Futures and Options Strategy

Question 1

Derivatives

Answer 1

A derivative security is so named because its value is derived from the value of another asset, referred to as the underlying asset. As that asset’s value changes, so does the value of the derivative. A big appeal with derivatives is that the change in their value is usually far greater, percentage-wise, than the value change in their underlying assets. In this sense, they are said to have built-in leverage.

Question 2

Calls

Answer 2

Calls - option contracts where the writer gives the buyer the right to purchase a set quantity of securities at the exercise price from the writer. The Microsoft Options were of type “calls”

Question 3

Puts

Answer 3

Puts - option contracts where the writer gives the buyer the right to sell a set quantity of securities at the exercise price to the writer.

Question 4

Binomial Option Pricing Model (BOPM)

Answer 4

The binomial option pricing model can be used to estimate the fair value of a call or put option. It is easier to show the model using European-style options where the exercise can only happen on the expiration date. American-style options allow the contracts to be exercised any time before the expiration date.

Question 5

Put-Call Parity

Answer 5

The relationship between the market prices of a call and a put on a given stock that have the same exercise price and expiration date is known as the Put-Call Parity. Given the price of a call for a security, you can determine the price of a put for the same security with the same expiration date and strike price.

Question 6

Put-Call Parity Equation

Answer 6

C − P = S − PV(X)*

(*please note that given any combination of three out of the four formula components, you should be able to algebraically rearrange to solve for the fourth.)

Where:

C = price of call

P = price of put

S = market price for underlying stock

PV(X) = present value of the strike price = X(1+r)T
Where:

X = Future Value of Security (aka Strike Price)

r = risk-free rate

T = time to expiration date

Question 7

Call Option premium

Answer 7

When buying call options, investors buy contracts that enable them to buy shares in a company at a negotiated price in the future. The call option premium, or the call premium, is the amount an investor pays to receive the call option.

Question 8

Black-Scholes-Merton Limitation

Answer 8

The Black-Scholes-Merton model might seem to have limited use due to some drawbacks:

1. Almost all options in the United States are American options that can be exercised at any time up to their expiration date, whereas the Black-Scholes-Merton model applies only to European options.

2.The model is applicable only to options on stocks that will not pay any dividends over the life of the option. However, most of the common stocks on which options are written do in fact pay dividends.

Question 9

Options Trading

Answer 9

Exchanges begin trading a new set of options on a given stock every three months. The newly created options have roughly nine months before they expire. For example, options on Widget might be introduced in January, April, July and October, with expiration dates respectively in September, December, March and June.

The exchange might decide to:

introduce long-term options on Widget, dubbed LEAPS by the exchanges, for long-term equity anticipation securities that expire into the future as far as two years.
allow the creation of customized options on Widget, dubbed FLEX options for flexible exchange options that have exercise prices and expiration dates of the investor’s choosing.

Question 10

Roles of Exchange (OCC)

Answer 10

The Options Clearing Corporation (OCC) is a company that facilitates the trading of call and put options. It maintains a computer system that keeps track of all contracts by recording the position of each investor. As soon as a buyer and a writer decide to trade a particular put option contract and the buyer pays the agreed-upon premium, the OCC steps in, becoming the effective writer as far as the buyer is concerned and the effective buyer as far as the writer is concerned. All direct links between original buyer and writer are severed. If the buyer exercises the option, then the OCC will:

randomly choose a writer who has not closed his or her position, and assigns the exercise notice accordingly, and
guarantee delivery of stock or cash if the writer is unable to come up with the shares.
Therefore, the OCC makes it possible for buyers and writers to close their positions at any time.

Question 11

Options Quotes

Answer 11

Common stock options are currently traded on the Chicago Board Options Exchange (CBOE), the American, and Philadelphia stock exchanges.

Question 12

Use Limit Orders for Options

Answer 12

It is often advisable to use limit prices when trading options. Even limit prices that are below (purchase) or above (sale) the current trading price. This protects against the risk of a trade having a poor fill. This is more prevalent in option trading than other markets.

