502-8 Derivatives

Question 1

Define the following term related to options: premium

Answer 1

The premium is the market price of the option (i.e., the price paid by the option buyer to the option seller). Although an option premium may be stated as $3, for example, it represents a price of $300. The premium is stated on a per-share basis, but there are 100 shares in an option contract.

Question 2

Define the following term related to options: expiration date

Answer 2

The expiration date is the last date on which an option can be exercised. The standard options expiration date is the third Friday of each month. For most options, the latest expiration date possible is the end of the furthest three-month interval—a maximum of nine months. (However, there are some options that have expiration dates of from one to three years.)

Question 3

Define the following term related to options: intrinsic value

Answer 3

The intrinsic value of an option is the difference between the current market price of the underlying stock and the per-share exercise price (or strike price) of the option. It represents the true value of the option. The current market price of an option (its premium) is greater than its intrinsic value. When the intrinsic value is zero, the option will still sell for a premium (its time premium only), assuming it is still marketable.

Question 4

Define the following term related to options: time premium

Answer 4

The time premium is the amount by which an option’s price (premium) exceeds its intrinsic value.
Total premium = Intrinsic value + Time premium

Question 5

Define the following term related to options: exercise price

Answer 5

The exercise (or strike) price is the per-share price at which the stock may be purchased (in the case of buying a call) or sold (in the case of buying a put). The option’s intrinsic value is positive (in the money) when the strike price is lower than the stock’s current market value (for a call option); for a put option, the intrinsic value is positive when the strike price is higher than the stock’s current market value.

Question 6

What is a call option, and how is its intrinsic value determined?

Answer 6

A call option is an option to buy 100 shares of stock at a specified price (the strike price) on or before a specified expiration date. The intrinsic value of a call option is the current market price of the stock minus the per-share exercise price (strike price) of the option. For example, if a stock’s current market price is $42 and the call’s exercise price is $40, the option’s intrinsic value is $2 ($42 – $40).

Question 7

Under what circumstances does a call have a positive intrinsic value? Under what circumstances does it have no intrinsic value?

Answer 7

A call has a positive intrinsic value when the stock’s current market price exceeds the per-share exercise price. A call with a positive intrinsic value is said to be “in the money.” A call has a zero intrinsic value when the exercise price equals or exceeds the stock’s current market price. The intrinsic value of a call increases as the current market price of the stock increases above the strike price. If the common stock is selling for a current market price that equals the strike price, the call option is “at the money.” If the stock’s current market price is less than the exercise price, the call option is “out of the money

Question 8

What is a put option, and how is its intrinsic value determined?

Answer 8

A put option is an option to sell 100 shares of stock at a specified price (the strike price) at any time before a specified expiration date. The intrinsic value of a put option is the exercise price of the option minus the current market price of the stock. For example, if a stock’s current market price is $47 and the put’s exercise price is $50, the intrinsic value of the option is $3 ($50 – $47). The intrinsic value of a put increases as the current market price of the stock decreases below the strike price.

Question 9

Under what circumstances does a put have a positive intrinsic value? Under what circumstances does it have no intrinsic value?

Answer 9

A put has a positive intrinsic value when the exercise price exceeds the stock’s current market price. A put with a positive intrinsic value is “in the money.” If the current market price of the stock is greater than the strike price, the put has zero intrinsic value; it is “out of the money.” If the current market price of the stock equals the strike price, the put is “at the money.”

Question 10

Why does an individual purchase a call?

Answer 10

If investors expect a stock’s market price to rise, they purchase calls because the premium of a call and the price of its common stock move in the same direction. Calls permit investors to use leverage to speculate on a rise in the common stock price without buying the stock itself. Using calls reduces the initial cash outlay, specifies the maximum dollar loss that may be suffered (the premium), and provides the potential for maximum leverage. Calls are also purchased to protect a short sale. If the stock price rises, the call can be exercised and stock can be acquired to cover the short sale.

Question 11

Why does an individual write (sell) a call?

