2.1: Introduction to Options Flashcards
What is a call option?
A contract that gives the owner the right to buy an asset
What is a put option?
A contract that gives the owner the right to sell an asset
What is an option writer?
The person who takes the other side of the contract
What is a derivative?
Any security whose payoff derives from the value of another asset or security
What are some examples of derivatives?
- Futures contract. Agreement to buy or sell a fixed quantity at a set price on a fixed date.
- Forward contract. Same as futures, but trade is made directly with counterparts (ex bank).
- American option
- European option
What is hedging?
When a derivative is used to offset risk of the existing position, leading to lower net risk
What is speculating?
A derivative is used to increase risk, so that large gains are achievable when the market moves the “right” way
What is the strike price of an option?
The price at which the option holder can purchase the stock (underlying asset)
What is the expiration date of an option?
The final date at which the option can be used
What does it mean to exercise an option?
To use the option to purchase/sell stock
What are European options?
Allow holders to exercise the option price only on the expiration date
What are American options?
Allow holders to exercise the option on any date up to and including the expiration date
What is another name for the market price of an option?
The option premium
When does individual stock options expire by convention?
The third Friday of the month
On how many shares of stock are stock option contracts always written?
100 shares
When is an option in-the-money?
The payoff from exercising it is positive.
- Call: strike price < current stock price
- Put: strike price > current stock price
When is an option out-of-the-money?
The payoff from exercising it is negative.
- Call: strike price > current stock price
- Put: strike price < current stock price
Is there a downside for a short positions in call and put options?
- Call: No limit
- Put: limited to strike price of option since stock price cannot fall below 0
What are some of the most common combinations of options that investors hold?
- Straddle
(- Strangle) - Butterfly spread
- Portfolio insurance
What is a Straddle?
You are long in both a put and a call with the same strike price. You receive cash as long as the options don’t expire at the money. However, profits may still be negative after deducting costs for purchasing both options
What is a Strangle?
A straddle where the exercise prices of the put and the call differs
What is a butterfly spread?
Pays off when the stock price is close to the strike price. Purchase two different calls that sum up to same value of two short positions in a call between them. Payoff is positive so the cost of the two calls must exceed the proceeds from selling two call options
What is portfolio insurance?
Purchasing a put in protection, so you hold both stocks and put options. Can also be achieved by purchasing a bond and a call option
What are some factors that affect option prices?
- Strike price. Lower strike price –> higher value of otherwise equal call. (opposite for put).
- Stock price. Higher current stock price –> higher value of call option (opposite put)
- Arbitrage bounds on option prices. American option cannot be worth less than European counterpart (carries same rights). Put option cannot be worth more than strike price. A call option cannot be worth more than the stock itself
What is the intrinsic value of an option?
The value it would have if it expired immediately. The amount by which it is currently in-the-money, or 0 if out-of-the-money.
Can American options be worth less than its intrinsic value?
No, because then you could make arbitrage profits by purchasing the option and exercising it immediately
What is the time value of an option?
The difference between the current option price and its intrinsic value. American options cannot have a negative time value
Is an option with longer time to exercise date more valuable?
- American: cannot be worth less than identical option with earlier exercise date
- European: Can be worth less
How does the value of an option relate to the volatility of the underlying stock?
Value of option generally increases with the volatility of a stock (higher likelihood of very high/low stock returns).
Is an American option always more valuable than an equivalent European option?
No. Sometimes they have equal value
Why is it never optimal to exercise a call option on a non-dividend-paying stock early?
You are always better off just selling the option, since the price on any call option on a non-dividend-paying stock always exceeds its intrinsic value. Hence, in this case American price = European price
When does it make sense to exercise an American put option early?
When a European put has a negative time value, it will sell for less than its intrinsic value. The American counterpart cannot sell for less than its intrinsic value, implying it can be worth more. If you exercise the put early, you can get the strike price today and earn interest on the proceeds in the interim. Dividends reduce the likelihood of early exercise.
What is the requirement for it to be good to exercise a call early?
To do it just before the stock’s ex-dividend date, to capture the dividend before the stock price drops to reflect the dividend
How can we think of equity in terms of options?
We can think of equity as a call option on the assets of the firm with a strike price equal to the value of the debt outstanding
How can we think of debt in terms of options?
We can think of debt holders as owning the firm and having sold a call option with a strike price equal to the required debt payment.
Also,
Risky debt = Risk-free debt - Put option on firm assets
