Equity Options, part 2

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EQUITY OPTIONS Part 2

Термины в модуле (140)

2. Boston Stock Exchange (BSE)

3. American Stock Exchange (AMEX)

4. Chicago Board Options Exchange ( CBOE)

5. NYSE – EUROnext (NYX)

6. International Securities Exchange (ISE)

7. NASDAQ Options Market (OMX

You SELL @ the LOWER price & BUY @ the HIGHER price.

10:59 PM CENTRAL TIME

11:59 PM EASTERN TIME

on the THIRD FRIDAY of the EXPIRATION MONTH.

Generally begin at 3,000 contracts.

Example: ALL IBM CALLS = ONE CLASS

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2. February, May, August, November (FMAN)

3. RIGHTS Distribution

LONG (2) ABC Aug (25) CALLS after the split.

2/1 x 100/1 = 200 SHARES which will CREATE 2 Options (1 Option Contract = 100 Shares)

100 SHARES x $50 = $5,000

1 Contract = 100 Shares

100 Shares x .50 (Stock Dividend) = 50 additional shares

100 original shares + 50 additional shares = 150 share value per contract

When an OPTION is BOUGHT or SOLD, SETTLEMENT is the NEXT BUSINESS DAY FTER TRADE DATE. (T + 1)

SETTLEMENT by the firm to the OCC is the NEXT BUSINESS DAY AFTER TRADE DATE. (T + 1)

Customer to be assigned is determined on a:

2. FIFO – FIRST IN, FIRST OUT or OLDEST SHORT position.

(No premium/long or short)

YES. $55 Market Price is > than $50 Exercise Price. $55-$50 = in-the-money by 5 POINTS

The CALL is NOW trading @ a Premium of 8. Is the position STILL in-the-money?

Is the investor making a PROFIT?

(No premium/long or short)

2. LONG OR SHORT

INTRINSIC VALUE = 5 Points ($55 market price – $50 strike price)

1. MARKET PRICE of underlying stock

2. TIME UNTIL EXPIRATION of the option

3. VOLATILITY of the underlying stock.

4. Changes in INTEREST RATES

1. A LONG (BUY) & SHORT (SELL) position AT the SAME TIME.

2. LONG & SHORT position must be on the SAME TYPE of option.

Example: BUY a CALL & SELL a CALL = SPREAD

BUY a PUT & SELL a PUT = SPREAD

SHORT 1 ABC July [70] CALL – Vertical Bull CALL spread

LONG 1 ABC July [60] PUT

SHORT 1 ABC July [20] CALL – Vertical Bear CALL spread

LONG 1 ABC July [25] PUT

Calendar/HORIZONTAL/Time Spread (Horizontally)

VERTICAL Spread (Vertically)

2. When an investor does a Spread they: BUY an option (-) & SELL an option (+)

3. Call (-) a DEBIT, Call (+) a CREDIT.

SHORT 1 ABC June [50] CALL @ 2 (+)

VERTICAL BULL CALL Spread done at a Net DEBIT = 2 (-)

We ALWAYS want DEBIT Spreads to WIDEN by MORE THAN the ORIGINAL DEBIT.

What is the MAXIMUM LOSS potential?

NET DEBIT in the PREMIUMS – 2 or – $200

What is the MAXIMUM PROFIT potential?

2. MAXIMUM PROFIT potential is the DIFFERENCE BETWEEN the TWO STRIKE prices LESS the Net DEBIT.

VERTICAL BULL PUT Spread done at a Net CREDIT = 4 (+)

2. MAXIMUM LOSS potential is the DIFFERENCE BETWEEN the TWO STRIKE prices LESS the Net CREDIT in the PREMIUMS.

BULLISH CALL Spread – Net Debit – Widen – Close

BEARISH CALL Spread – Net Credit – Narrow – Expire

BEARISH PUT Spread – Net Debit – Widen – Close

CALL = LONG EXERCISE price + the Net DEBIT of the PREMIUMS.

1. Vertical (Different Strike Prices) BULL (Bought LOWER Strike/SOLD Higher Strike) Call Spread at a Net Debit (-600 + 300 = -300) or (3)

2. Breakeven = LONG EXERCISE price ($50) + Net Debit (3) = $53

3. Maximum LOSS: Net Debit/Premiums Paid = (3) or $300

2. Will be EITHER 2 LONG or 2 SHORT positions.

3. NEVER have SAME TYPE of option.

1. Investors would establish a LONG Straddle if they anticipate a MAJOR MOVE in price but are UNSURE of DIRECTION of the price.

