Derivatives Flashcards
what is an options contract?
an agreement between two parties, the seller (writer) and the buyer
derivative security
what determines the value of an option?
the value of the underlying asset
how many shares of the underlying security are in one option contract?
1 contract = 100 shares
what are the two types of options?
call option and put option
what is a call option
the right to BUY a specified number of shares at a specified price within a specified period of time or at a specified future date
what is a put option
the right to SELL a specified number of shares at a specified price within a specified period of time or at a specified future date
what is another name for the specified price that a contract is exercised at?
strike price (exercise price)
what is the difference between an American option and a European option?
American options can be exercised at any time prior to the expiration date
European options can only be exercised on the expiration date
what does the buyer of a call option believe about the price of the underlying stock?
the buyer of the call option believes the stock price will rise
wheat does the buyer of a put option believe about the price of the underlying stock?
the buyer of the put option believes the stock price will fall
what does the seller of a call option believe about the price of the underlying stock?
the seller of the call option believes the price will fall or stay the same
what does the seller of a put option believe about the price of the underlying stock?
the seller of the put option believes the price will rise or stay the same
what is the formula for the intrinsic value of a call option?
intrinsic value = stock price - strike price
what is the formula for the intrinsic value of a put option?
intrinsic value = strike price - stock price
can you have a negative intrinsic value?
no. if the calculation comes to a negative value, then the intrinsic value is $0
what is the formula for time value?
time value = premium - intrinsic value
practice problem: Holly purchases a call option on Starbucks. The strike price is $50 and the stock is trading at $53. The call expires in two months and the premium is $5. What is the intrinsic value of her call option? What is the time value?
intrinsic value = stock price - strike price
intrinsic value = $53 - $50
intrinsic value = $3
time value = premium - intrinsic value
time value = $5 - $3
time value = $2
when is a call “in the money”?
a call is “in the money” when: stock price > strike price
when is a call “out of the money”?
a call is “out of the money” when: stock price < strike price
when is a call “at the money”?
a call is “at the money” when: stock price = strike price
when is a put “in the money”?
a put is “in the money” when: stock price < strike price
when is a put “out of the money”?
a put is “out of the money” when: stock price > strike price
when is a put “at the money”?
a put is “at the money” when: stock price = strike price
what does it mean to be “in the money”?
the intrinsic value is positive
what does it mean to be “out of the money”?
the intrinsic value is negative (which then adjusts to be $0)
what does it mean to be “at the money”?
the intrinsic value is $0 (calculation came to $0 directly, it wasn’t adjusted to be $0)
what is a covered call?
involves selling call options on stock that is currently owned by the investor
what is a married put?
this strategy involves buying a put option on a stock or index that is currently owned by the investor
aka “portfolio insurance”
what is a long straddle?
an investor buys a put and a call option on the same stock
when would an investor use the long straddle strategy?
when the investor expects volatility, but is unsure as to the direction
what is a short straddle?
an investor sells a put and a call option
when would an investor use the short straddle strategy?
when the investor does not expect volatility and is hoping to keep the premiums with little to no volatility in the stock price
what is a collar
an investor owns the underlying stock, and sells a call option at a strike price that is slightly higher than the current stock price, creating a premium received
the investor then uses the dollars from the premium received to buy a put option that is lowed than the current stock price
what is a collar
an investor owns the underlying stock, and sells a call option at a strike price that is slightly higher than the current stock price, creating a premium received
the investor then uses the dollars from the premium received to buy a put option that is lowed than the current stock price
what are the types of option pricing models?
- Black/Scholes
- Put/Call Parity
- Binomial Pricing Model
describe the Black/Scholes pricing model
- used to determine the value of a CALL option
- all variables have a direct relationship on the price of the coupon, except the strike price
- as the strike price increases, the option decreases in value
describe the Put/Call Parity pricing model
attempts to value a PUT option based on the value of a corresponding call option
describe the Binomial Pricing Model
attempts to value an option based on the assumption that a stock can only move in one of two directions
(ex: over the short-term you have determined that a security, now worth $10, will be either $12 or $8)
how is a call option taxed if the contract lapses (or expires)?
the premium paid is a short-term loss and the premium received is a short-term gain
how is a call option taxed if the contract is exercised?
the premium is added to the stock price to increase the basis in the underlying stock
if the underlying stock is held for more than 12 months, it is a long-term cap gain or loss
if the underlying stock is held less than or equal to 12 months, it is a short-term cap gain or loss
what does LEAPS stand for?
Long Term Equity Anticipation Securities
what is a LEAPS?
has an expiration period that lasts for 2 years or more (versus traditional options that have expirations up to 9 months)
has a higher premium because of the extended time period
what is a warrant?
long-term call options issued by the corporation
expiration period is much longer than options, usually 5-10 years
terms are NOT standardized
what is a futures contract?
a derivative contract that OBLIGATES the holder to make or take delivery of the underlying asset
futures contracts do not state the per unit
what is a futures contract?
a derivative contract that OBLIGATES the holder to make or take delivery of the underlying asset
futures contracts do not state the per unit price of the underlying asset
what are the two types of futures contracts?
- commodity futures contracts
2. financial futures contracts
what is a commodity futures contract?
a futures contract where the underlying asset is copper, wheat, pork bellies, oil, etc.
what is a financial futures contract?
a futures contract where the underlying asset is currency, interest rate, or stock indices
what is the key difference between an option contract and a futures contract?
option contracts give the holder the RIGHT to do something
futures contracts OBLIGATE the holder to make or take delivery of the underlying asset
if you are using the hedging strategy, and you are long in the commodity, what should you do?
short the contract
if you are using the hedging strategy, and you are short the commodity, what should you do?
long the contract
when you buy a call option, what is your max possible loss and max possible gain?
max loss = premium paid
max gain = unlimited
when you sell a call option, what is your max possible loss and max possible gain?
max loss = unlimited
max gain = premium received
if you buy a put option, what is your max possible loss and max possible gain?
max loss = premium paid
max gain = strike price - premium
if you sell a put option, what is your max possible loss and max possible gain?
max loss = strike price - premium
max gain = premium received
