Are you going to appear for the FINRAs SIE exam? Approximately 3 to 4 questions are asked from the Options section. It’s a straightforward topic that you can prepare with less effort. This SIE study guide page covers all the essential information about Options in the securities market.
Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price before a specified date. They are a crucial part of the securities market and are often used for hedging and speculative purposes.
Types of Options
- Call Option: A call option gives the holder the right, but not the obligation, to buy an underlying asset at a specified strike price within a set period. Investors purchase call options when they anticipate the underlying asset’s price will rise, allowing them to buy the asset at a lower price and potentially sell it at a higher market price for a profit.
- Put Option: A put option gives the holder the right, but not the obligation, to sell an underlying asset at a specified strike price within a set period. Investors buy put options when they expect the underlying asset’s price to decline, enabling them to sell the asset at a higher strike price and potentially repurchase it at a lower market price for a profit.
Selling Vs. Buying
Selling options involves writing contracts and receiving premiums, which generates income but comes with obligations if the option is exercised. Buying options provide the right to buy (call) or sell (put) the underlying asset without obligation, offering potential profits from favorable price movements while limiting the buyer’s risk to the premium paid.
Options Terminology
- Underlying Assets: Underlying assets are the financial instruments (e.g., stocks, bonds, commodities) on which options contracts are based. The value and price movements of these assets directly influence the pricing and profitability of the options. Common underlying assets include individual stocks, stock indexes, ETFs, and commodities.
- Premium: The premium is the price paid by the buyer of an option to the seller (writer) for the rights conveyed by the option. It represents the cost of acquiring the option and compensates the seller for taking on the risk associated with the potential obligation to buy or sell the underlying asset.
- Expiration Date: The expiration date is the last day on which an option can be exercised. After this date, the option becomes void and worthless. The expiration date is crucial in determining the time value of an option, as options lose value as they approach their expiration due to the decreasing likelihood of profitable exercise.
- Intrinsic Value: Intrinsic value is the difference between the underlying asset’s current price and the option’s strike price. A call option is calculated as the current asset price minus the strike price. For a put option, the strike price is minus the current asset price. Options with intrinsic value are considered “in the money.”
- Strike Price: The strike price, also known as the exercise price, is the fixed price at which an option holder can buy (call) or sell (put) the underlying asset. The strike price is critical in determining an option’s intrinsic value and profitability, as it defines the price level at which the option can be exercised.
- In the Money: An option is “in the money” (ITM) when it has intrinsic value. For a call option, this occurs when the underlying asset’s current price is above the strike price. For a put option, it happens when the asset’s price is below the strike price. ITM options are more likely to be exercised.
- At the Money: An option is “at the money” (ATM) when the underlying asset’s current price equals the strike price. At-the-money (ATM) options have no intrinsic value but may still have significant time value, reflecting the potential for future price movements before the option’s expiration.
- Out of the Money: An option is “out of the money” (OTM) when it has no intrinsic value. For a call option, this occurs when the underlying asset’s current price is below the strike price. For a put option, it happens when the asset’s price is above the strike price. OTM options are less likely to be exercised.
Example: Let’s consider a Tesla share trading at $200. In this scenario, the strike price of $200 will be regarded as At-the-money (ATM). However, for an option buyer, a strike price above $200 (say $250, $300, $350, $400, …) will be regarded as out of the money (OTM), and a strike price below $200 (say $150, $100, $50, …) will be regarded as in the money (ITM).
Options Strategies
Risk Mitigation/Hedging: Risk mitigation, or hedging, involves using options to reduce potential losses in other investments. For example, an investor holding a stock can buy a put option to hedge against a potential decline in the stock’s price, thus limiting their downside risk while benefiting from any upside.
Here are a few option strategies to hedge your investments:
- Covered Call Writing: It involves owning the underlying asset and selling call options on that asset. This strategy generates income from the premiums received for writing the call options. However, it limits potential upside gains because if the asset’s price exceeds the strike price, the seller must sell the asset at the strike price.
- Protective Put Buying: It involves purchasing a put option for an asset the investor already owns. This strategy provides downside protection, as the put option allows the investor to sell the asset at the strike price if its market price falls. It acts as an insurance policy, limiting potential losses while allowing for gains if the asset’s price rises.
- Capital Gains: These refer to the profit realized from the sale of an asset when its selling price exceeds the purchase price. In options trading, capital gains can be achieved by buying low and selling high or exercising profitable options.
- Buy to Cover: This strategy is used to close a short position by purchasing the same number of shares that were initially sold short. In options trading, this term often refers to buying back options contracts previously written (sold) to close the position and limit potential losses or lock in profits.
Options Knowledge
- Options Clearing Corporation (OCC): This organization issues guarantees and clears options and future contracts. It acts as an intermediary between buyers and sellers, ensuring the integrity and stability of the options market by managing the risks associated with options trading.
- Options Disclosure Document (ODD): The Options Disclosure Document (ODD) is a comprehensive document provided to investors detailing the characteristics and risks of options trading. It is a crucial resource for understanding trading options’ potential benefits and pitfalls, helping investors make informed decisions.
American vs. European: American options can be exercised at any time before the expiration date, offering greater flexibility to the holder. European options, on the other hand, can only be exercised on the expiration date, making them more predictable but less flexible. The choice between the two depends on the investor’s strategy and preferences.