2. If the stock price moves UP or DOWN the investor could make money by EXERCISING ONE & letting the OTHER one EXPIRE.

1. Investors would establish a SHORT Straddle when they EXPECT market PRICE to remain NEUTRAL.

2. Investors make money from he PREMIUMS COLLECTED from the sale of the PUT & CALL.

2. Investors make money from he PREMIUMS COLLECTED from the sale of the PUT & CALL.

3. The SHORT CALL in a Combination is ASSUMED to be UNCOVERED & therefore represents UNLIMITED LOSS potential on the SHORT Combination

LONG 1 ABC JUNE 40 PUT @ 4

1. LONG STRADDLE
(Bought CALL/PUT & SAME/SAME/SAME)

2. UPSIDE Breakeven: (5 + 4 = 9 + 40 = 49)

LONG 1 ABC APRIL 50 PUT @ 3

2. If PRICE moves to 65, EXERCISE CALL.

3. UPSIDE Breakeven: (LONG Premium) 4 + (SHORT Premium) 3 = (7) + (STRIKE price) 50 = (57)

When exercised (SELLER): EXERCISE price of the PUT MINUS the PREMIUM RECEIVED for the sale on the PUT = COST BASIS of the stock purchased

Expires (BUYER): REPORT the PREMIUM COST of the PUT as a CAPITAL LOSS on the date it EXPIRES.

Expires (SELLER): REPORT the PREMIUM RECEIVED for the sale of the PUT as a CAPITAL GAIN on the date it EXPIRES.

Sold by holder (BUYER): REPORT the DIFFERENCE between the COST of the PUT & the AMOUNT you RECEIVE for it as a CAPITAL GAIN or LOSS.

When exercised (SELLER): EXERCISE price PLUS the PREMIUM RECEIVED for the CALL = SALE PROCEEDS of the stock sold

Expires (BUYER): REPORT the PREMIUM COST of the CALL as a CAPITAL LOSS on the date it EXPIRES.

Expires (SELLER): REPORT the PREMIUM RECEIVED for the sale of the CALL as a CAPITAL GAIN on the date it EXPIRES.

Sold by holder (BUYER): REPORT the DIFFERENCE between the COST of the CALL & the AMOUNT you RECEIVE for it as a CAPITAL GAIN/LOSS.

Equity 101 Part 2: Stock option strike prices

This article is part 2 of our series on the basics of startup stock options. Here’s part 1 and part 3. Follow us on Twitter @cartainc for more educational content.

Part 2: Strike prices and dilution

When a company offers you stock options, the hope is you’ll be able to sell them for more than you paid for them. If you’ve ever wondered what determines these prices and how to figure out how much your options could be worth, we’ve got you covered. Here, we’ll cover:

1. Strike prices (the price you pay to purchase shares)

3. Stock dilution (how the number of shares issued affects how much of the company you own)

Stock option strike prices

Remember: stock options are the right to buy a set number of company shares at a fixed price, typically called a strike price, grant price, or exercise price. In this example, your stock option strike price is $1 per share.

To come up with that $1 price, Meetly (our example company) had to determine its fair market value (FMV). For private companies, FMV is essentially what the price would be if the stock were traded publicly on the open market. Your stock option strike price is usually equal to the FMV of the company’s stock on the day the option is granted.

It’s easy for public companies to determine their strike price: all they have to do is look at what the stock is currently trading at. That’s the price that people are willing to pay on the open market. If Facebook, for example, is trading at $180 per share, their FMV is $180 that day.

If we try to look up Meetly on an online brokerage platform, we won’t find anything—and not just because we made the company up. Like all startups, Meetly is a private company, and the stock can’t be traded publicly until an IPO or other public listing of the company’s stock on an exchange.

To determine the fair market value of their common stock, private companies usually use an independent 409A valuation provider like Carta. This can help protect them from costly audits and their employees from significant penalties.

How stock options gain value

“At-the-money” stock options

In the graph above, the blue line represents your strike price. The strike price doesn’t change at all over time because it’s a fixed price. The yellow line is Meetly’s stock price (or FMV). Right now, those prices are the same. If you decide to exercise your options and buy your shares, you would have to pay $1 to get $1 in return. In this situation, your options are considered “at-the-money.”

