5. Derivatives Flashcards
What is an option?
An option gives a buyer the right, but not the obligation,mot buy or sell a specified quantity of an underlying asset at a pre-agreed exercise price, on or before a pre-specified future date or between two specified dates. The seller, in exchange for the payment of a premium, grants the option to the buyer.
What is a derivative
A financial instrument that is derived from something else - a derivative is, therefore, a financial instrument whose price is based on the price of an underlying asset. Examples include bonds, shares, stock market indices and interest rates; for commodities they include oil, silver & wheat.
Futures and options are commonly used derivative instruments.
What is a call option?
A call option is where a buyer has the right to buy the asset at the exercise price, if he chooses to. The seller is obliged to deliver if the buyer exercises the option.
What is a put option?
A put option is where the buyer has the right to sell the underlying asset at the exercise price. The seller of the put option is obliged to take delivery and pay the exercise price, if the buyer exercises the option.
What is the premium?
The premium is the amount paid for the option. It will reflect the prevailing price of the underlying asset and other factors such as interest rates and the time remaining to the exercise date.
What is an ‘in the money’ call option?
An option that is worth exercising because it is a call option and the price of the shares is greater than the exercise price at which those shares can be purchased under the option.
What is an out of the money option?
An option which is not worth exercising because the share price is less than the exercise price at which the shares can be purchased under the call option.
What is an at the money option?
A call option that enables the buyer to purchase the shares at exactly the same price as the underlying shares.
When will a buyer of a call option break even?
When the underlying share price is equal to the the exercise price plus the premium paid. Known as the break even point.
