Topic 8: Option Markets and Valuation

Question 1

In the money call and put

Answer 1

• Call: market price>exercise price

- Put: exercise price>market price

Question 2

Out of the money call and put

Answer 2

• Call: market price < exercise price

- Put: exercise price < market price

Question 3

At the money call and put

Answer 3

• exercise price and asset price are equal

Question 4

Payoffs and Profits at Expiration - Calls

Answer 4

• Notation
  Stock Price = ST Exercise Price = X
• Payoff to Call Holder
  (ST - X) if ST >X
  0 if ST < X
• Profit to Call Holder
  Payoff - Purchase Price
• Payoff to Call Writer
  (ST - X) if ST >X
  0 if ST < X
• Profit to Call Writer
  Payoff + Premium

Question 5

Payoffs and Profits at Expiration - Puts

Answer 5

• Payoffs to Put Holder
  0 if ST > X
  (X - ST) if ST < X
• Profit to Put Holder
  Payoff - Premium
• Payoffs to Put Writer
  0 if ST > X
  (X - ST) if ST < X
• Profits to Put Writer
  Payoff + Premium

Question 6

What is a protective put?

Answer 6

• long the stock and long the put

Question 7

What is a cover call?

Answer 7

• own the stock and write a call

Question 8

What is a collar?

Answer 8

• Collars are the combination of buying stocks, buying put and writing calls
• Suppose you are holding IBM, selling at $100. You can buy protective put with exercise price of $90, and write call option with exercise price $110. The two premiums may cancel out

Question 9

What is a long straddle?

Answer 9

• long call A, long put A (same exercise price A=X
• When to use: If market is near A and you expect it to start moving but are not sure which way to move.
• Profit: Profit open-ended in either direction. At
  expiration, break-even is at A, plus or minus cost
  of spread
• Loss limited to cost of spread. Maximum
  loss incurred if market is at A at expiration

Question 10

What is a short straddle?

Answer 10

• Short call A, short put A (same exercise price A=X)
• When to use: If market is near A and you expect market is stagnating. Because you are short options, you reap profits as they decay—as long as market remains near A
• Profit: Profit maximized if market, at
  expiration, is at A. In call-put scenario,
  maximum profit is credit from establishing
  position; break-even is A plus or minus
  that amount
• Loss: Loss potential open-ended in either
  direction. Position, therefore, must be
  closely monitored and readjusted to
  neutrality if market begins to drift away
  from A

Question 11

What is a bull spread?

Answer 11

• Bull spread: long call A, short call B; or long put A, short put B (A=X1, B=X2)
• When to use: If you think the market will go up somewhat or at least is a bit more likely to rise than fall. Good position if you want to be in the market but are unsure of bullish expectations. This is the most popular bullish trade
• Profit: Profit limited, reaching maximum if market
  ends at or above B at expiration. If call-vs.–call
  version (most common) used, break-even is at
  A + net cost of spread
• Loss: What is gained by limiting profit potential is
  mainly a limit to loss if you guessed wrong on
  market. Maximum loss if market at expiration is
  at or below A. With call-vs.-call version,
  maximum loss is net cost of spread

Question 12

What is a bear spread?

Answer 12

• Bear spread: short call A, long call B; or short put A, long put B
• When to use: If you think the market will fall somewhat or at least is a bit more likely to fall than rise. This is the most popular position among bears because it may be entered as a conservative trade when you are uncertain about bearish stance
• Profit: Profit limited, reaching maximum at
  expiration if market ends at or below A. If put-vs.
  –put version (most common) used, break-even
  is at B - net cost of spread
• Loss: By accepting limit to profits, you gain a
  limit to risk. Losses, at expiration, increase as
  market rises to B, where they stabilize. With putvs.-put version, maximum loss is net cost of
  spread