Chapter 10 - Option Securities Flashcards
Explain the logic of an option:
An option contract is a contractual agreement between a buyer and a seller of the transaction of an underlying asset in the future. The option contract gives the option to either buy or sell (depends on the nature of the contract) the option at a strike price, which is determined when the contract is entered. The price is agreed upon before the transaction.
What is the logics of call, put, long and short when talking of option?
Call option: give its owner the right to buy an asset at a specified price on or before a specified (maturity) date.
Put option: the right to sell an asset at a specified price on or before a specified (maturity) date
Long (paying the premium): buying an option contract
Short (receiving the premium): selling an option contract
How is the profit and losses of an option calculated? And what is the break even point?
P&L = payoff - option premium
The break-event point is the value of the underlying asset such as your profit is equal to 0.
Explain the logic of the terms “in the money”, “at the money” and “out of the money”
Call (put) in the money: market price above (under) the strike price
Call (put) at the money: market price at the strike price
Call (put) out of the money: market price under (above) the strike price
How can hedging help reducing risk?
Hedging = take a position on the market allowing to reduce the losses in case of unfavourable market movement
If you are worried of a decreasing market, you can hedge against risk by longing put options at a strike price that is relatively high. This gives you the option to sell the underlying asset at a price that is possibly higher than the market price, if the market price decreases.
What is the logic behind a hedging strategy long put?
the investor fears a decrease of the price of the assets which he holds . His objective is to take advantage of a possible increase while having an insurance against the downside risk
What is the logic behind a hedging strategy short put?
the investor wants to buy the underlying asset in the future but he is afraid that the price might increase slightly . Writing a put can bring a premium that offsets the potential slight increase in price .
What is the logic behind a hedging strategy short call?
the investor holds the underlying asset and is afraid of small decrease in asset price. Writing a call can compensate potential small loss.
What is the logic behind a hedging strategy long call?
the investor wishes to buy the underlying asset in the future date but he fears an increase of price. His objective is to take advantage of a price decrease while having an insurance against the upside risk.
