Topic 11 - Financial Options Flashcards
What are financial options?
A contract that gives its owner the right to trade an underlying asset at a specified exercise price (a.k.a strike price) on or before a specified expiration date
Call option
Right to buy the asset at the strike price
Put option
Right to sell the asset at the strike price
Long put
Right to sell
Want stock to Fall (or stay) below strike price
Can buy at market price, then sell at higher strike for a positive payoff
Long Call
Right to buy
Want the stock to Rise (or stay) above the strike price
Can buy at strike from writer, then sell at higher market price for a positive payoff
Short Call
Want stock to Fall (or stay) below strike price
If the option is unexercised, then the seller keeps the premium and has no further liability
Short Put
Want the stock to rise (or stay) above strike price
If the option is unexercised, the the seller keeps the premium and has no further liability
What are the three types of option contracts?
European
Bermudian
American
Bermudian Option Contracts
Can only be exercised on select pre-specified dates before the options expiration date
European Option Contracts
Can only be exercised on the option’s expiration date
American Option Contracts
Can be exercised at any time up to and including its expiration date
Who trades financial options?
Like any contract, an option contract has two counterparts
- The option buyer (holder)
- The option seller (writer)
What is the price of an option, and why would an option seller require compensation?
Price of an Option: The buyer pays an option premium to the seller.
Compensation: Sellers demand an option premium to compensate for the risk of loss if the holder exercises the option.
What is the intrinsic value of an option?
The intrinsic value is the greater of the option’s payoff if exercised today and $0. It’s the value it would have if it expired immediately.
What is extrinsic (time) value in options pricing?
Extrinsic (time) value is the remaining value that makes up the option’s premium. It derives from the probability that the intrinsic value will increase in the future before expiry due to favorable movements in the price of the underlying asset.
On what types of assets and where are options traded?
Underlying Assets: Options are traded on a variety of assets, including stocks, ETFs, foreign currency, commodities, futures, and other derivatives.
Market Places: Options are traded on financial exchanges and over-the-counter markets.
How are options used for hedging (insurance)?
Put Option: Guarantees you can sell an owned asset for at least the strike price.
Call Option: Ensures you won’t pay more than the strike price for a future purchase.
What are the primary objectives of hedging and speculation?
Hedging: Primarily defensive, aimed at protecting against potential losses.
Speculation: Primarily offensive, aimed at making a profit from market movements.
What is required when options are purchased and sold?
When options are purchased, they are paid for in full.
Margin is required when options are sold, and there are special rules set by the broker for other trading strategies.
What do the following notations in options trading mean?
T
St
K
Ct
Pt
ATM
ITM
OTM
T - expiration time
St - stock price at time t
K - strike price
Ct - value of call option at time t
Pt - value of put option at time t
ATM - at the money
ITM - in the money
OTM - out of the money
What does “ATM” (At The Money) mean in options trading?
ATM (At The Money) means that the stock price 𝑆𝑡 is equal to the strike price 𝐾.
What does “ITM” (In The Money) mean in options trading?
ITM (In The Money) means that the holder would receive a positive payoff from immediately exercising an option.
What does “OTM” (Out Of The Money) mean in options trading?
OTM (Out Of The Money) means that the holder would receive a negative payoff from immediately exercising an option.
At what price would you exercise a call option with a strike price of $30 and a premium of $4.69 upon expiry?
The option should be exercised if the stock price is above $30 at expiry. The premium paid ($4.69) is a sunk cost and does not affect the decision to exercise the option. The investor focuses on the option’s payoff, which is positive if the stock price exceeds $30.
How do calls and puts amplify risk and reward in options trading?
Call options are like leveraged investments because they allow you to control a large amount of stock with a relatively small upfront cost (the premium).
This leverage means that potential gains can be significant if the stock price rises, but you also risk losing the entire premium if the price does not go up.
Put options function similarly, but they bet on the stock price decreasing.
You can achieve substantial gains if the stock price drops, but you risk losing the premium if the price stays the same or increases.
In both cases, the options magnify both potential rewards and risks, providing an opportunity for higher returns but also higher losses.
What are two types of option combinations?
