Series 7 Unit 10
General Characteristics of Yield Based Options
-Contract size multiplier of $100 -Settlement is the next business day in cash rather than in delivery of underlying security.
Single Option Strategies
4 basis strategies available to options investors -Buying Calls -Writing Calls -Buying Puts -Writing Puts
The Options Contract
A 2 party contract that conveys a right to the buyer and an obligation to the seller. The terms of the contracts are standardized by the OCC. Options are Derivative Securities b/c their value is derived from the value of an underlying instrument. Standard equity option has each contract representing 100 shares of underlying stock. Mini options have contracts overlaying only 10 sahres of the underlying security.
Your customer is interested in buying call options on CDL common stock. The client asks you, "Who issues CDL options?" The proper response is A) the exchange where the option is traded. B) CDL Corporation. C) the Options Clearing Corporation. D) the seller of the option.
A) the exchange where the option is traded. B) CDL Corporation. C) the Options Clearing Corporation. D) the seller of the option. Answer is C E: The issuer and guarantor of the options covered on the exam is the Options Clearing Corporation (OCC). Unlike other derivatives, such as rights and warrants, a corporation does not issue options on its own stock. Please do not confuse this with employee stock options, which is a different topic. As the guarantor, the OCC guarantees that the writer (seller) of the option will perform. That is, if exercised on a call, the stock will be delivered at the strike price, and if exercised on a put, the seller will pay the strike price.
Time or Calendar Spread
AKA horizontal spread, 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 value of the two option premiums erode. Their outlook is neutral. Time spreads are called horizontal spreads b/c expiration months are arranged horizontally on options reports. Long ABC Nov 60 call for 3 Short ABC Jan 60 call for 5 Time/horizontal spread b/c the difference in the two options is in the Nov and Jan expiration dates.
An investor purchases 100 shares of JKL common stock at a price of $42 per share on April 22, 2018. On June 27, 2019, JKL's market price is $51 and the investor liquidates the position. Which of the following transactions made on October 17, 2018, would have an effect on the investor's tax treatment of this gain? A) Buying a Feb 45 JKL put B) Selling a Feb 45 JKL call C) Selling a Feb 45 JKL put D) Buying a Feb 45 JKL call
Answer is A E: Long-term capital gains tax rates are available when one has a holding period of more than 12 months. Although this investor held the JKL stock for more than 14 months, the purchase of the put caused the holding period to be tolled (the IRS term for suspended). It means that the holding period from April 22 to October 17 (almost 6 months) is put on hold until the put is disposed of or expires. When that happens in February, the "clock" picks up where it left off and runs another 4+ months until June 27. The total time period is approximately 10 months, less than the 12 months required for long-term treatment. None of the other positions affects the holding period of a long stock position.
On a single day, a customer purchases 15 TPL Sep 50 puts at 6 and 15 TPL Sep 50 calls at 1. If the price of TPL is $45 per share and the customer has no other security positions, what is this position called? A) Covered B) Spread C) Combination D) Straddle
Answer is D E: A long straddle is the purchase of a call and a put on the same stock with the same strike price and expiration. A straddle differs from a combination in that the strike prices and/or the expiration dates on a combination are different. A spread is a long put and a short put or a long call and a short call, rather than a put and a call.
If an investor sold two BCD Feb 40 calls at 4 on August 4, 2018, and the call expired unexercised, what were the tax consequences? A) $800 ordinary income for tax year 2019 B) $800 ordinary income for tax year 2018 C) $400 short-term capital gain for tax year 2019 D) $800 short-term capital gain for tax year 2019
Answer is D E: For tax purposes, any premiums earned are recognized at the expiration date. In this case, the February call options sold in August 2018 for $400 each and expired in February 2019. Uncovered options writers always have short-term gains or losses.
For a regular standardized option, any gain on the sale of the contract is A) deferred until the underlying asset is sold. B) a long-term capital gain. C) a short-term or long-term capital gain depending on the holding period. D) a short-term capital gain.
Answer is D E: Regular standardized options have a maximum expiration of 9 months, so a gain on these types of contracts can only be short term for tax purposes. It is only the LEAPS options where it is possible to hold a long option position for more than 12 months. That is the only case where a long option can realize long-term treatment. The question is dealing solely with the options contract, not the underlying security.
Tax Rules for Options
B/c options are capital assets, capital gains tax rules apply. The tax consequences will vary depending on what the investor does with the option position.
Breakeven -- Index Options
B/e follows the Call UP and Put DOWN rule.