Question 13

Options Margin

Answer 13

All option contracts are with the OCC, so it is the concern of the OCC to see that the writer is able to fulfill the terms of the contract. To relieve the OCC of this concern, the exchanges where the options are traded have set margin requirements. Brokerage firms are allowed to impose even stricter requirements if they so desire, because they are ultimately liable to the OCC for the actions of their investors:

In the case of a call, shares are to be delivered by the writer in return for the exercise price.
In the case of a put, cash is to be delivered in return for shares.

Question 14

Spread

Answer 14

A spread is the purchase of one option and sale of another option that is similar but different. An option spread can be created from either two puts or two calls, but not from both puts and calls. These options may have either differing maturities or different exercise prices.

Question 15

Vertical Spread

Answer 15

Vertical spreads are options with different exercise prices but the same expiration date. The name is derived from the practice where newspapers list all options with the same expiration dates in vertical columns.

Question 16

Horizontal Spread

Answer 16

Horizontal spreads include those combinations of options having different expiration dates but the same exercise price. They are called horizontal spreads because different options that all have the same exercise prices are listed in horizontal rows in the newspapers. Horizontal spreads are also called time spreads and calendar spreads.

Question 17

Diagonal spreads

Answer 17

Diagonal spreads include mixtures of vertical spreads and horizontal spreads from the newspaper quotations. They include options in which both the expiration dates and the exercise prices differ.

Question 18

Strangles

Answer 18

A strangle uses a put and a call, typically with the same expiration date, but with different exercise prices. A strangle is a vertical spread that is like a straddle with an exercise price that is “points away,” or is different, from the current market price of the underlying security.

Question 19

Bull Spread

Answer 19

A bull spread is a vertical spread, because the two calls comprising it have the same expiration date. A bull spread is a debit transaction because selling the call generates less cash inflow than the call purchase requires. As a result, there is a net cash outflow from the investor’s brokerage account when a bull spread is initiated.

Bull spreads are for people who believe the price of the optioned stock will rise, but won’t rise a lot.

Question 20

Bear Spread

Answer 20

A bear spread is a vertical spread because both options compromising it usually have the same expiration date. Bear spreads and bull spreads both have limited gain-loss potentials. Only asset price declines between the exercise prices of the two options are profitable for a bear spread. Additional gains or losses are not possible if the price of the optioned security moves below the lower exercise price (security’s price < XP1) or above the higher exercise price (security’s price > XP2). Cautious investors like bear spreads because their losses are limited if the investor’s expectations are wrong.

Question 21

Butterfly Spread

Answer 21

A butterfly spread is a combination of a bull spread and a bear spread on the same underlying security. The owner of a long butterfly spread enjoys the maximum gain if the price of the optioned asset does not fluctuate. In contrast, the short butterfly spread is profitable if the price of the optioned asset fluctuates very far in either direction.

Question 22

Short Sale

Answer 22

Short sale creates a position where the number of contracts sold exceeds the number of contracts bought. Such a position results when the selling party sells something it does not own. The short-seller typically borrows what is needed to make delivery in the future.

Question 23

Futures

Answer 23

Futures are also known as futures contracts, which are based on the future delivery of commodities, like frozen orange concentrate, or financial instruments, like U.S. Treasury Bonds. The steps in creating a futures contract are as follows:

One party agrees to accept delivery of a standardized quantity of an item at a future date.
The second party agrees to make such delivery.
Both parties agree on the price at which the exchange will take place.
The person taking delivery is called the buyer:

If the market price of the item goes above this contract price, the buyer will make a profit.
If the price goes below this contract price, the buyer suffers a loss.
Whereas options are rights to exercise, it is important to note that the futures contract is a legal obligation to perform (deliver or take delivery). If you buy a futures contract, then your losses are virtually unlimited, that is, they continue to mount as long as the commodity’s price falls. The situation works in reverse if you are the seller of a futures contract; you lose when prices go above the contract price and gain when they go below it.

Question 24

Futures Market

Answer 24

The futures contracts are traded on various organized exchanges. Although this method is similar to the way stocks and options are traded, some aspects of the method are different. As with stocks and options, customers can place market limits and stop orders with a Futures Commission Merchant (FCM), which is simply a firm that carries out orders involving futures. Once an order is transmitted to an exchange floor, a member must take it to the pit to be executed. What happens here is what distinguishes trading in futures from trading in stocks and options.