8 Flashcards
Option - buyer
An option is a contract giving the buyer (holder) the right, but not the obligation, to buy (for a ‘call option’; to sell in the case of a ‘put option’) a given quantity of an underlying asset at a pre-determined ‘strike price’ up to or on a specified date
Option -seller
At the inception of the contract, the seller (writer) is
compensated by receiving from the buyer the price of the
option (the ‘premium’), but has to comply with the terms of
the option when the buyer ‘exercise’ the option:
Option terminology
1) At-the-money
2) In the money
3) Deep-in-the-money (and vice-versa for Deep-out-of-the-money)
4) Out of the money
Option Terminology - At the money -
● The current market price of the underlying is equal to the strike price.
Option terminology - Out of the Money
Current market price of underlying is less than the strike price for a call (more for a put), so there is no profit to exercise.
Option terminology- In the money
Current market price of underlying is more than the strike
price for a call (less for a put), so it is profitable to exercise.
Option terminology- Deep in the money
● Current market price of underlying is much higher than the strike price for a call (much lower for a put), so it would be very profitable to exercise (making the option very valuable).
A naked option (or a naked position)
● The writer (seller) of the option does not have a position in the underlying asset
A covered option (or a covered position)
● The writer (seller) of the option has a position in the
underlying asset.
● If the position in the underlying asset offsets the option, then
the risk-return of that position and the option taken
altogether is likely very different from writing a naked option.
● The investment objectives sought through writing a covered
option are likely different (and more complicated) than
through writing a naked option.
Exchange-traded options
Traded on an exchange (i.e. prices and quantities are quoted).
● Can buy or sell any options (new and existing) any trading day.
● Quantities of underlying and strike prices are standardized.
● Expiry dates are as per a schedule (TMX: 3rd Friday is the last
trading day while the option expire the following Sunday).
● A ‘compensation chamber’ insures that the buyer is made
whole in case of a default by the seller.
American options
● Options that may be exercised at any time on or before expiry.
European options
● Options that may be exercised only on the day they expire.
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