Breakeven -- Straddles and Combinations
Call UP and Put DOWN. There are two break even points b/x there are two options. The b/e for the call is the strike price plus both premiums paid. The b/e point for the put is the strike price minus both premiums paid.
Out of the money
Call is out of the money when the market price is less than the strike price. Put option is out of the money when the market price is more than the strike price. Sellers benefit when the contracts are out of the money. They keep the premium and do not have to perform on the contract.
TTA*****
Debit = widen = exercise Debit spreads are profitable if the difference between the premiums widens or if the options are exercised. Credit = narrow = expire Credit spreads are profitable if the difference between the premiums narrow or the options expire.
Price spread or Vertical spread
Different strike prices but the same expiration date. Long ABC Nov 50 call for 7 Short ABC Nov 60 call for 3 This is a price/vertical spread b/c the difference in the two options being 50 and 60 for strike prices, not b/c the premiums differ
Taxation for Options
Expiration: The buyer reports a capital loss equal to the premium amount. The seller reports a capital gains equal to the premium amount. -Tax treatment for LEAPS writers at expiration is unique. LEAPS writers MUST report short-term capital gains at expiration no matter what. LEAPS buyers report a long or short term gain depending on the contract. Closing out sales: closing sales or purchases generate a capital gain or loss equal to any price difference. This gain or loss must be reported on the basis of the date of the closing transaction. Exercise: the exercise of options does not generate a capital gain or loss until a subsequent purchase or sale of the stock occurs. If a long call is oxercised, the option holder buys the stock. B/c the investor paid a premium for the stock, the total cost basis for the stock includes the premium and strike price.
Breakeven -- Spreads
Finding the breakeven point on a spread uses the same Call UP and Put DOWN formula. With 2 calls or 2 puts, the trick is knowing which strike price to use. In the case of a call spread, the net credit or debit is always added to the lower strike price. In the case of a put spread, you always subtract the net credit or debit from the higher price. The breakeven price is always between the two strike prices.
Breakeven -- Call Options
In the case of calls, the breakeven is the strike price plus the premium (Call UP). For the call buyer, the contract is profitable above the breakeven point. For the call seller, the contract is profitable below the breakeven point. .
Nonequity Options
Index Interest Rate Foreign Currency
TTA**
Option exercise alone does not create a taxable event.
Breakeven -- Put Options
The breakeven of puts is the strike price minus the premium. (Put DOWN). For the put buyer, the contract is profitable below the break even point. For the put seller, the contract is profitable above the breakeven.
Breakeven
The breakeven point is the point at which the investor neither makes nor loses money.
Two ways for unlimited potential loss
Writing an uncovered call option Selling stock short
Long Straddle
an investor using long straddle expects substantial volatility in the stock's price but is uncertain of the direction the price will move. To be ready for either occurrence, the investor purchases both a call and a put. Long one ABC Jan 50 call at 3 and Long one ABC Jan 50 put at 4 Long straddle by purchasing a call and a put with the same strike price and expiration date. If the market price of the stock rises sufficiently, the call will be profitable and the put will expire. If market price falls, the put will be profitable and the call will expire. As long as the stock's price moves, the investor can make money.
Straddles
composed of a call and a put with the same exercise (strike) price and expiration month. Straddles can be long or short and are used by investors to speculate on the price movement of stock. Straddles are identified by vertical ovals rather than horizontal ovals.
Combinations
A combination is composed of a call and a put with different strike prices, expiration months or both. Combos are similar to straddles in strategy. Investors typically use combos b/c they are cheaper to establish than long straddles if both options are out of the money. Buying ABC Jan 40 call Buying ABC Jan 45 put. Here its a long combination. The holder makes money if the underlying stock price moves up or down far enough. The writer of a short combination makes money if the stock stays relatively stable.
Types of Spreads
A price or vertical spread A time or calendar spread A diagonal spread
Debit and Credit Spreads
A spread is a debit spread if the long option has a higher premium than the short option A spread is a credit spread if the short option has a higher premium than the long option. Use a T Chart to determine if it is a credit or debit. Draw a chart with DR for debit and CR for credit on the right side. ***The lower the strike price on a call, the HIGHER the premium***
Spreads
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
Collars
A strategy used to protect an unrealized gain on a long stock position. An investor bought 1,000 shares of ABC at $22 and its now trading at $30. To collar the stock, the customer could write an out of the money call and buy an out of the money put. Write 10 ABC 32.50 Calls Buy 10 ABC 27.50 puts. If the stock were to decline sharply, the writer can always sell the shares at $27.50 by exercising the puts. If the stock were to rise sharply, the customer's calls would be exercised and he could sell them at $32.50. The investor has protected profit, but has limited the upside potential.
