Derivatives (Lesson 8) Flashcards
How many shares does an option contract control
- 100 shares
What is call option
- is the right to buy a specified number of shares at a specified price within a specified period of time (American option) or at a specified future date (European option)
What is a put option
- is the right to sell a specified number of shares at a specified price within a specified period of time (American option) or at a specified future date (European option)
What are the three reasons that people invest in options
- Hedging
- Speculation
- Income
What does a buyer of a call option believe
- the price of underlying stock will rise
What does a buyer of a put option believe
- the price of underlying stock will fall
What does a seller of a call option believe
- the price of underlying stock will fall or stay the same
What does a seller of a put option believe
- the price of the underlying stock will rise or stay the same
If the investor wants to maximize the gain if the stock price appreciates the investor will
- buy a call
If the investor wants to maximize the gain if the stock price falls the investor will
- buy a put
What does the option premium consist of
- Intrinsic value
- Time premium
What is the intrinsic value of an option
- Call Option: Stock Price - Strike price
- Put Option: Strike Price - Stock Price
- Cannot be less than $0
What is the time value of an option
- TV = Premium - Intrinsic Value
How do you calculate the gain or loss of an option
- consider two components:
- Intrinsic value and premium paid
- 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
(Options Trading Strategies)
Covered Call
- selling call options on stock that is currently owned by the investor
- appropriate for a stock that has been in a trading range and the investor wants to generate some income and continue to own the stock
(Options Trading Strategies)
Married Put
- involves buying a put option no a stock or index that is currently owned by the investor
- called portfolio insurance if the investor owns a diversified portfolio of common stocks
(Options Trading Strategies)
Long Straddle
- investor buys a put and a call option on the same stock
- investor expects volatility but is unsure as to the direction
(Options Trading Strategies)
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 no volatility in the stock price
(Options Trading Strategies)
Collar or Zero Cost Collar
- investor owns the underlying stock but wants to protect the downside risk without paying the entire cost of the put option
- Investor sells a call option at a strike price that is slightly higher than the current stock price (Creates the a premium received)
- Investor then buys a put option that is below the current stock price
- Premium dollars received by selling the call are used to buy the put option
When an investor wants to protect profits or lock in gains the correct option strategy is
- buying a put
What does the Black/Scholes model determine
- the value of a CALL option
What are the variables for the Black/Scholes model
- Current price of the underlying asset
- Time until expiration
- Risk free rate of return
- Volatility of the underlying asset
All the variables for the Black/Scholes model have a ____ relationship on the ______ of the option except the _____ _____
- Direct relationship
- Price of the option
- Strike Price
As the strike price increases the option _____ in value
- Decreases
What is the Put/Call parity option pricing model
- Attempts to value a PUT option based on the value of a corresponding call option
What is the binomial pricing model for pricing options
- attempts to value an option based on the assumption that a stock can only move in one of two directions
Tax consequences of a call or put option expiring
- if contract lapses or expires then the premium paid is a short term loss or premium received is a short term gain
Tax consequences of a call option being exercised
- premium is added to the stock price to increase the basis
- if underlying stock is held for more than 12 months it will be considered a LT capital gain, if less than or equal to 12 months it is a ST capital gain
What are Long Term Equity Anticipation Securities (LEAPS)
- options that have longer expiration periods than traditional options
- Premium is higher because of the extended time period
What are warrants
- essentially long term call options issued by the corporation
- Call options written by investors
Are warrant terms standardized
- Not standardized
- call options are standardized
Which way of purchasing of selling an option has the greatest loss potential
- Selling a naked call
What are the two types of future contracts
- Commodity futures
- Financial futures
What are the differences between futures and options contracts
- option contracts give the holder the right to do something and futures contracts obligate the holder to make or take delivery of the underlying asset
- Futures contracts do not state the per unit of the underlying asset which is determined by supply and demand
Who are the two primary players in the futures market
- Hedgers and speculators
What kind of accounting are futures contracts on and what does it mean
- Marked to Market
- the gain or loss is credited to your account on a daily basis
Types of hedging using futures:
Long the commodity, Short the contract
- Have the commodity and want to lock in profits
Types of hedging using futures:
Short the commodity, Longthe contract
- Don’t have the commodity but have to purchase it to make their own product
