Basics Of Simple Options

TJ GuptaBasics of Simple Options

An Option is a contract between two investors, a buyer (holder) and a writer (seller).A holder is the person who bought the option, and the writer is the person who sold the option.An option holder has the right but not the obligation to buy or sell the underlying security. An option writer has the obligation but not the right to buy or sell the underlying security.Option Definition

Transfer of RiskProtect Your PortfolioSpeculate on the Direction of the MarketWhy Options ?

Call Options A call option gives the right to buy the underlying asset at the strike price any time until the expiry date. Put Options A put option gives the right to sell the underlying asset at the strike price any time until the expiry date.Two Types of Options

Call Options (1) Call options give the holder (buyer) the right (but not the obligation) to buy the underlying asset at the strike price any time until the expiry date. (2) Call options obligate the writer (seller) to sell the underlying asset at the strike price any time until the expiry date.Note: the writer has the exact opposite position in comparison to the holder, this is because they are on opposite sides of the same contract. Put Options (1) Put options give the holder (buyer) the right (but not the obligation) to sell the underlying asset at the strike price any time until the expiry date. (2) Put options obligate the writer (seller) to buy the underlying asset at the strike price any time until the expiry date. Note: the writer has the exact opposite position in comparison to the holder, this is because they are on opposite sides of the same contract.Four Basic Option Positions

Summary of the Four Basic Options Positions

Call Option A contract that gives the holder the right to buy the underlying for the strike price any time until expiry. Put Option A contract that gives the holder the right to sell the underlying for the strike price any time until expiry. Strike Price (Exercise Price) The price that the underlying asset will be bought or sold at if an option contract is exercised. Premium A premium is the price that is paid for an option contract. Underlying The underlying is something which an option contract is based on. This could be a stock, index, foreign currency, interest rate, or a futures contract. The underlying is commonly referred to as the: underlying interest, underlying asset, underlying security, or the underlying stock. Need to Know Options Terms

Writer A writer is someone who sold an option contract to open a position. The writer is the person who is taking on the risk, (underwriting the risk). Someone who sells an options contract they already own is not a writer, they are just closing an existing position. An option writer is said to be "short" the option they wrote. Holder The holder is the person who bought an option contract. Someone who buys an option they previously wrote is not a holder, they are just closing an existing position. An option holder is said to be "long" the option they bought. Long If you own a security you are said to be long that security. Short If you sell a security that you didn't already own you are said to be short that security. Need to Know Options Terms

Stock OptionsStock options will be the primary focus of this course as they are one of the most popular types of options. Naturally stock options use common stocks as the underlying interest. Stock options have physical settlement (they are settled by physical delivery of and payment for the stocks). Options are not available on all stocks, however they are available on most major stocks. Index OptionsThere are index options based on most major indexes. Index options can be very useful in hedging the risk in a well diversified portfolio. Since an index is intangible and can not be bought or sold, index options are cash settled.Types of Options & Features

American StyleAmerican style options can be exercised any time until expiry.Some examples of American-style options are: stock options, bond options, and currency options, . European StyleEuropean style options can only be exercised on expiry (not before).Some examples of European-style options are: index options and interest rate options.Exercise Styles

Last Trading DayThe last trading day for stock options is typically the third Friday of the expiration month. Expiry DateStock options expire the day following the last trading day. The expiry date is the Saturday following the third Friday of the expiration month. Settlement Day Trading OptionsThe settlement day for buying and selling stock options is "T+1" (one business day after the trade day). The settlement day for trading options is simply the day when the buyer must pay for the option and the day that the seller must deliver the contract. Exercising OptionsThe settlement day for exercising stock options is "T+3" (three business days after the trade day). The settlement day for exercising options is simply the day when the money must be paid and the stock must be delivered.Dates

Components of an Option's Price (also called the Premium):Premium = Time Value + Intrinsic ValueTime value is the value that can be attributed to the possibility that the option will increase in value during the time before expiry.Intrinsic value is the current value that could be realized by exercising the option and simultaneously liquidating the position at the same time. For example: exercise a call option to buy XYZ at a strike price of $20, then sell XYZ at the current price of $25; in this example there would be an intrinsic value of $5.Option Premium

Buy to Open Buying to open a position is when you buy a contract that you don't already own. Sell to Close Selling a contract that you currently own. Write (Sell to Open) Selling an options contract that you don't already own. The writer is the person taking on the risk, (underwriting the risk). Someone who sells an options contract they already own is not a writer, they are just closing an existing position. An option writer is said to be "short" the option they wrote. Buy to Close Buying to close is when you buy a contract that you are currently short. Basic Options Strategies

Covered Writing- Writing an option when you also hold a position that can fulfill the obligation being taken on by writing the option. The position could be in cash a convertible security or the underlying security itself. For example you could write a covered call option if you owned enough shares of the underlying stock Uncovered (Naked) Writing- Selling an option when you don't have a position that could be used to fulfill the obligation of the option. Naked call writing carries unlimited risk, while naked put writing is limited to the strike price of the option. Exercise & Assignment- Exercise is when the option holder decides to use the option to buy or sell the underlying stock at the strike price. Assignment is when an option writer is required to buy or sell the underlying stock due to the obligation from writing the option. An option holder exercising an option will cause an option writer to be assigned.