Which of the following positions subject an investor to unlimited risk? Short naked call Short naked put Long put Short sale of stock
A) II and III B) I and III C) I and II D) I and IV Answer is D E: Short stock and short naked calls subject an investor to unlimited risk because there is no limit on how high a stock's price might rise. Risk is limited for the other positions.
Which of the following listed option orders can be combined to form a spread order? Buy 1 XYZ Jul 30 put Sell 1 XYZ Jul 35 call Sell 1 XYZ Jul 35 put Buy 1 ABC Jul 30 call
A) III and IV B) II and IV C) I and III D) II and III Answer is C E: Spreads are deemed to be of the same class; class is defined as the same underlying security and the same type of option. Options II and III would be a short straddle. The ABC call cannot be combined with anything because you'd be combining ABC stock with XYZ stock.
Index Options
Allow investors to profit from the movements of markets or market segments and hedge against these market swings. Broad-Based Indexes: reflect the movement of the entire market and include the S&P 100, S&P 500, and the Major Market Index. Narrow Based Indexes: track the movement of market segments in a specific industry, such as a technology or pharmaceuticals.
Short Straddle
An investor who writes a short straddle expects that the stock's price will not change or will change very little. Short ABC FEB 45 call at 4 Short ABC FEB 45 put at 3 Selling a call and put with the same strike price and expiration date. The terms are identical except one is a call and one is a put. If the market price changes a little or not at all, the call and put will expire. The investor's max profit is the two premiums collected. If the market price rises or falls substantially, either the put or the call will be exercised against the investor. The max loss is unlimited b/c of the short naked call.
Which of the following is a bull spread? A) Short Aug 40 call, short Aug 40 put B) Long Jul 30 put, short Jul 35 put C) Long May 40 put, short May 35 put D) Long Aug 30 call, short Aug 25 call
Answer is B E: A debit call spread is bullish and a credit put spread is bullish. Long Jul 30 put, short Jul 35 put is the only bullish position in the answer choices. Short Aug 40 call, short Aug 40 put is a short straddle, not a spread, and the remaining two positions are bearish: long Aug 30 call, short Aug 25 call and long May 40 put, short May 35 put. Remember, buying the low strike and selling the high strike is always a bull spread, regardless of the spread being puts or calls.
Your client's position is long 100 MNO purchased at 90. Which of the following strategies will limit the customer's loss to $700? A) Short one MNO 90 call at 4, short one MNO 90 put at 3 B) Long one MNO 90 call at 4, long one MNO 90 put at 3 C) Sell a MNO 90 call at 7 D) Buy a MNO 90 call at 7
Answer is B E: It is the long put in this straddle position that limits the maximum loss on the long stock position. If the MNO stock drops to $0, the customer loses $9,000 on the long stock position but retains the right to sell the stock to someone at $9,000, to prevent loss beyond the premium of $300. The call would expire out of the money, for a total loss of $700.
Which of the following would establish a covered put? A) Long stock at 40, short put at 35 B) Short stock at 40, long put at 45 C) Short stock at 40, short put at 35 D) Long stock at 40, long put at 45
Answer is C E: A covered put is created when a short stock is combined with a short put. Covered puts are established when the investor is neutral or slightly bearish; therefore, the strike price of the put is less than the cost of the stock sold short. The reason the put writer is covered (protected) is that if the stock's price should decline below 35 and the holder of the option exercises, the stock purchased by the writer is used to cover (replace) the borrowed stock for the short sale at 40.
In a strong bull market, which of the following positions utilizing leverage has the potential for the highest percentage gain? A) Selling short B) Writing puts C) Holding calls D) Holding stocks
Answer is C E: Both a long call and a long stock position are profitable in a rising market. However, because options use leverage, the profit relative to the money invested is larger with option positions. A put writer also profits in a rising market, but only by the amount of the premium. A short seller loses money if the stock rises.
If an investor establishes a call spread, and buys the lower exercise price and sells the higher exercise price at a net debit, he anticipates that A) the price of the underlying stock will not change. B) the spread will narrow. C) the spread will widen. D) the exercise prices will change.
Answer is C E: Debit spreads are profitable when both sides are exercised or the spread widens between the premiums. Credit spreads are profitable when both sides expire or the spread narrows between the premiums.
