Textbook
1. Introduction
2. Investment vehicle characteristics
3. Recommendations & strategies
4. Economic factors & business information
5. Laws & regulations
6. Wrapping up
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2.4.1.1 Fundamentals
Achievable Series 66
2. Investment vehicle characteristics
2.4. Derivatives
2.4.1. Options

Fundamentals

Options are relatively difficult to understand but are not heavily tested. We expect most test takers to encounter 1-2 options questions on their Series 66 exam. Good news - if you learned options for the Series 7 Exam, you are already prepared for the information presented over the next 13 chapters. If you have no experience with options, don’t attempt to master them. Spend your studying time accordingly, given it’s a lightly tested topic.

Investors utilize options to speculate (bet) on market price movements, protect their portfolios from risk, and make income. Each strategy has its own unique set of risks, benefits, and typical investors.

Options are contracts between two parties. On one side, the contract buyer gains the right to perform a specific transaction at a fixed price. On the other, the contract seller is obligated to fulfill the buyer’s right. For example, if an option buyer has the right to purchase stock at $50, the option seller must sell the stock at $50 (if the buyer exercises their right).

Options don’t last forever, as each maintains a defined expiration date in the future. Most options expire within nine months after issuance*, but longer-term options exist. The option buyer has until expiration to exercise their right. If the option is not exercised by expiration, it expires and no longer exists. Standard options that maintain expirations of up to nine months typically expire on the third Friday of the expiration month at 11:59pm ET**.

*Like most securities, options are issued to investors in the primary market, then are traded in the secondary market.

**Options primarily trade in Chicago on the CBOE (Chicago Board Options Exchange). Chicago is in the Central time zone, which is one hour behind Eastern. When you encounter test questions on expiration, be careful and watch for time zones!

While many options expire nine months from issuance, one notable exception exists. LEAPS (long-term equity anticipation securities) are long-term options that last up to three years. This type of option allows investors to bet on stock prices over longer periods.

Equity & index options

Options are considered derivative securities, which are investments that obtain (derive) value from price changes in an underlying asset. The underlying asset could be a stock, an index, a currency, or a commodity. When the market values of these assets fluctuate, so do option values. For example, an option that allows an investor to buy stock at $50 gains value as the stock’s market price rises. If the market price goes to $90, the option allows a stock purchase $40 below its market value. The higher the market price rises, the more valuable the option (and vice versa).

There are two primary types of options contracts:

  • Equity (stock options)
  • Index options

Equity (stock) options derive their value from the price fluctuations of a specific stock. For example, if you bought or sold an Apple Inc. (ticker: AAPL) option, you would pay close attention to Apple’s stock price. Depending on the option you invest in, you may make money if Apple stock price falls, is flat, or rises. You could use an Apple option to speculate on its price, protect your Apple stock investment, or make additional income in your portfolio.

Index options derive their value from fluctuations in a specific index’s value. For example, you could invest in an S&P 500 index option that may provide a return if the index value falls, is flat, or rises. Index options are used to speculate on general market movements, make additional income, or protect entire portfolios from market risk.

Sidenote
Indices (or indexes)

Instead of investing based on stock price changes, investors in index options bet on index value fluctuations. An index is a list of stocks that typically cover a large market or a large segment of the market. For example, the S&P 500 tracks the prices of 500 of the largest US-based publicly traded companies. While there are numerous indices available to trade options on, these are the five to be aware of for the exam:

SPX - S&P 500

  • Tracks 500 large-cap US-traded companies

OEX - S&P 100

  • Tracks 100 large-cap US-traded companies
    • Subset of the S&P 500

DJX - Dow Jones Industrial Average

  • Tracks 30 large-cap US-traded companies

RUT - Russell 2000

  • Tracks 2,000 small-cap US-traded companies

VIX - Volatility index

  • Tracks volatility of the market

Indices are used to provide a “high-level” view of the market. You’ve seen the news talk about the Dow Jones and the S&P 500, which are both commonly used to gauge the US markets and economy. Various indices have different perspectives on the market. For example, if the Russell 2000 is down but the S&P 100 is up, it can be assumed small businesses are having a rough day in the market, but large businesses are doing well.

Long options

Most people feel like they’re learning a new language when they encounter options for the first time. To successfully master this concept, understanding the vocabulary is vital. One of the most important elements of options language relates to buying and selling contracts.

Long’ is a term used across the securities industry. If an investor is ‘long’ a security, they purchased and continue to hold the security. We also use this term with options, although its meaning is slightly more complex. When an investor goes long an option, they are buying a contract that gives them a specific right. Known as a holder, investors with long options maintain the right to buy or sell an asset at a particular price (depending on the contract).

The cost of an option is known as its premium. Option buyers pay a premium to purchase an option; a specific right is provided in return. The more valuable the option, the higher its premium. For example, if the market price of a stock is $70 and an options contract provides the right to buy the stock at $50, the premium will be at least $20 per share. Premiums are determined in the options markets and function similarly to stock prices. The more demand for an option, the higher its premium (and vice versa).

Premiums can be expensive. Accordingly, holders need their options to make a return to offset the option’s cost. Purchasers of options incur a debit (cost) to go long. A bad scenario for an option holder is for their option to expire unused. If this occurs, they are left with a loss equal to the premium paid for the option (the maximum potential loss for a holder).

