Chapter 9: Options Basics

Question 1

The Options Contract:
An option is a two-party contract that conveys a right to the buyer and an obligation to the seller. The terms of option contracts are standardized by the _________. This standardization allows options to be traded easily on an exchange such as the _________, the _________, and other exchanges.

Answer 1

Options Clearing Corporation (OCC)

Chicago Board Options Exchange (CBOE)

Nasdaq Option Market

Question 2

The Options Contract:
The value of the options contract comes from the underlying security for which an option contract is created which may be a:
1. _________
2. _________
3. _________
4. _________
5. _________

Answer 2

1. stock
2. stock market - index
3. foreign currency
4. interest rate
5. government bond

Question 3

The Options Contract:
Options are called _________ securities because their value is derived from the value of the underlying instrument, such as stock, an index, or a foreign currency. The most common type of option contract is an _________ option where each contract represents ownership of 100 shares of the underlying stock.

Answer 3

derivative securities (derivatives)

equity

Question 4

The Options Contract:
The _________ was the first exchange to trade listed options. The _________ trades more options than any other exchange in the world. Not all option contracts are alike, even though they are all standardized.

Answer 4

Chicago Board of Options Exchange (CBOE)

Nasdaq Options Market

Question 5

The Options Contract:
Example: With standard contracts, the multiplier is _________.
How much is the standard contract premium of $2?

Answer 5

100
Therefore, a standard option contract premium of $2 represents only $200.

Question 6

The Options Contract:
Example: Some option contracts cover only a certain number of shares of the underlying stock. These are known as mini-options. With mini-option contracts, the multiplier is only __________. How much is the mini-option contract premium of $2?

Answer 6

10 shares

Therefore, a mini-option contract premium of $2 represents only $20.

Question 7

The Options Contract:
Example: Institutions sometimes trade jumbo contracts representing _________ shares of the underlying stock.
How much is the jumbo option contract premium of $2?

Answer 7

1,000 shares

Therefore, a jumbo option contract premium of $2 represents $2,000.

Question 8

The Options Contract:
• Pays premium (the cost of the contract). There is a debit to their account when the premium is paid.
• This investor open their position with a debit to their account.
• Has the right to exercise (buy or sell stock).

What Position is this investor in?

Answer 8

Buyer = Long = Holder = Owner

Question 9

The Options Contract:
• Receives premium. There is a credit to their account when the premium is received.
• This investor opens their position with a credit to their account.
• Has the obligation when contract is exercised. They will be assigned an option contract and must buy or sell as required by contract.

What Position is this investor in?

Answer 9

Seller = Short = Writer

Question 10

The Options Contract:
An investor in this Position is:

Long a __________:

has the RIGHT to

BUY

the underlying asset at the strike price from a person who is short a call.

Contract: For agreeing to these contract provisions, the call buyer pays the premium.

What position is this investor in?

Answer 10

CALL (bought the call)

Long Position

Question 11

The Options Contract:
An investor in this Position is:

Long a __________:

has the RIGHT to

SELL

the underlying asset at the strike price at any time to a person who is short a put.

Contract: For agreeing to these contract provisions, the put buyer pays the premium.

What position is this investor in?

Answer 11

PUT (bought the put)
Long Position

Question 12

The Options Contract:
An investor in this Position is:

Short a __________:

has the OBLIGATION to

SELL

the underlying asset at the strike price to a person who is long and exercised the option.

Contract: For agreeing to these contract provisions, the call writer receives the premium.

What position is this investor in?

Answer 12

Call (sold the call)
Short Position

Question 13

The Options Contract:
An investor in this Position is:

Short a __________:

has the OBLIGATION to

BUY

the underlying asset at the strike price from a person who is long the put if the option is exercised.

Contract: For agreeing to these contract provisions, the put writer receives the premium.

What position is this investor in?

Answer 13

Put (sold the put)
Short Position

Question 14

The Options Contract:
Every option contract must have three specifications:
• ____________: Anything with fluctuating value can be the derivative of an option contract. We will focus on common stock.

