Options

Question 1

What are options?

Answer 1

• 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)

Question 2

What is a call option?

Answer 2

The right to buy

Question 3

What is a put option?

Answer 3

The right to sell

Question 4

What does S symbolise?

Answer 4

The share price

Question 5

What does X symbolise?

Answer 5

The exercise price

Question 6

What is the role of the writer?

Answer 6

The writer (seller) receives 0.50 (premium), sits & waits

Question 7

What is the role of the buyer?

Answer 7

The buyer pays 0.50 (the premium) and can:
1. sell the option to other investors on an option exchange
2. exercise the option

Question 8

What effect does stock price have on the premium of an option?

Answer 8

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.

Question 9

What happens when the stock price goes up?

Answer 9

• premium of call goes up
• premium of put goes down

Question 10

What happens when the stock price goes down?

Answer 10

• premium of call goes down
• premium of put goes up

Question 11

What is the gain/loss at expiration?

Answer 11

It is a zero sum game, the gain for the buyer = loss for the writer
Gain = pay off - option premium

Question 12

When is an option at the money?

Answer 12

Both call and put are atm when S=X

Question 13

When is a call in the money?

Answer 13

S > X

Question 14

When is a call out of the money?

Answer 14

S < X

Question 15

When is a put in the money?

Answer 15

S < X

Question 16

When is a put out of the money?

Answer 16

S > X

Question 17

Percentage returns

Answer 17

gain or loss / how much I paid (premium)

Question 18

Are options a risky investment?

Answer 18

• 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)

Question 19

What is the difference between a naked and a covered call?

Answer 19

Covered - as the option writer you already own the underlying asset
Naked - you don’t yet own the stocks

Question 20

What is the value of an option?

Answer 20

• total price of the contract is = premium
• the option has intrinsic value and time value

Question 21

What is intrinsic value?

Answer 21

• How valuable is it to exercise the option?
• Can never be negative (min = 0)
• Usually option premium > IV

Question 22

How do we calculate IV of a call?

Answer 22

S - X (min = 0)

Question 23

How do we calculate IV of a put?

Answer 23

X - S (min = 0)

Question 24

What is the time value of an option?

Answer 24

More time to expiration makes the option more valuable

Question 25

How do we calculate TV?

Answer 25

TV = premium - IV

Question 26

What is the IV of a call and put when S=X?

Answer 26

call - IV = 0
put - IV = 0

Question 27

What is the IV of a call and put when S > X?

Answer 27

call - IV > 0
put - IV = 0

Question 28

What is the IV of a call and put when S < X?

Answer 28

call - IV = 0
put - IV > 0

Question 29

What is the relationship between the value of a call option and S & X?

Answer 29

• higher S - higher option value
• higher X - lower option value

Question 30

What is the relationship between the value of a put option and S & X?

Answer 30

• higher S - lower option value
• higher X - higher option value

Question 31

What role does volatility of the shares have in options?

Answer 31

• 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

Question 32

What is the influence of share price on option value?

Answer 32

Call - positive
Put - negative

Question 33

What is the influence of exercise price on option value?

Answer 33

Call - negative
Put - positive

Question 34

What is the influence of time to expiration on option value?

Answer 34

Call - positive
Put - positive

Question 35

What is the influence of volatility of share price on option value?

Answer 35

Call - positive
Put - positive

Question 36

What is the influence of interest rates on option value?

Answer 36

Call - positive
Put - negative

Question 37

What are American options?

Answer 37

Can be exercised at any moment

Question 38

What are European options?

Answer 38

Can only be exercised at maturity

Question 39

Should you exercise before maturity?

Answer 39

By exercising before maturity, you give away the time value. If you want to get out it’s better to sell the option.