SIE Exam Part 13 - Options

Overview of Options

• Definition of Option:

  • An option is a derivative that derives its value from an underlying asset (e.g., common stock).

  • The value of equity options is based on the value of the underlying common stock.

• Two main types of options:

  • Call options: The right to buy the underlying asset.

  • Put options: The right to sell the underlying asset.

Basics of Options Contracts

• Each option contract is a contract between two parties:

  • Buyers (owners/holders) have rights and pay a premium for the option.

  • Sellers (writers or shorts) have obligations to fulfill the terms of the option.

  • Example for a call option:

  • Buyer of a call has the right to buy the stock at the strike price.

  • Seller of a call is obligated to sell the stock at the strike price when exercised.

  • Example for a put option:

  • Buyer of a put has the right to sell the stock at the strike price.

  • Seller of a put is obligated to buy the stock at the strike price when exercised.

Call and Put Options Explained

• Call Option Details:

  • If you buy a call option at a strike price of $50 for $5 premium:

  • You gain profit if the stock price increases beyond the strike price plus premium.

  • Break-even point for a call option:

    • ext{Break-even} = ext{Strike Price} + ext{Premium} = 50 + 5 = 55

  • Illustration:

    • Example with stock price at $52:

    • Cost to buy at 50, but selling at 52 results in a loss of $3 (due to premium).

    • At stock price of $55, you break-even (gain nothing).

    • At stock price of $57, profit of $2.

• Put Option Details:

  • If you buy a put option at a strike price of $50 for $5 premium:

  • You gain profit if stock price declines below the strike price minus premium.

  • Break-even point for a put option:

    • ext{Break-even} = ext{Strike Price} - ext{Premium} = 50 - 5 = 45

  • Illustration:

    • Example with stock price at $48:

    • Buy at 48, sell at 50 leads to a loss of $3 (due to premium).

    • At stock price of $40, profit of $5.

    • At stock price of zero, maximum profit of $45.

Characteristics of Option Buyers and Sellers

• Buyers:

  • Buyers of calls expect the underlying stock price to increase.

  • Buyers of puts expect the underlying stock price to decrease.

• Sellers (Writers):

  • Sellers of calls expect the stock to decline or remain stagnant (so the option expires worthless).

  • Sellers of puts expect the stock to rise or remain above the strike price (so the option expires worthless).

Options Expiration and Trading

• Expiration Dates:

  • Options typically expire on the third Friday of the expiration month at 11:59 PM.

• Trading options:

  • An opening transaction occurs when you buy/sell an option for the first time.

  • A closing transaction occurs when you liquidate or close your position.

American vs. European Options

• American Options:

  • Can be exercised at any time up to the expiration date.

• European Options:

  • Can only be exercised on the expiration date.

Options and Their Values

• Intrinsic Value:

  • The real, tangible value of an option when it is in-the-money.

  • For calls, any stock price above the strike price is in-the-money; for puts, any stock price below the strike price.

• Time Value:

  • The additional amount that traders are willing to pay for an option above its intrinsic value, based on the time remaining until expiration.

  • Formula: ext{Premium} = ext{Intrinsic Value} + ext{Time Value}

    Example: If premium is 6 and IV=2, then TV=4

Speculation and Hedging

• Speculation:

  • Buying an option to speculate on stock price movement.

  • Buying calls bets on increases, whereas buying puts bets on decreases.

  • Long stock - You’re either going to buy a put or sell a call (Buying a put is for protection and selling a call is for income)

• Hedging:

  • Protecting against losses in underlying stock positions using options.

  • Example: If you own 100 shares at $50 and fear a drop, buying a put option allows selling at a pre-set price.

  • Short stock - You’re either going to buy a call or sell a put (Buying a call is for income and selling a put is for protection)

Final Tips and Recap

• Remember:

  • Buyers have rights while sellers have obligations.

  • Max loss for buyers is the premium paid; potential for unlimited gains exists for calls.

  • Max gain for sellers of options is the premium received; potential for total loss can occur.

• Important concepts summarized:

  • Breakeven points for calls and puts.

  • Components of option pricing.

  • Risk management strategies using options.

• Encouragement to stay engaged, seek help, and reach out for clarification.