“In-the-money” stock options

When the stock’s value increases, the difference between the FMV and your strike price is called “the spread.” This is the underlying value of the stock. When the spread is positive, your options are considered “in-the-money.”

If you buy at a strike price of $1 and sell when Meetly’s FMV is $5, your spread is $4 (per share).

Underwater stock options

Unfortunately, things don’t always go well for startups.

If Meetly’s FMV goes down to $0.75, your spread becomes negative, and your options are “underwater.” Since you would have to pay $1 to get $.75 in return, you decide not to exercise your options. (Meetly could choose to reprice the options, or replace the worthless options with new ones at a different strike price.)

Stock dilution

Stock dilution is when a company issues additional shares and subsequently reduces how much of the company you (and the other shareholders) own. It usually happens when a company raises money.

When you received your options from Meetly, they had 5,000 shares outstanding. In other words, they’ve issued 5,000 shares in total to all of their shareholders.

This means your 100 shares represent 2% ownership of the company:

One year later, Meetly decides to raise another round of financing. It creates 2,000 new shares to issue to the new investors.

While you still own 100 shares, the new shares cause your ownership percentage to drop. Your 100 shares divided by the new total (7,000) equals 1.4%. The effect the increased amount of shares outstanding has on your ownership percentage is called stock dilution.

Now let’s look at what your shares were/are worth before and after the new investors came in.

Before the new financing round, Meetly was valued at $100 million, so your 2% stake was worth $2 million. After the new fundraising, Meetly’s stock value increases to $120 million.

In the above example, your 1.4% of $120 million is still equal to $2 million. Even though your ownership percentage was diluted, the value of your options stayed the same. You essentially own a smaller piece of a bigger pie.

Here’s a quick recap of what we covered:

  1. We defined strike price. This is a fixed price you pay to buy one share of stock.
  2. We discussed the economic value of your options, which is basically the spread between your strike price and the FMV of the company’s common stock.
  3. We explained dilution, or how your ownership percentage can change if the company issues more stock to other shareholders.

These are the three things you should consider when determining the value of your option grants. We’ll cover exercising options and the tax implications in part three.

Special thanks to Alex Farman for writing the first version of this article.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.

Jenna Lee

Jenna is on the content team at Carta. Despite working in Fintech her entire career, she has never had a La Croix.

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What is stock dilution?

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume […]

What is fair market value (FMV)?

Unlike public companies where value is set by the market, private companies use independent appraisers to assess their value. Fair market value is the current value of a private company’s common stock and it determines the strike price.

How to value your equity offer (free startup equity calculator)

Learn how to evaluate the equity portion of your job offer and download our free equity calculator to see what your options could be worth.

Equity Options, part 2

Strategically an Equity Option Position is similar to a long term Binary Option that you can exit or adjust at any time. The value of the position changes over time in a predictable way that can used to fit your market view so that you have a position that will be profitable & easy to manage if your market opinion is correct. If you’re wrong you can actively hedge until a predetermined exit point.

If you have an expectation of significant movement on a daily chart for a currency or a major index you’re most likely going to best off trading in the spot or futures markets. But if your read is that the given market is extended & likely to stall or reverse over the next few days to week(s) then you may be better off with an equity option position. The caveat being that there needs to be a liquid options market and mostly that points to the indexes & a handful of individual stocks. There are currency ETFs with option markets that can be used but it’s a little trickier because those markets are not as deep.

There are many, many ways to construct these positions but they are all made of basically the same ingredients & it’s not necessary to get all that complex. The basic construct I’m going to use for illustration is called a vertical spread.

This is a daily chart of the SPY. I’ve highlighted several good spots for option positions. Personally I don’t like using ES futures for anything other than hedging SPY option positions because they just don’t move as well as currencies or the NQ. The SPY though is great for options.

Following are two different vertical spread risk graphs at close of day 8/12, the leftmost highlighted candle. August 12 is not a great entry. Waiting for a return to & failure to break the Tenkan over the next day or two would be considerably better – but this way illustrates more. As time passes the white line will converge to the red line. In this case the white line will become the red line in about 23 days. In the next post we’ll step through these verticals, note how they behave & illustrate decision points as the trade develops.

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