Answer 14

Underlying instrument

Question 15

The Options Contract:
Every option contract must have three specifications:
• ____________: The contract specifies an exercise price at which the purchase or sale of the underlying security will occur.

Answer 15

Strike price

Question 16

The Options Contract:
Every option contract must have three specifications:
• ____________: All contracts have a specified life cycle and expire on a specified date. Once a contract is issued, it can be bought or sold anytime during its life cycle up to and including this date.

Answer 16

Expiration Date

Question 17

The Options Contract:
Every option contract must have an expiration date:
• ____________: contracts are issued with nine-month expirations and expire on the third Friday of the expiration month at _____ pm ET.

Answer 17

Standard contracts

11:59 pm ET

Question 18

The Options Contract:
Every option contract must have an expiration date:
• ____________: contracts have maximum expirations. Although the maximum is ________ months, most trade with a 30-month life cycle. That’s because it reaches ________ months it becomes a standard option contract.

Answer 18

39 months

9 months

Long-term equity anticipation securities (LEAPS)

Question 19

The Options Contract:
Every option contract must have an expiration date:
The length of time until the contract expires is a contract specification that can be ____________ between buyer and seller when the contract first trades.

Answer 19

negotiated

Question 20

The Options Contract:
Example:

A standard option contract might look like this: ABC NOV 40 Call. That means the underlying asset is ________ shares of ABC common stock. The option expires in November. The strike price or exercise price is $________ per share.

Answer 20

100
$40

Another option might be a XYZ JUL 65 Put. The underlying asset is 100 shares of XYZ common stock. The option expires in July, and the strike price is 65.

Question 21

The Options Contract:
Types of Options:
Options are categorized by type, class, and series:
__________: There are two types of options:
1. Calls
2. Puts

Answer 21

Type.

Question 22

The Options Contract:
Types of Options:
Options are categorized by type, class, and series:
__________: All options of the same type on the same underlying security are considered being one of these (e.g., all ALF calls make up one; all ALF puts make up another one).

Answer 22

Class

Question 23

The Options Contract:
Types of Options:
Options are categorized by type, class, and series:
__________: All options of the same class, exercise price, and expiration month are in the same one of these. For instance, all Jan 45 ACM puts make up one; all Jan 50 ACM puts make up another.

Answer 23

Series

Question 24

The Options Contract:
Calls:
An investor may buy calls (go long) or sell or write calls (go short). The features of each side of a call contract are as follows:
__________: A call buyer owns the right to buy 100 shares of a specific stock at the exercise (strike) price before the expiration if he chooses to exercise. The holder (owner) of the option can also sell the option before the expiration if the holder desires.

Answer 24

Long call

Question 25

The Options Contract: Calls: An investor may buy calls (go long) or sell or write calls (go short). The features of each side of a call contract are as follows: __________: A call writer (seller) has the obligation to sell 100 shares of a specific stock at the strike price if the buyer exercises the contract.

Answer 25

Short call

Question 26

The Options Contract: Puts: An investor may buy puts (go long) or sell puts (go short). The features of each side of a put contract are noted as follows: __________: Long put. A put buyer owns the right to sell 100 shares of a specific stock at the strike price or exercise price if the holder (owner) chooses to exercise. The holder (owner) of the option can also sell the option before expiration if the holder desires. The Options Contract: Puts: An investor may buy puts (go long) or sell puts (go short). The features of each side of a put contract are noted as follows: __________: A put writer (seller) has the obligation to buy 100 shares of a specific stock at the strike price if the buyer exercises the contract.

Answer 26

Short put.

Question 27

The Options Contract: Buyers of options call the shots; they are in control. They choose to exercise or not to exercise. That is why buyers pay _________.

Answer 27

premiums

Question 28

The Options Contract: The writer is at the mercy of the buyer's decision. Options are exercised _________ the writer when the buyer makes that decision. Writers do not have the opportunity to choose to exercise.

