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**I. Introduction**

- Understanding the importance of the options market
- Risk for sale

**II. Basics**

- What is an option?
- Two types of options – Calls and Puts
- Buyers have rights, sellers have obligations
- Options buyers have no other benefits associated with shares of stock

**III. Terminology**

- Long and short
- Understanding short sales
- Roles of long and short positions

a. Long calls have the right, not the obligation to buy shares

b. Short calls have the potential obligation to sell shares

c. Long puts have the right to sell shares

d. Short puts have the potential obligation to buy shares

4. Reversing trade

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**

- Contracts are the unit of trade

a. Each contract controls 100 shares of the underlying stock

- Total exercise value
- Options are standardized contracts
- Options have a limited number of exercise prices available

- Stocks priced less than $50 will have $2.50 increments
- Stocks priced between $50 and $200 have $5 increments
- Stocks priced above $200 have $10 increments

- Customized contracts – FLEX options
- Standardization eliminates performance risk
- OCC assigns by a random process
- Option market hours are 9:30am – 4:02pm ET (4:15 ET for index options)
- Classifications of Options
- Types – two types of options, calls and puts
- Class – represents all options of the same type
- Series – all options of the same class, exercise price, and expiration date

- OPRA (Option Price Reporting Authority)
- Option premiums
- Option premiums must reflect immediate benefits (intrinsic value)
- Total cost of option = premium * 100 (plus commissions)

**VI. Understanding Option Quotes**

- Bid and Ask (Offer) prices

- Bid price represents the highest price someone is willing to pay
- Ask price represents the lowest price at which someone is willing to sell

- Bid – ask spreads
- Net change
- Volume
- Open interest

**VII. More Terminology**

- Intrinsic value and time value (extrinsic value)

a. Option premium = intrinsic value + time value

b. Time value = premium – intrinsic value

2. Moneyness

- In-the-money
- At-the-money
- Out-of-the-money
- Deep-in-the-money (deep out-of-the-money)
- Moneyness and time value relationship 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 optionsz

**VIII. Option Pricing Principles**

- Principle #1: Lower Strike Calls (and Higher Strike Puts) are More Expensive
- Financial proof
- Statistical proof
- Arbitrage proof

- 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 or near expiration

4. Pricing Principle #4: Prior to expiration, all calls must be worth at least the stock price minus the present value of the exercise 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. Pricing Principle #5: The maximum price for a call option is the price of the stock.

a. The maximum price for a put option is the strike price

6. Pricing Principle #6: For any two call options (or any two puts) on the same stock with the same expiration, the difference in their 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 with the stock

c. At-the-money options move about 50 cents on the dollar

d. Out-of-the-money options move a small percentage of the underlying stock

e. Deep-out-of-the-money options may not move at all

10. Options have asymmetrical pricing structures

11. Delta of an option

a. Relationship between call and put deltasz

**IX. Profit and Loss Diagrams**

- Constructing profit and loss diagrams by hand
- Characteristics of profit and loss diagrams
- Profit and loss diagram will bend at each strike price
- A portion lies above and below zero
- The curve crosses zero at one or more points (break-even point)
- Effects of reversing trades
- Using profit and loss diagrams to determine the best strategy
- Options are a zero-sum game.

**X. 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 (the multiplier)

a. Effects of whole and fractional stock splits

6. Effects of dividends on option prices

a. Call and put strikes are reduced by amount of special dividends

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 to collect a dividend

a. Record date

b. Payable date

c. Ex-date

10. Put options can have early exercise advantage

11. Automatic exercise

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 restrictions (AON)

d. Day orders and good-til-cancelled orders (GTC)

e. Stop and stop limit orders

f. Limit order display rule

g. Leaning against the book

13. The economics of large bid-ask spreads

**XI. Put-Call Parity and Synthetic Options**

- Understanding the put-call parity equation
- Synthetic Options
- Applications for synthetics
- Valuing corporate securities as options

**XII. 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 options trading

i. Understanding implied volatility

9. Volatility is relative

10. The effect of the Black-Scholes Model inputs on option prices

**XIII. Option Strategies
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- Definition and construction
- Philosophy
- Return calculations
- Return if exercised
- Static return
- Breakeven return
- Max gains and losses
- Which strike to write
- Writing in-the-money calls
- Writing out-of-the-money calls
- Writing at-the-money calls

10. Risk of covered calls

11. Hedging with covered calls

12. Early assignment

13. Buy-writes

14. Rolling up, down, out

15. In long run, covered calls are less risky than long stock

**XIV. Long Calls and Puts**

1. Long options provide protection, leverage, and 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 the same amount of money (risky use)

b. Control the same amount of shares with less money (conservative use)

6. Constant-dollar diversification

7. The roll-up strategy

8. Delta considerations when using long puts as a substitute for short stock

9. The roll-down strategy

**XV. 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 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

**XVI. Hedging with Options **

- What is a hedge?
- Benefits of hedging
- Types of risk takers
- Risk-averse
- Risk-neutral
- Risk-seeker

- Stock swaps
- Roll-ups
- Laddering strategy

7. Selling spreads against long stock