Answer 11

Call writers seek the premium income. The writer (seller of the option right) profits by the amount of the premium. Unlike call purchasers, call writers primarily expect the stock price to fall slightly or remain stable. Some options writers may want the call exercised if a capital gain exists in the underlying stock and they are satisfied with the gain they would have if the stock were called away. If an individual writes a “covered call,” whereby a call is written on stock owned by the call writer, the motivation might be to offset, to the extent of the premium, a decline in the stock’s price.

Question 12

How does writing a covered call differ from writing a naked call?

Answer 12

Writing a call without owning the underlying stock is called “naked call writing.” The risk is that if the price of the stock rises, the writer of the option will have to buy stock at the higher market price in order to supply the stock to the option buyer at the lower strike price. Therefore, naked call writing is more risky than covered call writing. The maximum profit is the option premium received, and the loss is theoretically unlimited, as theoretically there is no limit to how high a stock’s price could go.

A more conservative method of writing a call is to buy the stock first and then write the option (a covered call). If the option is exercised, the call seller uses the previously purchased stock to “cover” the exercised option. The hope is that the price of the underlying stock will not exceed the option’s strike price. If the price of the underlying stock does move ahead of the strike price, the call writer’s profit is limited to the premium income from the sale of the call plus any difference between the original purchase price of the stock and its strike price. On the other hand, the option premium that is received helps to cushion a loss from a decline in the stock price (long position), but only to the extent of the premium.

Question 13

Why does an individual purchase a put?

Answer 13

An investor buys a put when he or she believes that the price of the underlying stock will fall. If the value of the stock does decline, the put owner can purchase the stock at a lower price and deliver it to the writer of the put at the higher exercise price, making a profit on the difference. The purchase of puts provides leverage, which can magnify gains. The maximum loss is the premium paid.

Question 14

How do purchases of puts and short sales compare?

Answer 14

The purchaser of a put option anticipates that the price of the underlying stock is going to decline; so does the investor who sells stock short. Puts offer more leverage (short sellers have a minimum margin requirement that must be met), and puts have a definite time frame. With a short sale, the investor has no time constraint—a period in which the price of the stock must decline in order for the short sale to be profitable. Unlike the execution of a short sale, purchasing a put option does not subject the investor to a large potential capital loss because the most the investor can lose is the premium paid for the option. A short sale ties up more money than does the purchase of a put.

Question 15

Why does an individual write (sell) a put?

Answer 15

Writers (sellers) of puts want the premium income. Put writers believe that the price of the underlying stock will remain relatively stable or will rise.

Question 16

Briefly describe the purpose of the following type of option: options on debt instruments

Answer 16

Options on debt instruments, such as Treasury notes and bonds, allow investors to participate in the movements of interest rates without acquiring the underlying securities. They also allow investors to establish hedge positions that reduce the risk of loss from price fluctuations of any bonds owned by the investor. An investor might buy a call option, for example, in anticipation of declining interest rates (and increasing bond prices).

Question 17

Briefly describe the purpose of the following type of option: options on foreign currencies

Answer 17

Options on foreign currencies allow investors to speculate on foreign exchange rates or to hedge their holdings of foreign securities or currencies.

Question 18

According to the Black-Scholes option valuation model, what five variables affect the price of a call option (an option to buy)?

Answer 18

• The current price of the underlying stock
• The length of time to the expiration date of the option, expressed in years
• The variability of the underlying stock price, expressed as the standard deviation of the stock’s annual return
• The risk-free rate of interest, expressed on an annual basis
• The exercise price (strike price) of the option

Question 19

An investor currently holds $25 put options on a stock that is trading at $22 per share. She doesn’t anticipate the stock changing in price between now and expiration. The $25 put option is currently trading at $4.50. What action should the investor take?

Answer 19

The investor should consider selling the put options. Currently there is a $3 intrinsic value ($25 – $22), so the remaining $1.50 is a time premium ($4.50 – $3.00 intrinsic value = $1.50 time premium). As the expiration date approaches the time premium will disappear, leaving only intrinsic value at expiration. If the investor doesn’t anticipate the stock changing in price between now and expiration she could capture the $1.50 time premium if she sells now. If she waits until expiration, only intrinsic value will be left.

