Topic 4 - Option Prices Flashcards
Definition of an Call/Put Option
A financial contract that gives the owner the right but not the obligation to buy/sell an asset at a fixed price at some future date
Option Holder
the buyer of the contract, referred to as having a long position
Option Writer
is the seller of the contract, referred to as having a short position
what is the difference between American and European options
US options can be exercised at any time before expiration whereas EU options can only be used on the expiration date.
At-the-money
when the current market price is equal to the exercise price
in the money / at the money / out the money
at the money = when the current market price of a stock is equal to the exercise price
in/out the money = when the current market price of a stock is higher or lower than the exercise price
Why use an option ?
if someone sees a good opportunity but doesn’t have the money yet, they can buy put options to capture the gain
Call Option
Gives us the right to buy a stock at a predetermined price.
If the current price is higher than our exercise price then we buy it at our lower price and sell it at the current price to make a profit
Put Option
Gives us the right to sell a stock at a predetermined price. If the current price is lower than out exercise price then we will buy it now at current price and sell it at our higher price
hedging
using an option to reduce risk
long position
You’re buying a contract that gives you the option to buy or sell an underlying asset at a predetermined price.
short position
You’re selling a contract that gives you the obligation to fulfill it if the buyer exercises it.
Binomial Option Pricing Model
This model prices option by making the assumption that upon expiration the stock has 2 possible values - up or down.
It models the potential movements of the underlying assets in attempt to value the option.
put call parity + formula
This describes the relationship between a put and call option with the same exercise price. Because they both provide the same payoff, the law of one price states that they must have the same price, so:
C = P + S - PV(K) - PV(Div)
Inputs of Black-Scholes Option Pricing Model
A mathematical framework used to find the fair prices of stock options based on 6 variables:
S - current market price
PV(K) - strike price
rf - risk free interest rate
volatility - the stocks volatility
time - time until expiration
