Introduction To Options Flashcards
What are the uses of Derivatives?
- Hedging: Derivatives are a tool for companies and other users to reduce risks.
- Speculation: Derivatives can serve as investment vehicles. Derivatives provide a way to make bets that are highly leveraged. Potential gain or loss on the bet can be relatively large relative to the initial cost of making the bet.
- Arbitrage: Derivatives can be used to take advantage of a price differential between two or more markets.
What are the Main Classes of Derivatives?
- Futures / Forwards
- Options
- Swaps
What is a Futures Contract?
An agreement to buy or sell an asset at a certain time in the future for a certain price.
– Futures contracts are traded on organized exchanges.
– Futures contracts are standardized.
– Futures contracts require a safety deposit known as “margin”.
What is a Forward Contract?
An agreement to buy or sell an asset at a certain time in the future for a certain price.
– Forward contracts trade in the over-the-counter market.
– Forwards can be tailored to the needs of the counterparty.
What is a Long Call? And a Short Call?
A Long call option is a contract where the buyer has the right, but not the obligation, to buy the underlying instrument.
A Short call is the obligation to sell the underlying instrument.
What is a Long Put? And a Short Put?
A Long Put option is a contract where the buyer has the right, but not the obligation, to sell the underlying instrument.
A Short Put is the obligation to buy the underlying instrument.
What’s the difference between European and American Options?
A European style option can only be exercised at expiry.
An American style option can be exercised at any time during the life of the option.
Graph the profit and payoff of a Long Call with a Strike price of $40 and a premium of 4.
Graph the profit and payoff of a Long Put with a Strike price of $30 and a premium of $6.
An option’s value consists of two components, what are these?
Its intrinsic value and its time value.
To determine the value of the option before maturity, we need to use a valuation formula, such as the Black-Scholes.
What is a complex Payoff?
It’s where we combine an option with its underlying asset or with another option to create a different payoff structure.
What is a Spread?
A spread is where an investor takes a position in two or more options of the same type.
What is a covered call?
A covered call is a strategy in which the writer of the option has a long position in the underlying asset. E.g. A short position in a call option plus a long position in the underlying asset (stock, for example).
A covered call will have limited downside risk should the underlying asset price increase.
We might do this if we like this stock for one particular reason. This is a way to further increase one’s return on that particular stock. You can therefore write an option in such a way that the probability that the option will be exercised against you will be small.
Keeping the long stock position limits the loss from the exercised short call while allowing you to profit from the short call initial premium.
What is a Protective Put?
A protective put is a strategy in which the buyer of the put option has a long position in the underlying asset.
E.g. buy one BHP stock and a put option on one BHP stock.
The protective put strategy will have limited downside risk if stock price falls.
If you want to buy the shares of a certain stock, believe that the price will increase in the long run, but realize the price might go down, so the buyer would be doing this to protect him or herself from potential downside.
What is a Bull Spread?
A Bull Spread is a position in which you buy a call and sell an otherwise identical call with a higher strike price.
Bull spreads can also be constructed using puts (buy a low-strike put and sell a high-strike put).
This requires initial investment because the lower strike price will cost more than the higher strike price, so the sale of the higher strike price option won’t cover the cost.
You’d create a bull spread because we think the stock price will go up, so we could just buy a call option, but if we’re wrong we’ll lose our premium, which we want to decrease. The bull spread allows us to do this.
What is a Bear Spread?
A Bear Spread is where one buys a put with one strike price and selling another with a lower strike price. In this sense, it’s the opposite of a bull spread.
As in bull spreads, we can create it with call options (buy a call with a high strike price and sell another with a lower strike price).
Bear spreads created using put options involve an initial cash outflow because the sale of the lower strike price put won’t cover the cost of the higher strike price put option purchase. The higher strike value gives it a higher price.
An investor who creates a bear spread believes that the stock price will decrease.
