Options Flashcards
Define options
Option contracts provide holders with right (without obligation) to buy/ sell standard quantity of underlying asset on fixed future date
So called (holders have option to exercise or walk away)
Leveraged derivative products
Agreed price from outset payable on expiry date
Holders must pay upfront premium (non refundable)
Categories of options
OTC - bespoke financial products without exchanges / contract with individual T&Cs negotiated between buyer and seller
Exchange traded options (Euronext.liffe)
Options terminology
Options writer - original seller/ person who agrees to create option and sell to holder
- must provide underlying asset FFD in event of exercise
- options once created can be traded through broker/ traded in secondary markets
- risk taking
Holder - party in possession of option: holds the right/ brought from broker or seller directly
Underlying - asset which option is based (commodity that’s price changes)
Standard quantity - agreed contact size/ whole numbers/ standardised
Expiry date - specific date holder must have brought sold or abandoned option/ last day it can be exercised
(American, European styles and Bermuda system; exercisable @ number of pre specified times before expiry (hybrid)
Strike price - price holder can purchase form or sell underlying asset if they exercise option (FIXED)
Option premium - upfront payment holder must pay to writer or broker for the option (non refundable)
Types of options
Call;
Give holder right (without obligation) to buy standardised quantity of an underlying asset on fixed future date @ strike price
- writer has obligation to sell asset in event of the option being exercised
- max loss is premium
- no further margin calls required
- holders only exercise if profitable; must take into account strike price, premium & commissions to calculate NP
Put options;
Give holder right without obligation to sell standardised quantity of an underlying asset @ strike price to writer
- writer has obligation to buy asset
- Short positions/ anticipate price fall/ exercise option to writer and holder can buy asset in spot market for cheaper (knowing can resell for more)
How to work out holders profit made
Holders profit
Strike price
Less market price (p) or price paid (c)
Less premium
= profit per share and % return
Users of options
Institutional or individual writers & traders
High degree of leverage affords large returns from small initial outlay (only fraction of amount required to gain same degree of exposure as direct investment)
Uses
Speculators
- increase exposure to markets / huge potential returns from price volatility
- sell put options through broker
Hedgers
- attempt to reduce exposure by covering existing position (insurance policy)
- buy call options (want to hold or buy asset)
- losses of assets can be offset by increase in value of options
Risks of options
(Purchaser perspective)
Purchase of options know max potential loss which included premium & transaction costs
-limited to amount paid/ if large prem due to size of option could lose a lot
- Option holder won’t exercise if strike price higher than market price (no profit as buy directly in market cheaper)
- risks vary for writers depending if they created covered or naked options
- covered warrants created by writers who own underlying asset / security to protect themselves from adverse price movements
- naked warrants created by writers who don’t own asset, for call options must go buy in market to sell to holders; for put must commit to buy and sell and can either sell at loss in market or hold onto and hope price recovers
Rewards of options
(Seller perspective)
- option premium guaranteed
- maximise return/ favourable returns to minimise losses/ anticipate matters won’t go holders way
- considerable rewards as it’s unlikely share will change from £1 to £1000 prior expiry
How is option premium priced
1) price volatility of underlying asset
2) period of time until expiry date (longer = more risk = larger premium)
3) risks involved
4) strike price @ close out date (difference in today’s price and close out day price)
What does the option premium consist of
Intrinsic value
-difference in value now and strike price / profit is option exercised immediately
= market price - exercise price
Time value
= option premium - intrinsic value
If exercise price > market price no intrinsic value and option premium only made of time value alone
What happens when holder pays premium
They become in possession of the option without any obligation, however contractual obligation when option is exercised for writer to deliver (call) or buy (put)
Once prem paid no rights to asset unless option exercised
Holder obligations to pay premium now as agreed & pay strike price or provide asset at expiry date
Outline the 3 money options
In the money;
Value to holder / option has intrinsic value
At the money;
Market price and exercise price are equal (both the same)
Out the money;
Option has no intrinsic value
Market price £3 and exercise price is £5
