Options Overview

• An option is a contract between two parties
• The Owner
  • The buyer
  • Long the option
  • Pays the premium (cost of the option)
  • Acquires a right/control
• The Writer
  • The seller 
  • Short the option
  • Receives the premium
  • Assumes an obligation

Types of Contracts

• If an option is exercised…

Standardized Components

• An equity option is a contract to buy or sell a specific number of shares of a particular stock at a fixed price over a certain period. An option contract is described by:
  • The name of the underlying security
  • The expiration month of the contract
  • The exercise (or strike) price
  • The type of option
• Buy 1 ABC June 50 Call at 5
  • If you decide to exercise, the aggregate contract price is $5,000 (100 shares * $50/share)
  • The premium is $500 ($5/share * 100 shares) 
  • We paid $500 for the right to call 100 shares of ABC at $50/share up until the 3rd Friday of June
  • Risk is limited to what you paid

In-the-Money versus Out-of-the-Money

• CALLS: In the money if market price is above strike price
• CALLS: Out of the money if market price is below strike price
• PUTS: In the money if market price below strike price
• PUTS: Out of the money if market price is above strike price 
• Calls and Puts are at-the-money if the stock’s market price is the same as the strike price of an option

Terminology

• Premium = Intrinsic Value + Time Value
  • Premium is determined by market (supply & demand)
• The concept of INtrinsic value is tied to options that are IN-the-money
  • If it’s ITM, it has intrinsic value
  • Its intrinsic value equals its in-the-money amount
  • It has zero intrinsic value if it is out-of-the-money or at-the-money
    • It can’t be negative. The premium would all be time value
• Time value is the portion of an option’s premium that exceeds its intrinsic value
  • Based on time left until expiration
  • Market volatility
    • The more volatility, the greater the premium

Matching

• Owner has right to buy stock; seller has obligation to sell the stock at fixed price
  • Call option
• Pays the option’s premium; is long the option
  • buyer
• A contract entered into by two parties
  • option
• The amount by which an option is in-the-money
  • Intrinsic value
• Receives the option’s premium; is short the option
  • seller
• Owner has right to sell stock; seller has obligation to buy the stock at fixed price
  • Put option
• The portion of an option’s premium that exceeds its intrinsic value
  • Time value

Fill in the table

Basic Options: Long and Short Calls 

• July 50C @ $5

• Creating a basic option position is considered speculative

Breakeven – Long Call

• When current market value of XYZ Stock is at $47
• Buy 1 XYZ Feb 45 Call at $3
• Breakeven:
  • Strike Price + Premium
  • 45 + 3 = $48
• Debit (Cash Out)
  • $3
  • $45 if we exercise
  • $48/share go out

• Sell 1 XYZ Feb 45 Call at $2.5
• Breakeven:
  • Strike Price + Premium
  • $45 + $2.5 = $47.50
• Credit (Cash In)
  • $2.5
  • $45 (if buyer exercises)
  • $47.50/share 

Basic Options: Long and Short Puts

• July 50 Put @ $5

• Creating a basic option position is considered speculative

Breakeven

• If Call Option: Strike Price + Premium
• If Put Option: Strike Price – Premium

Breakeven – Long Put

• When current market value of XYZ stock is at $92
• Buy 1 XYZ Apr 95 Put @ $3.50
• Breakeven:
  • $95 – $3.50 = $91.50
  • Debit (Cash out)
    • $3.50
  • Credit (Cash in)
    • $95
  • $91.50 cash in

• Sell 1 XYZ Nov 35 Put @ $4
• Breakeven:
  • $35 – $4 = $31
  • Debit (cash out)
    • $35
  • Credit (cash in)
    • $4
  • $31 cash out

Which of these are TRUE with regards to Long and Short Calls and Puts

• Buyers of calls are bullish (they want the stock to rise)
• Sellers of calls are bearish (they want the stock to fall)
• Breakeven for the seller of a call is the strike price minus the premium
  • It’s plus the premium
• Breakeven for the buyer of a put is the strike price plus the premium
  • It’s minus the premium
• The maximum loss for a buyer of a call is the premium
• The maximum loss for a buyer of a put is the premium

