SIE Unit 5 - Options

Unlike Stocks or Bonds, an Option is a...

contract

(2) types of options:

Call contracts

Put contracts

A contract allows the buyer of the contract to either buy a security (calls) or sell a security (puts) at a specified price called the...

strike price

Why are options are called derivative securities?

their value is derived from the difference between the security's current price and the strike price

Expiration

how long the contract is good for

Strike Price

price at which the transaction takes place

Option Clearing Corporation (OCC)

the primary options regulator

In an option, which side is "long the contract" or "holds a long position"?

the buyer

On the contrary, who is "writer" and is said to be "short the contract"?

the seller

When the buyer buys the contract, it is called an _______ ___; if they sell a contract, it is called a _______ _____

Opening buy; Closing sale

When the seller writes the contract, it is called an ___________ ______; if they purchase the contract back, it is called a _______ _________

Opening Sale, Closing Purchase

What is the size of the contract based on?

100 shares of the underlying security

So 5 contracts = ....

500 shares

On the exam, the underlying security is represented by a symbol. Usually this is the ticker symbol that identifies the security in the market.

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The month is identified by the abbreviation for the month. JAN for January, FEB for February, MAR for March, and so on through the rest of the year.

All monthly option contracts expire on the third Friday of the month at 11:59 pm.

Any contract that is not exercised by the end of the day of its expiration is no longer any good, because it's expired. The last day to trade an option is the day it expires.

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The buyer has a right to buy; the seller has an obligation to sell.

Call Option

The buyer has the right to sell; the seller has an obligation to buy

Put option

How is the premium represented?

the price of the option on a per share basis

If the premium is represented as @3, this means...

its $3 per share, if it's one contract that would be 100 shares for $300

L 2 XYZ Jan 60 Call @3

L is for long. The investor has bought the contract and has the right to exercise the contract.

2 is the number of contracts. This investor has 2 contracts that cover 100 shares each, a total of 200 shares.

XYZ is the ticker symbol. The contracts are for XYZ common stock.

60 is the strike price. If the contract is exercised, the transaction takes place at a price of $60 per share.

Call. These are call contracts, as opposed to put contracts.

@3. The contracts have a premium of $3 per share. Two contracts are worth $600 total.

When would the buyer of a call option choose not to exercise the option?

The stock price is at or under the strike price

The buyer of a call contract thinks the stock will go up in price, so they are...

Bullish

The seller of a call contract wants the stock's price to stay at or below the strike price and the option to expire unexercised. They are...

Bearish

When would the buyer of a put contract allow the option to expire unexercised?

When the stock price is at or above strike price

In a put contract, the buyer is ______ and the seller is _______

Bearish, Bullish

For both calls and puts, why does the seller want the option to go unexercised

so they can keep the premium that the buyer paid for the right to exercise the option

Your customer, Steve Newsome, recently purchased one put contract on Napa Valley Spirits, Inc., stock. The strike price was $50 and the premium was $4.50. He later exercised the contract. How much did he pay for the contract?

$450

A customer is long 5 ABC 60 call contracts. This investor is best described as....

Bullish on ABC stock and expects it to increase in value

A customer is long 10 XYZ 55 put contracts. This investor's attitude towards XYZ common stock is described as

the customer is bearish on the stock

Intrinsic Value

the potential profit to be made from exercising an option.

A call option has intrinsic value when...

the underlying stock is trading above strike price

intrinsic value can never be a

negative number

0 is the lowest

When is an option at parity?

When strike price = intrinsic value

Call: if the stock price is higher than the strike price, the contract is....

IN the money

Call: the stock price is lower than the strike price, the contract is...

OUT of the money

Call: the stock price is = to the strike price, the contract is....

AT the money

Formula for Intrinsic Value of a Call Option =

Stock Price - Strike Price

Example: An ABC 50 call when the stock is trading at 57.

1. is it in, at, our out of the money and by how much

2. what is the intrinsic value?

$7 in the money

Intrinsic value of 7

It doesn't matter which side of the contract you're looking at -- buyer or seller -- the intrinsic value is

The same for both

Put: if the stock price is higher than the strike price, the contract is....

OUT of the money

Put: the stock price is lower than the strike price, the contract is...

IN the money

Put: the stock price is = to the strike price, the contract is....

AT the money

Formula for intrinsic value of a Put option =

Strike price - stock price

Time Value

Subjective, based on current market perception and the longer the time to expiration, the higher it is

Time Value Formula =

Intrinsic Value + Time Value(x) = Premium

Example: An ABC 50 call is trading at 3 when the stock is at 52.

