Chapter 13 Part 12 Flashcards
Call Options
In a call option contract, the owner has the right to exercise the contract and buy the underlying security at a specified price (the exercise or strike price). The writer has the corresponding obligation to sell the security ifthe owner exercises the call option
Put Options
In a put option contract, the owner has the right to exercise the contract and sell the underlying security at a specified price (the exercise or strike price). The writer has the corresponding obligation to buy the security if the owner exercises the put option
Listed Options To create an option, an owner and a writer need to agree on the terms of the contract. Options may be purchased either on one of the options exchanges
(the Chicago Board Options Exchange (CBOE), the American Stock Exchange (AMEX), the Philadelphia Stock Exchange (PHLX), or the Pacific Stock Exchange (PSEJ), or in the over-the-counter market. Options purchased on an exchange are referred to as listed options. A key feature of listed options is that they are standardized-the terms of the contracts are set and uniform.
Components of an Option Every listed option is characterized by the following terms: the name of
the underlying security, the expiration month, the exercise price, the type of option, and the premium. The premium is the market price of an option at a particular time.
Underlying Security
The security underlying an option contract appears first in the description, in this case, XYZ. Each exchange-traded equity option represents the right to buy or sell one round lot (100 shares) of the underlying stock.
Expiration Date
Options do not last forever. The owner can exercise his rights anytime up to the date that the option expires. In our example, the buyer may purchase 100 shares of XYZ stock from the writer until the expiration date in May. If the owner does not act by this date, the option ceases to exist. Listed options are assigned an expiration date by the exchanges on which they trade. Most stock options expire in nine months or less, but some may last as long as three years.
Exercise (Strike) Price
In a call option, this is the price at which the owner is entitled to buy the underlying security. In a put option, this is the price that the owner is entitled to sell the underlying security. In our example, the owner is guaranteed a purchase price of $30 per share for XYZ stock, regardless of how high the price of XYZ rises
Premium
The premium is the price the option buyer pays for the contract. This amount represents the compensation to the writer for the risk she assumes under the terms of the option contract. The writer keeps the premium regardless of whether the owner chooses to exercise the option. In our example, the buyer paid the premium of $300 ($3.00 x 100 shares).
Equity Options In an equity option
common stocks are the underlying securities. Each equity option represents 100 shares of a pmticular stock
Stock Index Options As the name suggests, the underlying securities for stock index options are
stock indexes. A stock index tracks the performance of a particular group of stocks or stock markets. For example, the Standard & Poor’s 500 Index tracks the performance of 500 widely
held common stocks
Interest-Rate (Debt) Options Interest-rate options give the owners the right to buy or sell a
group of bonds (debt securities) at a set price. The underlying bonds are usually issued by the U.S. Treasury, but they may also be issued by smaller governmental units, such as cities and states (municipalities), or by foreign governments
Foreign Currency Options The underlying instruments for these options are specific amounts
of foreign currencies. The options could be based on the euro, British pound, Swiss franc, Canadian dollar, or Japanese yen.
Most investors use options either to
hedge their positions in other securities or to speculate on the direction that the market is moving. Investors who wish to hedge are attempting to protect an existing stock position. Investors may also take an option position to speculate because they feel that a stock’s price is going to move up or down
A hedge is a way to protect against investment risks and usually involves two position
the security being protected and the hedging instrument. A hedge is normally set up so that if the security being protected loses value, the hedging instrument increases in value
An investor who is bullish on a stock (thinks it will go up in value) might buy
call options. Buying call options allows the investor to employ leverage-to gain control of the stock for a smaller amount of money than if she purchased the stock outright. If the investor is correct and the price of the stock increases, she will profit. Theoretically, her potential profit is almost unlimited, since there is no ceiling to how high the price of the stock may rise. The investor’s risk is limited to the premium that she pays for the option plus the commission costs. If the stock does not go up in value, the call huyer can simply choose to allow the call to expire unexercised. The investor will, however, lose her entire premium, since an option is worthless once it expires