Chapter 13 Part 13 Flashcards
An investor believes that the price of STC stock is going to remain the same for the next couple of months. STC common stock is currently selling for $80 per share. The client does not own the stock, and writes a naked call on STC with a strike price of $110 and a premium of $5. If the stock increases to $140 per share, what will most likely occur?
The call may be exercised by the buyer when the price of STC increases above the strike price. The seller of the call must buy 100 shares of STC at the current price of $140 per share to cover his position, which costs him $14,000 ($140 x 100 shares). He then must deliver the stock to the call owner at the strike price of$110–receiving only $11,000 for the stock ($110 x 100 shares). Disregarding commission costs, the investor has lost $2,500 ($500 premium+ $11,000 received for the stock - $14,000 purchase price). As bad as this may seem, his losses could have been greater if the stock had appreciated further.
An investor who is bearish (believes that tbe price of a stock is going to decline) may speculate by buying
a put on that stock. For these investors, buying a put may be an alternative to selling the stock shmt. An investor who sells stock short–sells stock she does not own–assumes unlimited risk. Since there is no way to predict how high the market price of the stock may rise, the short seller may be required to buy the shares at an exceptionally high price in order to cover his
position.
In contrast, the put buyer’s potential profit is
almost as great as if he sold the stock short, but his risk is considerably less. If the stock’s price remains the same or increases, the put buyer can just let the option expire, losing only the premium he paid for the option plus the commission costs
A client purchases one STC May 30 put at a premium of $5. The underlying security decreases in value to $20 per share. What is the client’s profit if he exercises the option?
If the client is right and the price ofSTC starts dropping, he would buy 100 shares of stock at its current market price of $20, paying $2,000. Then, he could exercise the put and sell the shares for $3,000 (100 x $30 strike price). His profit would be $500 ($3,000 exercise - $2,000 purchase price - $500 premium).
A client bought 100 shares of XYZ at $105 a share, investing a total of $10,500. He is concerned that the market is due for a major correction, which will send the price down sharply. To protect his position, he buys one XYZ May 100 put at a premium of $3. If the stock starts dropping in price, what action could the client take?
If the price of XYZ starts dropping, the investor may exercise the put and sell the shares for $10,000 (100 x $100 strike price). In this example, he could not lose any more than $800 on the stock ($10,500 purchase price + $300 premium) - $10,000 for exercising the option= $800 loss. If the stock remains stable or increases in price, the client would then let the option expire unexercised. In that case, his only loss is the $300 premium he paid for the put.
An investor who is bullish on a stock might sell
puts. If the stock rises, the investor gets to keep the premium. However, if the stock falls and the owner exercises the put option, the investor will need to buy the stock for more than its current value. The investor’s maximum potential loss is the exercise price on the option minus the premium he received for selling the put.
STC common stock is currently trading at $122 per share. A client is bullish on STC and thinks that the price ofSTC stock will increase in the nearfuture, so she sells one STC May 120 put and receives a premium of $5. What may happen if the stock starts rising in price?
A rising price will cause the option to expire unexercised, allowing the investor lo keep the $500 premium she received. However, if the price of STC falls to $110 and the put is exercised, the client will be required to buy the stock for $120 per share, well above STC’s current market price of$110.
Many equity options never actually get exercised. Instead, investors will
offset (close) their position. Offsetting involves effecting the opposite transaction on the same series of options. An investor who initially bought an option may simply decide to sell the same contract in the market, while an investor who initially sold an option may decide to buy the same contract in the market. The resulting profit or loss is based on the difference between the premium paid for the option purchased and the premium received for the option sold.
a forward contract is an agreement between a
buyer and seller for the future delivery of a commodity at a specified price, time, and place. Forward contracts were originally used lo facilitate the exchange of agricultural goods, but today they arc also used to hedge interest-rate risk through the trading of credit default swaps. Today, forrwards are frequently used to hedge interest rates (interest-rate swaps) and foreign currencies. An importer who knows he will need 10 million euros may purchase a forward contract from a bank, and obtain the ability to buy the euros at a future price the day before he needs to make the payment to the exporter. This would protect the importer from any changes in currency rates.
the major difference between futures contracts and forward contracts is that forward contracts are
not typically exchange traded, and their features are customized. Generally, in a forward contract, both the buyer and the seller must agree if either party wants to transfer the contract to a third party. In contrast, futures contracts can be readily bought and sold on venues such as the Chicago Mercantile Exchange. Some futures contracts are extremely liquid, while others are not
A futures contract is an agreement to
buy or sell a specific amount of a commodity or a financial instrument at a specific price on a stipulated date in the future. As with options, most investors use futures to either speculate or hedge a position in the underlying commodity or financial instrument. For commodities, hedgers are usually businesses that produce or use the underlying commodity. Many buyers and sellers of financial futures are trying to protect their portfolios against interest-rate risk, currency risk, or fluctuations in the stock market (market risk).
In a futures contract, the buyer must
purchase the underlying security and the seller must sell it at the agreed-upon price, unless the contract is offset before the settlement date. Futures contracts differ from options in that the buyer may be forced to take delivery of the commodity. In an option contract, the buyer can choose simply to let the contract expire
Although prices of futures are negotiated between buyers and sellers, most other terms offutures contracts are set by
the exchanges on which they trade. The size of the contract, the point of delivc1y, the delivery month, and the grade of the underlying security or commodity are all set by the exchanges.
Most buyers and sellers of futures never take
delivery of the underlying commodity or financial instrument. Instead, they offset their position in the futures market. An investor who bought a futures contract that is still open is long the futures contract (or long futures), while the seller is short futures. A long futures position is offset (liquidated) when the investor sells the same contract. A short futures contract is offset when the investor buys back the same contract
In order to be viable, a futures contract must have two characteristics.
The first is that the supply and the demand for the underlying commodity or financial instrument must be large, and the second is that the different units of the underlying commodity or financial instrument must be fungible (easily interchanged).
