Chap 14 Flashcards
Financial assets
An asset that represents a financial claim on an issuing organization.
Stocks, bonds and convertible securities are examples.
Option
gives the holder the right to buy or sell an underlying asset (such as common stock) at a fixed price over a limited period of time.
Call
enables the holder to buy the underlying stock at the strike price over a set period of time.
Put
gives the holder the right to sell the stock at the strike price within a set period of time.
Derivative securities
Options, as well as Futures, are derivative securities because they derive their value from the price behavior of the underlying asset.
Option premium:
the price an investor pays to buy an option.
Option Seller (Option Writer):
Receives the option premium from the buyer up front.
Has the obligation to sell (in the case of a call option) or buy (in the case of a put option) the underlying asset according to the terms of the option contract.
This obligation is legally binding; option seller cannot walk away from the deal if it turns out to be a money loser for them.
Option Buyer:
Has the right to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a fixed price (called the exercise price or strike price) for a given period of time.
To acquire this right, the option buyer must pay the option seller a fee known as the option premium (or option price).
Buyers do not have to exercise their options; they can walk away if exercising the option isn’t profitable.
Strike Price
the fixed contract price at which an option holder has the right to buy (for a call) or sell (for a put) the underlying stock.
Conventional (OTC) options may have any strike price (no constraints; mutually agreed upon by the two parties).
Listed options have standardized (by the exchange) prices with price increments determined by the price of the stock.
Expiration Date
Stated date when the option expires and becomes worthless if not exercised
American Options
allow investors to exercise their right to buy or sell the underlying asset at any time up to the expiration date.
European Options
only permit investors to exercise on the expiration date.
Intrinsic Value (options)
determined by the relationship between an option’s strike price and the underlying stock’s market price.
In-the-Money:
Call option: when the strike price is less than the market price of the underlying security.
Put option: when the strike price is greater than the market price of the underlying security.
When an option is in the money, its intrinsic value is greater than zero.
Out-of-the-Money:
Call option: when the strike price is greater than the market price of the underlying security.
Put option: when the strike price is less than the market price of the underlying security.
At-the-Money
strike price = market price for a call or put option
Put-Call Parity:
future payoffs of a portfolio containing a put option and a share of underlying stock are the same as payoffs of a portfolio containing a call option and a risk-free bond.
Price of a put option + price of stock = price of a call options + price of a risk-free bond
major forces that influence the price of an option:
The price of the underlying financial asset
The option’s strike price
The amount of time remaining to expiration
The underlying asset’s volatility
The risk-free interest rate
Hedge
a combination of two or more securities into a single investment position for the purpose of reducing risk.
Naked options:
writer does not own the optioned securities and has to buy them. No limit on loss exposure
Covered options
writer owns the optioned securities. Loss exposure is limited to the price originally paid for the securities.
Option spreading:
combination of two or more options into a single transaction.
Options differ in strike price and/or expiration date.
Bull spreads, bear spreads, money spreads, vertical spreads, butterfly spreads and more.
Purpose is to take advantage of differences in prevailing options prices and premiums.
Option Straddle
Simultaneous purchase (or sale) of both a put and a call on the same underlying common stock.
Straddles normally involve the same strike price and expiration date.
Object is to earn a profit from either a big or a small swing in the price of the underlying stock.
Long straddle
buy an equal number of puts and calls. As long as you make more money on one side than the cost of the options for the other side, you earn a profit.
