Chapter 8: Derivatives Flashcards
Options
A derivative security. The value of an option is derived from the value of another underlying asset. One option contract controls 100 shares of the underlying asset. Two types of options:
- Call Option: the right to buy a specified number of shares at a specified price (strike price) within a specified period of time.
- Put Option: the right to sell “ “
**EXAM TIP: if asked about maximizing gains..
if the price rises, “Buying a Call” is the right answer.
if price falls, then “Buying a Put”
Invest in Options for 3 reasons - hedging, speculation, or income
*See image attached
Option Premium
Option Premium: consists of the intrinsic value & a time premium.
- Call Intrinsic Value: Stock Price - Strike Price
- Put Intrinsic Value: Strike Price - Stock Price
- Time Value = Premium - Intrinsic Value
*EXAM TIP: intrinsic value cannot be < zero.
*For problems, assume 1 call/put option = 100 shares (unless specified)
**BE CAREFUL on calculations if problem states individuals is “SELLING” an option rather than “BUYING”.
Investors normally BUY options. SO be on lookout if wording says “SELL”. If selling option, then will be opposite of gain/loss would be for a “BUY”. (ex. pg 122).
Option Trading Strategies
- Covered Call: selling call options on stock that is currently owned by the investor. Appropriate if investor wants to generate income on stock he owns.
*Prac Q: Selling covered call options will generate income. A “covered call” is an income-producing strategy where you sell, or “write”, call options against shares of stock you already own. - Married Put: buying a put option on a stock or index that is currently owned by the investor. AKA - portfolio insurance.
*Exam Tip: When asked about “protecting profits” or “locking in gains”, the right answer is always buying a put. This is whether put on a single stock or an index to protect a diversified portfolio of common stocks. - Straddles: long & short
a. Long Straddle: investor buys a put and a call option on the same stock; investor expects volatility but is unsure of direction
b. Short Straddle: investor sells a put and a call; investor does not expect volatility and is hoping to keep the premium with little/no volatility
Option Pricing Models
1) Black/Scholes: used to value of a Call. It considers variables:
- current price of underlying asset
- time until expiration
- risk-free rate of return
- volatility of underlying asset
*All variables have direct relationship on price of the option EXCEPT for strike price. As strike price incr, option price decr.
2) Put/Call Parity: Values a Put based on the value of a corresponding Call option.
3) Binomial Pricing Model: explains value of an option based upon the underlying asset price moving in two directions.
*EXAM TIP: make flashcard for all pricing models.
Taxability of Options
Call Options create two possible tax consequences:
1) If contract expires/lapses without being exercised, the premium paid is a short-term loss & premium received is a short-term gain.
2) (dont need to know)
Warrants
Essentially, long-term Call options issued by a corporation. Expiration period is much longer than options, usually 5-10 yrs.
Futures Contracts
Two Types:
1) Commodity Futures Contracts: underlying asset is copper, wheat, pork bellies, or oil.
2) Financial Futures Contracts: underlying asset is currency, interest rate, or stock indices.
Futures are “market to market” which means the gains/losses in cash are credited/debited directly to your account on a daily basis.
*Exam Tip: Primary players in Futures are Hedgers & Speculators
Futures vs. Options Contracts
- Option contracts give holder the right to do something;
Futures obligate the holder to take underlying asset - Futures contracts DONT state per unit price of underlying asset (rather, its determined by Supply and Demand)
