Options Flashcards
What are options?
- right to buy or sell something (counterparty has the obligation to do the opposite)
- at a predetermined price (strike price/exercise price)
- within a specified timeframe
- the right is granted by the option writer to the option buyer
- for a certain fee (option premium)
What is a call option?
The right to buy
What is a put option?
The right to sell
What does S symbolise?
The share price
What does X symbolise?
The exercise price
What is the role of the writer?
The writer (seller) receives 0.50 (premium), sits & waits
What is the role of the buyer?
The buyer pays 0.50 (the premium) and can:
1. sell the option to other investors on an option exchange
2. exercise the option
What effect does stock price have on the premium of an option?
The premium of call options moves in the same direction as the underlying asset, while the premium of the put option moves in the opposite direction.
What happens when the stock price goes up?
- premium of call goes up
- premium of put goes down
What happens with the option premium when the stock price goes down?
- premium of call goes down
- premium of put goes up
What is the gain/loss at expiration?
It is a zero sum game, the gain for the buyer = loss for the writer
Gain = pay off - option premium
When is an option at the money?
Both call and put are atm when S=X
When is a call in the money?
S > X
When is a call out of the money?
S < X
When is a put in the money?
S < X
When is a put out of the money?
S > X
Percentage returns
gain or loss / how much I paid (premium)
Are options a risky investment?
- buying options is risky as there is high volatility of return
- writing options is risky as the gain is limited (max premium), but the loss depends on the share price at the moment (unlimited)
What is the difference between a naked and a covered call?
Covered - as the option writer you already own the underlying asset
Naked - you don’t yet own the stocks
What is the value of an option?
- total price of the contract is = premium
- the option has intrinsic value and time value
What is intrinsic value?
- How valuable is it to exercise the option?
- Can never be negative (min = 0)
- Usually option premium > IV
How do we calculate IV of a call?
S - X (min = 0)
How do we calculate IV of a put?
X - S (min = 0)
What is the time value of an option?
More time to expiration makes the option more valuable
How do we calculate TV?
TV = premium - IV
What is the IV of a call and put when S=X?
call - IV = 0
put - IV = 0
What is the IV of a call and put when S > X?
call - IV > 0
put - IV = 0
What is the IV of a call and put when S < X?
call - IV = 0
put - IV > 0
What is the relationship between the value of a call option and S & X?
- higher S - higher option value
- higher X - lower option value
What is the relationship between the value of a put option and S & X?
- higher S - lower option value
- higher X - higher option value
What role does volatility of the shares have in options?
- higher volatility, higher chance of the option becoming in the money
- the TV of an option will be bigger when volatility of share price is bigger
What is the influence of share price on option value?
Call - positive
Put - negative
What is the influence of exercise price on option value?
Call - negative
Put - positive
What is the influence of time to expiration on option value?
Call - positive
Put - positive
What is the influence of volatility of share price on option value?
Call - positive
Put - positive
What is the influence of interest rates on option value?
Call - positive
Put - negative
What are American options?
Can be exercised at any moment
What are European options?
Can only be exercised at maturity
Should you exercise before maturity?
By exercising before maturity, you give away the time value. If you want to get out it’s better to sell the option.
