Digital Log

    SIE 5.1 Characteristics Of Options

    • Options are a derivative investment; they drive value from some underlying asset.
    • Futures are derivatives based on commodities.
    • Options are a two-party contract:
      • Buyer: "long", pays premium for contract, has right to exercise it
      • Seller: "short", receives premium, takes on obligation
    • Options can exist for any item with a fluctuating value

    Equity Options

    • Equity Options are those created for common stocks.
      • Evidently, these option purchases/sales settle the next business day.
      • But their exercise settles in two business days.
    • Two types of options: calls and puts, and each can be bought/sold.
    • Long Call: i.e. purchase a call
      • Call buyer has right to execute: buy 100 shares of the specified stock at the strike price before the expiration.
        • Hence bullish: expects stock price to rise.
    • Short call: i.e. sell a call
      • The other side of the long call; they are obligated to sell the 100 shares at the strike price if buyer chooses to execute.
      • If buyer does not execute, they keep the premium and lose the obligation.
        • Hence bearish: expects stock price to fall (or stay the same).
    • Long Put: i.e. purchase a put
      • Same thing as call except a sell instead of a buy contract. So, bearish.
    • Short Put: i.e. sell a put
      • Same thing as call except a sell instead of a buy contract. So, bullish.
    • A contract is in the money if it is in favor for the contract buyer (i.e. market price exceeds strike price for call, vice versa for put)
    • The intrinsic value is the amount by which the contract is in the money (nonnegative value, since you wouldn't execute a disadvantageous contract).
    • The option is at parity when the premium equals the intrinsic value.
    • We write Premium = Intrinsic + Time, where the Time value is a subjective amount determined by supply/demand/duration of contract.

    Nonequity Options

    These function similarly, but differ in delivery/exercise/sizes.

    • Index options
      • Use a 100x multiplier
      • Settlement of contract and exercising contract occur next business day
      • Broad-based (e.g. SPX tracking SP500) stop trading at 4:15 ET
      • Narrow-based (e.g. a pharmaceutical index) stop trading at 4:00 ET
      • Settles in cash rather than in an actual security - cash must be delivered the next business day.
        • The writer of the contract simply delivers the intrinsic value of the option to the buyer.
      • Settlement is based on the closing value on the day the index option is exercised, not the value at the exact time of exercise.
      • Expire on the third Friday of expiration month, like equity options.
      • Buying an index put can be seen as portfolio insurance.
    • Interest Rate options
      • Yield based: buy a call if you expect a rate to rise and get $1000 per percentage increase.
      • 'European-style exercise': Can only be exercised on expiration day!
    • Currency options
      • These options allow investors to speculate on exchange rates against USD.
      • Popular to hedge risk for importer/exporters.
        • Exporters buy puts
        • Importers buy calls
      • Settlement of contract and exercising contract occur next business day
      • These also expire third Friday of the expiration month.
      • 'European-style exercise': Can only be exercised on expiration day!

    As mentioned:

    • European-style options can only be exercised on expiration day. (Foreign currency and yield-based options.)
    • American-style options can be exercised anytime before expiration. (Nearly all equities and equity index options.)

    Insurance

    • A protective put is having a long equity position and a long put to sell the stock at some minimum price if the price falls instead of rising.
    • A protective call is having a short equity position and a long call to buy back the stock at some maximum price if the price rises instead of falling.

    Coverage

    • A call/put option is covered if the contract writer already owns the underlying security/cash. When uncovered, the writer will have to buy-security-at-the market-price/come-up-with-cash.

    Regulation

    • Options stuff regulated by OCC and CBOE
    • Customers have to register and sign an options agreement document, confirming they've read the ODD.
    • Customers are allowed to trade immediately following ROP approval, however:
    • If doc not signed within 15 days after ROP approval, no new options positions can be opened. Only closing transactions are allowed.
    • OCC provides mad services, BD notifies OCC when client wants to exercise.
    • They also provide automatic exercise on expiration if in the money by $0.01.
    • OCC seems to provide "matching": assigning an obligation to a customer who shorted the contract to buy/sell at strike.