Derivatives Flashcards
ABS
Asset-Backed Security
Accrual Swap
An interest rate swap where interest on one side accrues only when a certain condition is met
Accrued Interest
The interest earned on a bond since the last coupon payment date
Adaptive Mesh Model
A model developed by Figlewski and Gao that grafts a high-resolution tree on to a low-resolution tree so that there is more detailed modeling of the asset price in critical regions
What is an Option?
An option is a contractual agreement between two parties, the buyer and the seller
Option Contract stipulations
- Expiration date (Usually the third Friday of the month)
- Strike price
- Underlying (can be stock, ETF, or index) that the contract will be cased upon
* A standard option represents 100 shares of the underlying - When the holder can exercise the option (convert to the underlying)
* Anytime before expiration (American Style)
* Only at expiration (European Style)
Reason to Trade Options?
- Leverage: One option contract controls 100 shares of underlying stock
- Capital Outlay: You can purchase an option for significantly less than purchasing the underlying stock outright
** There are many different reasons people trade options. This only represents two of the most common**
What the tradeoff for trading options?
- Time: Options have a finite expiration date. They are a “wasting asset. They will either expire worthless or be turned into long/short shares of the underlying.
- Leverage: Leverage goes both ways, it can hurt you as much as it helps you.
Call Option
** Call option is a contract that allows the option holder (buyer) to
buy 100 shares (typically) at the strike price up to the defined
expiration date. Said to be LONG THE CALL. Bullish
** Call options obligate the seller (writer) to sell 100 shares (typically) of the underlying at the strike price up to the defined expiration date. Said to be SHORT THE CALL. Bearish
Put Option
** Put option is a contract that allows the option holder to sell 100 shares (typically) at the strike price up to the defined expiration date. LONG THE PUT. Bearish
** Put options obligate the seller to buy 100 shares (typically) of the underlying at the strike price up to the defined expiration date. SHORT THE PUT. Bullish
Standardized option terms
One contract represents 100 shares of the underlying
Options can be adjusted in a number of ways to account for corporate events (i.e., stock splits). These are called Adjusted Options.
For example:
You have 1 contract for XYZ Stock with a strike price of $75.00, when the company announces a 3 for 2 stock splits. Here is what would happen to your 1 contract:
Old option contract 100 X $75.00 = $7500
New option contract 150 X $50.00 = $7500
The adjustment keeps the notional value the same, the number of shares and the strike price are adjusted to maintain the notional value of the contract post split. Other adjustments may occur from corporate actions. Terms can be found in the option chain or check with the Options Clearing Corp to find out the new terms of an adjusted option.
Buyer
** Have a right to exercise and buy or sell 100 shares of the
underlying
** Also, called a call/put holder (long the option)
Seller
** Have an obligation to buy/sell at Assignment, 100 shares of the
underlying
** Also, called a call/put writer (short the option)
Buy to Open and Sell to Open
Any time you are creating a new position in your account, you are OPENING and either buying or selling the option to Open that new position
Buy to Close and Sell to Close
Anytime you are removing a position from your account, you are CLOSING it out and either buying it back or selling it to Close the position
Anatomy of an Options Symbol
On the options screen you will see at the top a set of numbers and letters. Example: -SPY241219C211
SPY = the symbol of the underlying
24 is the year of the expiration
12 is the month of the expiration
19 is the day of the expiration
C indicates that this is a Call Option (as opposed to P for Put Option)
211 is the Strike Price
So the example means that a holder (Buyer) of this call has the right to BUY 100 shares of SPY at $211 per share at any time until December 19, 2024
Bid
The highest price that a buyer is will to pay for the option. Similar to a Bid on stock (options are typically quoted in $0.01 or $0.05 increments)
Ask
The lowest price that a seller is willing to sell the option at. Also, similar to Ask on a stock.
Volume
The total number of that particular contract that has traded on that trading day. Once again similar to stock
The Option Chain
Where you can find options quotes and information
What is Open Interest
Open interest is the number of ALL of those contracts in the world. It is not static! The number is updated daily based on the previous day’s trading activity
Premium
Premium is the amount that you pay for the option contract, or the proceeds that you receive from the sale of a contract.
Example:
You buy the AAPL November 2024 120 Call shown in the Option Chain Open Interest column. The premium you would pay is $4.45 (the A next to the price stands for ASK, which is the price someone is willing to sell the contract for)
***Remember the option contract represents 100 shares so you would actually pay $4.45 x 100 = $445. If you were the seller of the call in this example, you would have received a premium for $445.00
Breakeven
Breakeven is the price the underlying needs to be trading at expiration for your trade to “breakeven”, that is, to not gain or lose any money.
Example:
You buy the AAPL November 2024 120 Call shown in the Options Chain Open Interest column. The premium you would pay is $4.45. Your breakeven on this trade would $124.45. Whjy? Because you have the right to buy AAPL at $120, but you paid $4.45 for the right. so that $120 plus the $4.45 you paid for the premium equals $124.45.
Exercise
LONG OPTIONS GET EXERCISED
> Exercising a call is when the option holder opts to buy the underlying at the strike price (typically 100 shares)
Exercising a put is when the option holder opts to sell the underlying (typically 100 shares)
If the option has an intrinsic value of at least $0.01 at expiration, it will automatically exercised
> If your account cannot support the position that will be created by auto-exercise, you should close the option position!!!
Assignment
SHORT OPTIONS GET ASSIGNED
> Assignment of a call is the option writer fulfilling their obligation to sell the shares at the strike price. (Typically 100 shares). A short option can be assigned at any time!
Assignment of a put is the option writer fulfilling their obligation to buy the shares at the strike price (Typically 100 shares).
