Options, Futures, and Other Derivatives Flashcards
In the Money
At the Money
exercise of the option produces a positive cash flow
Call: exercise price < asset price
Put: exercise price > asset price
At the Money exercise price and asset price are equal
Put/Call Parity
Formula on sheet
• Defines the relationship between a European put option and a European call option where the strike prices and expiration are identical
• This concept says the price of a call option implies a certain fair price for the corresponding put option with the same strike price and expiration and vice versa.
• Put-call parity doesn’t apply to American options because you can exercise them before the expiry date.
If the put-call parity is violated, then arbitrage opportunities arise.
Straddles
- a strategy in which an investor purchases both a put and call on the same security with the same strike price and expiration
- used when an investor believes the stock price will move significantly but does not know which way the stock will go (up or down)
Spread Options
A spread is a combination of two or more calls (or two or more puts) on the same stock with differing exercise prices or times to maturity.
•Some options are bought, whereas others are sold, or written.
•A bullish spread is a way to profit from stock price increases.
Vertical Spread Options
Horizontal Spread Option
Diagonal Spread Options
- a strategy where an investor buys and sells two options on the same underlying asset that have the same expiration date but different strike prices
- a strategy where an investor buys and sells two options on the same underlying asset that have the same strike price but different expiration dates. Also called “calendar spreads” and “time spreads”
- a strategy where an investor simultaneously enters into a long and a short position in the same type of option (call options or put options) and where the contracts have different strike prices and expiration dates
Collars
• an options based hedge that involves selling (writing) an out of the money call and buying an out of the money put on an underlying asset that has imbedded gains
• this strategy is intended to lock in profits by buying downside protection while calls are sold to generate income to help pay for this downside protection
–Net outlay for options is approximately zero.
A advantage of covered call
If you planned to sell the stock when the price rises above X anyway, the call imposes “sell discipline.”
Forward vs Future
•Forward a deferred delivery sale of an asset with the sales price agreed on now.
•Futures similar to forward but feature formalized and standardized contracts.
•Key difference in futures
–Standardized contracts create liquidity
–Marked to market
–Exchange mitigates credit risk
Basics of Futures Contracts
- A futures contract is the obligation to make or take delivery of the underlying asset at a predetermined price.
- Futures price the price for the underlying asset is determined today, but settlement is on a future date.
- The futures contract specifies the quantity and quality of the underlying asset and how it will be delivered.
Basics of Futures Contracts 2
- Long a commitment to purchase the commodity on the delivery date.
- Short a commitment to sell the commodity on the delivery date.
- Futures are traded on margin.
- At the time the contract is entered into, no money changes hands.
Calculating profit on futures contracts
- Profit to long = Spot price at maturity - Original futures price
- Profit to short = Original futures price - Spot price at maturity
- The futures contract is a zero sum game, which means gains and losses net out to zero.
- Unlike a call option, the payoff to the long position can be negative because the futures trader cannot walk away from the contract if it is not profitable.
Four main categories futures are traded in
- Agricultural commodities
- Metals and minerals
- Foreign currencies
- Financial futures
Futures: Margin and Marking to Market
- Marking to Market each day the profits or losses from the new futures price are paid over or subtracted from the account
- Convergence of Price as maturity approaches the spot and futures price converge
Spot futures parity theorem
two ways to acquire an asset for some date in the future:
1.Purchase it now and store it
2.Take a long position in futures
These two strategies must have the same market determined costs
Variables on formula sheet:
F represents the cost of something on the futures market
S represents the cost of something on the spot market
R represents the applicable rate
y represents the storage cost
T represents time
Spreads on futures contracts
•If the risk free rate is greater than the dividend yield on commodity (rf > d), then the futures price will be higher on
longer maturity contracts.
•If rf < d, longer maturity futures prices will be
•For futures contracts on commodities that pay no
dividend, d=0, F must increase as time to maturity
increases.
