Options New Flashcards
What is an Option ?
An agreement that gives the investor the right (but not the obligation) to buy (or sell) an asset at a specific price on a particular date in the future.
What information do you need to price an option ?
- ) Price of the Underlying Asset
- ) Volatility of the Underlying Asset
- ) Risk Free Interest Rate
- ) Strike Price (the agreed price the asset can be bought or sold at)
- ) Maturity Date
What is the difference between a European Option and an American Option ?
A European option can only be exercised on the maturity date where as an American option can be exercised at any time.
Under what circumstances would you exercise an American Call Option on an Equity that pays no dividend ?
Never. American options are rarely exercised early.
All options have a positive time value and are usually worth more not exercised.
Owners who want to close out of an option position would prefer to sell it and sacrifice “some” time value rather than exercise early and sacrifice “all” the time value.
What is the Drift ?
This is a measure of the average rate of growth of the underlying asset.
What is the Option Premium ?
This is the price of the option contract.
What aspects do you have to consider when buying and selling options ?
Premium - The amount charged for the right
Strike Price - The agreed price the asset can be bought or sold at
Maturity Date - The date when the option can be exercised
Historical Volatility - derived from past data, usually the previous x number of daily closes
Implied Volatility - considers past data and also takes a view on the future
What is Historical Volatility ?
This is the annualized standard deviation of past stock price movements.
It measures the daily price changes in the stock over the past year.
What is Implied Volatility ?
This is derived from an option’s price and shows what the market “implies” about the underlying asset’s volatility in the future.
Implied volatility shows the market’s opinion of the asset’s potential movement in the future.
It does not forecast direction.
What is an ‘Uncovered’ Option ?
This is an option that is not backed by the an offsetting position in the underlying.
Also known as a naked option.
Can you draw the payoff diagram for buying a European call option ?
payoff = max(Current Price - Strike Price, 0)
Can you draw the payoff diagram for going short a European call option ?
payoff = -max(Current Price - Strike Price, 0)
Can you draw the payoff diagram for buying a European put option ?
payoff = max(Strike Price - Current Price, 0)
Can you draw the payoff diagram for going short a European put option ?
payoff = -max(Strike Price - Current Price, 0)
What is the Put-Call Parity ?
This is a relationship that must exist between the price of a European Call option and the price of a European Put option that has the same exercise price and maturity date.
It says that: if I buy a call option and an amount of cash equal to the present value of the exercise price then this gives me exactly the same payoff as selling a put option and buying the actual asset.
If this relationship did not exist then there would be an opportunity for risk-less profit (or arbitrage).