Definitions
Debit
Money paid to purchase an investment

Assume an investor purchases an option that provides the right to buy a stock at $50. If the stock’s market price falls to $40, the buyer will not use the option. Why would they exercise their option and buy stock at $50 when they can go to the market and buy it for $40? In this scenario, the option has no intrinsic value.

Definitions
Exercise
Using the right that an option provides; only holders (purchasers of options) can exercise

Intrinsic value is the profit the holder makes when an option is exercised. When exercise is not profitable (like in the previous example), the option lacks intrinsic value. Options without intrinsic value are referred to as “out of the money” (OTM). In the previous example, the option was out of the money by $10. If an option remains “out of the money” on the expiration date, it expires worthless. At this point, the holder absorbs their maximum potential loss, which is the premium paid for an option they didn’t use.

Let’s again assume an investor purchases an option that gives them the right to buy the stock at $50. If the stock price rises to $75, they can lock in a significant gain by exercising their option and buying the stock at $50. After the exercise, they can take the stock to the market and sell it for $75. When an option is in “exercise territory,” it has intrinsic value. In this example, the option has $25 of intrinsic value. An option with intrinsic value is known as " in the money" (ITM).

In summary, option purchasers are “long” options and are known as holders. Holders pay premiums (creating a debit) to gain the right to transact at a fixed price before expiration and hope to exercise the option if it goes “in the money” (gains intrinsic value).

Short options

When investors sell an option, they go short. The terms ‘sell’ and ‘short’ are used interchangeably with options.

When an investor sells an option, they may be placing themselves at considerable risk. To fulfill the rights provided to the holder, sellers obligate themselves to do something they most likely want to avoid. However, option sellers force themselves into this position by receiving a premium in return for their obligation.

Why would anyone obligate themselves to do something they didn’t want to do? What’s the answer to 99 out of 100 questions? Money.

Option sellers are credited a premium when they go short options. It’s a short-term benefit in exchange for selling an option, which may turn out to be a good or bad move. In the best-case scenario, the option expires worthless and the investor is no longer obligated to participate in any transactions.

Definitions
Credit
Money received to sell an investment

Option sellers are also known as writers. An option is a contract between two parties, and the seller is metaphorically “writing up” a contract and selling it to another investor. If the option holder has the right to buy the stock at a fixed price, the option writer is obligated to sell stock at that price. Conversely, if the option holder has the right to sell stock at a fixed price, the option writer is obligated to buy the stock at that price.

Writers hope the options they sell expire worthless and avoid gaining intrinsic value. As a reminder, intrinsic value represents the profit made by the option holder if an option is exercised. The holder’s profit is the writer’s loss; the more intrinsic value a contract has, the more the writer loses. Therefore, the writer hopes their option stays “out of the money” (OTM)" (has no intrinsic value). Let’s work through a few examples to understand this better.

An investor sells an option that gives the holder the right to buy stock at $50. Therefore, the investor (option seller/writer) has the obligation to sell the stock at $50, but only if the holder exercises.

If the market price goes to $45 per share, the holder will not exercise the contract. Why would the holder exercise and purchase shares at $50 when the market is trading the stock at $45? The writer is not forced to do anything if the market price stays there through expiration. They make their maximum gain - the premium received when the option was sold. This option had no intrinsic value and was “out of the money” at expiration. This is exactly what they hoped for.

Conversely, let’s say the stock instead goes to $70 per share. At this point, the holder will definitely exercise their right to buy the stock at $50. The contract maintains $20 of intrinsic value and is “in the money.”

When a writer’s option is exercised, they are “assigned” their contract and are forced to perform their obligation. In this example, they must sell the stock at $50. If they don’t already have the stock in their possession, they must go to the market and purchase it at $70. Essentially, they’re buying stock in the market at $70 and selling it at $50 to the option holder, locking in a $20 per share loss. The writer still keeps the premium, which may not offset the losses realized when the contract is assigned. This is why option sellers hope their contracts go unexercised. Writers hope to receive premiums and never hear back from the holder. Assignment results in the seller being forced to perform an unprofitable transaction.

In summary, option sellers are “short” options and are known as writers. Writers receive premiums (creating a credit) in return for obligating themselves to perform a transaction at a fixed price. Option sellers hope their options remain “out of the money” (without intrinsic value) and expire worthless.

Key points

Options contracts

  • Derivative securities
  • Provide the right to perform a transaction at a fixed price
  • Can be used for:
    • Speculation
    • Protection
    • Income

Derivative securities

  • Obtain value from the underlying asset

Options expiration

  • Standard options have expirations of up to 9 months
  • Typically expire at 11:59pm ET on the third Friday of expiration month

Option buyers

  • Obtain the right to perform a transaction at a fixed price

Option sellers

  • Have an obligation to perform a transaction at a fixed price

LEAPS

  • Long-term options of up to three years

Equity (stock) options

  • Derive value from stock prices

Index options

  • Derive value from index levels

Long options

  • Right to exercise the contract
  • Bought option contract (debit)
  • Investors are “holders”
  • Seek intrinsic value

Short options

  • Obligation to do the transaction if assigned (exercised)
  • Sold option contract (credit)
  • Investors are “writers”
  • Want to avoid intrinsic value

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