What's the time value?

$1

The DEF July 75 call is trading at $4 when the stock is at $78. Which of the following is true regarding this DEF option contract?

A)

The contract is out of the money.

B)

The contract has intrinsic value.

C)

The contract has no intrinsic value.

D)

The contract is at the money.

B

An investor is long 1 Aug XYZ 30 put and XYZ has a current market value of 25. Which of the following is true?

A)

The Aug 30 put is out of the money by 30 points.

B)

The Aug 30 put is at the money.

C)

The Aug 30 put is in the money by 5 points.

D)

The Aug 30 put has no intrinsic value.

C

The DEF July 75 call is trading at $4 when the stock is at $78. Which of the following is true regarding this DEF option contract?

A)

The contract is in the money and has $3 of time value.

B)

The contract is out of the money and $1 of time value.

C)

The contract is in the money and has $4 of time value.

D)

The contract is in the money and has $1 of time value.

D

Note: breakeven is calculated on a ___ _____ basis, Maximum gain/loss is on a _____ ______

whole amount

Breakeven Point for Call Option =

Strike Price (XP) + Premium (PR)

Your customer is long 1 ABC Jan 50 call at 3

What is the XP?

What is the Premium @

What is the BE?

XP = $50

Pr = $3

BE = $53

Maximum Gain for a long call =

Unlimited

Maximum gain for a short call =

the premium

Maximum Loss for a long call =

the premium

Maximum Loss for a short call =

Unlimited

Breakeven point for Put Option =

Strike Price (XP) - Premium (Pr)

Maximum gain for a long put =

breakeven (x100)

explain why the maximum gain for a long put is breakeven x 100

Because the maximum gain is when the stock price drops to zero, you would then be able to sell your 100 shares of stock at the BE point of 47 and profit $4,700

Maximum gain for a short put =

the premium

Maximum loss for a long put =

premium

Maximum loss for a short put =

breakeven (x100)

Your customer is long 1 ABC Jan 50 put at 3 -- what is the maximum gain?

$4700

Your customer is long 1 ABC Jan 50 put at 3 -- what's the maximum loss?

$300

Your customer is short 1 ABC Jan 50 put at 3 -- what is the maximum loss?

$4,700

An investor is long 1 Jan 30 call at 2. Calculate the breakeven, maximum gain, and maximum loss.

A)

BE 32, MG unlimited, ML 200

B)

BE 32, MG 200, ML unlimited

t

C)

BE 30, MG unlimited, ML 200

D)

BE 2, MG 500, ML 32

A

Your customer is short 2 DEF Jun 40 puts at 3. What is their breakeven, maximum gain, and maximum loss for this position?

A)

Breakeven =43, maximum gain =$600, maximum loss = $7,400

B)

Breakeven = 37, maximum gain = $300, maximum loss = $3,700

C)

Breakeven =43, maximum gain =$300, maximum loss = $7,400

D)

Breakeven = 37, maximum gain = $600, maximum loss = $7,400

D

Selling calls is a way to...

generate premium income

Uncovered Call

option investor who writes (seller) a call on an option they don't own

Covered Call

when the writer of a call owns enough of the underlying stock to meet an exercise, they've sold a covered call

Why do covered calls have little risk?

Because if you already own the shares you don't need to purchase them at current market price, you can just give them to the buyer

5.5 - non equity options

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Even if the underlying asset is not a security (currency or index), we still refer to them as

the underlying security

The most common type of nonequity options (and the one you'll be asked about on the exam) is

Index option

(2) most famous index funds

Dow Jones (DJIA) and S&P 500 (SXP)

Broad Based Index

an index designed to reflect the movement of the market as a whole, based on large cap stocks

Narrow-based indices

only track a small number of securities, often in a specific sector

For a non-equity option, there is no underlying stock to deliver so the seller of the option pays...

cash equal to the in-the-money amount when the option is exercised

The customer owns 1 SPX Jan 5200 call @ 3. The S&P 500 index is currently at 5210.

- how much in/out/at of the money are they

- how much does the contract cost

- what is the breakeven

- How much gain/loss could the contract be exercised at

$10 in the money

Contract costs $300

BE = 5203

Contract could be exercised for a $700 gain

Non equity options are usually used to

hedge against a downturn in the market

When a contract is sold, the buyer must pay the seller...

the premium the next business day

When an index option is exercised, there is no stock to deliver, so the writer pays the holder

the amount the contract is "in the money" x 100 per contract the next business day

The in-the-money amount is based on the closing value on the day of exercise

American-style

option contract that may be exercised at any time between the date of purchase and the expiration date.