As an option seller, you do not choose if/when an assignment will occur. The option buyer controls this, assignment happens when they choose to exercise their option.
> IMPORTANT - A Short (sold) option can be assigned at any time!! Even if it has no intrinsic value.
Example of Exercise of Call
Using the above AAPL example, here is what the Exercise of a call would look like:
If you exercised your long AAPL call, you would purchase 100 shares of AAPL at 120. 100 x $120 = $12000.
NOTE Many people use options for leverage, if you had 10 of those contracts and exercised them, it would be 10 X 100 X 120 = $120,000!
Example of Assignment of Call
Using the same example, here is what an Assignment would like:
If you were assigned on the one call, you would need to deliver 100 shares of AAPL, and you would receive $120 per share, 100 x $120 = $12,000. But what if you didn’t already own the shares? You would have to go into the market and buy them at whatever price they were trading at, which would likely be higher than $120.00 per share.
Another Example: What if AAPL was now trading at $130.00? It would now be 100 X 130 = $13,000
Example of Exercise of Put
Here is what an Exercise of put would look like:
If you exercised your Long AAPL put, you would sell 100 AAPL shares at 120. You would receive the proceeds of 100 X $120= $12000.
Example of Assignment of Put
Here is what an Assignment of put would look like:
If you were assigned on the one put, you would need to buy 100 shares of AAPL and you would pay $120 per share 100 x $120 = $12000.
Remember leverage, if you sold 10 of the puts it would be 10 x 100 x $120 = $120,000 you would be paying for 1000shares of AAPL
Index Options
Index options are “European” style, meaning they can only be exercised at expiration, as opposed to “American” style which can be exercised at any time. Additionally, index options are based on an index, which cannot be delivered, therefore, they settled in cash.
Example of Index Option
You are Long (own) 1 SPX call expiring on 12/19 with a strike price of 2080.
If your one SPX call were exercised because SPX closed ate 2081 on expiration, you would receive $100 cash into your account.
Your option has $1 intrinsic value X the multiplier for SPX which is $100 = $100
Intrinsic Value
- The difference between the strike price of the option and the current market price of the underlying asset
- The payoff the buyer would receive if they exercise the option right away
- The profit that would realized if the option were exercised immediately
- The concrete, real-world worth of an option at any given point
There are 2 components to an option’s price
- Intrinsic Value - the measure of the true value; it is the difference between the stock price and the strike price
- Time Value - is a measure of “uncertainty” - the potential that the option could hold more intrinsic value in the future
All else equal, the time value erodes as expiration nears - the uncertainty about the stock’s price movements between now and the expiration gets lower and lower
Importance of Time Value
► The Time Value of calls and puts at each strike price is nearly equivalent
► A covered call and a cash secured put of the same strike price have almost identical risk (max loss, breakeven) and reward (max gain) profiles
► The only difference to the trader is the probability that the trade will result in the acquisition or sale of the underlying security
► At the money contracts have the most time value, but is not always the best choice
In the Money (ITM)
~ In-the-money options are those options that have intrinsic value
~ Calls with strikes below where the underlying is currently trading
~ Puts with strikes above where the underlying is currently trading
At the Money (ATM)
~ At the money options are options that have a strike price closest to where the underlying is currently trading
Out of the Money (OTM)
~ Out of the Money options are those which have no intrinsic value
~ Calls with strikes above where the underlying is currently trading
~ Puts with strikes below where the underlying is currently trading
What factors affect the premium?
► Money-ness of the option being sold (Strike Selection)
► Out-of-the-money options offer lower premiums
► At-the-money option contracts have the most time value
► In-the-money options offer higher premiums
► Time to Expirations (Expiration Selection)
► Nearer term expirations offer the potential for the highest
annualized return but off a lower upfront premium
► Longer-dated expirations decay at a slower rate but offer the
advantage of more upfront premium (income certainty)
► Expected Movement from the Underlying (Implied Volatility)
► Higher implied volatility (expected price movement) results in
higher premiums
► When selling options, if that expected volatility becomes
realized volatility, it can result in substantial losses
Accreting swap
A swap in which the principal increases in each time period
Listed Stock Option
A Contractual agreement between two parties with standard terms.
All listed options contracts are governed by the same rules.
When you create a new position you are triggering what two things?
► By buying an options, you are buying a specific set of rights
► By selling an option, you are acquiring a specific set of obligations
Option Clearing Corporation (OCC)
√ Serves as a central clearinghouse and regulator for listed options traded in the United States under the auspices of the SEC and CFTC.
√ The OCC clears exchange-traded transactions in options contracts and interest rate composites
√ Value-added solutions provided by the OCC include research services, investor education, customer support, and marketing outreach
Time-Value decay
Where the time value of the option falls on a daily basis until the expiration date - stocks don’t possess it
Pricing Relationships
The price of a call option rises when its underlying stock goes up. But if the move in the stock is too late, because it happens too close to the expiration date, the call can expire worthless. You can literally buy yourself more time, though - some options have expiration periods as late as 9 months to 2½ yrs.
When you own call options, your rights allow you to
» Buy a specific quantity of the underlying stock (exercise)
» Buy the stock by a certain date (expiration)
» Buy the specific quantity of stock at a specified price (known as the strike price)
In other words, the price of the call option rises when the stock price goes up because the price of the rights you bought through the option is fixed while stock itself is increasing in value.
Backtesting
This means that you review how a set of strategies has worked in the past
Hedging
** Hedging in option trading involves taking positions that
offset risk, effectively reducing overall risk exposure.
** Hedging strategies are used to reduce uncertainty and
limit losses without significantly reducing potential
retuns.
** A properly design ed