Answer 28

against the favor of

Question 29

The Options Contract: The buyer wants to exercise the contract or sell the contract at a price _________ than the original premium. This would give the buyer a profit. You can answer a significant number of test questions by knowing that buyers have rights and sellers have obligations.

Answer 29

higher

Question 30

The Options Contract: The seller wants the contract to _________. The seller would make a profit at expiration because the seller gets to keep the entire premium and no _________ or _________ of stock is required. You can answer a significant number of test questions by knowing that buyers have rights and sellers have obligations.

Answer 30

expire worthless purchase or sale

Question 31

The Options Contract: Example of an Options Order Ticket: The following is an example of what an options trade ticket would reflect: • Long 1 XYZ Jan 60 call at 3 Long: The investor has bought the call and has the _________ to exercise the contract. XYZ: The single contract represents 100 shares of XYZ stock. Jan: The contract expires on the third Friday of January at _________ pm CST. 60: The strike price of the contract is 60. Call: The type of option is a call, and the investor has the right to _________ the stock at 60 because he is long the call. 3: The premium of the contract is $3 per share. Contracts are for 100 shares, so the total premium is $300. The investor paid the premium to _________. The seller (writer) received the $300 premium for selling the option.

Answer 31

right 10:59 pm CST buy buy the call option

Question 32

The Options Contract: Opening and Closing Positions: When an investor establishes the option position by buying or writing calls or puts, the order ticket and confirmation are marked as a _______ or a ________. The key is the first step: to . A customer who buys an option may generally sell that option at any time before it ________ expires.

Answer 32

Opening Purchase Opening Sale open the transaction

Question 33

The Options Contract: Opening and Closing Positions: This offsetting transaction is written on the ticket memorandum and the trade confirmations are marked ________. Therefore, as with much that we buy, we open with a purchase and close (unload it) with a sale.

Answer 33

Closing Sale

Question 34

The Options Contract: Opening and Closing Positions: A customer who sold an option as an ________ transaction may, at any time before the option expires, ________ the option. This transaction is known as a closing purchase, and the ticket and confirmation are marked ________ Purchase. The price of the underlying stock will change over the life of the option. Gains or losses on closing transactions result from the ________ between premiums paid and received.

Answer 34

opening buy back Closing differences

Question 35

The Options Contract: Settlement Dates: When options are bought and sold, the settlement is the next business day. We refer to that as T+1. Unlike stocks and bonds, there are no ________ for options. That makes settlement much quicker.

Answer 35

certificates

Question 36

The Options Contract: Settlement Dates: When options are bought and sold, the settlement is the next business day: An investor PURCHASING an option on Tuesday must pay for it by the close of business ________.

Answer 36

Wednesday

Question 37

The Options Contract: Settlement Dates: When options are bought and sold, the settlement is the next business day: Investors SELLING an option on Tuesday will have the proceeds credited to their account by the close of business ________.

Answer 37

Wednesday

Question 38

The Options Contract: Settlement Dates: Without a certificate, how does the client prove ownership? The investor's proof of ownership of an option is the _________ and _________.

Answer 38

trade confirmation proof of payment

Question 39

The Options Contract: Role of the ___________: They are an SRO, is the issuer of listed options contracts. It is owned by the exchanges that trade options. Its primary functions are to standardize, guarantee the performance of, and issue option contracts.

Answer 39

Options Clearing Corporation (OCC)

Question 40

The Options Contract: Role of the Options Clearing Corporation (OCC): They determines when ___________ contracts will be offered to the market. It designates the ___________ and ___________ for new contracts within market standards to maintain uniformity and liquidity. It is important to note that they do not determine option premiums. ___________ in the trading markets determines the premium for the contracts.

Answer 40

new option strike prices expiration months Supply and demand

Question 41

The Options Contract: Role of the Options Clearing Corporation (OCC): One of the important guarantees of the OCC is the exercise of options contracts. That means if for some reason a seller is unable to perform, the OCC _______. If a holder of an option wishes to exercise, the broker-dealer notifies the OCC. The OCC then assigns the _______ against a broker-dealer with a customer who has sold or written that option. The broker-dealer then _______ that exercise notice to a customer with a short position.

