Futures and Options strategies Flashcards
What is the purpose of using margin
to increase money made without increasing money invested
Margin is
the amount of cash the investor contributes as a percentage of the current market value of the securities held
Say you have 50k cash and 50k margin on a 100k investment and the price goes up 20%, what is your percent gain?
20k/50k = 40% gain
vs. if you contributed all 100k the gain would be 20%
Say you have 50k cash and 50k margin on a 100k investment and the price goes down 20%, what is your percent loss?
20k/50k = 40% loss
vs 20% loss if you contributed all 100k
Margin requirement is
the percentage of the investment that is required to be equity that your cash bought
Who sets the initial margin requirement?
The Federal Reserve Board
If you have a 60% margin requirement and you want to invest 100k how much cash must you commit?
60k and you can borrow the other 40k
Maintenance Margin means
% total equity can drop to before a margin call
Say you invest 60k and borrow 40k margin and buy 2000 shares. How low can the price of the investment go before a margin call? Margin requirement is 35%
amount borrowed
————————-
(1-.35)
40,000/.65 = 61,548
61,548/2000 = $30.76 per share
at a value of $61,548 equity is
$61,548 - $40,000 = $21,538
$21,538/$61,538 = .35
To get back to 60% equity needs to be:
.60 * 61,538 = $36,923 (equity needed) - $21,538 (equity you have = $15,385 cash to be added
Short selling
borrow the shares from broker hoping the price will fall then buy back at a lower price and return to broker
Hedging
making an investment (futures or forward contracts) to reduce the risk of adverse price movement in an asset you either hold or intend to hold in the future
Speculator does what
opposite of hedging, investor who buys and sells contracts in anticipation of price changes
Short hedge
used by someone long a commodity, stock or currency and will need to sell in the future
Wheat farmer can hedge the price of wheat against price drop
Are forward contracts traded?
No
Futures for a stock index are settled how?
in cash - don’t receive shares of the index
Straddle
simultaneous purchase of a call and a put for the same stock at the same exercise date and same strike price
Buyer of a straddle is anticipating what type of movement in the stock?
volatility - allows to exercise both contracts at favorable prices
Writer of a straddle is betting on what?
little volatility - a move in one direction is ok. They profit if the underlying asset’s price remains relatively unchanged, avoiding significant movements that could trigger losses on either the call or put option they sold.
Spread
simultaneous purchase and sale of an option (call or put) differing only in time or strike price
Bull Spread
purchase and sale of calls (net debit, more purchase than sales)
Bear Spread
purchase and sale of puts (net credit, more sales than purchases)
Collar (zero cost)
used to protect a long position in a stock. Sell a call buy a put. Sell the call at one strike price and buy the put at a lower price.
The put protects you from a decline in the price of the stock. The call will force liquidation if price goes up - locking in a range of prices.
Why would you buy a collar?
When an investor has a stock with a large gain they want to lock in
Covered call
-sell a call - don’t own the stock
-profit is limited to the premium
Naked call
-sell a call - don’t own the stock
-profit limited to premium
-unlimited risk of loss if stock rises
Selling a put your profit is limited to what
profit limited to premium
Buying a put - loss is limited to what
loss is limited to cost of the put
Protective put
-option to sell a specific stock
- buy a put in anticipation of price decline
- sell a put in anticipation of price rising
How can you protect a short with an option?
buy a call in case the stock goes up instead of down
Covered put
short a stock, sell a put to cover short
Protective put
long a stock, buy a put to protect against loss
Black-Scholes Option Valuation Model
used to calculate theoretical present value of a stock based on 5 variables. Allows you to calculate the fair value of an option. Main advantage is speed - allows you to calculate large number of option prices in a short time
Black-Scholes only prices an option when?
At expiration - so it’s not accurate with American options
5 variables for Black-Scholes and Binomial Pricing model
- Volatility of underlying stock - Standard Deviation
- Current price of underlying stock
- Strike price of option
- Time to expiration
- Risk free rate of interest
Which pricing model would you use for American options? Black-scholes or Binomial?
Binomial
Binomial Option pricing model values the option when?
At select periods throughout the life of the option - uses an iterative process to build a binomial tree
Which model would you use if you need to price many options at once? Black-Scholes or Binomial
Black-Scholes
How to remember a collar
think of it as “protecting your pet” (stock). The call option is like a leash, limiting upside, while the put option acts as a protective collar, limiting downside risk.
Way to remember straddle
Picture a straddle as “straddling the fence.” In a straddle option strategy, you’re sitting on the fence, betting on significant price movement—buying both a call and a put option at the same strike price. It’s like preparing for a jump in either direction.
Black Scholes think Paul Scoals
British
