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Investment Planning > Derivatives: Options and Futures > Flashcards

Derivatives: Options and Futures Flashcards

1
Q

What is a “Call Option?”

A

Provides the right to buy a certain amount of underlying security at a specified price

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1
Q

What is a “Put Option?”

A

Provides the right to sell a certain amount of underlying security at a specified price

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2
Q

Describe the process of “opening position” as it relates to call options:

A
  • Seller (aka writer) writes call option contract
  • Contract specifies price and duration
  • Buy (aka owner, holder) pays premium for call option
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3
Q

Describe the process of “closing position” as it relates to call options:

A

At any point in duration of the contract the Holder/Buyer/Owner pays the stated amount for securities.

The seller/writer is legally obligated to deliver

(contract can expire)

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4
Q

Describe the process of “opening position” as it relates to put options:

A
  • Seller (aka writer) writes put option contract
  • Contract specifies price and duration
  • Buy (aka owner, holder) pays premium for put option
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5
Q

Describe the process of “closing position” as it relates to put options:

A

At any point in duration of the contract the Holder/Buyer/Owner can sell the securities to writer for contractually specified price

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6
Q

What is the “Strike Price?”

A

Price at which the option may exercised

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7
Q

What does “In-the-money” mean?

A

Call option - When current stock price is greater than strike price

Put option - When strike price is greater than current stock price

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8
Q

What does “Out-of-the-money” mean?

A

Call option - When current stock price is lower than strike price

Put option - When strike price is lower than current stock price

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9
Q

What does “Intrinsic Value” mean?

A

The amount by which the option is “In-the-money”

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10
Q

What is “Time Value” as it relates to options?

A

Time Value = Option Premium - Intrinsic Value

Represents the potential for the option to increase in value due to passage of time, asset price change, or change in market conditions

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11
Q

What is a “LEAP?”

A

A long term option on a security up to 2 years or more to expiration

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12
Q

What is the “American Options” style of option contract?

A

Most common form;

Options can be exercised at any time up to the expiration date

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13
Q

What is the “European Options” style of option contract?

A

Options can only be exercised at the specific expiration date

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14
Q

What is the “Capped Options” style of option contract?

A

Options are automatically exercised when the price reaches a target or “Cap Price” before expiration

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15
Q

All options that trade on the US Securities Exchanges are issues and cleared through the…

A

Options Clearing Corporation (OCC)

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16
Q

2 types of options settlements that can take place

A
  1. Cash Settlement - OCC assigns closing transaction to a clearing firm and position is closed out; cash delivery to account
  2. Physical Delivery - security goes to your account
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17
Q

What do “long” and “short” mean with regard to stocks, calls, puts, etc.?

A

Long = own

Short = sold

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18
Q

What is a “Covered Call?”

A

You own the stock on which you wrote the call option

(You have to deliver)

19
Q

What is an Uncovered Call/Naked Call?

A

You do not own the stock on which you wrote the call option

(You still have to deliver; RISKY)

20
Q

In a long call position, the investor has a

bullish or bearish

outlook regarding the stock price

A

Bullish

21
Q

In a short call position, the investor has a

bullish or bearish

outlook regarding the stock price

A

Bearish

22
Q

The “Break Even Point” for calls is equal to the strike price ___ the premium.

A

Plus

23
Q

In a long put profile is

bullish or bearish

regarding the stock price

A

Bearish

24
Q

In a short put profile is

bullish or bearish

regarding the stock price

A

Bullish

25
Q

The “Break Even Point” for puts is equal to the strike price ___ the premium.

A

Minus

26
Q

You’re not always able to get a match to a buyer if you’re trying to sell an option.

This is an example of ____ playing a role in pricing an option.

A

Liquidity

27
Q

5 variables used by the Black-Scholes Model to value the call option of a non-dividend paying stock.

A
  1. Price of underlying security
  2. Strike price
  3. Time remaining to expiration
  4. Interest rates
  5. Volatility of underlying stock
28
Q

What are 5 big assumptions that limit effectiveness of Black-Scholes Model?

A
  1. Assumes security pays no dividend
  2. Assumes efficient market
  3. Assumes European contracts
  4. Assumes no commissions
  5. Assumes a risk free rate; (i.e. interest rates remain known and unchanged)
29
Q

What is a “Binomial Option Pricing Model?”

A

Models out over the course of contract a tree of successive stock prices. It’s CRAZY complicated.

30
Q

What is the great advantage of the crazy Binomial Option Pricing Model?

A

It’s possible to check at every point of the option’s life for the possibility of early exercise

(i.e. favors American options)

31
Q

What is a “Straddle?”

A

Combo of puts and calls on same stock.

Good for volatile markets.

32
Q

What is the difference between “options” and “futures” generally?

A

Both are derivatives

Options - you have the future right/option to buy/sell

Futures - you are obligated to buy/sell based on the contract terms

33
Q

What does “Forward Contract” mean?

A

It’s a contract that obligates one party to buy and another to sell at a specified future date

34
Q

What are the 2 Broad categories of futures contracts currently traded in US markets?

A
  1. Commodities - (Agriculture, metals, energy commodities, etc.)
  2. Financials - (Equities, Debt Instruments, Currencies, etc.)
35
Q

2 Reasons Futures are good/important

A
  1. Risk Management
  2. Price Discovery (reflect expected future prices)
36
Q

Where are Futures Contracts traded?

A

On designated Future Exchanges (e.g. Chicago Mercantile Exchange, New York Mercantile Exchange)

37
Q

All futures transactions are cleared through ___ each business day. Aside from the name, describe what the blank is.

A

The Clearinghouse

A separate corporation from each exchange

38
Q

-The seller of a futures position enters the (short or long) position.

-The buyer of a futures position enters the (short or long) position.

A

Short - (seller)

Long - (buyer)

39
Q

Describe how Margin works in futures trading

A

Margin is basically a down payment. You need a certain amount of margin in your margin account to guarantee obligations.

Investors’ equity can’t drop below the Maintenance Margin.

40
Q

What happens if investor’s equity falls below the maintenance margin?

A

They get a Margin Call.

“Hey you need more cash in your margin account.”

41
Q

What is the Risk Basis for futures contracts?

A

The difference between Cash Price and Future’s Price of hedged asset.

Risk Basis = Cash Price - Futures Price

42
Q

What are the 2 key Elements of a Futures Hedge?

Explain them

A
  1. Short Hedge - Selling a futures contract while holding underlying asset
  2. Long Hedge - Buying a futures contract while not holding the underlying asset
43
Q

What is a Warrant?

A

They are like long calls (contract w/ option to buy a security at a certain price) but term is 2-10 years AND the contract is issued by corporations not exchanges

44
Q

How are most futures contracts settled?

A

By offsetting the position; (Buyers sell their position through clearinghouse to other investors)

45
Q

Define Leverage

A

Leverage is the degree to which an investor is utilizing borrowed money

Investment Planning (14 decks)

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