chapter 12: options Flashcards
call option price characteristics
· They approach their intrinsic value for deep in and deep out of the money calls.
· They increase with the price of the underlying asset
· They decrease with a higher strike price
· They increase if the underlying asset is riskier
· They increase as the time to expiration increases
· They decrease as the dividend payments of the underlying asset increase
· They increase as interest rates increase
call option
the right, but not the obligation, to buy an underlying asset at a fixed price for a specified time
exercise price or strike price
the price at which an investor can buy the underlying asset
exercise
to implement the rights of options by buying (in the case of call options) or selling (in the case of put options)
expiration date
the last date on which options can be converted or exercised
in the money
the option would generate a positive payoff if exercised today
out of the money
the option would generate a negative payoff if exercised today
how can we see the payoffs of a call option on a graph
it is a 45 degree line with a slope of $1 payoff to $1 price
it is a horizontal line right before it slopes up until it reaches the strike price (after that, it goes up)
option writer
the person who sells an option
short position
the position taken by the option writer
what is the payoff of a short position?
the mirror of the payoff of someone having a call position
intrinsic value (IV)
the value of an option at expiration
it is positive when the option is in the money and zero when it is at or out of the money
time value (TV)
the difference between the option premium and the intrinsic value
option premium
the market value of the option
the sum of an option’s IV and TV
deep
options that are so far in (out of) the money that they are almost certain (not) to be exercised
A put option
the opposite of a call option
gives the owner the right, but not the obligation, to sell an underlying asset at a fixed price for a specified time
we start with the opposite of a long position in the underlying asset, which is a short position
describe graphically the short position
it is a 45-degree line going through the forward price of $50
this is the mirror image of the long position (from left to right)
the payoff on the put option
If the asset price increases, the investor does not exercise the put option
–> there is no reason to sell the asset for $50 when the investor can sell it in the open market for, say, $55
if the asset price drops to $45, the investor exercises the put
pay off when the asset price drops below the strike price, and they are worthless when the asset price is above the strike price
the payoff for the put writer
a short position in the put
when it goes above the strike price, it is worthless for him too
The put writer’s payoff is the opposite of the put holder’s, because they have to pay $50 for an asset that can be sold for only $45, thereby incurring a $5 loss
it is the mirror image of the put holder’s payoff
intrusive value formula for a call option
MAX (S - X, 0)
intrusive value formula for a put option
MAX (X, 0 - S)
what happens to the market price of call options when they are deep in and deep out of the money calls?
They approach their intrinsic value
what happens to the market price of call options when the price of the underlying asset increases?
it increases as well
what happens to the market price of call options the higher the strike price?
the more the call option price decreases
what happens to the market price of call options when the underlying asset is riskier?
they increase
what happens to the market price of call options when the time to expiration increases?
They increase
what happens to the market price of call options when the dividend payments of the underlying asset increase?
They decrease
what happens to the market price of call options when the interest rates increase
They increase
what happens to the market price of call options when the interest rates increase
They increase
what happens to the market price of put options when they are deep in and deep out of the money calls?
They approach their intrinsic value
what happens to the market price of put options when the price of the underlying asset increases?
decreases the price
what happens to the market price of put options the higher the strike price?
the price increases
what happens to the market price of put options when the underlying asset is riskier?
increase in price as does for the call option
what happens to the market price of put options when the time to expiration increases?
increase in price as does for the call option
what happens to the market price of put options when the dividend payments of the underlying asset increase?
they increase
what happens to the market price of put options when the interest rates increase
they decrease
the major difference between puts and calls when it comes to whether or not an investor can exercise the option before the expiration date
when is this distinction important?
if they are European options or American options
the distinction is important for put options
European options
options that can be exercised only at maturity
options that can be exercised at any time up to and including the expiration date
American options
