Chapter 11: Options

call options

a contract where the buyer is bullish on a stock and the seller is bearish; if the stock rises above the strike price, the buyer will exercise their right to buy the stock from the seller at the strike price in exchange for a premium

premium

the fee the buyer pays for an option contract and which the seller receives

breakeven price

is the price at which the combined cost of the premium and the stock is offset by the gain; it is also the amount of gains needed to meet the net cost (costed-earned)

in-the-money

market price is above the strike price

At-the-money

the market price is at the strike price

out-of-the-money

when the market value is below the strike price

put options

where the buyer is bearish on the stock and the seller is bullish; if the stock price drops below the strike price, the buyer can exercise their right and buy the stock at the market value and sell it to the seller who has the obligation to buy the stock at the strike price at a premium to the market value

options are leveraged

each options contract consists of 100 shares and therefore it is leveraged

speculation trading

buying or selling an option to profit from stock swings without actually owning the stock until exercising the right

hedging

is when you own stock and use options as a means to limit risk by offsetting prices

hedging (long stocks)

if you are hedging long, to prevent from downside risk, you can buy put options

hedging (short positions)

to hedge a short portfolio you want to buy calls so that if the stock rises you can buy it back at the discounted strike price

reading an option

Buy 1 XYZ Dec 60 call at 4

intrinsic value of an option

intrinsic value of an option is above 0 when the option is in-the-money; it is 0 when at-the-money; cannot be negative

factors affecting premium price (options secondaries trading)

1) time left before expiration 2) whether option in-the-money 3) volatility of underlying stock 4) investor sentiment

time value of option

Premium = intrinsic value + time left; all things kept equal, the amount of time left determines the premium price, hence if there’s no intrinsic value then the time value is driving the premium price and vice versa

opening transaction

is when the buyer purchases and the seller sells the contract (two transactions)

closing transaction

when the option is being closed and the buyer sells and the seller purchases back in order to cancel out the transaction; closing transactions do not apply to contracts that are expiring

Covered call/put

Is when the buyer or seller owns the underlying stock and thus limits their downside risk

index options

instead of single-stock options, you can increase exposure to the market or a sector through index options; index options don’t involve underlying stock and instead use the cash equivalent; the closing price is at the end of the trading day

broad-based index options timing

options trade till 4.15pm ET

narrow-based index options timing

options trade till 4pm ET

Options Clearing Corporation

is the body that serves as the intermediary between buyers and sellers; they issue and guarantee all options trade and they do not hold any cash or stock

Options Risk Disclosure Document (ODD)

a document highlighting the risks of options trading such as the limitless loss on call trades as a seller and tax rules; every broker must ensure that their client reads before trading options

Registered Options Principal

are managers with a series 4 pass that sign and approve every any new client accounts before they trade options

Options Account Agreement (OAA)

within 15 days of the ROP approving the account, the client must sign the OAA certifying that they have read the ODD, rules, and regulations

Last Options Trade

4pm ET on the date of expiration

Last Options Exercise Timing (American style)

5.30pm ET on expiration

Europe style options exercise

Europe style only allows options traders to exercise their options on the day that it expires

Option Expiration

on the 3rd friday of every month at 11.59pm ET

Options trade/exercise settling time

because stocks trading settles in 2 days and exercising the rights means trading the stocks, it takes 2 days to settle an options exercise; the options contract trading however takes only 1 day to settle

options right exercising flow

when an investor exercises their right, the broker for the buyer notifies the OCC which randomly finds another broker who will randomly find a client to be the seller; when the right is exercised, the seller will transfer the stock or cash to the broker who will transfer to the buyers broker without going through the OCC

aggregate exercise price

is simply the strike price times the 100 shares that the option governs

class of options

options of the same type (call/put) covering the same security

series of options

option contracts that are exactly the same in everything: type, underlying security, expiration, strike price, etc.

clearing member

a person from FINRA assigned to the OCC

Conventional Index Options

options that overly at least 9 securities where no single one security has more than 30% of the portfolio

conventional option

an option not subject to issuance by the OCC

delta neutral

when an investor fully hedges their portfolio

net delta

this is the total directional risk of your entire options and stock position combined. It tells you how much your total portfolio value will change if the underlying stock moves up by $1.00

outstanding contract

an option contract that is neither closed/expired/exercised

position limits

is the number of options an investor can trade on one side of the market (bear/bull)

exercise limits

a limit on the number of exercises that can be executed by an investor on the same side of the market within 5 consecutive bus. days

Limit on uncovered short positions

Limit set by FINRA due to the high risk on option selling

restrictions on option transactions/exercises

FINRA imposed limits on any series of any class of options to ensure fairness of options market

open order on the “ex-dividend date”

when the underlying stock announces a dividend, the stock reduces in value by the dividend amount; hence the strike price will also automatically reduce by the dividend amount

confirmations

the receipt that must be written for every options trade containing all the info about the transaction

account statement

clients will receive account statements every month or quarterly if they have not traded in the past month showing the security/money positions, the interest charges, and other charges

opening an account

the broker opens the account and he must make sure the client has received and read the ODD and done due diligence on the client to determine their risk capacity; the account is then approved by the ROP within 10 days and there may be selective approval

options account agreement

customer signs the OAA within 15 days of the ROP approval

maintenance record

broker must maintain a record of all options-related complaints by the customer and it must be easily retrievable with all information pertaining to the complaint including the ROP’s name

discretionary account

is when the broker manages the clients account without their pre-approval; the broker needs written approval from ROP and the client and it is under frequent ROP watch

suitability

broker should know what the investors suitability for risk and trade accordingly

supervision of accounts

brokers running an options business must have a written supervisory system to address the customers and each branch needs an ROP

fingerprinting on options facilities

fingerprinting required on options facilities