European-Style

an option contract that can only be exercised on the last trading day (usually Friday) before expiration

A customer owns a portfolio made up of large U.S. corporations. They would like to protect their portfolio against a potential sharp drop in the market. Which of the following options would provide the best hedge against a drop in the market?

A)

Buy SPX puts

B)

Sell SPX calls

C)

Sell SPX puts

D)

Buy SPX calls

A

Which of the following is true for an option with a European-style exercise but not for an American-style exercise option?

A)

The contract may be exercised at any time.

B)

A call is in the money when the underlying security is higher than the strike price.

C)

A put is in the money when the underlying security is higher than the strike price.

D)

The contract may only be exercised on the day it expires.

D

5.6 - Options Rules and Regulations

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Speculation

trading commodity with higher than average risk in return for a higher than average profit potential. Trade is effected solely for the purpose of profiting and not as a means of hedging

The primary regulators that oversee the options markets in the U.S. are the

1. Option Clearing Corp (OCC)

2. Chicago Board of Options Exchange (CBOE)

both overseen by the SEC

The steps for adding option trading to an account are listed here (5)

1. A representative must have reasonable grounds for believing that options are a suitable investment for a client, based on the client's circumstances and objectives.

2. The representative provides the customer with a copy of the options disclosure document.

3. The account must be approved for options trading by a registered options principal (ROP).

4. Option trades may be entered after account approval.

5. Then, not later than 15 days after the account approval, the customer must return the signed options agreement.

Listed Option

option that is listed on a national securities exchange with standardized strike prices and expiration dates

The following are some standards and characteristics of listed options contracts:

Trading times. Listed options trade from 9:30 am to 4:00 pm ET.

Settlement. Settlement rules are set by the OCC.

Expiration. Listed options expire on the third Friday of the expiration month at 11:59 pm ET.

Exercise. Listed options can be exercised by the owner from the time of purchase until they expire. The exercise process is guaranteed by the OCC. If a holder of an option wishes to exercise their contract, they notify their broker-dealer (BD), who notifies the OCC.

Automatic exercise. Any contract that is in the money by at least $0.01 at expiration will be exercised automatically unless the holder gives do-not-exercise instructions.

Assignment. When the OCC receives an exercise notice, it assigns the exercise notice to a BD that has a customer who is short the contract. The short BD assigns a short customer who is now obligated to perform (buy or sell the stock at the strike price).

The OCC assigns exercise notices to short BDs on a random basis. BDs may then assign exercise notices to their short customers on a random basis, on a first-in, first-out (FIFO) basis, or any other fair method.

Take Note

Only owners of options contracts (those who are long the contracts) have the right to exercise them. Writers of contracts (those who are short the contracts) will be required to meet their obligation under the contract if assigned an exercise.

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A customer of a broker-dealer is opening a new options account. The customer must return the options agreement

A)

before they will be allowed to view the options disclosure document.

B)

before the first transaction can occur.

C)

signed before the account can be approved.

D)

signed and not later than 15 days after the account approval.

D

The exercise of an option contract is guaranteed by which of the following organizations?

A)

The Financial Industry Regulatory Authority

B)

The New York Options Exchange

C)

The U.S. Treasury

D)

The Options Clearing Corporation

D

Which of the following option positions would offer a full hedge to a short stock position?

A)

Long put

B)

Short call

C)

Short put

D)

Long call

D - Long Call

The maximum loss on a short put is

A)

the premium.

B)

strike price + premium.

C)

strike price - premium.

D)

the strike price.

C

A customer believes the price of MJS stock will rise but is not currently in a position to purchase the stock outright. How could the customer use options to profit from a rise in the stock's price?

Buy calls

Write calls

Buy puts

Write puts

A)

II and III

B)

I and III

C)

I and IV

D)

II and IV

C

Which of the following statements about the Options Clearing Corporation (OCC) is correct?

A)

The OCC regulates the options markets and provides market liquidity by trading options.

B)

The OCC sets option premium prices and strike prices for all listed options.

C)

The OCC approves options trading for customer accounts and ensures that investors meet suitability requirements.

D)

The OCC guarantees the performance of options contracts and determines when new options contracts should be offered.

D