A stock is trading consistently between $20 and $24. The investor with a long position is neutral on the stock. The goal is to generate income. Which of the following recommendations is most appropriate? A) Buy a put B) Buy a call C) Sell a call D) Sell a put
Answer is C E: The investor should sell a call on the stock and collect the premium (income). The investor is long the stock, so it would be better if the price goes up rather than down. Therefore, the sale of a call is better than the sale of a put, and those are the only real choices when the investor wants income through options.
A technology fund manager concerned about a downturn in the value of his portfolio would hedge by A) selling broad-based index calls. B) selling narrow-based index calls. C) buying narrow-based index puts. D) buying broad-based index puts.
Answer is C E: The portfolio consists of sector-specific securities, so broad-based index puts such as the OEX would not be appropriate. Instead, the manager should buy narrow-based index puts (for example, indices on technology and electronics).
An investor buys two ABC Nov 50 calls, three ABC Dec 45 calls, and one ABC Jan 50 call. The best way to describe the portfolio is that it consists of A) six options of the same type. B) two options of one class, three of another class, and one of a third class. C) six options of the same series. D) six options of the same class.
Answer is D E: A class of options is when they are all of the same type (in this case, calls) and all on the same underlying security (in this case, ABC). Yes, they are all of the same type, but, in a question like this, FINRA is asking for the most specific answer. Same class is more specific than same type. The same series would be if they all had the same expiration date and exercise price.
If an investor purchases 500 shares of an aggressive growth stock, which strategy would limit his downside risk? A) Buying five calls on the stock B) Writing five straddles C) Writing five puts on the stock D) Buying five puts on the stock
Answer is D E: A put gives the investor the right to sell stock at a set price (the strike price) for a period of time, and it protects against losses below the strike price. Buying calls can protect a short stock position. If the customer is long stock, the purchase of calls on that security increases leverage and risk. Writing a put creates the obligation to buy more stock at the strike price, which increases downside risk.
Individuals with diversified stock holdings in their portfolios write covered calls to A) benefit from share price increases. B) lock in profits. C) increase the number of shares they own. D) increase their rate of return on the stocks held in their portfolio.
Answer is D E: Covered call writing is frequently used by persons who own the underlying stock to increase rate of return. If the options expire unexercised, the writer keeps the premium, which provides additional portfolio income.
Customer Notification of Allocation Method
BDs have 3 ways to allocate exercise assignments. -random basis -FIFO -any other method that is fair and reasonable This notification of allocation method must be informed to its customers in writing.
Credit Call Spreads
Bearish investors use credit call spreads to reduce the risk of a short option position. The investor reduced the unlimited risk of being short a naked call by also purchasing a call. A short call is covered with a long call having a lower strike price and the same or longer expiration. The investor is Bearish.
Debit Call Spreads
Bullish investors use these to reduce the cost of a long option position. There is, however, a trade-off, b/c the investor's potential reward is limited. Example: Long 1 ABC Nov 55 call at 6 Short 1 ABC Nov 60 call at 3 Investor's cost was reduced to $300 due to selling the call. The investor profits if the exercise occurs. Investors always want net debit spreads to widen.
Bull and Bear Spreads
Bulls buy low and sell high. A bull spread is created when the investor buys the option with the low strike price and sells the option with the high strike. A bear spread is buying high and selling low.
Opening and Closing Positions
Buying an option opens up the position. Then they sell that option in the closing sale. Selling an option opens up the position. Then they buy back the option in a closing purchase.
Married Put
Buying stock and buying a put option on the same day on that stock as a hedge, that put is "married" to the stock. For tax purposes, the cost basis of the stock is adjusted upward by the premium paid. Even if the put expires worthless, there is no capital loss on the put. Rather, the premium paid is reflected in the cost basis of the stock, which is the B/E point for long stock/long put (cost of stock purchased plus premium). Example: If on same day, a customer buys 100 ABC at 52 and buys 1 ABC Jan 50 put at 2, the customer's cost basis is 54.
Put Spreads
Debit Put Spreads: used by investors to reduce the cost of a long put position. The investor who establishes a debit put spread is bearish. Credit Put Spreads: Bullish investors use these to reduce the risk of a short put position. The investor can reduce the risk of being short a naked put by also purchasing a put. You can cover a short put by buying a long put. The investor is Bullish. The investor profits when the options expire.
Wash Sale Rule
Does not apply to call options or puts. an ABC Jan 50 put is a different security than an ABC Mar 50 put.
