Ch 11 - Options

Question 1

What are options?

Answer 1

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

Question 2

What’s the difference between options ad forwards/futures?

Answer 2

Options provide the right to transact, whereas the forwards and futures if held to maturity gives the obligation to transact

Question 3

What are the 2 types of plain vanilla options?

Answer 3

1. Call options - gives the holder the right to buy an asset at a pre-specified price at a pre-specified date
2. Put options - gives the holder the right to sell an asset at a pre-specified price at a pre-specified date

Question 4

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

Answer 4

Buying, selling

Question 5

What is the strike/ exercise price?

Answer 5

Price at which the option is exercised/ transaction is carried out

Question 6

What is an option premium?

Answer 6

Cost of the option which is paid at the inception of the option contract

Question 7

What are the 5 determinants of option price as per Black Scholes?

Answer 7

Spot price, exercise price, risk free rate, volatility of the underlying asset, time to maturity of the option

Question 8

What is put call parity?

Answer 8

The relationship between puts and calls when they have the same exercise price, maturity and underlying asset

Question 9

Why are options strategies created?

Answer 9

To achieve zero risk portfolios and to make arbitrage

Question 10

What are the 3 main types of options strategies?

Answer 10

1. Straddles and strangles
2. Bull and bear spreads
3. Butterfly spreads

Question 11

What is a straddle?

Answer 11

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

Question 12

Why would investors go for a long straddle?

Answer 12

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

Question 13

What are strangles?

Answer 13

Buying a call option with a higher strike price and buying a put option with a lower exercise price

Question 14

When are strangles useful?

Answer 14

When the investor thinks its likely that the stock will move one way or the other but wants to be protected just in case

Question 15

What are bull markets?

Answer 15

Simply when prices increase call S>Ex

Question 16

What is a bull call spread?

Answer 16

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

Question 17

Max gain on a bull call =

Answer 17

Spread width - net debit

Question 18

What are protective puts?

Answer 18

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

Question 19

What are covered calls?

Answer 19

When the investor writes a call option and at the same times goes long on the underlying asset

Question 20

Price of a commodity forward F=

Answer 20

1+rf + cost of carry - convenience yield)^t

Question 21

What is convenience yield?

Answer 21

Benefit associated with holding the physical good, rather than the associated derivative contract

Question 22

Cost of carry comprises of

Answer 22

Finance costs, storage costs, insurance

Question 23

What is meant by backwardation?

Answer 23

In commodity markets, the forward price of commodities may be lower than the spot price

Question 24

What is a butterfly spread?

Answer 24

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

Question 25

What does a long call butterfly involve?

Answer 25

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

Question 26

What does a long put butterfly involve?

Answer 26

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

Question 27

What are bear put spreads?

Answer 27

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

Question 28

What are bear call spreads?

Answer 28

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

Question 29

What is a bull call spread?

Answer 29

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

Question 30

What is a bull put spread?

Answer 30

Purchasing one put option while simultaneously writing another put option with a higher strike price

Question 31

What is the difference between an American and European option?

Answer 31

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