Buying a call gives you the right to buy the underlying stock at the strike price any time until expiry. Long Call (Buy a Call)You would buy a call if you think the price of the underlying stock is going to rise (when you are bullish on the underlying stock).Buying a call with a strike price of $25 for a premium of $5.If the price of the stock rose to $40 by the expiry date the call option would be worth $15 ($40 the stock price - $25 the strike price). In this example the holder of the call option would have a profit of $10 ($15 the value of the option at expiry - $5 the premium paid for the option).Long Call

Writing a call obligates you to sell the underlying stock at the strike price any time until expiry if you are assigned.Short CallYou short a call when you write (sell) a call that you don't currently own. There are two basic types of short calls covered and uncovered (naked). Naked Call (Uncovered Call) You could write a call if you think the price of the underlying stock is going to stay the same or fall (when you are neutral or bearish on the underlying stock).Covered Call A covered call is when you own the underlying stock and you write a call. The call is covered because if you get assigned and have to sell the underlying stock it is OK because you already own it. If you think that a stocks price will stay the same or move up slightly you could write a covered call.Short Call

Buying a put gives you the right to sell the underlying stock at the strike price any time until expiry. Long PutWhen you buy a put to open a position you are said to be "long a put". You can buy a put either to speculate or to protect a position. Speculative PutA speculative put is when you buy a put in hopes that the stock will fall, as opposed to buying a put to protect a position in the underlying stock.Protective PutA protective put is when you have a position in the underlying stock and you buy a put to protect against a drop in the stock's price. A protective put is like buying an insurance policy on your stock to protect against the drop in price. You may want to buy a protective put if you think the underlying stock is going to rise buy you have some short term concerns, and you want to protect yourself in case there is a sharp drop in the stock price.Long Put

Writing a put obligates you to buy the underlying stock at the strike price any time until expiry if you are assigned. Short Put (Writing a Put)When you write (sell) a put that you don't already own you are said to be "short a put". You could write a put if you think the price of the underlying stock is going to stay the same or rise (when you are neutral or bullish on the underlying stock). Naked Put (Uncovered) vs. Short Put Covered by CashThere are two basic types of short puts covered and uncovered (naked). When you write a put you are taking on an obligation to buy the underlying stock at the strike price. You can cover this obligation by having enough cash to buy the shares at the strike price.Short Put

Summary of Basic Option Strategies

Sell the OptionsYou can sell an option that you previously bought on or before the expiry date. Selling an option is often the best way to close out a position if there is still time remaining before expiry. Exercise the OptionsYou can only exercise an option if you are long the option (if you own the option).Let the Options Expire When you let an option expire, you lose all the money you invested in the option.Closing an Option Position

What right and/or obligation does a call holder have? a) The obligation to sell the stock at the strike price any time until expiry.b) The right to sell the stock at the strike price any time until expiry.c) The obligation to buy the stock at the strike price any time until expiry.d) The right to buy the stock at the strike price any time until expiry.QUIZ

When is the last trading day for an option? a) The last business day of the expiry month.b) The last Friday of the expiry month.c) The first business day of the expiry monthd) The third Friday of the expiry monthQUIZ

What right and/or obligation does a put writer have?a) The obligation to sell the stock at the strike price any time until expiry.b) The right to sell the stock at the strike price any time until expiry.c) The obligation to buy the stock at the strike price any time until expiry.d) The right to buy the stock at the strike price any time until expiry.QUIZ

What right and/or obligation does a put holder have?a) The obligation to sell the stock at the strike price any time until expiry.b) The right to sell the stock at the strike price any time until expiry.c) The obligation to buy the stock at the strike price any time until expiry.d) The right to buy the stock at the strike price any time until expiry.QUIZ

You own a stock and you think that it will perform well over the long term, however you think it will stay within the current price range for the next couple of months. What strategy would be the most suitable?a) buy a putb) buy a callc) write a naked calld) write a covered calle) write a naked putf) write a put that is covered with cashg) sell the stock now then buy it back in a couple of months.h) just hold the stock because it should rise in a couple of monthsQUIZ

What is the maximum risk involved in buying a call option?a) There is no risk involved in buying a call option.b) The risk is limited to the premium paid.c) The risk is limited to the strike price.d) The risk is limited to the strike price plus the premium.e) There is unlimited risk involved with buying a call option.QUIZ

What is the maximum risk involved in writing a naked put option?a) There is no risk involved with writing a naked put.b) The risk is limited to the premium of the option.c) The risk is limited to the strike price less the premium.d) There is unlimited risk involved with writing a naked put.QUIZ

Basics Of Simple Options

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Basics Of Simple Options