Position Limits
For the most heavily traded equity options contracts, position limits are 250,000 contracts on the same side of the market. The limit is subject to frequent adjustment. Position limits apply to individuals, RRs acting for discretionary accounts, and individuals acting in concert (acting together as one person). You can't split a large position to circumvent the limits. LEAPS are added to traditional options to determine whether a violation of the position limit rules has occurred. "Acting in concert", the CBOE looks for control, which indicates the ability to make investment decisions for an account or influence the investment decisions made for an account. Control is presumed when -All parties to a joint account have authority to act on behalf of the account -A person has the authority to exercise transactions in an account Therefore, the following accounts will be presumed to be acting in concert unless evidence to the contrary is provided and accepted by the exchange: -An individual account or a joint account, a spouse clearly exercises control over his account and has the authority to act in a joint account. In this case, positions in both accounts would be aggregated to determine whether a violation of position limits exists. -An individual who has discretion over an account and the account itself, the option position in the account of the person holding 3rd party trading authority is aggregated with positions in the account over which this individual has discretion to determine whether a position violation exists.
Intrinsic Value
In the money: A call is in the money when the market price of the underlying asset exceeds the strike price of the option. Buyers want the call in the money, sellers do not. A put is in the money when the market price of the underlying asset is less than the strike price. Buyers want the call in the money, sellers do not.
Index Options Strategy
Index options may be used to speculate on movement of the market overall. If an investor believes the market will rise, he can purchase index calls or write index puts. If an investor believes the market will fall, he can purchase index puts or write index calls. Hedging a portfolio is an important use of index options. If a portfolio manager holds a diverse portfolio of equity,he can buy a put on the index to offselt loss if the market value of the stocks fall. This use of index puts is known as "portfolio insurance". Index options protect against the risk of a decline in the overall market, which is "systematic" or "systematic risk". ***Weekly index options contracts provie an efficient way to trade optinos around certain news or events, such as economic data or earnings announcements. New options series are listed on Thursday and expire the Friday of the following week. Other than the expiration date and time to expiry, weeklies have the same contract specifications as standard options. ***
Interest Rate (Yield-Based) Options
Interest rate options are yield based. These are based on yieldds of Tbills, Tnotes, and Tbonds. A yield based option with a strike price of 35 reflects a yield of 3.5%
Closing Positions: Gains and Losses
Investors can close out their spread positions at any time. They can sell their long position (closing sale) and buy back the short position (closing purchase). A debit spread is profitable if it can be closed out at a greater credit than the initial debit. That is, the spread between the sale price of the long and the purchase price covering the short must be greater (wider) than the initial debit. A credit spread will be profitable when the difference to close out the short position (closing purchase) and the long position (closing sale) is a smaller debit than the initial credit when the position was opened.
American or European Style Contracts
Investors with a long position can exercise their contract anytime before expiration if the contract is an American Style option. European options can be exercised on expiration day (last day of trading) only. Nearly all equity options are American style. FCOs may be either American Style or European style, and most index options are European-style contracts, including weekly index contracts. Yield-based options are European-Style contracts.
Ratio Call Writing
Involves 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. Example: Investor who is long 100 shares of ABC common stock writes 2 ABC OCT 45 calls. This is a 2:1 ratio write b/c the ratio of total calls to covered calls is 2:1. The 100 shares in the account is enough to cover one of the calls. The other call is uncovered and has potential loss unlimited.
Investment strategies and Different Levels of Approval
Level 1: covered options (calls and puts) Level 2: Long calls, puts, straddles, and combinations Level 3: Spreads (calls and puts) Level 4: Uncovered (naked calls and puts, short straddles, combinations and ratio spreads For customers approved to write uncovered calls or puts, the firm must have written procedures in place covering: -specific criteria used in approving such accounts -specific minimum equity requirements for such accounts -the requirement to provide the customer with a special written document describing the risks involved in uncovered writing. This document must be provided to the customer before the initial uncovered sale.
Maximum Gains and Maximum Losses
Long Calls: -Max gain is unlimited. -Max loss is the premium Short Calls -Max gain is premium -Max loss is unlimited Long Puts -Max gain is Strike Price - Premium -Max loss is the premium Short Put -Max gain is the premium -Max loss is strike price - premium
Options Hedge Position
Long Stock, Long Put (protective Put: an investor buys 100 shares of ABC at 53 and buys an ABC Put at 2 as protection. Should the stock price fall belowe the strike price of 50, 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 BE point is reached when the stock rises by the amount paid for the put; in this case, 53 + 2 = 55 ***Protective put strategies are most often employed with equity positions, as in the previous example or with index options to protect an entire portfolio.
