Lecture 1: Options Flashcards
1.) Major types and characteristics of Options 2.) Explain the 6 factors which affects option values
Definition of an Option
The right (not an obligation), to force a transaction to occur at some future time on terms & conditions decided now.
Define: Call Option
Buyer obtains right to buy an asset from a seller in the future at a price determined now
Define: Put Option
Buyer obtains right to sell an asset to the seller in the future at a price determined now
Is a long call the opposite to a long put?
NO. The payoff from a long call is not the opposite of the payoff from a long put.
The opposite of a long call is a short call.
What is the value of an option
Intrinsic Value (IV) + Time Value (TV)
Define: IV
Payoff (Not profit) from an option if it were exercised immediately
Define: TV
Total value of an option minus the intrinsic value of an option.
For a call, intrinsic value is the difference between asset price and exercise price (if the difference is positive), or zero (if the difference is negative).
What is the IV from a call option
Max [Snow - X, 0]
What is the IV from a put option
Max [X - Snow, 0]
What is the moneyness of an option. Do we refer to the IV or the total option value?
Value of underlying asset relative to the exercise price (See IV not total option value)
What are the factors affecting IV?
- ) Current value of underlying asset
- ) Exercise Price
3) Expected Dividends
What are the factors affecting TV?
- ) Volatility
- ) Term to expiry.
- ) Risk-free interest rate
Current Value of Underlying Asset (Relationship / Explanation)
Call: +ve, Put: -ve
Asset more valuable > Increased payoff / increased probability of call option being exercised
Exercise Price (Relationship / Explanation)
Call: -ve, Put: +ve
Right to buy asset > Pay more > Less probability of call to be exercised / More payoff for put
Expected Dividends (Relationship / Explanation)
Call: -ve; Put: +ve
Dividends > Stock prices decreases > Lower underlying value of asset > decreases payoff/probability of call option being exercised
Volatility (Relationship / Explanation)
Call: +ve; Put: +ve
Increased probability of option value higher/;lower than exercise price
Term to Expiry (Relationship / Explanation)
Call: +ve; Put: +ve
Increased probability of option value higher/;lower than exercise price
Risk-free interest rate (Relationship / Explanation)
Call: +ve; Put: -ve
Call option expects a future cash outflow (X). As r increases, the PV of exercise price decreases, leading to higher payoff.
Put option expects a future cash inflow (X). As r increases, the PV of exercise price decreases, leading to lower payoff.
What happens to the buyer of a call option if he exercised his right on the day before the ex-dividend date
The buyer of the option will receive the dividend
What happens to the seller of a call option if the buyer exercises his rights after the ex-dividend date
The seller of the option receives the dividend despite not owning the stocks anymore
European option v. American option
Value (American) > Value (European)
American Option: Can be exercised at any time (including) expiry date
European Option: Can be exercise only on the expiry date
What is the minimum value of a call option
Min C = Max [S - (X/(1+r)), 0] because S - (X/(1+r)) is what will be received today.
However, a call does not require such an irrevocable declaration, and it is therefore worth more than the minimum value shown here.
What is the value of a call option on the expiry date.
Call value = Max [S * – X, 0]
Any other value would create an arbitrage opportunity
For example, if the 0 < call value at expiry < S*-X . Buy call >Exercise Option (buy asset) > Sell asset and it will be greater than the price of the call that you purchased!
What is the value of a put option on the expiry date. (CHECK)
Put value = Max [X - S*, 0]
Any other value would create an arbitrage opportunity
For example, if the 0 < put value at expiry < X - S*. Buy put > Buy Asset > Exercise option (sell asset) and it will be greater than the price of the put and asset that you purchased!
Should an American call option be exercised early?
No. Lose the Time Value of the option.
S - (X/1+r) > S - X
When should an American call option be exercised early?
It should be exercised before the ex-dividend date if the benefits of receiving the dividend outweighs the cost of losing the time value of option.
Should an American put option be exercised early?
May be optimal for deep-in-the-money put options.
Exercise price received early. By not exercising early, the option holder is incurring the opportunity cost associated with not being able to generate a return from the proceeds received.