Options can be combined with other options or assets into portfolios to create a wide variety of payoff/profit patterns
Long Straddle
Short Straddle
What factors affect the values of call and put options?
Call value increases and Put value decreases with the price of the stock
Volatility
Time to Expiry
Strike Price
Risk-Free rate
How does volatility affect the values of call and put options?
Volatility increases the value of both call and put options. Higher volatility means there is a greater chance for the stock price to move significantly, increasing the potential for both positive and negative payoffs.
How does time to expiry affect the values of call and put options?
Time to expiry increases the value of both call and put options. More time allows greater opportunity for the stock price to move favorably, thereby enhancing the potential payoff for both types of options.
How does the strike price affect the values of call and put options?
Put Options: A higher strike price makes a put option more valuable because it gives the holder the right to sell the stock at a higher price, which can be beneficial if the stock price falls.
Call Options: A higher strike price makes a call option less valuable because it gives the holder the right to buy the stock at a higher price, which is less desirable if the stock price doesn’t rise significantly.
How does the risk-free rate affect the values of call and put options?
Impact: A higher risk-free rate decreases the value of both call and put options.
Discounting Effect: It increases the discounting effect on the option’s future payoff, reducing its present value (PV).
Future Payoff: As the risk-free rate rises, the future payoff is worth less today, making the option less valuable.
Calls and puts can have negative values (T/F)
False
Calls with lower strike are more valuable than otherwise identical calls with higher strike (T/F)
True
Puts with higher strikes are worth more than otherwise identical puts with lower strikes (T/F)
True
An American option can be worth less than its European counterparts (T/F)
False
A put option cannot be worth more than its strike price (T/F)
True
A call option cannot be worth more than its strike price (T/F)
False
An American option with a later expiration date cannot be worth less than an otherwise identical American option with an earlier expiration date (T/F)
True
What are the key characteristics of an option buyer (holder)?
Rights: Holds the right to exercise the option and has the long position in the contract.
Optionality: Exercising the option is not obligatory; the holder will only exercise if it is in their best interest.
Expiration: If not exercised, the option will expire unexercised, and the contract will cease to exist.
What are the key characteristics of an option seller (writer)?
Position: Sells (writes) the option and holds the short position in the contract.
Liability: Similar to repaying borrowed stock; has an obligation to fulfill the contract if exercised by the long side (called “assignment”).
Contingent Liability: If the long side exercises the option, the short side must buy or sell the stock, leading to potential losses.
How is the total price of an option determined?
The total price of an option is the sum of its intrinsic value and extrinsic (time) value.
What is a naked call (short position), and what are its risks and rewards?
Naked Call: Occurs when an investor sells a call option without owning the underlying stock. The investor is “naked” because they have no asset to deliver if the option is exercised.
Risk: The risk is unlimited because the stock price can rise indefinitely, forcing the seller to buy the stock at market price and sell it at the lower strike price.
Reward: The maximum reward is the premium received for selling the call option.
What is a naked put (short position), and what are its risks and rewards?
Naked Put: Occurs when an investor sells a put option without having enough cash or the underlying stock to cover the purchase if the option is exercised.
Risk: The risk is substantial, as the investor may be forced to buy the stock at the strike price, even if the stock price drops significantly.
Reward: The maximum reward is the premium received for selling the put option.
How do you interpret the details of “5 MVRE MAY 9 CALL for $3”?
5 Options Contracts: Represents 5 contracts.
MVRE: Ticker symbol for the underlying asset.
MAY: Expiration date (quote month).
9: Strike price (the price at which the asset can be bought).
CALL: Indicates a call option (right to buy the asset at the strike price).
$3: Call option premium (the price paid per share for the option).
What is a long straddle in options trading?
A long straddle involves buying both a call and a put option with the same underlying asset, expiration date, and strike price.
What is a short straddle in options trading?
A short straddle involves writing (selling) both a call and a put option with the same underlying asset, expiration date, and strike price.
Why would an investor use a long straddle?
A long straddle is used when expecting large movements in the stock price in either direction, such as an impending announcement that could be very good or very bad.
Long Naked Call
Long Naked Call: This refers to buying a call option without owning the stock or any other protective position. This is simply a regular call purchase, which is not usually called “naked.”
