Lesson 6: Options

spot price

term used to describe the current market price of a stock

call option

• an options contract that gives the purchaser the right to buy a stock at a fixed price

• obligates the seller to sell the stock at a fixed price if the contract is exercised

put option

• an options contract that gives the purchaser the right to sell stock at a fixed price

• obligates the seller to buy the stock at a fixed price if the contract is exercised

premium

• the cost of an options contract which is paid by the buyer who is purchasing the right to do something

• received by the seller who is taking on the obligation to do something

uncovered call

• the riskiest options position where an investor sells a call option without owning the underlying stock

• if the contract is exercised must purchase the shares in the market regardless of how high the price has gone up then sell them at the fixed strike price

risk of uncovered call

• this position has unlimited risk because no matter how high the stock price increases the writer is obligated to purchase the shares in the market

• due to the risk profile this strategy is inappropriate for retail investors

protecting a short put

• if an investor shorts (sells) a put option, they have an obligation to purchase the stock at the strike price regardless of how far the price has fallen if the option is exercised against them

• if the investor wants to hedge against some of the downside risk they can buy a put option with a lower strike price to lock in a sale price for the shares

foreign currency options

• allow investors to speculate on how foreign currencies will perform compared to the US dollar

• investors cannot buy or sell US dollar options

option contract adjustment

• adjusted for stock dividends and stock splits

• for a stock dividend: number of shares the contract represents will increase, while the strike price will decrease proportionately (total value of contract does not change), the same is true for a forward split

option class

• refers to all call and put options for a single underlying stock, regardless of their strike prices and expiration dates

• ex. ABC March 80 call and ABC March 80 put are the same class

time value

• the portion of an option’s premium that reflects the time remaining until expiration

• total premium - intrinsic value = time value

• at expiration: time value = 0

in the money (ITM)

• options that have intrinsic value

• for calls: if the stock can be bought for less than its current market value → always exercised

out of the money (OTM)

• options that have no intrinsic value

• for calls: if the strike price is higher than the MV → always expire

at the money (ATM)

options where the underlying asset’s market value equals the strike

options expiration

• options contracts expire on the 3rd Friday of their expiration month

• stand option contracts expire nine months after issuance

American style

• can exercise at any time

• most equity options

European style

• exercise at expiration only

• most index options

Index options

• use the value of an index as the underlying asset

• similar investment objective as equity options

• unlike equity options, they are settled for cash

VIX (Volatility Market Index)

• measures the volatility of S&P 500 index options

• also referred to as the “fear index”

• works in an inverted manner to the market → when market goes down the VIX goes up and vice versa

Options Clearing Corporation (OCC)

• issues and guarantees options contracts

• if an investor wants to exercise an options contract their broker-dealer notifies this group who then assigns the contract to an appropriate counterparty

• increases liquidity and reduces credit/counterparty risk for investors

options settlement

regular way settlement for listed options contracts is T+1

long call

• bullish market view

• speculate on upward stock move

• options strategy where you buy a call option because you expect the price of the underlying stock to rise

short put

• bullish market view

• options trading strategy where you sell a put option to another investor and collect a premium

• take on obligation to buy shares of the underlying stock at the strike price if the buyer exercises the contract

• objective is income

protective put

• bullish market view

• long stock + long put

• speculate on stock with downside protection

covered call

• market neutral view

• long stock + short call

• generate income on a long position

• forfeit appreciation in exchange for income

long put

• bearish market view

• speculate on downward stock move

short call

• bearish market view

• options trading strategy where you sell a call option to another investor and collect a premium

• take on the obligation to sell shares of the underlying stock at the strike price if the buyer exercises the option

• objective is income

protective call

• short stock + long call

• speculate on downward move of a stock with protection on appreciation