Unit 2 - Session 9 - Types & Characteristics of Derivative Securities

Question 1

Derivative Securities

Answer 1

They derive their value from that of an underlying instrument, such as a stock, stock index, interest rate, or foreign currency.

Question 2

Option

Answer 2

A contract that establishes a price and time frame for the purchase or sale of a particular security. Two parties are involved, one exercises the contract to buy or sell the underlying security, the other is obligated to fulfill the terms of the contract

Question 3

Standardized Terms of Option Contracts

Answer 3

1. ) Underlying asset - the option on the stock are for XX share of the company’s common stock
2. ) Expiration Date - all options that expire in the specific month have the same time in that month
3. ) Exercise or strike price

Question 4

Types of option contracts

Answer 4

Calls and Puts

Question 5

Call

Answer 5

Option gives its holder the right to buy a stock for a specific price within a specified time frame. A call buys the right to buy a specific stock and a call seller takes on the obligation to sell the stock. “exercising” a call means to buy the stock at the strike price

Question 6

Put

Answer 6

Option gives its holder the right to sell a stock for a specific price within a specified time frame. A put buyer buys the right to sell a specific stock, and a put seller takes on the obligation to buy the stock. “exercising” the put means to sell the stock at the strike price

Question 7

Option Contract

Answer 7

Covers a 100 shares of stock. An option’s cost is its premium. Premiums are quoted in dollars per share.

Question 8

Leverage

Answer 8

An option’s cost is normally much less than the underlying stock’s cost, option contracts provide investors with the leverage: relatively little money allows an investor to control an investment that would otherwise require a much larger capital outlay

Question 9

What types of transactions are available to an option investor?

Answer 9

1. ) Buy Calls
2. ) Sell Calls
3. ) Buy Puts
4. ) Sell Puts

Option buyers are long the positions
Option sellers are short the positions

Question 10

Opening and Closing Transactions

Answer 10

Option conveys rights and obligations for a limited time. Each transaction has a beginning and an end - open and a close. An option position opened by an investor buying a call is closed when the call is exercised, sold, or expires. A position opened by an investor selling a call is closed when the call is exercised, bough, or expires.

Question 11

What is the difference between American and European style options?

Answer 11

American: The option can be exercised at any time, up to the expiration date
European: May only be exercised on the last trading day before the expiration date

“A” for American means Anytimes
“E” for European means Expiration Date

Question 12

LEAPS

Answer 12

Long-Term Equity Anticipation Securities

Question 13

Length of Option Contracts

Answer 13

Standard options are issued for max of 9 months

Question 14

Writing Puts

Answer 14

Investors who write puts believe that the stock’s price will rise or remain stable. A put writer (seller) is obligated to buy a stock at the exercise price if they put buyer puts it to the put writer

Question 15

Writing Calls

Answer 15

A bearish investor can write (sell) a call b/c they believe a stock’s price will stay the same or decline. If they have a long position on the stock the call writer will do it to hedge their position by offsetting any loss on the sale of the stock by the option premium amount.

Question 16

Covered Calls

Answer 16

When the option writer owns the stock on which the call is being written, therefore limiting the risk b/c no matter how hire the stock price rises, the writer uses the stock already owned to make delivery

Question 17

Naked Calls

Answer 17

When the option writer does not own the stock, the option is uncovered, the risk is unlimited b/c the writer must pay the going market price to acquire the stock needed to fulfill the obligation of delivery.

Question 18

Buying Puts

Answer 18

One believes a stock will decline in price and can speculate on the price declining by buying puts

Question 19

Straddles

Answer 19

Combing of a put and a call on the same stock with the same exercise price and expiration date. If the stock moves up, a profit is made on the call; if the stock moves down, a profit is made on the put

Question 20

Forward Contracts

Answer 20

Developed as a means for commodity users and producers to arrange for the exchange of the commodity at a time agreeable to both. A direct commitment between one buyer and one seller. Not a security so not regulated by the SEC, they are regulated by the Commodity Futures Trading Commission.

Question 21

Forward Contracts components

Answer 21

1. ) quantity of the commodity
2. ) quality of the commodity
3. ) time of delivery
4. ) place for delivery
5. ) price to be paid at delivery

Question 22

Future Contracts

Answer 22

Exchange-traded obligations. The buyer or seller is contingently responsible for the full value of the contract. Not a security so not regulated by the SEC, they are regulated by the Commodity Futures Trading Commission.

Question 23

Buyers of Futures

Answer 23

Goes long and establishes a long position and is obligated to take delivery of the commodity on the future date specificed

Question 24

Sellers of Futures

Answer 24

Establishes a short position and is obligated to deliver the commodity on the specified future date. If the seller does not own the commodity, the potential loss is unlimited and must pay the market price to deliver

Question 25

Close a futures position before delivery

Answer 25

the investor must complete a transaction opposite to the trade that initiated (opened) the futures position. The offsetting must occur in the same commodity, same delivery month, and on the same exchange