I. Introduction
1. Understanding the importance of the options market
2. Risk for sale
II. Basics
1. What is an option?
2. Two types of options - Calls and Puts
3. Buyers have rights, sellers have obligations
4. Option buyers have no other benefits associated with shares of stock
III. Terminology
1. Long and short
2. Understanding short sales
3. Roles of long and short positions
a. Long calls have the right, not the obligation to buy shares of stock
b. Short calls have the potential obligation to sell shares of stock
c. Long puts have the right, not the obligation to sell shares of stock
d. Short puts have the potential obligation to buy shares of stock
4. Reversing trades
5. The Options Clearing Corporation (OCC)
a. OCC acts as the buyer to every seller and the seller to every buyer
6. Derivative instruments
7. Underlying asset
8. Exercise price (strike price)
9. Expiration date
a. Saturday following the third Friday of the expiration month
b. For trading purposes, the third Friday of the expiration month
10. Two styles of options
a. American - can be exercised at any time
b. European - can only be exercised at expiration
11. Physical versus cash delivery
12. Exercise versus assign
IV. Mechanics of Calls and Puts
1. Contracts are the unit of trade
a. Each contract controls 100 shares of the underlying stock
2. Total exercise value
3. Options are standardized contracts
4. Options have limited number of exercise prices available
a. Stocks priced less than $50 have $2.50 increments
b. Stocks priced between $50 and $200 have $5 increments
c. Stocks priced above $200 have $10 increments
5. Customized contracts - FLEX options
6. Standardization eliminates performance risk
7. OCC assigns by random process
8. Option market hours are 9:30am - 4:00pm ET (4:15 for most index options)
9. Classifications of Options
a. Types - two types of options, calls and puts
b. Class - represents all options of the same type
c. Series - all options of same class, exercise price, and expiration date
10. OPRA (Option Price Reporting Authority)
11. Option premiums
12. Option premiums must reflect immediate benefits (intrinsic value)
13. Total cost of an option = premium * 100 (plus commissions)
V. Understanding Option Quotes
1. Bid and Ask (offer) prices
a. Bid price represents the highest price someone is willing to pay
b. Ask price represents the lowest price at which someone is willing to sell
2. Bid-ask spreads
3. Net change
4. Volume
5. Open interest
VI. More Terminology
1. Intrinsic value and time value (extrinsic value)
a. Option premium = intrinsic value + time value
b. Time value = premium - intrinsic value
2. Moneyness
a. In-the-money
b. At-the-money
c. Out-of-the-money
d. Deep-in-the-money (deep-out-of-the-money)
e. Moneyness and time value relationships
i. At-the-money options have the greatest time value
ii. Time value decreases as you move in or out-of-the-money
3. Parity
a. Conditions for parity
4. Time decay
a. Time decay only affects time value
b. Time decay accelerates in last 30 days
5. Similarities and differences between stocks and options
VII. Option Pricing Principles
1. Principle #1: Lower strike calls (and higher strike puts) are more expensive
a. Financial proof
b. Statistical proof
c. Arbitrage proof
d. Role of arbitrageurs
2. Principle #2: Longer term options are more expensive
a. Arbitrage proof
b. Square root rule - option prices increase with the square root of time
3. Principle #3: All options are worth either zero or intrinsic value at expiration
a. Arbitrage proof
b. How to capture missing intrinsic value at expiration
4. Principle # 4: Prior to expiration, all calls must be worth at least the stock price
minus the present value of the exericse price, or S - Pv (E)
a. Time value of money
b. Present value and future value
c. Arbitrage proof
d. Minimum value for puts prior to expiration
5. Principle #5: The maximum price for a call option is the price of the stock.
a. The maximum price for a put is the exercise price.
