Options Flashcards
What is an option?
A contract giving the holder the right (but not the obligation) to buy/sell an asset at a specified price (strike price) on or before a specified date (expiration date). The buyer must pay the seller a premium for the option.
What is a call option?
An option contract giving the holder the right to buy the asset.
What is a put option?
An option contract giving the holder the right to sell the asset.
What is an in-the-money, at-the-money, or out-the-money option?
At the money:
S = X
In-the-money option has intrinsic value:
S > X (call option)
S < X (put option)
Out-the-money option has no intrinsic value:
S < X (call option)
S > X (put option)
What are the upper bounds for the price of options (above which arbitrage would be possible)?
c ≤ S0 and C ≤ S0
P ≤ X
p ≤ Ke^-rT
What are the lower bounds for the price of options (above which arbitrage would be possible)?
c ≥ max(S0 - Ke^-rT, 0)
p ≥ max(Ke^-rT - S0, 0)
What is a principal-protected note?
Combination of a zero-coupon bond and an option to protect the principal with upside potential. The return earned by an investor depends on the performance of the underlying asset but a PPN guarantees a minimum return equal to the investor’s initial principal amount.
What is a covered call?
Long stock + short call option
Generates premium income but upside limited to premium
What is a protected call?
Short stock + Long call option
Downside limited to premium
What is a covered put?
Short stock + Short put option
What is a protective put?
Long stock + Long put option
Downside limited to premium, unlimited upside
What is a bull spread?
Long low strike price option, short higher strike price option (same underlying asset, same maturity). Limits upside and downside risk. Done if the investor anticipates a moderate increase in price.
What is a bear spread?
Long high strike price option, short low strike price option.
An investor who enters into a bear spread is expecting the stock price to decline slightly.
What is a butterfly spread?
Long one high strike and one low strike price option, short two middle strike price options.
An investor who enters into a butterfly spread is expecting the stock price to fluctuate slightly near middle price.
What is the delta of a stock option?
The ratio of the change in the price of a stock option to the change in the price of the underlying stock. It is the number of units of the stock we should hold for each option shorted in order to create a riskless portfolio. The delta of a call option is positive whereas the delta of a put option is negative.
What are the key differences between American and European options?
American options can be exercised at any time before expiration, and are thus more flexible and expensive.
European options can only be exercised at expiration.
If a stock pays dividends, American call options might be exercised early to capture dividends. European options cannot be exercised early, so their valuation is adjusted for dividends.
European options are simpler to price and are priced using models like Black-Scholes, while American options often require binomial trees.