Answer 41

Performs exercise notice assigns

Question 42

The Options Contract: Assignment of Exercise Notices: As we have learned, an investor who is long an option contract (the holder or owner) can choose to exercise that option. In the case of a call, that would be exercising the right to ________ at the strike price. In the case of a put, that would be exercising the right to ________ at the strike price.

Answer 42

buy sell

Question 43

The Options Contract: Assignment of Exercise Notices: Customer Notification of Allocation Method: When the OCC is notified by a broker-dealer that one of its customers wants to exercise, the OCC randomly selects a firm with a short position in that option to which it assigns the exercise. The OCC assigns exercise notices on a _________. Then it is up to the assigned broker-dealer to determine which of its clients is going to be obligated.

Answer 43

random basis

Question 44

The Options Contract: Assignment of Exercise Notices: Customer Notification of Allocation Method: Once a stock option contract is exercised, the contract can no longer be _________. The assignment is binding and cannot be reversed. The assigned party (the writer) must either _________ the stock within one business day (for a call) or _________ the stock within one business day (for a put) from notification of exercise.

Answer 44

traded deliver buy

Question 45

The Options Contract: Assignment of Exercise Notices: Customer Notification of Allocation Method: Broker-dealers have three ways to allocate exercise assignments. They may allocate to customers on: A. _________ B. _________ C. _________

Answer 45

A. a random basis B. a first-in, first-out (FIFO) method C. any other method that is fair and reasonable.

Question 46

The Options Contract: Assignment of Exercise Notices: Most Common Method: Commonly referred to as the _________ method, each member firm must inform its options customers in _________ of how it allocates exercise notices (assignments) and the consequences of the method of allocation used. One method that is not considered fair and reasonable (and is often tested) is selecting based on the _________ of the writer's position. Although those who have written 100 contracts are more likely to be selected randomly than a client who is short one contract, the firm _________ cannot deliberately choose the client with the largest short position.

Answer 46

notification of allocation writing size

Question 47

The Options Contract: Delivery After Exercise: Upon exercise of an option, the parties are required to make settlement. The assigned party (the writer) must either deliver the stock within _____ business days (for a call) or buy the stock within _____ business days (for a put) from notification of exercise. This is the same T+1 settlement requirement as any stock trade.

Answer 47

two two

Question 48

The Options Contract: Delivery After Exercise: The settlement date for equity options is the next business day. In other words, when an option is bought or sold, that option trade settles T+1. If an equity option is exercised, what happens? Stock is either______ or _______, and that is treated as any other equity transaction. That means T+1 settlement date.

Answer 48

bought (call) sold (put)

Question 49

Factors in Options Valuation: Intrinsic Value: Probably the most important item is the option's intrinsic value. Intrinsic value is often referred to as _________.

Answer 49

In-The-Money (ITM)

Question 50

Factors in Options Valuation: Intrinsic Value: A CALL is In-The-Money (ITM) when the market price of the underlying asset exceeds the strike price of the option. Buyers want options to be In-The-Money (ITM); _________ do not. It is critical to understand that the term in the money (or out of the money) refers to the option, not to the investor.

Answer 50

sellers

Question 51

Factors in Options Valuation: Intrinsic Value of a CALL: Example: An ABC 50 call is in the money by _________ points when the price of ABC stock is 57.

Answer 51

7 points

Question 52

Factors in Options Valuation: Intrinsic Value: A PUT option is In-The-Money (ITM) when the market price of the underlying asset is _________ than the strike price of the option. Buyers generally benefit when contracts are In-The-Money (ITM), whereas sellers do not.

Answer 52

less

Question 53

Factors in Options Valuation: Intrinsic Value of a PUT: Example: An ABC 50 put is In-The-Money (ITM) by _________ points when ABC stock is at 46.

Answer 53

4 points

Question 54

Factors in Options Valuation: At-The-Money: A CALL or a PUT is At-The-Money (ATM) when the market price of the underlying asset _________ the strike price of the option.