Options Hedge Position
Long Stock, Short Call (covered call): A covered call has limited risk protection. The protection is the premium received, so the BE is the stock price purchased minus the premium. A covered call writer has a neutral to slightly bullish sentiment. If the price of he underlying stock declines, the option will expire and the writer keeps the premium. As the price is declining, the long stock position is losing money. Once the decline exceeds the premium received, the ML is all the way to zero. If the stock was purchased at $50 per share and a 50 call was sold for 4 points, anything below $46 per share results in a loss. If the stock becomes worthless, the investor loses $46 per share. Its only a partial hedge.
Debit Call Spreads
Max Gain: **The difference in strike price - net premium**an investor establishing a debit call spread is bullish. That is because the option purchased has a low strike and the one sold has the high streak. Buy low and sell high (BLSH) is a bullish strategy. If the market price of the underlying asset reaches or goes above the higher strike price, the investor's gain is maximized. Here is an example of what this means. Max loss: the ML in any debit spread is the debit. The max gain and max loss always add up to the spread.
Credit Call Spreads
Max Gain: as with any position established for a credit, is the net premium. The max gain will occur when the stock price is at or below the lower strike price. Max Loss: The ML on a credit call spread is the difference btween strike prices less the net premium. This occurs when the stock's price is at or above the higher strike price. B/E: The breakeven point is the lower strike price plus the net premium.
Debit Put Spreads
Max Gain: debit put spreaders will realize their max gain any time the stock's market price is at or below the strike price of the lower option. At that point, they will have to buy stock at the low strike price, but they can sell the stock at the higher strike price and keep the difference between the two prices, minus the net premium (net debit). Max Loss: If the stocks' price rises to or above the strike price of the higher option, bot puts will expire worthless. At any price above the higher strike price, the investor will sustain the ML b/c oth puts will expire worthless. The general rule is that the ML on a debit spread is the net premium (net debit). The maximum gain is the difference in strike prices less the net debit (ML)
Credit Put Spreads
Max Gain: max gain on a credit put spread is the net premium. Max Loss is the difference btween strike prices minus the net premium, which occurs when the stock's market price is at or below the lower strike price. B/e: the breakeven on a put spread is the higher strike price minus the net premium.
The Volatility Market Index
Measures the implied volatility of the S&P 500 Index Reflect investor expectations of market volatility over the next 30 days. "Fear gauge" "Fear Index"
Rules for Opening an Options Account
New Account Form: must be completed. The B/d must seek to obtain the following info from customers who want to trade options: -Investment Objective -Employment Status -Estimated annual income from all sources -Estimated net worth -Estimated liquid net worth -Marital status and number of dependents -Legal age In addition, the customer's account record may contain the following information (if applicable): -Investment experience and knowledge -Sources of background and financial information for the customer -Date the ODD was furnished to the customer (not later than the date the account is apporved for options trading -Nature and types of transactions for which the account is approved -Whether this is a retail account or institutional account -Signature of the RR introducing the account -Signature of the registered options principal (ROP) or the general sales supervisor approving the account and the date of approval.
Exercise Limits
OCC exercise limits are the maximum number of contracts that can be exercised on the same side of the market within a specified time frame. Currently, the time frame is five consecutive business days. As with position limits, the maximum number applicable to exercise limits can vary from one underlying stock to another, and to determine if a violation has occurred, long calls and short puts (bullish contracts) are aggregated, and short calls and long puts (bearish contract) are aggregated. Like position limits, exercise limits apply to individuals, individuals acting in concert, and registered representatives acting for discretionary accounts, among others.
Written Approval by the ROP
Once new account form is completed, a ROP or branch office manager must review and approve the account in writing at or before the initial trade. FINRA RULE 2360 "based upon such information, the branch office manager, a ROP (series 4) or a Limited Principal, General Securities Sales Supervisor (Series 10) shall especially approve or disapprove in writing the customer's account for options trading. The ODD and OCC must be given to the the customer no later than the time the account is approved for options trading.
A Cashless Collar
One where the premium received on the short call is the same amount or higher than the premium paid for the long put. Short 10 ABC Jan 55 calls at 4 Buy 10 AB Jan 45 puts at 4 B/c the 4 point credit and 4 point debit, the collar is established with no out of pocked cash.
