Derivatives

Question 1

What is difference between call options and put options and what are the three reasons people invest in options?

Answer 1

a call option- is the right to buy a specified number of shares at a specified price (Strike or exercise price) withina specified period of time (American options) or at a specified future date (European options)
1. Hedging
2. Speculating
3. Income

Question 2

Diagram of call option and put options

Answer 2

Call Options
1. Buyers- Believe price will rise
2. Sellers- Believe prices will fall or stay the same

Put Options
1. Buyers- Believe prices will go down
2. Sellers- Believe prices will go up or say the same.

IF CFP asks which option will maximize return when prices go up- “Buying a call”
What will maximize profits when stock prices go down? “Buying a put”

Question 3

Please explain the intrinsic value and time value of options

Answer 3

Intrinsic Value:
-Call Option: Stock Price - strike price
-Put Option: Strike Price- Stock Price

Time Value = Premium- Intrinsic Value

INTRINSIC VALUE CANNOT BE LESS THAN ZERO

Question 4

How to calculate a gain or loss using options?

Answer 4

Must consider two components
-Intrinsic value of the option
-premium paid or receivedc

Remember acronym STOPS
St- Stock gain or less (if you own underlying security
O- Options gain or loss
P- Premium paid or received
S- Shares controlled or owned

Question 5

What are some various option trading strategies and when are they appropriate?

Answer 5

Covered Call - Involves selling a call on a stock that is currently owned by the investor. Strategy is appropriate for a stock that has been in a trading range and investor wants to generate additional income to continue owning the stock. May also be appropriate if investor is considering selling a stock, but wants to generate some additional premium dollars and possibly get called out of the stock.

Married Put- Buying a put on a stock or index that is currently owned by investor. Considered to be “portfolio insurance”

When asked question about “protecting profits” or “locking in gains” the right answer is always buying a put.

Question 6

What are some various Straddles strategies?

Answer 6

Long Straddle- An investor buys a put and a call option on same stock.
-Investor expects volatility but is unsure of the direction.

Short Straddle- Investor sells a put and a call option, investor does not expect volatility and is hoping to keep the premiums with little to not volatility in stock price.

Zero Cost Collar- A strategy when the investor owns the underlying stock but wants to protect downside risk without paying entire cost of put option. Investor sells Call Option at a strike price that is slightly higher than the current stock price. (This created premium received which then can be used to buy put options.

Question 7

What are the various Option Pricing Models

Answer 7

1. Black/Scholes- Used to determine value of call options: Considers following variables
   -Current price of underlying asset
   -Time until expiration
   -Risk Free Rate of return
   -Volatility of underlying asset

-All variables have direct relationship on the price of the option, except strike price. As strike price increases, the option decreases in value.

2. Put/Call Parity Attempts to value PUT option based on the value of corresponding call option.
3. Binomial Pricing Model- Attempts to value an option based on the assumption that a stock can only move in one of two directions. Models fairly simplistic and used at many majors brokerage houses

Question 8

Taxability of Options

Answer 8

Call Options
if contract lapses or expires then the premium paid is short-term loss and premium received is short term gain.
If 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 will be considered a long term capital gain or less. Less than 12 months it will be considered a short-term gain or less.

Question 9

What is difference between Long Term Equity Anticipation Securities (LEAPS) and Warrants?

Answer 9

LEAPS have longer experation periods than traditional options- Have option periods that last for 2 years or more versus traditional option periods that have expirations up to 9 months. Premiums associated with LEAPS are higher because of extended time period.

Warrants- Long-term call options issued by corporations
- Call options written by the investors and experiations are much longer usually lasting 5-10 years. Call options have expirations of 9 months or less. Warrant terms are not standardized. Call options contracts are standardized in terms of expiration month and number of shares controlled.