4 - Intro to options Flashcards
What is an option?
Is a financial security that gives the buyer or the seller the right to buy or sell a specified asset at a specified price on or before a specified date
Buyer => Holder or Long Position
Seller => Writer or Short Position
Specified Asset => Underlying or Underlying Asset
Price => Strike Price or Exercise Price
Specified Date => Maturity Date or Expiration Date
What is a put option?
Provides the holder with the right to sell the underlying at the specified strike price on or the specified date ( put the underlying to the options seller at price x)
What is a call option?
Provides the holder with the right to buy the underlying at the specified strike price on or the specified date (call the underlying from the option seller at price x)
What is a long option?
A counterparty that takes a long position “Buys” the option and controls whether/not it is exercised
Long
Put
Short
but the contract
The opportunity to sell x at the strike price k
sell the contract
What is a short option?
A short position counterparty “sells” the option and has no control over whether/not it is exercised
Long
Call
Short
Buy the contract
The opportunity to buy x at the strike price k
sell the contract
Name two vanilla options
American - May be exercised anytime on or before the maturity date
European - May only be exercised on the maturity date
Name two exotic options
Bermudan - M ay be exercised on any one of a set of days specified in the contract
Asian - The strike price is the average price of the underlying over a certain time interval
For an equity long call position (European option) what does K T C St stand for?
At the strike price - K
On the specified date - T
The price of the call option is - C
The underlying share price is - St
Ignoring transaction costs for the moment, if:
ST < K then the counterparty should allow the Option to lapse
ST = K then the counterparty is indifferent
ST > K then the counterparty should exercise the Option
For an equity short call position (European option) what does K T C St stand for?
At the strike price - K
On the specified date - T
The price of the call option is - C
The underlying share price is - St
The options seller has no control, but ignoring transaction costs, if:
ST > K then the Option is likely to be exercised
ST = K the Option purchaser is indifferent – the Option lapses
ST < K the Option is likely to lapse unexercised
For an equity long put position (European option) what does K T P St stand for?
At the strike price - K
On the specified date - T
The price of the put option is - P
The underlying share price is - St
Ignoring transaction costs for the moment, if:
ST < K then the counterparty should exercise the Option
ST = K then the counterparty is indifferent
ST > K then the counterparty should allow the Option to lapse
For an equity short put position (European option) what does K T P St stand for?
At the strike price - K
On the specified date - T
The price of the put option is - P
The underlying share price is - St
The options seller has no control, but ignoring transaction costs, if:
ST > K the Option is likely to lapse unexercised
ST = K the Option purchaser is indifferent – the Option lapses
ST < K then the Option is likely to be exercised
What are the key things that options deliver?
Express a view regarding the direction that a share will follow
e.g. whether the underlying, for instance a share price, is likely to go up or
down
Express a view regarding the amount of volatility
e.g. the amount that the price of the underlying e.g. a market or a share price is
likely to be observed over the time period
What is a bullish view?
Where prices are expected to rise. A bull market is where the over-riding view is that markets will rise
What is a bearish view?
Prices are expected to fall. A bear market is where the over-riding view is that markets will fall.
Bullish view - prices are expected to rise therefore transact:
o A Long Call - If prices rise above the strike price then the you can
buy at the Strike Price and sell at the higher Market
Price thereby delivering positive returns.
o A Short Put - If an investor sells a Call, with prices rising the Call is
likely to be lapsed and the investor can class the
option premium as a “profit”
Bearish view - Prices are expected to fall therefore transact:
o A Long Put If you buy a put and prices fall you can take advantage by
buying at the Market Price and selling at the higher Strike
Price.
o A Short Call If an investor sells a Call as prices fall the Strike Price will be
higher than the Market Price so the option will be lapsed and
the Short Call investor can class the option premium as a
“profit”.
Long call
Long put
If prices rise the Option holder can exploit that to buy at the lower
Strike Price and sell at the higher Market Price. But if prices fall they
simply allow the option to lapse. The larger the price volatility the larger
the potential gain
If prices fall the Option holder can exploit that to buy at the lower
Market Price and sell at the higher Strike Price. But if prices rise they
simply allow the option to lapse. The larger the price volatility the larger
the potential gain.
Short call
Short put
For the Writer or Short Call, as the volatility increases,
the potential downside increases
For the Writer or Short Put, as the volatility increases,
the potential downside increases
Bullish View - Prices are expected to be very volatile therefore transact:
o A Long Call - If prices rise significantly above the Strike Price then
the potential gains to be made will increase.
o A Long Put - If prices fall significantly below the Strike Price the
potential gains to be made will increase
Bearish view - Prices are not expected to be volatile therefore transact:
o A Short Call - If prices rises are small then potential gains above the
Strike Price are unlikely so the best potential gains
may be made from premiums.
o A Short Put - If prices falls are small then potential gains as Market
Prices move below the Strike Price are unlikely so the
best potential gains may be made from premiums
Summary of views of volatility
Bullish on direction:
Short call
Short put
Bearish on direction:
Long put
Short call
High levels of volatility:
Long call
Long put
Low levels of volatility:
Short put
Short call
Bullish high level of volatility - Long call
Bullish lo level of volatility - Short put
Bearish high level of volatility - Long put
Bearish low level of volatility - Short call
what are protective puts?
Imagine that you have a portfolio in which you have:
» A Long Positions in the Underlying Asset (You have bought the Stock at
Price K)
» A Long Position on a Put Option (You have purchased the Option to Sell
the Stock at a given Strike Price of K).
By using this strategy you “insure” your portfolio :
» If prices rise you benefit because you can sell the Underlying
» If prices fall you can exercise the option and Sell at K
What are covered calls?
Imagine that you have a portfolio in which you have:
» Written a Short Call Option for a Stock
(You have written an Option that allows the Long Option holder to
purchase Stock at a given Strike Price of K).
» A Long Position in the Underlying Stock to cover the Short Call
(You have bought the Stock at Price K)
Using this strategy you “insure” your portfolio against Price rises :
» If prices rise your Option will be exercised and you will lose
» If prices rise you benefit because you can sell the Underlying and benefit
by receiving the Option Premium
