TRUE? A) The investor has a loss of $750 B) The investor has a gain of $200 C) The investor has a gain of $350 D) The investor has a loss of $350
C) The investor has a gain of $350 The call was purchased for $250, and sold prior to expiration for intrinsic value of $600. The call is in the money by $600 because the market price of the stock is more than the exercise price. The difference between the purchase price and sales price of the call results in a gain of $350.
Your customer owns ABC stock, but does not expect that the price will appreciate rapidly in the near future. To increase the income to his portfolio without adding significant risk, the customer should A) Buy ABC Leap calls B) Establish a married put strategy C) Write calls on ABC stock D) Write ABC puts
C) Write calls on ABC stock By writing calls on stock that is owned, an investor receives a premium and is not obligated to sell the stock if the call is not exercised. The call writer wants little or no movement in the price of the stock so the obligation to sell it is not exercised by the holder.
An investor that previously established a long position in puts makes an offsetting transaction in an identical put. This transaction is a(n) A) Closing sale B) Opening sale C) Opening purchase D) Closing purchase
Closing sale An investor that previously established a position by buying an option will close the position by selling an identical option to reduce or cancel the position.
Advanced Options Strategies
Combining stock and option positions can reduce risk or enhance returns -Covered call -protective put -short stock hedge *NOTICE: When using options as a hedge "Call up" and "Put Down" don't work
Covered Call Position Example
Covered Call Position 1.) Long 100 shares XYZ at $50 and 2.) Write 1 XYZ June $50 call for 2 Q: What is the gain or loss if the market value of XYZ.... 1.) Stays flat ($50) = $200 2.) Drops slightly ($48) = $0 (breakeven) 3.) Appreciates ($93) = $200 (upside to buyer of call)
Covered Call
Covered Call Position 1.) Long stock, and 2.) Write (sell) a call Investment Objectives 1.) Earn premium income 2.) Small hedge on the stock Costs (risk) 1.) Forfeit stock appreciation prior to call's expiration 2.) Cap max gain Goal is to earn that premium income
A customer sells short 100 shares of XYZ stock for 72 and buys one XYZ 75 calls for 1.50. The stock price rises to 77 and the option is exercised. The profit or loss to the investor is A) Profit of $650 B) Loss of $650 C) Profit of $450 D) Loss of $450
D) Loss of $450 The stock is sold short for $7,200. To protect the position the investor buys a call for $150. The call is exercised when the market price of the stock rises, so the investor buys the stock to cover the short position for $7,500. The customer received $7,200 from the short sale, but paid a total of $7,650 (premium + stock purchase price) for a loss of $450.
A holder of a call option contract would like to receive a cash dividend declared by the issuer of the underlying stock. In order to receive the dividend, what action must the holder take? A) The holder is not entitled to receive the dividend under any circumstances B) The holder must exercise the option before the record date C) The holder will receive the dividend automatically, and no action is required D) The holder must exercise the option before the ex-dividend date
D) The holder must exercise the option before the ex-dividend date Cash dividends are paid by issuers to owners of the stock as of the date of record. To receive a cash dividend, a call holder must exercise the option prior to the ex-date of the dividend. For an American-style call option, early exercise is possible and the investor needs to weigh whether the benefit of being long the underlying stock and receiving the dividend outweighs the cost of surrendering the option early. Typically, this makes sense only for call options that are deeply in the money before the dividend is paid.
Just prior to expiration the market price of XYZ is stock is $63.27. If an investor holds an XYZ $63.25 put, which of the following statements is TRUE? A) The put is subject to exercise but only if the investor gives written notice to the broker-dealer on the business day prior to expiration B) Although the put is in the money, it does not meet the OCC rules of automatic exercise C) The put will be exercised automatically and no notice is required D) The put will expire
D) The put will expire The Options Clearing Corporation will automatically exercise any expiring equity call or put in a customer account that is $0.01 or more in-the-money. No notice is required. Calls are in the money when the market price is higher than the exercise price; puts are in the money when the market price is lower than the exercise price. This put is not in the money and will expire.
