2.1: Introduction to Options

Question 1

What is a call option?

Answer 1

A contract that gives the owner the right to buy an asset

Question 2

What is a put option?

Answer 2

A contract that gives the owner the right to sell an asset

Question 3

What is an option writer?

Answer 3

The person who takes the other side of the contract

Question 4

What is a derivative?

Answer 4

Any security whose payoff derives from the value of another asset or security

Question 5

What are some examples of derivatives?

Answer 5

• 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

Question 6

What is hedging?

Answer 6

When a derivative is used to offset risk of the existing position, leading to lower net risk

Question 7

What is speculating?

Answer 7

A derivative is used to increase risk, so that large gains are achievable when the market moves the “right” way

Question 8

What is the strike price of an option?

Answer 8

The price at which the option holder can purchase the stock (underlying asset)

Question 9

What is the expiration date of an option?

Answer 9

The final date at which the option can be used

Question 10

What does it mean to exercise an option?

Answer 10

To use the option to purchase/sell stock

Question 11

What are European options?

Answer 11

Allow holders to exercise the option price only on the expiration date

Question 12

What are American options?

Answer 12

Allow holders to exercise the option on any date up to and including the expiration date

Question 13

What is another name for the market price of an option?

Answer 13

The option premium

Question 14

When does individual stock options expire by convention?

Answer 14

The third Friday of the month

Question 15

On how many shares of stock are stock option contracts always written?

Answer 15

100 shares

Question 16

When is an option in-the-money?

Answer 16

The payoff from exercising it is positive.
- Call: strike price < current stock price
- Put: strike price > current stock price

Question 17

When is an option out-of-the-money?

Answer 17

The payoff from exercising it is negative.
- Call: strike price > current stock price
- Put: strike price < current stock price

Question 18

Is there a downside for a short positions in call and put options?

Answer 18

• Call: No limit
• Put: limited to strike price of option since stock price cannot fall below 0

Question 19

What are some of the most common combinations of options that investors hold?

Answer 19

• Straddle
  (- Strangle)
• Butterfly spread
• Portfolio insurance

Question 20

What is a Straddle?

Answer 20

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

Question 21

What is a Strangle?

Answer 21

A straddle where the exercise prices of the put and the call differs

Question 22

What is a butterfly spread?

Answer 22

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

Question 23

What is portfolio insurance?

Answer 23

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

Question 24

What are some factors that affect option prices?

Answer 24

• 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

Question 25

What is the intrinsic value of an option?

Answer 25

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.

Question 26

Can American options be worth less than its intrinsic value?

Answer 26

No, because then you could make arbitrage profits by purchasing the option and exercising it immediately

Question 27

What is the time value of an option?

Answer 27

The difference between the current option price and its intrinsic value. American options cannot have a negative time value

Question 28

Is an option with longer time to exercise date more valuable?

Answer 28

• American: cannot be worth less than identical option with earlier exercise date
• European: Can be worth less

Question 29

How does the value of an option relate to the volatility of the underlying stock?

Answer 29

Value of option generally increases with the volatility of a stock (higher likelihood of very high/low stock returns).

Question 30

Is an American option always more valuable than an equivalent European option?

Answer 30

No. Sometimes they have equal value

Question 31

Why is it never optimal to exercise a call option on a non-dividend-paying stock early?

Answer 31

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

Question 32

When does it make sense to exercise an American put option early?

Answer 32

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.

Question 33

What is the requirement for it to be good to exercise a call early?

Answer 33

To do it just before the stock’s ex-dividend date, to capture the dividend before the stock price drops to reflect the dividend

Question 34

How can we think of equity in terms of options?

Answer 34

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

Question 35

How can we think of debt in terms of options?

Answer 35

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