Derivatives Flashcards
Derivative
A contract that derives its value from an underlying asset. The buyer has the right to take an action and the seller has the obligation.
Option
A two party contract: buyer has the right to exercise the contract to buy or sell the underlying security, the seller is obligated to fulfill the terms of the contract. The amount paid for the contract when purchased, or received for the contract when sold, is the premium.
Buyer
Owner of the contract, pays the premium. Called the owner, the holder, or the party who is long the contract. Has the right to exercise the contract. Risks losing the premium paid for the contract if the option expires as worthless.
Seller
Writer, party who is short the contract. Receives the premium Obligated to perform if the buyer chooses to exercise the contract. Sellers can potentially profit by the amount of the premium received for the contract if the option expires as worthless.
Calls
Long call: call buyer owns the right to buy 1000 shares of a specific stock at the strike price before the expiration if she chooses to exercise the contract. Bullish/anticipates the price of the underlying security will rise Short call: call writer (seller) has the obligation to sell 100 shares of a specific stock at the strike price if the buyer exercises the contract. Bearish/anticipates the price of the underlying security to fall
Puts
Long put: (purchase): A put buyer owns the right to sell 100 shares of a specific stock at the strike price before the expiration if she chooses to exercise the contract. Bearish/wants the price of the underlying security to fall Short put (sale): A put writer (seller) has the obligation to buy 100 shares of a specific stock at the strike price if the buyer exercises the contract. Bullish/wants the price of the underlying security to rise or remain unchanged
Option market attitudes
Call buyer=bullish, wants market to rise Call writer=bearish, wants market to fall or remain unchanged Put buyer=bearish, wants market to fall Put seller=bullish, wants market to rise or remain unchanged
Index options
Stock index option tracks the performance of a particular group of stocks. No delivery of shares, writer pays the options owner the differential in cash
VIX options
Volatility index, based on the S&P 500 index Fear index, tends to spike upward when the stock market experiences a severe downdraft. VIX options settle in cash with European exercise provisions
Call In the money
A call is in the money when the price of the stock exceeds the strike price of the call. Buyer will exercise calls that are in the money at expiration. Buyers want options to be in the money. sellers do not
Call at the money
A call is at the money when the price of the stock equals the strike price of the call. A buyer will not exercise contracts that are at the money at expiration. Sellers want at the money contracts at expiration. Buyers do not. Sellers then keep the premium without obligation.
Call out of the money
A call is out of the money when the price of the stock is lower than the strike price of the call. A buyer will not exercise contracts that are out of the money at expiration. Sellers want contracts to be out of the money, buyers do not. Sellers then keep the premium without obligations
Call Intrinsic value
The same as the amount a contract is in the money.
When the market price of the stock is above the strike price of the call.
Options never have negative intrinsic value.
Buyers like calls to have intrinsic value, sellers do not.
Call Parity
A call option is at parity when premium equals intrinsic value
Puts in the money
A put is in the money when the price of the stock is lower than the strike price of the put. A buyer will exercise puts that are in the money at expiration. Buyers want in the money contracts, sellers do not.
Puts at the money
A put is at the money when the price of the stock equals the strike price of the put. A buyer will not exercise contracts that are at the money at expiration. Sellers want at the money contracts, buyers do not.
Puts out of the money
A put is out of the money when the price of the stock is higher than the strike price of the put. A buyer will not exercise puts that are out of the money at expiration. Sellers want out of the money contracts, buyers do not.
Put intrinsic value
A put has intrinsic value when the market price of the stock is below the strike price of the put. Buyers like options to have intrinsic value, sellers do not. A put that has intrinsic value at expiration will be exercised. A put that has no intrinsic value at expiration will be allowed to expire.
Premium formula
Premium equals intrinsic value plus time value
IV + TV = Pr
Time value
Subjective number determined by supply and demand. The amount of time to expiration and volatility affect time value. The more time until expiration, the more time value a given option has. The more volatile the underlying asset’s price, the more time value in the premium.
Index options
typically use a multiplier of $100. Premium amount is multiplied by $100 to calculate the option’s cost and the strike price is multiplied by $100 to determine the total dollar value of the contract. Settle next business day. Broad based index options stop trading at 4:15. Narrow based index options stop at 4pm ET. Exercise of an index option settles next business day.
Index options strategy
May be used to speculate on movement of the market overall. If an investor believes the market will rise, he can purchase index calls or write index puts. If an investor believes the market will fall, he can purchase index puts or write index calls. Index puts is known as portfolio insurance.
Interest rate options
Yield based (have a direct relationship to movements in interest rates). Options are based on the yields of T-bills, T-notes and T-bonds. If a portfolio manager believes rates will fall, the manager will buy puts or write calls. If the manager believes rates will rise, she will buy calls and write puts.
Currency options
Currency options available for trading on US exchanges for Australian dollar, British pound, Canadian dollar, Swiss franc, Japanese yen, and the euro. Settle on the next business day. European style exercise only EPIC Explorters buy Puts Importers buy calls