XII. OPTIONS

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XII. OPTIONS
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A. DEFINITIONS

• Underlying instrument the financial product
  that is represented by the option, the option
  specifies that the underlying instrument can be
  bought or sold at a specific price at a specific
  time
• Option units for stocks, 1 option represents
  100 shares of the underlying instrument
• Exercise asserting the right to buy or sell as
  specified by the option

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A. DEFINITIONS

• Hold to own an option, does not require the
  holder to exercise the option
• Write to sell an options contract, it obligates
  the writer to buy or sell the underlying
  instrument the obligation can be terminated by
  buying an offsetting instrument
• Call purchase gives the holder the right to buy
  the underlying instrument from the writer at a
  set price before a set date

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A. DEFINITIONS

• Put Purchase gives the holder the right to sell
  the underlying instrument to the writer at a set
  price before a certain date
• Call sale requires the holder to sell the
  underlying instrument for a set price before a
  specific date
• Put sale obligates the holder to buy the
  underlying instrument for a set price at a
  specified date
• Equity options where the underlying instrument
  is shares of an individual stock

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B. PURCHASE AND SALE OF OPTIONS

• Strike price or exercise price what the
  investor pays for the underlying security when
  the option is exercised
• Premium the difference between the market price
  of the option and the strike price, where the
  market price is above the strike price
• Discount the difference between the market
  price of the option and the strike price, where
  the market price is below the strike price

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B. PURCHASE AND SALE OF OPTIONS

• Purchase of an option the purchasers risk of
  loss of capital is limited to the premium paid
  for the option
• Sale of an option the sellers risk of loss of
  capital is unlimited, except that the potential
  loss for a seller of a call option is limited to
  lost investment gains on the underlying security

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B. PURCHASE AND SALE OF OPTIONS

• Covered option where an option is sold (for a
  call option) or purchased (for a put option) and
  the investor owns the underlying security in the
  amount specified by the option
• Naked option where an option is sold (for a
  call option) or purchased (for a put option) and
  the investor does not own the underlying security

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B. PURCHASE AND SALE OF OPTIONS

• At the money option where the option strike
  price is the same as the price of the underlying
  security
• In the money option where the market price for
  the underlying security is higher than the strike
  price (for a call) and lower than the strike
  price (for a put)

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B. PURCHASE AND SALE OF OPTIONS

• Out of the money option where the market price
  of the underlying security is lower than the
  strike price for a call and higher than the
  strike price for a put
• Wasting asset any category of asset or
  investment that decreases to no value over time

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B. PURCHASE AND SALE OF OPTIONS

• Intrinsic value what an option is worth at any
  given time, excluding the market premium
• Time value the difference between the market
  premium and the options intrinsic value

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C. OPTION CONTRACT TERMS

• Options class the entire group of puts or calls
  written on the underlying investment
• Options series all puts or calls in the same
  class with the same terms
• Contract size how much of the underlying
  security is covered by the option, generally 100
  shares

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C. OPTION CONTRACT TERMS

• Expiration month when the option must be
  exercised or it becomes worthless
• Expiration styles
• American can be exercised at any time prior to
  expiration
• European can only be exercised on the
  expiration date
• LEAPS Long term equity anticipation securities
  can be written for as much as 3 years in
  advance, compared with the normal option time
  limit of 1 year in advance

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C. OPTION CONTRACT TERMS

• Delivery
• Physical delivery requires the delivery of the
  underlying instrument when the option is
  exercised
• Cash settled options cash is paid to either
  party based upon the difference between the
  strike price and the value of the underlying
  instrument

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D. OPTIONS TRANSACTION STYLES

• Hold to maturity once the option is purchased,
  it is not sold until the expiration date when
  gains are realized
• Trade before expiration closing out an option
  position prior to the expiration date
• Let option expire realizing a loss on the
  option transaction at the expiration date

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D. OPTIONS TRANSACTION STYLES

