Options Trading Flashcards
Option
An option gives the buyer the right to buy or sell a specified quantity of a specified underlying asset at a fixed price on or before a specified future date
Call
The right to buy the underlying
Put
The right to sell the underlying
Holder
The buyer
Writer
The seller
Exercise price
The price at which the holder of a call option can buy the underlying (or the holder of a put option can sell)
When describing an option what must be included?
Underlying asset name Expiry date Exercise/strike price Whether the option is a call or a put Notional size of trade
European style
May only be exercised in the expiration date
Bermuda style
May be exercised only on predetermined dates, or the expiration date
American style
May be exercised at any time up fo and including the expiration date. More expensive due to extra flexibility
Buying options advantages
- risk is limited to the option premium
- unlimited potential for profit
- you can select the strike price and expiry date
- can be used for speculation or hedging
Buying options disadvantages
- 90% of FX options expire worthless
- option premiums can be very expensive
- pricing is not transparent
- potential credit/ counterparty risk
Selling options advantages
- 90% of options expire worthless
- premiums can be lucrative and are likely to be retained
- you can select the strike price and expiry date
- can be used for speculation or hedging
Disadvantages of selling options
- unlimited potential for loss
* potential credit/ counterparty risk
Basic option positions
- long call: right to buy the underlying
- short call: potential obligation to sell the underlying
- long put: right to sell the underlying
- short put: potential obligation to buy the underlying
American style options pricing
Premium= intrinsic value + time value
Intrinsic value
Intrinsic value= underlying price -strike price
Intrinsic value is the inherent value of an option were it to be exercised now
Time value
The extra amount of premium that a buyer must pay due to potentially favourable price move in underlying between now and expiry
General rules of option pricing
The more chance of an option being in the money (ITM) at expiry, the higher the option premium
What increases the chances of being ITM?
Longer time to maturity
Higher implied volatility
Strike price being increasingly in the money relative to the forward outright (higher DELTA)
Time value decay
Time value decreases as the life of the option progresses. Means longer dated options are generally more expensive than shorted dated options. More time to expiry= higher premium
Backwardation
When longer dated options are cheaper than shorter dated options
Who does time decay act in favour of?
It acts in favour of the option writer and against the option holder
Hedging with options
The process of reducing the uncertainty due to changing prices
Hedging a long
To reduce the risk with owning an asset (e.g. if you are long the underlying, you should buy a put option)
Complex option strategies
•Directional strategies
- call spreads- moderately bullish
- put spreads- moderately bearish
•Volatility (you don’t need to know which direction the market is moving in, you’re banking on volatility increasing or decreasing)
- straddle
- strangle
Call spread
Strategy: moderately bullish
Buy call options at a specific strike price. Sell the same number of call options with the same asset, same expiry and higher strike.
Benefits of call spread
- lower cost (since the short call premium helps pay for the long call)
- spot doesn’t need to move far for the trade to become profitable
Disadvantages of call spread
•gains are capped at the difference between the two strike prices minus the net premium
Put spread
Buy an OTM put
Sell a put (same asset, same maturity, lower strike, hence lower premium)
Benefits of put spread
- Lower cost hence lower downside
* spot doesn’t have to move far for trade to be profitable
Disadvantages of put spreads
Gains are capped
Straddle
You expect spot volatility to increase but you don’t know which direction the price will move in.
Buy a put
Buy a call (same strike as put, typically close to ATM)
Benefits and drawbacks of straddle
You profit of spot moves significantly up or down.
You lose if spot doesn’t move far either way
Strangle
You expect spot volatility to increase but you don’t know which direction the price will move in.
Buy a put
Buy a call (with a higher strike than the put)
Benefits and drawbacks of strangle
+cheaper than a straddle
+profit if spot moves significantly up or down
-loss if spot doesn’t move far either way
-spot has to move quite far to generate profit