Speculation versus Hedging

• Speculation
  • Options can be purchased or sold to generate a profit
  • The investor has no existing position in the underlying security
  • Long Calls and Short Puts are bullish
  • Long Puts and Short Calls are bearish
• Hedging
  • Purchasing options to protect the movement of an underlying security 
  • Long puts protect long stock positions
  • Long calls protect short stock positions

The Life of an Option

• Expire Worthless
  • If an option is at or out-of-the-money on the expiration date, the holder of the contract has no incentive to exercise the contract. The contract expires worthless
  • The expiration triggers:
    • The maximum profit for a seller of a call or put 
    • The maximum loss for the buyer of a call or put
• Exercised
  • The investor who is long an option has the exclusive right to exercise that option at his own discretion
  • The two styles of exercise are:
    • American Style – options may be exercised at any time up until expiration
    • European Style – options may only be exercised on the day of expiration
• Liquidated
  • Liquidating (closing out) an option position is essentially an alternative to exercising the option. The investor executes an opposite transaction on the same series of options. In other words, what was bought is sold or what was sold is bought

Liquidate, Trade, or Close-Out

Note

• Profit or loss is determined by the difference between the price paid for option and price received from sale

Example: Exercise v. Close-Out

• When ABC”s current Market value is $64, an investor buys:
• 1 ABC May 65 Call at $3
• Later, ABC’s Market Value rises to: $72
• Now, ABC May 65 Calls are trading at: $8 (made up, but logical)
  • 7 points of intrinsic value + 1 point from time value

• The $500 includes $100 of time value

The OCC and Options Trading

• The Options Clearing Corporation:
  • Issues and guarantees listed options contracts
  • Eliminates counterparty risk by acting as the third party in an all option transactions
    • Acts as the buyer for all sellers and the sellers for all buyers (even though they’re not actually trading)
  • Deals directly with broker-dealers, not customers
  • Creates and requires the distribution of the Options Disclosure Document (Characteristics and Risks of Standardized Options)
    • Must be sent to customers prior to a customer actually trading options, saying they can trade options
  • Regulates exchange-traded options
  • Trade settlement between broker-dealers and the OCC is next business day (T + 1)

Deadlines of Equity Options

• Third friday of expiration month
• If option is ITM, then OCC assumes that the buyer wants to exercise because it has value
  • If you don’t want it exercised, you can give counter instructions 

Exercising an Equity Option

• Long ABC Feb 60 Call

Index Options

• Index options provide the opportunity to speculate on (or hedge against) the movement of the market, rather than movement of a specific stock
• SPX tracks the S&P 500 Index
• Unlike equity options, these options are cash settled
  • S&P 500 has too many stocks in it for example, so we exercise cash
  • The seller is obligated to deliver the cash difference between the closing index value and the strike price 

Hedging Long and Short Positions

• If investors have either long or short stock positions and want to hedge or protect against potential risk, they may purchase options
• To protect (or hedge) stock in a volatile market
  • When long stock: buy a put
    • If the stock decreases, the gain on the put can offset the loss on the stock 
  • When short stock: buy a call
    • If the stock increases, the gain on the call can offset the loss on the stock

Covered and Uncovered Positions

• Covered call
  • A call is written against stock that’s already owned
  • The sale of the call generates income, thereby increasing the yield on the underlying security
  • Considered a conservative option strategy
    • If stock goes way up, we gave up the upside potential
• Uncovered call
  • A Call is written against stock that’s not owned
  • Considered the most speculative option position with unlimited potential risk
• Covered put
  • A put is written when the investor has a sufficient amount of cash to satisfy the obligation of being exercised against on the put
• Uncovered put
  • A Put is written without having sufficient cash to meet the obligation of being exercised against on the put
  • There is significant risk if the underlying security falls
• Uncovered options are done in margin accounts, not cash accounts
• Covered options can be done in either