Call Option Example
FB Inc. Strike: $170 (the price at which the contract can be exercised, shares of FB will trade at $170) Expiration: Jun 2018 Premium: $8.00 (the premium is represented as a per share #, at the premium while it's $8, it really indicating $8 x 100 shares) Buyer: Right to buy FB stock Seller: Obligated to sell FB stock -They transact at $170 strike price they agreed on, regardless of FB's market price) Buyer: Pays premium, and is bullish Seller: Earns premium and is bearish Buyer = right to buy, pays premium, bullish Seller = obligated to sell FB, earns premium, bearish
With the current level of the S&P 500 index at 1815.94, an investor buys a three-month SPX call option with a strike price of 1820 that is currently trading for 54.40. At expiration, the value of the index is 1850. Which two of the following statements are TRUE? I. The investor will receive cash at expiration II. The investor must pay cash at expiration III. The breakeven is 1761.54 IV. The contract is in the money at exercise A) II and IV B) I and IV C) I and III D) II and III
I and IV An SPX index call is in the money when the index value is above the strike price, as in this example. At expiration, the holder of the call receives cash equal to the intrinsic value. The breakeven is calculated by adding the premium to the index strike price. 1820 + 54.40 = BE of 1874.40. Although this contract was in the money, the investor did not profit because the index was not higher than the BE point at exercise.
An investor writes an S&P 500 2025 put for 10. Just prior to expiration the S&P is 1980. Which two of the following statements are TRUE? I. The contract will be exercised II. The contract will expire III. The investor profits in this transaction IV. The investor has a loss in this transaction
I and IV The investor received $1,000 to write the index put. The put is exercised because the index value is below the exercise price. Index options settle in cash so the writer must pay $4,500 (2025 â€" 1980 x 100 multiplier) at exercise. The investor's loss on this transaction is $3,500 (Paid $4,500, received $1,000).
Which two of the following statements regarding exercise of index options is true? I. Exercise settlement requires delivery of stock II. Exercise settlement requires delivery of cash III. Transactions are settled the business day following the trade IV. Transactions are settled on the third business day after the trade
II and III Index options are settled in cash equal to the in-the-money amount based on the closing value of the index. Cash settlement takes place on the business day following the settlement date.
An investor writes 2 ABC Mar 76 calls for 2.50. Which two of the following statements are TRUE? I. The breakeven is 73.50 II. The breakeven is 78.50 III. The contract will be profitable if it expires IV. The investor wants the contract to be exercised
II and III The breakeven of a call is the strike price + the premium. The writer of a call will profit if the stock price is below the breakeven and the contract expires. The writer will keep the premium received and is not obligated to sell the stock.
All of the following are characteristics of listed options EXCEPT A) Fixed strike prices B) Exchange trading C) Limited liquidity D) Standardized expirations
Limited Liquidity Listed options are puts and calls that are exchange traded. They have standardized strike prices and expiration dates which make them marketable and liquid for buyers and sellers.
What can an investor do with any options position prior to expiration?
Liquidate the position
Protective Put: Long 100 shares at 35, and Buy 1 XYZ 34 Put at 1 What is the gain or loss if the market value of XYZ... 1.) Stays Flat at $35 2.) Drops to $30 3.) Appreciates to $40
Long 100 shares at 35, and Buy 1 XYZ 34 Put at 1 What is the gain or loss if the market value of XYZ... 1.) Stays Flat at $35 -($100) 2.) Drops to $30 -($200) 3.) Appreciates to $40 -$400 (you still retain upside)
Put Option: 1 ABC May 30 Put at 4
Long Party (buyer, owner) Hope the stock goes down so you can sell at $30 -Market View: Bearish -Use Case: short stock substitute, protect long position -Max Gain: Substantial -Max Loss: Premium ($400) -Breakeven: Strike - Premium ($26) Short Party (seller, writer) -Market View: Flat or bullish -Use Case: Income, strong bullish view Max Gain: Premium ($400) Max Loss: Substantial Breakeven: Strike - Premium ($26)
1 ABC Jan 50 Call at 3 Short Party (seller, writer)
Market View: Bear Use Case: Income, strong bearish view Max Gain: Premium ($300) Max Loss: Unlimited Breakeven: Strike + Premium ($53)
1 ABC Jan 50 Call at 3 Long Party (buyer, owner)
Market View: Bull Use Case: -stock substitute or protect short position Premium = $300 Max Gain: Unlimited Strike Price = $50 Max Loss: Premium ($300) Breakeven: Strike + Premium ($53)
When do Standard Option Contracts Expire?