Trading at Parity
Option is trading at parity when the premium equals the intrinsic value of the contract. Options generally trade at parity just before the expiration date.
The Functioning of the Listed Options Market
Options trade on several US exchanges and OTC. Exchange traded options are LISTED OPTIONS and have standardized exercise prices and expiration dates. OTC options are called conventional options and are not standardized. Little secondary market activity exists b/x contract terms are individually negotiated between the buyer and seller. No two contracts are the same. Locations for trading listed options: CBOE NYSE Nasdaq Stock Market PHLX **If a security is subject to a trading halt on its trading market, options on that security stop trading as well.
Time Value
Premium - Intrinsic Value = Time Value (PIT) Time value is a function of the time remaining before the option expires. On expiration date, the time value is zero. Time value is higher the further away from the expiration date the contract is.
Index Option Features
Premium Multiplier: Use a multiplier of $100. The premium amount is multiplied by $100 to calculate the option's cost, and the strike price is multiplied by $100 to determine the total value of the index. Trading: Purchases and sales of index options -- like equity options -- settle on the next business day. Narrow based closes 15 minutes earlier than broad based. Exercise: The exercise of an index option settles in cash rather than in delivery of a security. Cash needs to be delivered on the next business day. (T+1) If the option is exercised, the writer of the option delivers cash equal to the INTRINSIC VALUE of the option to the buyer. If an index option is in the money by 5 points, the owner of a put can exercise and receive $500 from the assigned seller. Settlement Price: when index options are exercised, their settlement price is based on the closing value of the index on the day of exercise, not the value at the time of exercise during the trading day. Expiration Dates: Index options expire on the 3rd Friday of the expiration month. ***TTA***The exercise of an index option settles the next business day whereas the exercise of an equity option settles in 2 business days.
Max Loss/Gain on Spreads
Remember CAL ad 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.
Settlement Dates
Settlement of Options is T+1 . There is no certificate for options so proof of ownership is the trade confirmation.
Options Hedge Position
Short Stock, Long call: an investor sells short 100 shares of ABC at 58 and buys an ABC 60 call at 3. The investor's max gain is $5,500. If the stock becomes worthless, the investor gains's $5,500 from the short sale minus the $300 paid for the call. The max loss is $500. If the stock rises above $60, the investor will exercise the call to buy the stock for $60, incurring a $200 loss on the short sale, in additino to the $300 paid for the call. The BE point is the stock's sale price minus the premium paid, in this case, 58-3 or 55.
Options Hedge Position
Short Stock, Short Put (covered Put): A short put can be covered by a long put and this strategy offers limited protection for a short stock seller.
Strategies Combining Puts and Calls
Straddles Combinations Collars
Stock Holding Periods
The IRS does not allow the use of options to postpone the sale of stock to generate long-term capital gains treatment. Options that allow an investor to lock in a sale price are long puts. If a stock's holding period is 12 months or less before the purchase of a put, the gain will be classified as short-term. Buying a put at 11 months of holding a stock and then havin that put push the time past 12 months does not turn it into a long term gain. It is still an 11 month hold so it is short term. **When an investor buys a put on a stock, the time the stock was held up to the purchase of the put is the holding time for tax purposes. Once the put expires, a new clock will start over for the holding time. The overall cost basis includes the premium purchase and the final sales return.**
Role of the OCC
The OCC is the issuer of listed options contracts. It is owned by the exchanges that trade options. Its primary functinos are to standardize, guarantee the performance of, and issue options contracts. OCC determines when new option cnotracts will be offered to the market. It designates the strike prices and expiration months for new contracts within market standards to maintain uniformity and liquidity. Supply and demand in the trading markets determines the premium for the contracts. One of the important guarantees of the OCC is the exercise of options contracts. That means, if for some reason a seller is unable to perform, the OCC does. If a holder wants to exercise their contract, they notify their BD who notifies the OCC. THe OCC then assigns the exercise notice against a BD with a customer who has written that option. The BD then assigns that exercise noted to a customer with a short position . ***The OCC is the issuer of ALL listed options.***
Determining a Spread Investor's Market Attitude (Bull or Bear)
The market attitude of a spread investor is determined by the option that is the more costly of the 2 --- the one with the higher premium. For call spreads, the option contract with the lower strike price has the higher premium. Whether the spread is a debit or credit spread will depend on if the investor purchased or sold the option with the lower strike price. It is a DEBIT if the investor purchased the one with the lower strike price (higher premium). It is a CREDIT if the investor sold the one with the lower strike price (higher premium). For PUT spreads it is opposite. The option with the Higher strike price has the higher premium. -It is a debit if the investor purchased the one with the higher strike price (higher premium) -It is a credit if the investor sold the one with the higher strike price (higher premium)
Straddles and Combinations
The max gain of a long straddle is unlimited b/c the potential gain on a long call is unlimited. The max loss of a long straddle is both premiums paid. 2 BE points b/c there are two options. The BE for the call is the strike price plus both premiums paid; the BE for the put is strike price minus both premiums paid. The investor does not experience profit unless the market price is above the BE of the call or below the BE of the put.
