Options
Options Basics
Premium is the price of the contract
Calls go in the money when the market price goes up; out of the money when market price goes down
Puts go in the money when the market price goes down; out of the money when market price goes up
In the money is always determined from the holders (buyers) perspective!! (long short doesn’t matter)
In the money and intrinsic value are the same thing
Out of the money is in favor of the writer/seller
Time premium is the amount of premium paid, above the in the money amount. If the option is not in the money, the entire premium is the time premium
Opening Purchase: order ticket to buy an initial option
Closing Sale: order ticket if the long contract is traded to someone else
Opening Sale: order ticket for selling (short) a contract
Closing Purchase: order ticket if the short contract is traded to someone else
Open interest: total number of open call contracts, and the total number of open put contracts
Opening purchase + opening sale = +1 open interest
Closing purchase + closing sale = -1 open interest
Closing sale + opening purchase = 0 open interest
Opening sale + closing purchase = 0 open interest
Soo open + open = +1. Close + close = -1. Open + close = 0.
long = opening purchase. Liquidate long = closing sale
short = opening sale. Liquidate short = closing purchase
Speculative Strategies
“Naked writing” is when you are selling contracts to which you do not already own the stock for
The sale of an at the money call is a bear/neutral strategy
Long Call
Bullish strategy
Allows holder to buy stock at a fixed price
Make money when stock price rises
Maximum loss to a holder is the premium
Breakeven is: in the money profit + premium (negative number)
Maximum gain is unlimited (less the premium)
If contract is sold, P/L is the difference between premium paid and received
Short Call
Bearish strategy
Forces holder to sell stock at a given price, if exercised
Make money when stock price goes down
Loss is unlimited as price can go up infinitely
Lose money when stock prices go up
Maximum gain is the premium collected
Long Put
Bearish strategy
Allows holder to sell a stock at a fixed price
Makes money when prices fall
Loses premium when prices rise
Maximum loss is the premium
Maximum gain is when price falls to 0 (less the premium)
Short Put
Bullish strategy
Forces holder to buy a stock at a given price, if exercised
Makes money when prices go up, loses when prices go down
Max gain is the premium
Maximum loss is when the stock hits 0
Options Hedging Strategies
Long Stock / Long Put
Go long a stock (bullish), and go long a put (bearish – protection)
AKA a bullish strategy with downside protection
If the market rises, the put expires out of the money, and the stock can be sold at whatever price it rises to
To profit, the stock must appreciate by more than the premium of the put. Max gain is unlimited
If the market falls, the stock can be sold at the put strike price
The put is the hedge for the long position
Cost for this protection is the premium paid
In a falling market, loss is limited to the premium paid, and any difference in between the strike price and the cost basis of the stock
Short Stock / Long Call
Bearish strategy, with upward protection
If the market falls, the call is out of the money and the short can be covered at whatever the price falls to. Max gain is stock to 0, minus premium paid
If market rises, short position loses money, but is recovered by the long call. Max loss is premium paid, less any difference between call strike price and stock cost basis
Premium is the cost of protection
Income Strategies
Long Stock / Short Call: Covered Call
Used to generate extra premium income in a flat market
Market stays flat, the call expires at the money, and you receive the premium
If markets rise, call goes in the money and delivers the owned stock, and keeps the premium
If markets fall, the call is out of the money, and you lose on the stock position.
Only suitable for flat markets. If markets rise, customer loses the gain on the stock price. If markets fall, customer loses on the long stock position
Maximum loss is the stock going to 0 – the premium
Gain is fixed if the call is exercised. Gain is the premium, less any difference between call strike price and cost basis of the long position
Short Stock / Short Put: Covered Put
Used to generate extra income (premium) in a flat market
If flat, put expires at the money, and you are left with the premium
If market falls, you lose money on the put, but offset it with gains on the short
Maximum gain is collected premium, less difference between put strike and cost basis of short stock
Maximum potential loss is unlimited – from losing on the short position
Collars
Long put, short call while going long a stock
Long put provides downside protection, while the short call gives a premium that offsets the cost of the put
Usually buy options out of the money, to keep the cost down (goal is zero cost collar)
Straddles
A long straddle is going long a call and long a put, on the same stock, with the same strike and expiration
A short straddle is going short a call and short a put, on the same stock, with the same strike and expiration
Short is good for flat markets, Long is good for volatile markets,
Long Straddle
Long call, long put
Profitable in a volatile market, whether markets rise or fall
In a rising market, the call goes in the money, and the put expires out of the money
Maximum gain, rising market, is unlimited since markets can rise infinitely
In a falling market, the call expires out of the money, the put goes in the money
Maximum gain, falling market, is when the stock goes to 0
In a flat market, both call and put expire at the money, and the loss is the cost of the premiums
Short Straddle
Short call, short put
Profitable when the market is flat!
When the markets stay flat, the gain is the combined premiums collected
In a rising market, the short call goes in the money, and the put expires out of the money. Receive premium from the put and then lose on the appreciation of the call.
