Series 7 Options Notes

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