Options, Futures and Other Derivatives Ch4

Question 1

Define an options contract.

Answer 1

An options contract grants the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a specific timeframe.

Question 2

Differentiate between a call option and a put option.

Answer 2

A call option gives the holder the right to buy an asset at a specified price within a predetermined period, while a put option gives the holder the right to sell an asset at a specified price within a predetermined period.

Question 3

Explain the concept of the strike price in options contracts.

Answer 3

The strike price is the pre-defined price at which the underlying asset can be bought (for call options) or sold (for put options) upon exercise of the option.

Question 4

Define intrinsic value in options.

Answer 4

Intrinsic value is the measure of the option’s value based on the difference between the current price of the underlying asset and the option’s strike price.

Question 5

Explain time value in options contracts.

Answer 5

Time value represents the additional value of an option beyond its intrinsic value, influenced by factors like time to expiration, volatility, and interest rates.

Question 6

What factors influence the price of an option?

Answer 6

Underlying asset price, strike price, time to expiration, volatility, risk-free interest rate, and dividends impact an option’s price.

Question 7

What is volatility in options trading?

Answer 7

Volatility represents the degree of variation of the underlying asset’s price, influencing the option’s price.

Question 8

Explain the significance of time to expiration in options.

Answer 8

As time to expiration decreases, the time value of options decreases, leading to potential decreases in option prices.

Question 9

Define implied volatility in options.

Answer 9

Implied volatility is the market’s expectation of the future volatility of the underlying asset, inferred from the option’s price.

Question 10

Explain the relationship between option prices and volatility.

Answer 10

Higher volatility generally leads to higher option prices due to increased uncertainty and potential for larger price movements.

Question 11

Explain the impact of interest rates on options pricing.

Answer 11

Changes in interest rates can affect the present value of future cash flows associated with options, influencing their prices.

Question 12

Define the concept of the option writer and the option holder.

Answer 12

The option writer (seller) is obligated to fulfill the terms of the contract, while the option holder (buyer) has the right but not the obligation to exercise the option.

Question 13

What are the advantages of using options contracts?

Answer 13

Potential for leverage, risk management, speculation, and flexibility in investment strategies are advantages of using options contracts.

Question 14

Explain the concept of delta in options trading and how it influences option prices.

Answer 14

Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset. It ranges from -1 to 1 for put options and from 0 to 1 for call options. A higher delta indicates a stronger relationship between the option price and the underlying asset price.

Question 15

Define gamma in options trading and its relationship with delta.

Answer 15

Gamma measures the rate of change of an option’s delta concerning changes in the underlying asset’s price. It represents the convexity of an option’s price curve. Higher gamma values imply more significant changes in delta for small changes in the underlying asset’s price.

Question 16

Explain the concept of theta in options trading.

Answer 16

Theta represents the rate of decline in an option’s value due to the passage of time. It measures the time decay of an option’s price, with options losing value as they approach expiration.

Question 17

Define vega in options trading and its significance.

Answer 17

Vega measures an option’s sensitivity to changes in implied volatility. Higher vega values indicate that the option’s price is more responsive to changes in implied volatility. It is crucial for assessing an option’s price sensitivity to changes in market volatility.

Question 18

Explain the significance of rho in options trading.

Answer 18

Rho measures an option’s sensitivity to changes in interest rates. It indicates the change in an option’s price concerning changes in the risk-free interest rate. Rho is more relevant for longer-dated options and can impact pricing in relation to interest rate movements.

Question 19

Discuss the concept of moneyness in options trading.

Answer 19

Moneyness refers to the relationship between an option’s strike price and the current price of the underlying asset. Options can be classified as in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM) based on this relationship, influencing their value and potential profitability.

Question 20

Explain the impact of dividends on options pricing.

Answer 20

Dividends can affect options pricing, especially for stocks, as they impact the underlying asset’s price. Ex-dividend dates and dividend amounts can influence the value of call and put options, particularly around dividend payment times.

Question 21

Define the concept of implied volatility skew and its significance.

Answer 21

Implied volatility skew refers to the differing implied volatilities for options with the same expiration date but different strike prices. It reflects market perceptions of potential price movements and risk at various strike prices, providing insights into market sentiment and potential trading strategies.

Question 22

Explain how options pricing models, like Black-Scholes and binomial models, are used in options markets.

Answer 22

Options pricing models, such as Black-Scholes and binomial models, help determine theoretical option prices based on underlying asset prices, strike prices, time to expiration, interest rates, volatility, and dividends. They aid in pricing options and assessing potential risks and profitability.