Options and Futures Questions Flashcards
What is a market maker?
A trader/invest firm that trades on the bid ask spread with the goal of reducing volatility in the market whilst improving liquidity.
They make money buy putting orders to market and hedging the risk using options.
Ie if they put in an ask order and buy a call option, if the price rises and they sell for less, they can buy back the stock for a theoretically lower price and sell again reducing the chance of losses.
What is a derivative?
A financial instrument that is derived from an underlying asset.
The derivative itself is a contract between two parties.
What is a future contract?
Future contracts are an agreement between two parties for the purchase and delivery of an asset. It is exercised at a specific date.
They can be used to hedge their risk or make use of an arbitrage opportunity.
Futures are traded on exchanges.
What is a forward contract and what is the difference between them and futures ?
Foward’s are similar but are not exchange-traded. They are only available OTC.
This means custom terms can be agreed (as the derivative is not standardised).
This increases counter-party risk. This means that the buyer or seller could fail to hold up their side of the contract.
What is an option and what is the difference between an option and a future?
An option is similar to a future contract, because it is an agreement to buy or sell an asset at a pre-determined maturity date for a specific price (which is called the strike price).
The key difference is that – at the maturity date – the buyer of the option is not obligated to either buy or sell the underlying asset.
This is a luxury for the buyer and a risk for the seller of the contract, which is incorporated in the price of an option.
What is an ETF?
An ETF usually tracks a basket of assets. Although similar in many ways, ETFs are different from mutual funds, because it will trade like common stocks on an exchange.
Give an example of an ETF trading at a premium?
The underlying assets are cheaper than the price of the ETF.
Benefits of an ETF?
Often diversified
Lower tax
Lower price
Negatives of derivatives
Difficult to value
What is a call option?
A call option is a financial contract that gives the buyer the right to BUY an asset at a specified price and within a specific time period. The buyer is not obligated to exercise the call option before- or at the maturity date
How do you profit off of a call option?
The buyer of a call option profits when the underlying asset increases in price. For example, if the buyer bought a call option for stock A at 50 dollars and in the meantime the price increases to 55 dollars, then the buyer of the call option could buy the underlying asset for 50 dollars instead of 55.
What is a put option?
A put option is a financial contract that gives the buyer the right to sell an asset at a specified price and within a specific time period. The buyer is not obligated to exercise the put option before- or at the maturity date.
How do you profit off of a put option?
The buyer of a put option profits when the underlying asset decreases in price. For example, if the buyer bought a put option for stock A at 50 dollars and in the meantime the price decreases to 45 dollars, then the buyer of the put option could sell the underlying asset for 50 dollars instead of 45.
What is the difference between an American option and a European option?
American options can be exercised before the maturity date.
European options cannot be exercised before the maturity date.
What is the difference between an American option and a European option?
American options can be exercised before the maturity date.
European options cannot be exercised before the maturity date.
Therefore American options are usually more expensive.
