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
Option Exercise rules
American style: allows owner of a contract to exercise anytime before expiration. Nearly all equity and equity index options are American style. European style: can only be exercised on expiration day. Foreign currency and yield-based options are European style.
Long call: BE, MG, ML
Call buyers are bullish. Investor can profit from an increase in a stock’s price Break even equals the strike price and the premium. For the call buyer, the contract is profitable above the BE MG: Potential gains available to call buyers are unlimited because there is no limit on how far a stock’s price can rise. ML: the most a call buyer can lose is the premium paid. This will happen if the stock price is below the strike price of the option at expiration
Short call: BE, MG, ML
Remember that call sellers (writers) are bearish. By writing calls, an investor can profit if the stock price falls. Break even for calls equals the strike price to the premium, but for the seller the contract is profitable below the BE. MG: Call writer’s maximum gain is the premium received. The MG is earned when the stock price is at or below the exercise price at expiration. ML: A call writer’s ML is unlimited because the writer could be forced to buy the stock at a potentially unlimited price, if the option is exercised by the buyer, for delivery at the strike price.
Call summary
BE is the same for both the buyer and seller, while one investor’s MG is the other’s ML. Call Buyer Seller BE Strike price + Pr Strike price + Pr MG Unlimited Premium ML Premium Unlimited
Long put: BE, MG, ML
Put buyers are bearish. By purchasing puts, an investor can profit from a decrease in a stock’s price. Break even: BE equals strike price minus premium. For the put buyer, the contract is profitable below the BE at expiration MG: Maximum potential gain available to put owners is the option’s strike price less than the amount of the premium paid (same as the BE). A stock’s price can fall no lower than zero. ML: The most a put buyer can lose is the premium paid. This happens if the market price is at or above the strike price at the option’s expiration.
Short put: BE, MG, ML
Put sellers/writers are bullish. By writing puts, an investor can profit if the stock price rises. Break even: equals strike price minus premium. For the put seller, the contract is profitable at or above the BE at expiration. MG: A put writer’s MG is the premium received. The MG is earned when the stock price is at or above the exercise price at expiration. ML: A put writer’s ML is the strike price minus the premium received (same as the BE). It occurs when the stock price drops to zero. The investor is forced to buy the worthless stock at the option’s strike price. The investor’s loss is reduced by the premium received.
Put Summary
BE is the same for both the buyer and seller, while one investor’s MG is the other’s ML. Put Buyer Seller BE Strike price - pr Strike price-pr MG Strike price - Pr Premium ML Premium Strike price - pr
Protective Puts
An investor who is long stock (bullish) can buy a put option as a hedge against the stock falling in value. The client could sell the stock at no less than the option’s strike price if the share declines. It locks in a minimum sales price if the long position moves the wrong way. A married put. Breakeven = stock price + premium
Protective calls
An investor who is short stock (bearish) can buy a call option as a hedge. The client could buy the stock back at no more than the option’s strike price if the shares rise in value. The call locks in a maximum purchase price to cover the short if the short position moves the wrong way. A call covers the unlimited risk of selling a stock short. Breakeven = stock price - premium
Protective options summary
Core position Hedge Long stock Put option Short stock Call Option
Covered contract
Writer already owns the underlying security
Uncovered contract
Naked; writer does not own the underlying security. Risk is unlimited.
Covered against a short stock
Customer short the stock and writes the put. If the option is exercised, the customer buys the stock from the option’s owner and then delivers the stock to cover the short. Still an unlimited risk position.
Options Account opening process
Options Clearing Corporation
OCC, clearing agent for listed options contracts, i.e., those trading on US options exchanges. Standardize, guarantee performance of, and issue option contracts
Option trading standards
Trading times: 9:30am-4pm ET
Settlement T+1
Expiration Third Friday of the expiration month at 11:59pm
Exercise: Listed options from the time of purchase until they expire
Automatic exercise: Any contract in the money by at least 0.01 will be exercised automatically unless holder gives the “do not exercise” instruction
Assignment: Assigned to a short BD on a random basis, BDs may assign to any short customers on a random basis, FIFO, or any other fair and reasonable method
Call intrinsic value formula
Call IV=CMV-Strike price
Put intrinsic value formula
Put IT=Strike price - CMV
Premium formula
Pr=IV+TV
