3 Options Flashcards
Intrinsic Value of a Call Option
3.90
Call Option = max(Market Value – Exercise Price, 0)
Remember: “COME”
Can never be < $0
Intrinsic Value of a Put Option
3.90
Put Option = max(Exercise Price – Market Value, 0)
Remember: “POEM”
Can never be < $0
Option Price Formula
Option Price = Intrinsic Value + Time Premium
Intrinsic Value of…
…Put Option = Exercise Price – Market Value
…Call Option = Market Value – Exercise Price
Can intrinsic value of an option be less than $0?
No
How does the Time Premium of an option contract change over time?
Decreases to $0 as time approaches expiration date. Since less room for excitement.
What is the option premium?
Price the option buyer pays to the option seller to establish the contract.
Covered call writing
Long the stock | short the call.
- Sell calls on stock you own.
- Only considered covered if you own enough shares to cover all contracts sold.
- Used to generate income for the portfolio.
Naked call writing
Short the call | (no stock position).
- Sell calls without owning the underlying stock.
- Writer bears UNLIMITED risk.
Protective put
Long the stock | long the put.
- Buy puts on your stock to protect your downside.
- This is the very essence of portfolio insurance.
Protective call
Short the stock | long the call.
- Used to protect a short position in the stock.
Covered Put
“Covered Put Writing”
Short the stock | short a put.
- Sell puts on your stock shorts.
- Writer uses the stock put to cover their short stock position.
Collar
Long the stock - long the put - short the call
- The put is used to protect against a stock price decrease, and the call premium is used to offset the cost of the put.
“Zero-cost collar”
Straddle
Straddle: Long a put and a call on the same underlying stock with the same expiration date and strike price.
- Used to capitalize on volatility regardless of the direction.
Spread
- Involves purchasing and selling the same type of contract (eg, 2 calls OR 2 puts)
- Benefit from stability (i.e., minimum moves in the underlying stock’s price).
Long vs Short Straddles
vs Call vs Put Spreads
Futures vs Forwards
- Futures are standardized, Forwards aren’t
- Forwards aren’t executed through a clearinghouse (and so carry counterparty risk)
Spot price
Current market value of an item
What does a Clearinghouse do in context of Futures?
- guarantees performance of both parties
- eliminates counterparty risk
Why would you sell a futures contract?
You’re long, so you need a short hedge
Selling a futures contract establishes a short hedge.
e.g., as a short hedge for your long position, e.g., gold miner selling futures contracts to lock in prices since worried about price decline
Why would you buy a futures contract?
You’re short, so you need a long hedge.
Buying a futures contract establishes a long hedge.
e.g., as a long hedge for your short position, e.g., a jewelry-maker buying futures contracts to lock in lower prices if worried about rises
Buying a futures contract
(and an example)
Promising to pay $X (to receive goods)
e.g., as a long hedge for your short position, e.g., a jewelry-maker buying futures contracts to lock in lower prices if worried about rises
Selling a futures contract
(and an example)
Promising to deliver 5,000 bushels (in exchange for $X)
e.g., as a short hedge for your long position, e.g., gold miner selling futures contracts to lock in prices since worried about price decline
Wash sale rules
- time window
- what is “substant. identical”
Can’t buy “substantially identical” security within 31 days before/after (61 days total) of a loss sale, or loss is disallowed and added to the basis of the new securities purchased… eventually you’re allowed to use the loss when the new replacements ecurities are sold (via the higher cost basis
- bonds: p much has to be exact same bond or bond fund to trigger it
- stocks: convertible bond or call option likely trigger it
Exception for if it’s in the ordinary course of business as a dealer in stock or securities