6. Principle #6: For any two call options (or any two puts) on the same stock with same
expiration, the difference in the prices cannot exceed the difference in their strikes.
a. Arbitrage proof
7. The role of volatility on option prices
8. Risk, reward, and option prices
9. Option price behavior derived from a simplistic stock price model
a. Deep-in-the-money options move nearly dollar-for-dollar with the stock
b. In-the-money options move a large percentage of the stock price change
c. At-the-money options move about 50 cents on the dollar
d. Out-of-the-money options move a small percentage of the stock price change
e. Deep-out-of-the-money option prices may not move at all
10. Options have asymmetrical pricing structures
11. Delta of an option
a. Relationship between call and put deltas
VIII. Profit and Loss Diagrams
1. Constructing profit and loss diagrams by hand
2. Characteristics of profit and loss diagrams
a. Profit and loss diagrams bend at each strike price
b. A portion of the curve lies above and below zero
3. Effects of a reversing trade
4. Using profit and loss diagrams to determine the best strategy
5. Options are a zero-sum game
IX. Option Market Mechanics
1. Understanding option symbols
2. Understanding and determining expiration cycles
3. Cycles with LEAPS options
4. Double, triple, quadruple witching
5. Contract size (multiplier)
6. a. Effects of whole and fractional stock splits
7. Understanding "open interest"
a. If both trades are opening, open interest increases
b. If both trades are closing, open interest decreases
c. If one trade is opening and the other is closing, open interest is unchanged
d. Dollar-weighted open interest
8. Risks of early exercise on call options for non-dividend paying stocks
a. Increase downside risk
b. Lose time value of call option
c. Lose time value of the exercise price
d. Mathematical proofs
9. Exercising a call option to collect a dividend
a. Record date
b. Payable date
c. Ex-date
10. Put options can have early exercise advantage
11. Automatic exercise and dangers
12. Types of orders
a. Market order - guarantees the execution, not the price
b. Limit order - guarantees the price, not the execution
c. Multiple fills
d. Tick size
e. "Or-better" orders
f. All-or-none restriction (AON)
g. Day orders and good-til-cancelled orders (GTC)
h. Stop and stop limit orders
i. Limit order display rule
j. Leaning against the book
13. The economics of large bid-ask spreads
X. Put-Call Parity and Synthetic Options
1. Understanding the put-call parity equation
2. Synthetic options
3. Applications for synthetics
4. Valuing corporate securities as options
XI. An Introduction to Volatility
1. Simple option pricing model
2. Fair value
3. Using the Black-Scholes Option Pricing Model
4. The importance of understanding volatility
5. Direction versus speed
6. Separating price and value
7. Volatility moves sideways over time
8. Using volatility for better option trading
i. Understanding implied volatility
9. Volatility is relative
10. The effect of the Black-Scholes Model imputs on option prices
XII. Option Strategies
1. Covered calls
2. Definition and construction
3. Philosophy
4. Return calculations
a. Return if exercised
b. Static return
c. Breakeven return
5. Risk of covered calls
6. Hedging with covered calls
7. Early assignment
8. Buy-writes
9. Rolling up, down, out
10. In the long run, covered calls are less risky than long stock
XIII. Long Calls and Puts
1. Long options provide protection, leverage, diversification
2. Delta considerations when using long calls as a substitute for long stock
3. Protection is due to time dependence, not path dependence
4. Leverage comes from partitioning stock's price
5. Two definitions of leverage
a. Control more shares with same amout of money (risky)
b. Control the same amout of shares with less money (conservative)
6. Constant-dollar diversification
7. The roll-up strategy
8. Delta considerations when using long puts as a substitute for long stock
9. The roll-down strategy
XIV. Vertical Spreads
1. Types of spreads
a. Vertical
b. Horizontal
c. Diagonal
2. Vertical spread - definition and construction
3. Vertical spreads create limited risk, limited reward profiles
4. Max gain, max loss, breakeven
5. Bull spreads
a. Using calls
b. Using puts
6. Bear spreads
a. Using calls
b. Using puts
7. Buying (selling) vertical call spread is the same as selling (buying) put spread
8. Rationale for using vertical spreads
9. Early assignment considerations
10. Risk-reward considerations
11. Price behavior of vertical spreads
12. Time considerations
XV. Hedging with Options
1. What is a hedge?
2. Benefits of hedging
3. Types of risk takers
a. Risk-averse
b. Risk-neutral
c. Risk-seeker
4. Stock swaps
5. Roll-ups
6. Laddering strategy
7. Selling spreads against long stock