Maximum loss is unlimited during rising markets
If the market falls, short put goes in the money, and the short call expires out of the money. Receive premium from call and then lose on the depreciation of the put
Maximum loss in a falling market is when the stock falls to 0
Combinations
Long combination is same as a long straddle, but with different strikes and/or expirations
Short combination is same as short straddle, but with different strikes and/or expirations
Strangle
Variation of a combo, where both contracts are out of the money
Long strangle is same as long straddle, but options are both out of the money. Markets must move more sharply to profit, but cost is less than a normal straddle
Short strangle is same as short straddle, but options are both out of the money. Premiums collected are lower, but markets must move more sharply (up or down) for it to be unprofitable
Spreads
A spread is the purchase and sale of a call on the same stock, or a put on the same stock, with different strikes and/or expirations
Spreads are gain limiting, and loss limiting (almost like a collar but no stock positions)
Net debit = long spread (debit is paying premium)
Net credit = short spread (credit is receiving premium)
If positions are closed out, the net reverses
Bearish/bullish is the same as the option it mimics (disregard the name spread)
**Short = profit when spreads narrow!!
**Long = profit when spreads widen!!
Long Call Spread
Buy a lower strike (higher premium) call
Sell a higher strike (lower premium) call
Result is a net premium paid
Bullish strategy
If the market price rises, the long call goes in the money first and is exercised: buying the stock at a lower price for a profit
If the market keeps rising, then the short call goes in the money, and is exercised: delivering the stock for the higher price (losing money)
In a rising market, profit is limited to the difference in the strike prices, net of the premium paid
Maximum loss is the net premium paid
Widening spread = profitable
Narrowing spread = unprofitable
Short Call Spread
Sell a lower strike price call (higher premium)
Buy a higher strike price call (lower premium)
Bear market strategy
When prices fall, both calls expire out of the money, and the profit is the net premium
Max gain is the net premium
Max loss is difference in strike prices, net of the premium received
Narrowing spread = profitable
Widening spread = unprofitable
Long Put Spread
Buy a higher strike price put (higher premium)
Sell a lower strike price put (lower premium)
Net debit
Bear market strategy
Widening spreads = profitable
Narrowing spreads = unprofitable
Max gain is difference in strike less debit
Maximum loss is debit paid
Short Put Spread
Sell a lower strike price put (higher premium)
Buy a higher strike price put (lower pemium)
Net credit received
Bullish strategy
Narrowing spreads = profitable
Widening spreads = unprofitable
Max gain is net premium received
Max loss is difference in strikes less credit received
Vertical Spread
The purchase and sale of a call or put, a different strike prices (same expiry)
Horizontal Spread
Purchase and sale of a call or put, with different expirations, but the same strikes
Ratio Call Writing
Income strategy for a flat market
Long 100 shares of stock, sell 2+ calls against the stock
Ideally, market stays the same, calls expire at the money, and you get 2x the premium income
If markets rise, one of the calls is cancelled out by the long stock position, the others lose with unlimited risk
Ratio Spread
Same as a spread strategy, but you double down on one side of the spread
Equity Stock Options
Options Clearing Corporation
Owned collectively by the exchanges that trade options
OCC is the technical issuer and guarantor of all listed options contracts
OCC sets standards to make them interchangeable (tradeable)
Trading of options takes place on exchange floors
Reports are sent daily to the OCC who keeps the records of all holders and writers
If a holder wishes to exercise, OCC gets notice, and assigns a writer
OCC is the guarantor and issuer
Even if the writer does not fulfill his obligations, the holder is still covered because the OCC is liable/obligated to perform
Contract Specs
Standard size is 100 shares
Strike prices are standardized!!
Standardized expirations and standardized maximum lives!
Premium is not standard, premium is set by the market
Options trade in 3 cycles
At any time, the contracts that can trade are
Current month
Next month
Next 2 months in the cycle??
Legal maximum life is 9 months!!
American style
Settle regular way next business day!
Cash settlements settle same day!!
Trade cutoff is 4pm Eastern! (same as NYSE)
Options expire 1159pm ET on the third Friday of the month
Writer must pay or deliver stock within 3 days of settlement!
To receive a dividend – exercise must occur at least 3 days prior to the record date!
Ex-date is 2 days prior to the record date – so you must buy 3 days prior to settle on the record date (unless cash – then less one day)
Exercise limits cover all exercises occurring on one issuer in a 5-business day period
Position Limits
OCC limits the number of options contacts that 1 person can take on 1 issuer, on 1 side of the market
Common control accounts are aggregated to determine position limits
Trading Halts
If there is a trading halt, the options for that stock halted stop trading, because you need pricing to determine premium costs. Can still exercise or let expire during a halt tho
Naked writers must put up margin!
Can’t cover a position with another option position – unless the strike is the same or lower and the expiration is same or later