Chapter 15: Options Markets Flashcards
What is a call option?
The right to buy an asset at a specified exercise price on or before a specified expiration date.
What is the exercise or strike price?
The price set for calling [buying] an asset of putting [selling] an asset.
What is the premium?
The purchase price of an option, representing the compensation the call buyer pays for the ability to exercise only when exercise is desirable.
Why would you sell (aka ‘write’) a call option?
You receive premium income now as payment against the possibility that you will be required at some later date to deliver the asset in return for an exercise price less than the market value of the asset. If the option expires, your profit is equal to the original premium. However, if the call is exercised, profit is equal to the original premium minus the difference between the value of the stock and the exercise price paid. If the difference is larger than the original premium, you have incurred a loss.
What is a put option?
The right to sell an asset at a specified exercise price on or before a specified expiration date.
What does “in the money” mean in the context of options?
An option is described as in the money when its exercise would produce a positive cash flow. On the opposite end, a call is “out of the money” when the exercise price exceeds the asset value. When both prices are equal, the option is said to be “at the money”.
What is the main distinction between American and European options?
American options can be exercised on or before their expiration, whereas European options can only be exercised at expiration.
What is the Option Clearing Corporation (OCC)?
It’s a clearinghouse for options trading, jointly owned by the exchanges on which options are traded.
What kinds of assets are optioned?
Stock options Market and industry options (e.g. the S&P 500) Futures options Foreign currency options Interest rate options
What is the formula for payoff to a call holder on a call option?
=S(t)-X, where S(t)>X
=0, where S(t)≤X
What is the formula for payoff to a call writer on a call option?
=-(S(t)-X), where S(t)>X
=0, where S(t)≤X
What is a protective put?
An asset combined with a put option that guarantees minimum proceeds equal to the put’s exercise price.
Example:
You purchase stock and a put option.
The strike price is $90, and the stock is selling at $87.
This makes the value of your portfolio $90, b/c your stock is worth $87 and the value of your put option equals
=$90-$87=$3
If the stock were to rise in value above $90, to say $94, you simply don’t exercise your put and stick with the value of the stock. Your p.f. is now worth $94.
What are the different types of strategy for risk management in a p.f.?
Covered Calls
Straddles
Spreads
Collars
What is a covered call?
Writing a call on an asset together with buying the asset.
This is a popular strategy amongst institutional investors.
What is a straddle?
A combination of a call and a put, each with the same exercise price and expiration date.