Nine Months After Issuance
Options Expiration
Options contracts expire on the 3rd Friday of their expiration month Q: When do standard option contracts expire? A: Nine months after issuance American Style Options Expiration: -Exercise at any time -Most equity options European Style Options Expiration: -Exercise at expiration only -Index Options
Trading Options
Options, like other securities, trade on exchanges (CBOE) Transaction 1: Opening Purchase -Buy an option, pay a premium AND Transaction 2: Closing Sale -Sell the contract, collect premium DIFFERENT TRANSACTION: Transaction 1: Opening Sale -Sell an option, earning premium AND Transaction 2: Closing Purchase -Buy an option, pay premium What is a regular way settlement when trading listed options contracts? B. T+1 Options
Options Premiums
PREMIUM = an option contract's market value Premium's INTRINSIC VALUE: -the options in-the-money amount -cannot be negative (zero is the lowest possible intrinsic value) Premium's TIME VALUE: -the value attributable to the time remaining before expiration -The more time before expiration the more time value (the greater the chance the option moves into the money)
Hedged Short Position
Protective Call 1.) Short stock, and 2.) Long (buy) a call Investment Objectives: 1.) Bearish 2.) reduce risk with call Costs (risk) 1.) Call premium reduces return 1.) Short 100 shares at 20 2.) Buy 1 XYZ 22 call at 1
Protective Put
Protective Put 1.) Long stock, and 2.) Long (buy) a put Investment Objectives 1.) Downside Protection (a floor price to exit) 2.) Retain upside potential Costs (risks) 1.) Put premium reduces return (need appreciation to breakeven) Premium will reduce your return
If ABC stock is trading at $43.25 just prior to expiration, which of the following options positions will expire? A) Long 44.75 put B) Short 43 call C) Long 42.75 call D) Short 42.75 put
Short 42.75 put Options expire when they are out of the money at exercise. A long or short call is in the money when the stock price is above the contract's exercise price. A long or short put is in the money when the stock price is below the contract's exercise price. The short 42.75 put is the only position that is not in the money.
What is a regular way settlement when trading listed options contracts?
T+1 Options
The Options Clearing Corporation (OCC)
The Options Clearing Corporation (OCC) issues and guarantees options contracts Do OCC listed options contracts have the following characteristics as compared to non-OCC listed options contracts? 1.) Increased liquidity? -Yes, the options are standardized uniform therefore more demand for them 2.) Reduced Credit risk & counterparty risk? -Yes, you don't need to dilligence or analyze the counterparty bc OCC stands in middle 3.) Reduced Market Risk? -No 4.) Reduced Capital Risk? -No
What is the settlement date that applies to the exercise of index options? A) The 5th business day after exercise B) The business day following the date of exercise C) The 3rd business day after exercise D) The 2nd business day after exercise
The business day following the date of exercise Cash settlement for index options must take place on the business day following the date of exercise.
An investor writes 2 XYZ June 73 calls at 8. Just before expiration XYZ is trading for 66. Which of the following statements is TRUE? A) The investor has a profit of $800 B) The investor receives 200 shares of stock at 73 C) The investor is required to sell 100 shares of stock at 73 D) The investor has a profit of $1,600
The investor has a profit of $1,600 his call is out of the money and will expire, so the writer is not obligated to sell the stock. The buyer will not exercise the right to buy stock at the strike price of 73 when it could be purchased on the market for 66. The writer profits from the premium of $1,600 received for writing 2 contracts at $800 each.
Which of the following statements about the purchase of a put is TRUE? A) The more out-of-the-money the put purchased, the more bearish the strategy B) A long put is an ideal tool for an investor that wishes to profit in an upward price move in the underlying stock C) Buying a put is often used as an alternative for purchasing a position in stock D) The purchase of a put offers the investor an unlimited amount of risk
The more out-of-the-money the put purchased, the more bearish the strategy A long put permits the holder to sell stock at the exercise price. The more out of the money the put is (the lower the strike price), the more the underlying stock price will have to decline before the put has value.