Unit 16: Options Flashcards
3 standardized terms for options:
- The underlying asset. All options on common stock are for 100 shares.
- The expiration date. All options that expire in a specific month have the same date
- The exercise or strike price. Strike prices are set at standardized intervals.
A for American means
anytime
E for European means
expiration date
Length of an option contract
- 1 week (weeklys) to 3 years (LEAPS)
- Most are 9 months
- All options, regardless of their length, are derivative securities
Why buy calls?
an investor can profit from the increase in the stock’s price while investing a relatively small amount of money
Why write calls?
generate income from the option premium, partially hedge a long stock position by offsetting any loss on the sale of the stock by the premium amount
Why buy put?
one who speculates a stock will decline in price, a hedging strategy when the investor is long the stock
Why sell puts?
source of income, investor believes the stock’s price will rise or remain stable
What is a straddle?
combining of a put and a call on the same stock with the same exercise price and expiration date, when an investor is not sure which direction the market will move but has a strong opinion that there will be dynamic movement
When you buy a straddle, you profit from:
volatility
When you sell a straddle, you profit from:
stability
Are rights and warrants derivatives?
Yes - their value is derived from the common stock
Rights:
- Given, not sold, to existing holder of the common stock
- Exercisable at a price below the current market
- Short lifespan - they will expire in 45-60 days
- Can be sold and then the buyer can exercise them
- Can be left to expire
Warrants:
- Exercisable at a price above the current market
- Life is considerable longer than rights and longer than call options as well.
- When detached, they can be traded like any other security (they are usually traded on the same exchange as the company’s common stock)
- Most securities professionals view warrants as call options with a very long time to expiration.
- Warrants do not have voting rights, the same as any other derivative.
One major difference between call options and rights/warrants is that
options originate on the exchange on which they are traded. Rights/warrants originate with the issuer of the stock.
Forward Contracts were developed as a means:
for commodity users and producers to arrange for the exchange of the commodity at a time agreeable to both.
A forward contract is a
direct commitment between one buyer and one seller. If the position is held until the closing date, the forward seller is obligated to make delivery and the buyer is obligated to take delivery.
Forward contracts are not:
therefore not traded on an exchange bc they are non-standardized
Futures:
- Exchange-trade obligations
- gains /losses are computed daily for all open futures
Futures are commonly used
by speculators while forwards are used by producers (farmers). That explains why such a small percentage of futures contracts ever end with delivery.
Farmers use forwards to
hedge the risk of the price of the commodity falling before it is able to be harvested and sold. To hedge, sell a forward contract on that commodity. However, the producer is giving up any potential gain in the event the prices rise above the agreed upon one.
Regulation of Futures and Forwards
- Because they are not securities, they do not come under the jurisdiction of the SEC
- SRO that is in charge of regulating the futures market is the Commodity Futures Trading Commission (CFTC)
- Forward contracts are NOT regulated by any agency
