U16LO2: Identify the difference between a put option and a call option and their strategies
TAKE NOTE: an invaluable phrase for figuring out options questions is:
"Call up and Put down" *That is, you would BUY a CALL b/c you are hoping (or are afraid) the price of a stock will go UP; and **BUY a PUT b/c you are hoping (or are afraid) the price of the stock will go DOWN
EXAMPLE: Because each option covers 100 shares, a premium of $3, would be:
$300 * $3 per share at 100 shares = $300
A call option:
-Gives its holder the RIGHT to BUY a stock for a specific price within a specified time frame. -A BUYER buys the RIGHT TO BUY a specific stock -A SELLER takes on the OBLIGATION TO SELL the stock
A put option
-Gives its holder the RIGHT to SELL a stock for a specific price within a specified time frame. - A BUYER buys the RIGHT to SELL a specific stock - A SELLER takes on the OBLIGATION TO BUY the stock
Buying Calls
-Investors expecting a stock to increase in value speculate on that price increase -An investor can profit from the increase in the stock's price while investing a relatively small amount of money -THE MOST THAT CAN BE LOST IS THE AMOUNT PAID FOR THIS OPTION -THE GAIN IS UNLIMITED
Length of an Option Contract:
-Issued with expirations as short as one week; and -As long as three years *Most standard options are issued with expiration days of a maximum of nine months
Exercising an option
-Means purchasing the underlying stock at the strike price; -Exercising a PUT means SELLING the underlying stock at the strike price -Only owners can exercise- it is one of their rights
Uncovered (naked) call
-Seller does not own the stock they are obligated to sell. -Unlimited risk, b/c the writer must pay the going market price (and there is theoretically no limit as to how high a stock's price can go) to acquire the stock needed to fulfill the obligation to deliver -Most risky option strategy
Dividends on underlying stock for options
-are not received by owners
TAKE NOTE: A tool for remembering the difference between American and European exercise is:
A for American means Anytime E for European means Expiration date
EXAMPLE of how buying puts works:
An investor following ABCD common stock believes that it is grossly overpriced at $75 per share and when the next earning report is released, the stock will drop at least 10 points -If the investor were to purchase an ABCD 75 put for a premium of $3 and was correct, once the stock was at $65 (the 10-point drop). -A purchase could be made at that price for $65 a share and then the put could be exercised at the $75 per share strike price -This would give the investor a $7 per share profit (the $10 difference between the cost of $65 and the sale at $75, minus the $3 premium paid) -A $700 profit on a $300 investment is a very handsome percentage return on an investment
European-style option
An option that can be exercised only on the expiration date
Premium (Options)
An options cost *Quoted is dollars per share
SAMPLE TEST QUESTION: Choose the term that best describes the following situation: A customer has the right to sell 100 shares of MNO at 60 any time between July and October. A. Long Call B. Long Put C. Short Call D. Short Put
Answer: B. **The Put buyer (long position) has the right to sell stock to a put writer (seller) who is obligated to buy that stock
TEST TOPIC ALERT: Those who buy a straddle will profit from:
volatility
Covered Call
when the writer of a call also owns the stock on which the call is being written -Risk is limited, b/c no matter how high the stock price rises (meaning the call will be exercised), the writer merely uses stock already owned (which has been deposited with the broker-dealer) to make delivery
A bearish investor may:
write (sell) puts which will make money if the stock price is stable or declines
TEST TOPIC ALERT: Those who sell a straddle will profit:
if the market is stable b/c the options will expired unexercised
Writing (selling) puts
investors believe that the stock's price will rise or remain stable. -is OBLIGATED to BUY stock at the exercise price if the put buyer puts it to the put writer
Option BUYERS are:
long the positions
Option SELLERS are:
short the positions
Bears believe:
the price of a security will go down
Bulls believe:
the price of a security will go up
(Writing Puts) If a stock's price is above the put strike price at expiration,
the put expires unexercised, allowing the put writer to keep the premium *receiving the premium is a source of income
(Writing Puts) If the price of the stock falls,
the put writer will lose, the buyer wins. *The loss is limited b/c the stock price can never fall below zero
Simplest way to close an option position:
Entering the transaction opposite of the opening transaction **Table showing potential opening and closing positions: OPEN CLOSE Buy Call Sell Call Sell Call Buy Call Buy Put Sell Put Sell Put Buy Put
EXAMPLE: of option exercise:
If you were long an ABC 50 CALL and the current market price of ABC is 60. -You would be able to exercise and PURCHASE stock worth $60 per share at the exercise price of $50. OR If you were long an XYZ $45 PUT and the current market price of XYZ is $35. -You might wish to purchase 100 shares of XYZ at $35 per share and then exercise your option to PUT the stock at $45
Long term options contract is known as:
LEAPS (Long-Term Equity Anticipation Securities)
LEAPS stands for:
Long-Term Equity Anticipation Securities
TEST TOPIC ALERT: Employers of companies issuing employee stock options (ISO or NSO) might want to use puts and calls to protect against:
Market Risk *When granting employees the option (the right) to buy shares at a set price, the company is obligated to deliver the shares at that agreed upon price. -If the company's stock price soars, the employees exercise their options, and the company has to go out into the stock markets and buy stock at a price far in excess of what they're going to be selling it for. SO -One way to protect themselves is to buy call options on the stock so that if this happens, they could use their options to buy the stock at whatever exercise price was part of the contract
Options Positions: Short Put
Obligation to buy Bullish (Seller, Writer, Grantor)
Options Positions: Short Call
Obligation to sell Bearish (Seller, Writer, Grantor)
Buying puts is a hedging (protection) strategy when the investor is:
afraid the stock price will fall
American style option
an option that can be exercised at any time until expiration
Options strategies:
are either bullish or bearish positions on the underlying stock
A bullish investor may:
buy calls seeking profit if the price of the underlying stock rises
If an investor is afraid a stock price will rise
buying calls is a hedging (protection) strategy for this
Straddles
combination of a put option and a call option, on the same stock with the same exercise price and expiration date *If the the stock moves up, profit is made on the call; *If down, a profit is made on the put *When an investor is not sure which direction the market will move, but has a strong opinion that there will be dynamic movement, this strategy might be used
REMEMBER: All options, regardless of their length are:
derivative securities
An investor who believes a stock's price will stay the same or decline can write a call to:
-Generate income from the premium -PARTIALLY protect (hedge) a long stock position by offsetting any loss on the sale of the stock by the premium amount; or -if the stock price increases the call may be exercised. *In addition to the premium received when the option was sold, the writer will be paid the strike price for the stock.
Buying Puts
-A bearish investor can speculate on the price by buying puts -Acquires the right to sell 100 shares of the underlying stock at the strike price before the expiration date
Writing (selling) Calls
-A neutral or bearish investor can do this and collect the premium
Length of time for options:
-An option conveys rights and obligations for a limited time. *Therefore, each transaction has a beginning and end- open and close **EXAMPLE: An option position opened by an investor selling a call is closed when the call is exercised, is bought, or expires
Primary reason for buying or selling options:
-Are to profit; or -Hedge against price movement in the underlying security
Options transactions
-Because 2 types of options exist (puts and calls); AND -2 types of transactions exist (buying and selling), -4 basic transactions are available to an option investor: *Buy calls *Sell calls *Buy puts *Sell puts
European-Style Option expiration date confusion:
-Can be exercise on the day before or the day of the expiration (means the same thing)
There are 2 different types of options contracts:
1. Put 2. Call
3 ways the owner (long position) of a put or call can close a position:
1. SELL the option contract before the expiration date 2. EXERCISE the option to buy or sell the security specified in the contract; or 3. let the option EXPIRE
Each options contract covers _____ shares
100
If an opening position is: Sell Call Then to close opposite:
Buy Call
If an opening position is: Sell Put Then to close opposite:
Buy Put
Options Positions: Long Call
Right to buy Bullish (Buyer, Holder, Owner)
Options Positions: Long Put
Right to sell Bearish (Buyer, Holder, Owner)
If an opening position is: Buy Call Then to close opposite:
Sell Call
If an opening position is: Buy Put Then to close opposite:
Sell Put
Short term options contract is known as:
Weeklys