Risk: The risk is limited to the premium paid for the option.
Reward: The reward can be unlimited if the stock price rises significantly.
Long Naked Put
Long Naked Put: This refers to buying a put option without owning the stock or having a protective position. Again, it’s simply a regular put purchase.
Risk: The risk is limited to the premium paid for the option.
Reward: The reward is substantial if the stock price falls significantly.
Protective Put
Long Stock and Long Put = Hedging against a decline in stock price.
Position: The investor owns the stock (long position) and buys a put option (long position).
Purpose: This strategy is used to protect against a decline in the stock price. The put acts as a hedge, limiting the potential loss if the stock price falls.
Risk: The risk is limited to the stock price drop plus the cost of the put premium.
Reward: The potential reward is the upside of the stock minus the cost of the put option.
Protective Call
Short Stock and Long Call = Hedging against an increase in stock price.
Position: The investor shorts the stock (sells stock without owning it) and buys a call option (long position).
Purpose: This strategy is used to limit losses on the short position if the stock price rises. The call acts as insurance, capping the loss if the stock price increases.
Risk: The risk is limited to the price increase of the stock (capped by the long call option) plus the cost of the call premium.
Reward: The potential reward is the downside of the shorted stock minus the cost of the call option.
Covered Call
Long Stock and Short Call = Generating income from a flat or moderately rising stock.
Position: The investor owns the stock (long position) and sells a call option (short position).
Purpose: This strategy generates income through the call premium while holding the stock. It is often used when the investor believes the stock price will stay flat or rise slightly.
Risk: The risk is the stock price falling (potentially large losses if the stock declines significantly).
Reward: The reward is limited to the stock’s price appreciation up to the strike price, plus the premium received from selling the call option.
How is the value of an option determined?
Option Value: Present value of the option’s expected payoff to the buyer, which is the writer’s liability.
Expected Payoff: Function of how likely the option is to be exercised and its expected value when exercised.
What is a key characteristic of option trading? (a.k.a what is a zero sum game?)
Option trading is a zero-sum game; the writer’s loss is the buyer’s profit and vice versa.
How is the intrinsic value calculated for call and put options?
Call Option:
max(𝑆−𝐾,0)
Put Option:
max(𝐾−𝑆,0)
How does the intrinsic value differ for ITM and OTM options?
ITM (In-The-Money): Positive intrinsic value.
OTM (Out-Of-The-Money): Zero intrinsic value as it’s not beneficial to exercise.
Why can’t an American option be worth less than its intrinsic value?
An American option can’t be worth less than its intrinsic value because it can be exercised at any time. This means the option holder can always choose to exercise the option if the intrinsic value is positive, ensuring that the option’s price (a.k.a option premium) is at least equal to its intrinsic value.
How is the time value of an option calculated?
The time value of an option is the difference between the current option price and its intrinsic value. It represents additional value due to the time remaining until the option’s expiration.
Why is time value important in options pricing?
Time value accounts for the possibility that the option could become more profitable before it expires. The longer the time to expiration, the higher the time value, making the option more valuable.
Where can you find quotes for options traded on the Chicago Board Options Exchange (CBOE)?
Quotes can be found on the CBOE website or in any brokerage account.
What should you consider when trading options on the TMX Montreal Exchange?
The TMX Montreal Exchange is smaller with lower volume. Consider liquidity risk carefully before trading, as the bid-ask spread may be wide.
How are options used for speculation?
Put Option: Bet on a stock price drop.
Call Option: Bet on a stock price increase.
Market Efficiency: These bets are subject to market efficiency, with amplified effects of being wrong or right.
How are options used to exploit arbitrage opportunities?
Options can exploit arbitrage opportunities by creating synthetic positions and opposite positions.
When you buy a call option and sell a put option at the same strike price and expiration date, you’re creating a synthetic long position.
The underlying asset is priced at $100.
Call option with a strike price of $100 is priced at $5.
Put option with a strike price of $100 is priced at $7.
By buying the call and selling the put, you create a synthetic long position that should theoretically cost you the same as buying the underlying asset, but here it costs you less ($5 for the call, and you receive $7 for the put, netting a $2 credit). If the underlying asset’s price moves up, your call option gains value, while you are not affected by the put option you sold.
