unit 2

Question 1

stocks vs. options

Answer 1

stocks have no expiration date, while options have expiration dates

Question 2

what is an option

Answer 2

options are contracts between a buyer and a seller, where the buyer has the right to buy or sell an underlying instrument at a specified price, and the seller has the obligation to fulfill the terms of the contract

Question 3

open interest

Answer 3

open interest is the number of contracts in existence, with long positions representing of puts or calls, and short positions representing sold (written) puts or calls

Question 4

intrinsic vs time value

Answer 4

intrinsic value is the amount by which an option is in the money, while time value is the amount of option value in excess of its intrinsic value

Question 5

exercise vs. assignment

Answer 5

exercise involves buying (call) or selling (put) shares of the underlying stock, while assignment is the reverse of exercise

Question 6

mechanics of being assigned

Answer 6

assignment occurs on short (written) positions, with the owner tendering an exercise notice to the broker

Question 7

strike price intervals

Answer 7

strike price intervals are generally 2 1/2 points when the strike price is between $5 and $25, 5 points when the strike price is between $25 and $200, and 10 points when the strike price is over $200

Question 8

premium quotation

Answer 8

premium quotation is stated in decimals, with one point equaling $100

Question 9

expiration date

Answer 9

the expiration date is typically the saturday following the third friday of the expiration month

Question 10

calls vs. puts

Answer 10

calls give the buyer the right to buy, while puts give the buyer the right to sell

Question 11

in the money, at the money, out of the money

Answer 11

these terms describe the relationship between strike price and the current price of the underlying instrument

Question 12

buyers

Answer 12

buyers can either by to open or buy to close positions

Question 13

sellers

Answer 13

sellers can either sell to open or sell to close positions

Question 14

why buy a call instead of the underlying stock

Answer 14

limit risk

Question 15

why buy a put

Answer 15

provides insurance for a position, lower profit potential than selling stock short

Question 16

mechanics of exercising

Answer 16

exercising an option involves the other side of assignment mechanics

Question 17

underlying instrument

Answer 17

the underlying instrument can be a stock, commodity, futures, foreign currency, or stock index

Question 18

exercise style

Answer 18

american-style options can be exercised on any business will result in delivery of the underlying stock on the third business day following exercise

Question 19

margin

Answer 19

purchase of puts or calls with 9 months or less until expiration must be paid for in full. writers of uncovered puts or calls must deposit/maintain 100% of the option proceeds plus 20% of the aggregate contract value

Question 20

last trading day

Answer 20

trading in equity options will ordinarily cease on the business day (usually a friday) preceding the expiration date

Question 21

call option

Answer 21

a call option lets you buy stocks at a set price for a certain time
- key point: buyer can choose to buy; seller must sell if asked
- quantity: each contract is for 100 shares

Question 22

buying calls

Answer 22

betting on stock price going up
-example: buy a call at $50, if stock goes to $56, profit $400

Question 23

selling calls

Answer 23

selling calls is betting the stock will go down

Question 24

two types of selling calls

Answer 24

covered calls (own stock) and naked calls (don’t own stock)

Question 25

put option

Answer 25

a put is a contract giving the holder the right to sell a set amount of stock at a specific price for a set time
- writers obligation: for the writer, it means they must buy the stock if the holder chooses to sell

Question 26

buying puts

Answer 26

buy puts if you think a stock will go down
- condition: stock price must drop below the put’s strike price for profit
-example: buy a $40 put for $2; if stock falls to $30, profit $800

Question 27

profit calculation

Answer 27

how it works: if you exercise your put at $30, you can sell stock at $40
-profit per share: buy at $30, sell at $40, profit $10 per share
- total profit: $10 x 100 shares= $1000; subtract cost of put ($200), net profit is $800

Question 28

black-scholes model components

Answer 28

key elements:
- strike price
- time value of money
- expected interest rates
- expected volatility (not measured)
-current stock prices
- expected dividends
- time to expiration

Question 29

assumptions of black scholes model

Answer 29

1. transaction costs (assumes no fees for buying options)
2. european costs (only considers options exercisable at expiration
3. interest rates and volatility (assumes known and constant rates)
4. effecient market theory (assumes no dividends during option life)

Question 30

black scholes formula

Answer 30

calculates option price without needing deep math
- formula: C= S(t) N(d1) - Ke^(-rt) X N(d2)
- components:
C= call option price
S= current stock price
K= strike price
r= risk-free interest rate
t= time to maturity
N= normal distribution