Investments: Derivatives Flashcards
What is an option?
An Option is a derivative security
All transactions are handled through an option clearing house.
What determines the value of an option?
The value of an option depends on (is derived from) the value of another underlying asset.
What is an option contract?
Agreement between two parties, the seller (or writer) and the buyer
How many shares does one option contract control?
100 shares
What is a call option?
-the right to buy a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American options) or a specified future date (European options)
What is a put option?
the right to sell a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American options) or at a specified future date (European options).
What are the three reasons people invest in options?
- hedging
- Speculation
- Income
Call & Put Option Diagram
What does an option premium consist of?
It consist of intrinsic value and time premium
Intrinsic Value + Time Premium
How is intrinsic value of an option premium calculated?
Call option: stock price - strike price
Put option: strike price - stock price
*intrinsic value cannot be less than 0
Out, in or at the money?
Calculating again or loss using options: “StOPS”
St: stock gain or loss - if you own the underlying stock
O: Options gain or loss (*intrinsic value)
P: premiums paid or received
S: shares controlled or owned
Selling call option - example
Selling Put Options - example
What is a covered call?
- selling call options on a stock that is currently owned by the investor.
https: //www.youtube.com/watch?v=vFiIDopDqhQ
When is a covered call appropriate?
- for a stock that has been trading in a range, and the investor wants to generate some income but continue to own the stock.
- if an investor is considering selling a stock, but wants to generate some additional premium dollars and possibly get called out of the stock.
What is a married put?
Buying a put option on a stock or index that is currently owned by the investor.
What is a long straddle?
purchasing a put and a call option on the same stock.
Used if the investor expects volatility but is unsure as to the direction
What is a short straddle?
An investor sells a put and a call option on the same stock
Investor does not expect volatility and is hoping to keep the premiums with little to no volatility in stock price.
What is a Collar or Zero-Cost collar?
- Investor sells a call option at a strike price that is slightly higher than the current strike price. This creates a premium received.
- Investor buys a put option below the current stock price using the premium received by selling the call.
When would you use a collar or zero cost collar?
When an investor owns the underlying stock and wants to protect the downside risk without paying the entire cost of the put option.
What are the 3 option pricing models?
- Black/scholes
- Put/Call Parity
- Binomial Pricing Model
What is the Black/Scholes model?
- used to determine the value of a CALL option
- considers the following variables:
current price of underlying asset
Time until expiration
Risk free rate of return
Volatility of underlying asset
- all variables have a direct relationship on the price of the option.
- as strike price increases, option price goes down.
What is the Put/Call Parity?
Attempts to value a PUT option based on the value of the corresponding call option
Binomial Pricing Model
-attempts to value an option based on the assumption the stock can only move in one of two directions.
Taxability of options: call
- if contract lapses ( or expires) premium paid is a short term loss and the premium received is a short term gain.
- if contract is exercised, premium is added to stock price to increase basis in stock,
Tax ability of options: Put
- if contract expires without being exercised, the premium paid is a short-term loss and the premium received is a short term gain
What are Long term equity anticipation securities (LEAPS)?
- have longer expiration periods than traditional options.
- expirations that last for two or more years.
- traditional options have premiums of 9 months or less.
- premiums are higher due to extended time period
What are warrants?
- long term call options issued by the corporation.
- expiration usually 5-10 years
- terms are not standardized. Call options are generally standardized in terms of expiration month and number of shares.
Option example: client owns the stock
What are the two types of futures contracts?
Commodity futures contracts; underlying asset is copper, wheat, pork bellies, oil.
Financial futures contracts: underlying asset is currency interest rates, and stock indices
What are the differences between futures and options contracts?
- options give the holder the right to do something; futures obligate the holder to make or take delivery of the underlying asset.
- futures do not state the per unit price of the underlying asset, which is determined by supply and demand.
Future contracts are “marked to market”, what does that mean?
The gain or loss (in cash) is credited/debited to your account on a daily basis
What is the loss potential for selling and buying puts/calls?
Buying a put - option premium paid
Buying a call - option premium paid
Selling a naked put - strike price
Selling a naked call - unlimited