Answer 54

equals

Question 55

Factors in Options Valuation: At-The-Money: Example: An ABC 50 CALL is At-The-Money (ATM) when the price of ABC stock is _________.

Answer 55

50

Question 56

Factors in Options Valuation: At-The-Money: Example: An ABC 50 PUT is At-The-Money (ATM) when the price of ABC stock is _________ .

Answer 56

50

Question 57

Factors in Options Valuation: Out-The-Money (OTM): A CALL option is Out-The-Money (OTM) when the market price of the underlying asset is _________ than the strike price of the option. A buyer will not exercise calls that are Out-The-Money (OTM) at expiration. Out-The-Money (OTM) contracts are advantageous to _________. The options expire, and sellers keep the premium without obligations to perform.

Answer 57

less sellers

Question 58

Factors in Options Valuation: Out-The-Money (OTM): Example: An ABC 50 call is Out-The-Money (OTM) by _________ points when the price of ABC stock is 46.

Answer 58

4 points

Question 59

Factors in Options Valuation: Out-The-Money (OTM): A PUT option is Out-The-Money (OTM) when the market price of the underlying asset is _________ than the strike price of the option. A buyer will not exercise puts that are out of the money. _________ benefit when PUT contracts are out of the money.

Answer 59

greater Sellers

Question 60

Factors in Options Valuation: Out-The-Money (OTM): Example: An ABC 50 put is out of the money by _________ points when the price of ABC stock is 57.

Answer 60

7 points

Question 61

Factors in Options Valuation Did you notice how puts and calls are opposite each other? When the call was in the money (the stock's price went up), the put was out of the money by an equal amount. What is the pneumonic?

Answer 61

Call goes UP and put goes DOWN. Put goes UP and Call goes DOWN.

Question 62

In, at, and out of the money: An option is in the money by the amount of its intrinsic value: Example: Calls: 40 Call, stock @ 42 In the Money, At the Money, Out of the Money?

Answer 62

Intrinsic Value: 2 points In the Money: 2 points

Question 63

Factors in Options Valuation: ___________: The second component in valuing an option is this value. This is a function of the time remaining before the option expires. At expiration, the time value is zero, there is NO more time left.

Answer 63

Time Value An option expiring in nine months has more time value than one expiring in six months. The option expiring in six months has more time value than one expiring in one month.

Question 64

Factors in Options Valuation: ________ options become beneficial to the owner when the price of the stock goes up.

Answer 64

Call Options

Question 65

Factors in Options Valuation: ________ options become beneficial to the owner when the price of the stock goes down.

Answer 65

Put Options

Question 66

Factors in Options Valuation: Intrinsic Value: Intrinsic value is the ________ as the amount a contract is in the money.

Answer 66

same Ex. A call option has intrinsic value when the market price of the stock is above the strike price of the call.

Question 67

Factors in Options Valuation: Intrinsic Value: Options never have ________ intrinsic value; intrinsic value is always a positive amount or zero. Options that are at the money or out of the money have an intrinsic value of zero.

Answer 67

Negative Intrinsic Value

Question 68

Factors in Options Valuation: Intrinsic Value: Buyers like _____ options to have intrinsic value vs. sellers (writers) do not.

Answer 68

Call Options An option that has intrinsic value at expiration will be exercised or sold by the buyer.

Question 69

Factors in Options Valuation: Intrinsic Value: Buyers like the purchased _______ options to have intrinsic value vs. sellers (writers) do not.

Answer 69

Call Options

Question 70

Factors in Options Valuation: Intrinsic Value: During the lifetime of an option contract, buyers want the contract to move ______-The-Money ; sellers want the contract to move _______-The-Money.

Answer 70

in the money out of the money

Question 71

In, at, and out of the money: An option is in the money by the amount of its intrinsic value: Example: Calls: 40 Call, stock @ 40 In the Money, At the Money, Out of the Money?

Answer 71

Intrinsic Value: 0 points At-The-Money: 0 points (strike price = stock)

Question 72

In, at, and out of the money: An option is in the money by the amount of its intrinsic value: Example: Calls: 40 Call, stock @ 38 In the Money, At the Money, Out of the Money?