• Covered calls used to provide additional income
  to the investor holding long the underlying
  security, or to realize gains at a set price
• Naked calls used for speculation, trade like
  stocks
• Long and short calls and puts using the sale of
  far out of the money calls or of far out of the
  money puts to finance the purchase of closer in
  calls and puts (closer to the strike price)

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D. OPTIONS TRANSACTION STYLES

• Spreads the purchase or sale of options on the
  same underlying security
• Each option in the spread is known as the leg
• Vertical spread legs with different strike
  prices
• Put and Call spread contains both puts and calls

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D. OPTIONS TRANSACTION STYLES

• Laddered put and call spread can be puts,
  calls, or a combination, with different strike
  prices
• Calendar spreads a combination of put and/or
  call options with different expiration dates
• Collar sell an out of the money call, buy an in
  the money put
• Straddle buy or sell an equal number of put and
  call options with the same strike price and
  expiration dates provides a profit from small
  moves in the underlying securitys price

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D. OPTIONS TRANSACTION STYLES

• Strangle sale or purchase of call or put
  options on the same underlying instrument with
  the same expiration date, with each one equally
  out of the money profits from large price moves

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E. OTHER OPTION TERMS

• Delta measures the relationship between stock
  and option prices (ex. a delta of 0.5 means
  that the option increases in price by 0.50 for
  every 1.00 change in the price of the underlying
  instrument)
• Theta measures the change in option prices as
  the expiration date approaches

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E. OTHER OPTION TERMS

• Gamma measures the change in delta
• Vega the change in the option price resulting
  from a change in stock volatility
• Site for more options information the Chicago
  Board of Options Exchange (CBOE)
• Options quotes

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E. OTHER OPTION TERMS

• The time value of options

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E. OTHER OPTION TERMS

• Hedging buying covered puts and/or selling
  covered calls to help limit risk
• Speculating investing in naked puts and/or
  calls
• Rolling
• Rolling out choosing the same option as was
  held previously with a later expiration date
• Rolling up choosing the same type and
  expiration date of option with a higher strike
  price
• Rolling down choosing the same type and
  expiration date of option with a lower strike
  price

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E. OTHER OPTION TERMS

• Closing out
• Original Position Close Out
• Buy (long) call Sell call
• Buy (long) put Sell put
• Sell (write) call Buy call
• Sell (write) put Buy put

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E. OTHER OPTION TERMS

• Expiration date set at the Saturday following
  the 3rd Friday of the month of expiration
• Index options written on an index rather than a
  specific stock can be used to hedge a diverse
  portfolio, cash settled
• Interest rate options options on bonds (yields
  up, bond prices down, put gains value yields
  down, bond prices up, call gains value)

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F. OPTION BENCHMARKS AND PRICING

• CBOE volatility index (VIX) measures volatility
  (expected price changes) in the SP 500
• Higher VIX greater expectation of rapid and/or
  substantial price changes
• Lower VIX - lesser expectation of rapid and/or
  substantial price changes

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F. OPTION BENCHMARKS AND PRICING

• Put/call ratio an indicator of the expected
  price of a security
• Higher put/call ratio indicates market
  expectations of underlying security price
  declines
• Lower put/call ratio indicates market
  expectations of underlying security price
  increases

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F. OPTION BENCHMARKS AND PRICING

• Theoretical option pricing
• Black-Scholes formula determines what the
  logical price of an option should be based upon
  stock price and time
• Theoretical option pricing can be used in a
  computerized trading model (built by rocket
  scientists, used by day traders) to indicate
  option and stock purchases and sales based upon a
  comparison of an options theoretical price, the
  options market price, and the stock price

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G. READING OPTION SYMBOLS

• Format quoted as

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G. READING OPTION SYMBOLS

• Option symbol guide
• Option quotes

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G. READING OPTION SYMBOLS

• Last most recent trade price
• Bid/Ask the price that buyers are willing to
  pay compared to the price that sellers want
• Net change in options price
• Open interest number of positions outstanding
  (not closed)