Diagonal Spread
The options differ in time and strike price. Long ABC Jan 55 call for 6 Short ABC Nov 60 call for 3
Options Contract Adjustments
The rules require adjusting options contracts for stock splits, reverse stock splits, stock dividends, and rights offerings. Adjustments are not made for ordinary cash dividends. Adjustments to the number of shares are rounded down to the next whole share. Investor bullish on ABC stock buys 1 ABC 50 Call. The contract is good for 100 shares at $50 per share, and if the stock rises, the investor stands to profit. What happens if ABC has a 2:1 split? The options contract will not be 2 contracts for 100 shares at $25. When an EVEN stock split occurs, additional options contracts are created. An uneven split, also known as a fractional split, such as a 3:2 or 5:4, does not create additional options contracts. Contracts adjusted for uneven splits include a larger number of shares and will receive a new option contract symbol. -Example: After a 3:2 split, a 1 ABC 60 call will be represented by a 1 ABC 40 call with 150 shares.
Standard Features of Options Trading and Settlement
Trading Times: Listed stock options trade from 9:30am to 4:00 pm ET. Broad based index options trade until 4:15 pm ET Exercise: The latest time for turning in an exercise notice is 5:30 pm ET Expiration: Listed stock options expire on the 3rd Friday of the month at 11:59 pm ET. The final time for trading an option is 4:00 pm ET on the final day of trading. (expiration). Settlement: Listed options transactions settle on the next business day. Stock delivered as a result of the exercise is settled on a regular way basis (two business days). Automatic Exercise: Contracts that are in the money by at least 0.01 at expiration are automatically exercised as a service to the customer unless other instructions have been given. Automatic exercise applies to both retail and institutional accounts. Customers may give do not exercise instructions for any contract in the money if they do not want to have their contract exercised. All instructions must be received by the OCC no later than 5:30 pm ET on the third Friday of the expiration month (last day of trading).
Option contract 3 specifications
Underlying Instrument Price Expiration: -standard contracts are issued with 9 month expirations and expire on the third Friday of the expiration month at 11:59pm ET -Long-term equity anticipation securities (LEAPS) have maximum expirations of 39 months. Though the max 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 the buyer and the seller when the contract first trades.
Delivery after Exercise
Upon exercise of an option, the parties now are required to make settlement. Settlement is T+2 business days. ***TTA*** Settlement for equity options is T+1 (when an option is being bought or sold. Exercising of options, stock is either bought or sold and that has a settlement time of T+2
Foreign Currency Options (FCOs)
When purchased, sold, or exercised foreign currency options contracts are cash settled in US Dollars with no physical delivery of foreign currency. Contract Sizes: small enough to accommodate retail investors. A British pound contract, for instance, covers 10,000 pounds. Each currency has its own contract size. Japanese Yen is the only contract size that isn't 10,000 Strike Prices: quote in US cents. The Japanese yen is quoted in 1/100 of a cent. Premiums: Currency options are quoted in cents per units. One point of premium = $100. The total premium of the contract is found by multiplying the premium by the number of units. Trading: primarily traded on the NASDAQ Expiration Date: 3rd Friday of the expiration month. Settlement: Settle on the next business day and when exercised, settle on the next business day. Delivery is made in US Dollars.
Assignment of Exercise Notes
When the OCC is notified by a BD that one of its customers wants to exercise, the OCC RANDOMLY selects a firm with a short position in that option to which it assigns the exercise. The OCC assigns exercise notices on a random basis. Then the assigned BD determines which of its clients is going to be obligated.
Verification by the Customer
Within 15 days of account approval, the firm must obtain from the customer a signed written agreement (customer option agreement) that the account will be handled under the rules of the OCC and the CBOE and that the customer will not violate position or exercise limits. The signature also verifies the accuracy of the information provided on the new account form. TTA** If the signed option agreement is not returned within 15 days of account approval, the firm can permit closing transactions only.
