Ch 11 - Options Flashcards
What are options?
Options are a type of derivative contract that gives the holder the right to buy/sell an asset at a pre-specified price on a pre-specified date
What’s the difference between options ad forwards/futures?
Options provide the right to transact, whereas the forwards and futures if held to maturity gives the obligation to transact
What are the 2 types of plain vanilla options?
- Call options - gives the holder the right to buy an asset at a pre-specified price at a pre-specified date
- Put options - gives the holder the right to sell an asset at a pre-specified price at a pre-specified date
When a party goes long on an options he will be _________ the option from the options writer, whereas when he goes short he will be _____ the option to the option buyer
Buying, selling
What is the strike/ exercise price?
Price at which the option is exercised/ transaction is carried out
What is an option premium?
Cost of the option which is paid at the inception of the option contract
What are the 5 determinants of option price as per Black Scholes?
Spot price, exercise price, risk free rate, volatility of the underlying asset, time to maturity of the option
What is put call parity?
The relationship between puts and calls when they have the same exercise price, maturity and underlying asset
Why are options strategies created?
To achieve zero risk portfolios and to make arbitrage
What are the 3 main types of options strategies?
- Straddles and strangles
- Bull and bear spreads
- Butterfly spreads
What is a straddle?
Involves either buying a put option and call option at the same exercise price (long straddle) or selling a put and call at the same exercise price (short straddle). The number of calls and puts bought/sold are usually the same
Why would investors go for a long straddle?
A long straddle hedges both upside risk and downside risk. This strategy is used by investors who expect the stock to be very volatile and move up or down by a large amount, but who d not necessarily have a view on which direction the stock will move
What are strangles?
Buying a call option with a higher strike price and buying a put option with a lower exercise price
When are strangles useful?
When the investor thinks its likely that the stock will move one way or the other but wants to be protected just in case
What are bull markets?
Simply when prices increase call S>Ex
What is a bull call spread?
Option strategy where a trader is anticipating that a stock will have a limited increase in its price
This spread involves buying call options at a lower exercise price and selling an equal no of calls at a higher exercise price for the same expiration date
The reason for selling the call option is to reduce the expense of buying the lower strike price call
Max gain on a bull call =
Spread width - net debit
What are protective puts?
When the investor goes long in a put and at the same time in a stock. The reason behind purchasing the put option is to protect the value of the investment
What are covered calls?
When the investor writes a call option and at the same times goes long on the underlying asset
Price of a commodity forward F=
1+rf + cost of carry - convenience yield)^t
What is convenience yield?
Benefit associated with holding the physical good, rather than the associated derivative contract
Cost of carry comprises of
Finance costs, storage costs, insurance
What is meant by backwardation?
In commodity markets, the forward price of commodities may be lower than the spot price
What is a butterfly spread?
This combines both bull and bear spreads, with a fixed risk and a capped (max) profit
Butterfly spreads use 4 option contracts with the same expiration but 3 different strike prices
This strategy is intended as a market neutral strategy and pays off the most if the underlying asset does not move prior to the expiration
What does a long call butterfly involve?
Buying one call at a lower strike price, selling 2 calls with a higher strike price and buying one call with an even higher strike price
What does a long put butterfly involve?
Buying one put at a higher strike price, selling 2 puts with a lower strike price and buying one put with an even lower strike price
What are bear put spreads?
This option strategy is created when an investor expects a moderate decline in the price of a security
This involved buying put options while selling an equal number of puts on the same asset with the same maturity with a lower exercise price
What are bear call spreads?
An option used when investors expect a decline in the price of the underlying asset
This involves purchasing call options at a specific exercise price while also selling the same number of calls but at a lower strike price
What is a bull call spread?
Buying call options at a lower exercise price and selling an equal number of calls at a higher exercise price for the same expiration date
What is a bull put spread?
Purchasing one put option while simultaneously writing another put option with a higher strike price
What is the difference between an American and European option?
American options allows the option holder to exercise the option at any date before maturity. Hence American options are pricier, but more flexible than European options
Put call parity does not hold for American options
