Derivatives Flashcards
Describe Options:
- A derivative security
- value depends on (is derived from) the value of another underlying asset
- Two parties
- the seller (the writer) and the buyer
- All transactions handled through options clearing house
- One option controls 100 shares of underlying security
What is a call option?
- The right to buy a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American) or at a specified future date (European)
What is a put option?
- The right to sell a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American) or at a specified future date (European)
What are three reasons people invest in options?
- Hedging
- Speculation
- Income
Describe call and put options from both sides:
Call Options Put Options
Buyers Believe the price of the under- Believe the POTUS will fall
lying stock will rise.
Sellers Believe the price of the under- Believe the POTUS will rise
lying stock will fall or stay or stay the same
the same.
EXAM TIP: buying a call will provide the investor max gains anytime CFP asks; buying a put is the right answer if the stock price falls
How do you calculate the value of an option?
- Intrinsic Value
- Call Option: Stock Price - Strike Price
- Put Option: Strike Price - Stock Price
- Intrinsic Value cannot be less than 0 (zero)
- Time Value
- TV = Premium - Intrinsic Value
Describe Calls and Puts that are “in the money”, “at the money” and “Out of the Money”
- Call
- In the money - Stock Price > Strike Price
- At the money - Stock Price = Strike Price
- Out of the money - Stock Price < Strike Price
- Put
- In the money - Stock Price < Strike Price
- At the money - Stock Price = Strike Price
- Out of the money - Stock Price >Strike Price
How do you calculate gain/loss using options?
- Consider two components
- The intrinsic value of the option, and
- The premium paid or received
What is the mnemonic for calculating gain/loss on an option position?
- STOPS
- St: Stock gain or loss - if you own the underlying stock
- O: Options gain or loss
- P: Premium paid or received
- S: Shares controlled or owned
Examples on p.123 of blue IP book
What is a Covered Call?
- Option Trading Strategy
- Sell call options on stock currently owned by investor
- Appropriate for:
- Stock in trading range, investor wants to generate income but continue to own stock
- Investor considering selling stock, but wants to generate some additional premium dollars and possibly get called out of the stock.
- Appropriate for:
- Sell call options on stock currently owned by investor
What is a Married Put?
Option Trading Strategy
- Buying a put option on a stock or index currently owned by the investor
- also known as “portfolio insurance” if investor owns a diversified portfolio of common stocks.
EXAM TIP: if question asks about “protecting profits” or “locking in gains” the right answer is always buying a put, either single stock or diversified portfolio of common stocks.
What is a Long Straddle?
Option Trading Strategy
- Investor buys a put and a call option on the same stock
- Investor expects volatility, but is unsure of the direction
- Ex: Boeing/McDonnell Douglas competing for a contract, one will go up and the other down
What is a Short Straddle?
Option Trading Strategy
- Investor sells a put and a call option
- 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 or Zero-Cost Collar?
Option Trading Strategy
- When investor owns underlying stock, but wants to protect downside risk without paying entire cost of the put option
- Investor sells a call option at a strike price that is slightly higher than the current stock price. This creates premium received.
- Investor then buys a put option that is below the current stock price. The premium dollars received by selling the call are used to buy the put optins
What are the Black/Scholes Option Pricing Model?
- Black/Scholes
- used to determine the value of a CALL option
- Variables:
- Current price of underlying asset
- Time until expiration
- The risk-free ROR
- Volatility of the underlying asset
- All variables have a direct relationship on the price of the option, except the strike price. As the strike price increases, the option decreases in value
EXAM TIP: KNOW
What is the Put/Call Parity Option Pricing Model?
- Attempts to value a PUT option based on the value of the corresponding call option
What is the Binomial Option Pricing Model?
- Attempts to value an option based on the assumption that a stock can only move in one of two directions ($10 stock, will be worth $12 or $8)
- Model can be extrapolated further into the future based on the value achieved at each interval
- Example: p. 127
- Simplistic, but used by many major brokerage firms
Describe the taxability of options:
- Calls:
- Two potential tax consequences:
- If contract lapses (or expires), premium paid is a short-term loss and premium received is a short-term gain
- If contract is exercised, premium is added to the stok price to increase the basis.
- If stock is held more than 12 months, then long-term gain/loss. Less than 12 monts, short-term gain/loss
- Two potential tax consequences:
- Puts
- Not likely to be tested
- KNOW: if not exercised, premium paid is short-term loss and premium received is a short-term gain
What are LEAPS?
- Long-Term Equity Anticipation Options
- longer expirations periods than traditional options
- Two years or more vs. traditional options that have expirations up to 9 months
- Premium for LEAPS is higher because of extended time period
What are Warrants?
- Long-term call options issued by the corporation
- Longer expiration period, usually 5-10 years
- NOT standardized
Describe Futures Contracts:
- Two Types:
- Commodity
- Copper, wheat, pork bellies, oil
- Financial
- Currency, interest rate, stock indices
- Commodity
- Differences from Options contracts
- Futures obligate the holder to make or take delivery, options give the holder the right to do something
- Futures do not state the per unit price of the underlying asset, which is determined by supply and demand
- Primary Players in futures market
- hedgers and speculators
- Futures contracts are “marked to market”
- The gain or loss (in cash) is credited/debited to your account on a daily basis