Answer 72

Intrinsic Value: 0 points (strike price > stock) Out-The-Money: 0 points (strike price = stock)

Question 73

Factors in Options Valuation: Time Value: How do you compute time value? An option has time value anytime the option's premium ___________ its intrinsic value. The amount an option buyer will pay (and a seller will accept) above an option's intrinsic value is the time value.

Answer 73

exceeds That will likely be a question on your exam.

Question 74

Factors in Options Valuation: Time Value: An option expires on a preset date; the further away that date is, the more time there is available for a change in the price of the underlying stock. The amount of time in the contract, therefore, has ___________ to the option buyer. You can expect buyers to pay more for a contract that has a long time to run than for a contract that is about to expire.

Answer 74

value ($)

Question 75

Factors in Options Valuation: Time Value: An option's premium reflects two different types of values: intrinsic value and time value. The option's premium is equal to the intrinsic value ___________ the time value.

Answer 75

plus

Question 76

Factors in Options Valuation: Time Value: Important: ___________: The amount by which the option is in the money.

Answer 76

Intrinsic value

Question 77

Factors in Options Valuation: Time Value: Important: ___________: The market's perceived worth of the time remaining to expiration.

Answer 77

Time value

Question 78

Factors in Options Valuation: Important: Premium – Intrinsic Value = __________ If an option is out‑of‑the‑money, intrinsic value is 0, so the entire premium is time value.

Answer 78

Time Value

Question 79

Factors in Options Valuation: Time Value: Important: As the option's expiration date approaches, its time value will diminish. That is known as __________. On the last trading day before expiration, the option's time value will erode to __________ and the premium will usually equal the intrinsic value.

Answer 79

time decay zero

Question 80

Factors in Options Valuation: Calculating Time Value: An option premium is composed of two components: intrinsic value and time value. To compute time value, __________ intrinsic value from the premium. If an option is at or out of the money, the entire premium is time value.

Answer 80

subtract

Question 81

Factors in Options Valuation: Calculating Time Value: Example: An XYZ NOV 40 put has a premium of 1.25 when XYZ stock is selling at 41. With the market price above the strike price (41 is higher than 40), the option is out of the money. That means the option has no intrinsic value. Therefore, the entire premium of $__________ is time value.

Answer 81

$1.25 ($125) is time value

Question 82

Factors in Options Valuation: Calculating Parity: An option is trading at parity when the premium __________ the intrinsic value of the contract.

Answer 82

equals

Question 83

Factors in Options Valuation: Calculating Parity: Example: A May 35 call is at parity when the market price is 40 and the premium is __________.

Answer 83

5

Question 84

Factors in Options Valuation: Calculating Parity: Example: A May 35 put is at parity when the market price is 30 and the premium is __________.

Answer 84

5

Question 85

Factors in Options Valuation: Calculating Parity: Options generally trade around parity just before their expiration date. Why is that? If the premium is equal to the intrinsic (in the money) value, what pricing component is missing? We are missing the time value. When is there no time value to an option? This happens when there is no __________ , which occurs just before the option expires.

Answer 85

time remaining

Question 86

Factors in Options Valuation: Calculating Parity: Example: Which of the following option contracts has no time value? A. ABC OCT 50 call @ 2 with ABC at 51 B. DEF NOV 60 call @ 2 with DEF at 62 C. GHI DEC 50 put @2 with GHI at 49 D. JKL JAN 60 put @ 2 with JKL at 62

Answer 86

Answer: B An option's time value is the difference between the premium and the intrinsic value. In choice B, the call option has 2 points of intrinsic value. It is in the money because the strike price is below the market. Therefore, the premium of 2 is equal to the intrinsic value. That means the option is selling at parity and had no time value. In choice A, the option is 1 point in the money. With a premium of 2, the other point represents time value. In choice C, the option is 1 point in the money. With a premium of 2, the other point represents time value. In choice D, the option is 2 points out of the money, so the entire premium is time value.