Derivatives

Question 1

How do you calculate the price of an option contract with a premium of $2?

Answer 1

An option contract has 100 shares. With a premium of $2 it would cost $200.

Question 2

Which option contract gives max gains if stock price appreciates? If it declines?

Answer 2

If stock appreciates, those who bought a call get max gain.

If it declines, those who bought a put get max gain.

Question 3

How do you calculate the intrinsic value of a stock option?

How do you calculate the time value?

Answer 3

Intrinsic value for call: Stock price - strike price. For put: Strike price - stock price. Intrinsic value can never be less than zero.

Time value = premium - intrinsic value.

Question 4

What are ‘in the money’, ‘at the money’, and ‘out of the money’, for calls and puts?

Answer 4

Calls are in when stock pice > strike price

Puts are in when strike price > stock price

Question 5

Explain the acronym ‘STOPS’ for options profit and loss calculation:

Answer 5

ST - stock (only applies if you owned it)
O - Options intrinsic value.
P - Premium
S - # of shares

Question 6

What is a covered call?

Answer 6

Selling a call option on shares you already own.

Question 7

What is a ‘married put’ aka, portfolio insurance?

Answer 7

Buying a put on stock you already own; it’s a tactic for locking in gains. Anytime a question asks about protecting profits or locking in gains, the answer is always buying a put.

Question 8

What is a long straddle?

When is it used?

Answer 8

Buying a put and call on the same stock. Use it when you expect volatility, but don’t know which way it’s going.

Question 9

What is a short straddle?

Answer 9

Selling a put and a call on the same stock. Do this when you don’t expect volatility, and want to keep the premiums.

Question 10

What is a collar?

Answer 10

For stock you already own, sell a call at slightly above the current price.

Use the premium to buy a put option slightly below the current price.

This protects against downside risk of stock.

Question 11

What is the Black/Sholes option pricing model?

Answer 11

It determines the value of a call.

It uses current price, time until expiration, volatility, and risk free rate to determine the value.

Value increases as all of these increase, but decrease as the strike price increases.

Question 12

What is Put/Call Parity?

Answer 12

Attempts to value a put option based on the value of a corresponding call.

Question 13

What is the Binomial Pricing Model?

Answer 13

A method for valuing options based on the stock price moving in two directions.

Question 14

How are options trades taxed?

Answer 14

For calls, if not exercised, premium is a short-term gain or loss, depending on if bought or sold.

For calls bought, premium becomes part of basis, LT if held for more than a year.

For expired puts, premium is also a ST gain or loss.

Question 15

What are LEAPS?

Answer 15

LT Equity Anticipation Securities

Options that have terms of 2 years or more, instead of the traditional 9 months.

Naturally they have higher premiums.

Question 16

What are warrants?

Answer 16

5 - 10 yr call options written by the corporations.

Not standardized like most option contracts.

Question 17

How are futures contracts different from options (3 ways)?

Answer 17

1. Options don’t have to be exercised, futures do.
2. Futures don’t specify a price, they rely on the market price on that date.
3. Futures are “marked to market” meaning the gain/loss in your account is credited/debited on a daily basis.

Question 18

What are the two methods of hedging with futures contracts?

Hint: One for protects sellers, one protects buyers.

Answer 18

For sellers: Long the commodity, short the contract. If you already have something, sell a futures contract in it to hedge against future price declines.

For buyers: Short the commodity, long the contract. If you’re going to have to buy something, buy a contract to lock in a price.