This is a basic way to exploit arbitrage by taking advantage of mispriced options.
Opposite positions involve selling overpriced options while holding the underlying asset. This allows traders to capitalize on discrepancies in pricing and earn risk-free arbitrage profits.
Sell the Overpriced Call Option: You sell a short call options at $15.
Buy the Underpriced Put Option: You buy the put option at $2 (creating safety net if the stock price drops)
Hold the Underlying Asset: You already own the stock, which is priced at $100.
If the price were to increase to $110 at expiration then the call option will be exercised so you will have to sell your stock at $100 (strike), and your put optionbecomes worthless as (St>K) but you still made a risk-free profit of $13 by selling an overpriced call option.
How should the success or failure of hedging be evaluated?
Success/failure should be interpreted within the broader business context for why the hedge was necessary.
A loss on the option position is not necessarily a failure if it served its purpose of protection.
How should the success or failure of speculative trading be evaluated?
For speculation, the option position is the end goal itself.
A loss on the speculative position is considered a failure that the trader must be capable of tolerating both financially and mentally.
How are option contracts typically structured and priced?
Option contracts have a strike price 𝐾 to buy (sell) 𝑁 shares, with 𝑁 typically being 100 shares.
Premiums quoted are per share amounts, so the cost of 1 option trade is 100 times the quoted premium.
How do regular cash dividends affect option terms?
No adjustments are made to the option terms for regular cash dividends, meaning the holder of a call option misses out on any regular dividends paid on the stock.
How do stock splits and dividends impact options?
Stock splits/dividends impact options by decreasing the strike price and increasing the underlying shares pro rata. For example, in a 2:1 stock split, the strike price is halved, and the underlying shares double.
Note: only special dividends can adjust strike prices (like decreasing the strike price by the dividend amount) but not for regular dividends which do not adjust for strike price but do affect option value indirectly b/c of ex-dividend date
How do expected cash dividends impact the value of a call option?
Dividend Payment and Stock Price Decline: When a company pays a dividend, the stock price typically drops by the dividend amount on the ex-dividend date.
Impact on Call Option Value: The potential profit from exercising the call option decreases, making the call option less valuable.
Reason for Value Decrease: The drop in stock price reduces the difference between the stock’s price and the strike price, lowering the intrinsic value of the call option.
Why would an investor use a short straddle?
A short straddle is used when expecting minimal movement in the stock price.
What is important to remember about profit and market movement when using straddles?
Profit in each direction sounds appealing, but you must expect more movement (or less for a short straddle) than the market, otherwise, you will not cover the option premium.
What is a formula to calculate the breakeven point for a Covered Call?
Breakeven Point = Purchase Price of Stock - Premium Receiving from Selling Option
You make money from the call premium and are protected if the stock price drops below your purchase price minus the premium
What is a formula to calculate the breakeven point for a Protective Call?
Breakeven Point = Initial Short Sale Price of Stock + Premium Paid from Buying Long Call Option
- You short the stock, betting on a price drop.
- You buy a long-call option as insurance against the rising price.
- If the stock price does rise, you exercise the call option to buy the stock at the strike price and cover your short position.
When the stock price reaches the breakeven point, you’re effectively breaking even on your initial short sale when accounting for the premium paid for the call option. Above this price, you would start incurring losses, but the call option will cap your maximum loss if the stock price rises significantly.
Ex:
Initial Short Sale Price: $50 per share (the price at which you shorted the stock).
Call Option Strike Price: $55 per share (the price at which you can buy the stock if needed).
Premium Paid for Call: $1.50 per share.
BreakevenPoint=$50+$1.50=$51.50
Potential Loss Management:
If the stock price rises to $60:
You exercise the call option to buy at $55 (strike price).
Your total cost per share is $55 (strike price) + $1.50 (premium) = $56.50.
Compared to the market price of $60, you limit your loss to $3.50 per share.
What is a formula to calculate the breakeven point for a Protective Put?
Breakeven Point = Purchase Price of Stock + Premium Paid for Put
You have the right to sell the stock at the strike price, so your protection is the premium paid plus the stock price.