Question 20

Compare the motivations, profit potential, and risks of call purchasers to those of covered call writers.

Answer 20

• A call purchaser is generally a speculator who wants to employ maximum leverage at minimal out-of-pocket cost in order to make a profit. (An investor who hedges with options is not a speculator.) The call purchaser’s advantage is that the maximum amount of potential cash loss is the amount of the premium paid, which would not be true if the stock itself were purchased instead of the option. Also, the return on equity can be very high because the premium paid is generally very small. A disadvantage is that the amount of time required for the call purchaser to be correct is measured in months. If the stock itself were purchased, the investor could hold it indefinitely, without executing any additional transactions, until the stock’s market price rises.
• A covered call writer is generally an income-oriented investor who wants to earn additional income above the dividend income that a stock may pay. As long as the underlying stock remains relatively stable, the call writer can add as much as 10% or more per year to the income from the stock. A major risk is that the stock may rise in price and then the call purchaser would exercise the option and call away the stock. The call writer thus forfeits the capital gain and limits his or her return to the dividend and the premium. Also, if the market price of the stock falls sharply while the call writer has an option outstanding, the capital loss could be far in excess of the premium income received.

Question 21

How can investors use puts to minimize losses on specific stocks held in a portfolio?

Answer 21

When stocks are held in a portfolio and options on those stocks are available on an options exchange, puts can be purchased on all of the stocks in the portfolio or just on selected stocks to minimize the potential loss on the stock if the market price of the stock declines. This strategy can be an expensive form of insurance protection if the put options are continuously maintained. However, if an investor is concerned (but unsure) about the price of a stock declining soon, a protective put can be beneficial. The investor can continue to hold the stock as a long-term investment, but he or she can protect against a short-term decline by purchasing a put option on the stock.

Question 22

What is a futures contract?

Answer 22

A futures contract is a commitment to deliver or receive a designated amount of a specified commodity, financial asset, or currency during a specified month in the future. The seller of the contract agrees to make the specified future delivery, and the buyer agrees to accept and pay for it during the designated month.

Question 23

What are the three types of futures contracts?

Answer 23

The three types of futures contracts are commodity futures, financial futures, and currency futures.

Question 24

What is the spot price of a commodity? What is the futures price?

Answer 24

The spot price of a commodity is its current price in the cash market. The futures price is the price specified in a contract for future delivery of the commodity.

Question 25

How does a forward contract differ from a futures contract?

Answer 25

Unlike a futures contract, which is standardized as to delivery month and the units of the commodity (e.g., 5,000 bushels), a forward contract is tailor-made for each transaction. A forward contract meets the needs of the parties involved and is not negotiable (i.e., no secondary market exists for it).

Question 26

Under what circumstances is the futures price of a commodity more than its spot price? Under what circumstances is the futures price less than its spot price?

Answer 26

The futures price is higher than the spot price when most investors believe that the price of the commodity will increase in the future. As these investors seek to buy contracts for future delivery of the commodity, the cost of storing the commodity and the anticipation of inflation help to drive up the futures price relative to the spot price. If investors believe that the price of the commodity will decline in the future, they will seek to sell contracts before the decline to lock in the higher prices. This selling of the contracts can drive the futures price down below the spot price.

Question 27

Explain what an initial margin in a commodity futures transaction is. Also, describe how the initial margin differs from the margin that is used in purchasing stocks or bonds.

Answer 27

With a futures contract, there is no borrowing required on the part of the investor in order to finance the balance of the contract. The initial margin, or deposit, is the minimum “good faith” amount paid by the investor to ensure completion of the contract. It represents collateral that would cover any loss in the market value of the contract that might arise from adverse price movements. An initial margin does not vary with the dollar amount of the transaction, as a margin for stock does. Each exchange sets its own minimum initial margin requirements for each contract in dollars.

Question 28

Explain the taxation of futures contracts.

Answer 28

Net profits on futures trades are taxed as capital gains (60% long term and 40% short term). All positions (including open positions) are considered closed at the end of the year and are taxed in that year