Unit 2 - Session 9 - Types & Characteristics of Derivative Securities Flashcards
Derivative Securities
They derive their value from that of an underlying instrument, such as a stock, stock index, interest rate, or foreign currency.
Option
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
Standardized Terms of Option Contracts
- ) Underlying asset - the option on the stock are for XX share of the company’s common stock
- ) Expiration Date - all options that expire in the specific month have the same time in that month
- ) Exercise or strike price
Types of option contracts
Calls and Puts
Call
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
Put
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
Option Contract
Covers a 100 shares of stock. An option’s cost is its premium. Premiums are quoted in dollars per share.
Leverage
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
What types of transactions are available to an option investor?
- ) Buy Calls
- ) Sell Calls
- ) Buy Puts
- ) Sell Puts
Option buyers are long the positions
Option sellers are short the positions
Opening and Closing Transactions
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.
What is the difference between American and European style options?
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
LEAPS
Long-Term Equity Anticipation Securities
Length of Option Contracts
Standard options are issued for max of 9 months
Writing Puts
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
Writing Calls
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.
Covered Calls
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
Naked Calls
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.
Buying Puts
One believes a stock will decline in price and can speculate on the price declining by buying puts
Straddles
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
Forward Contracts
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.
Forward Contracts components
- ) quantity of the commodity
- ) quality of the commodity
- ) time of delivery
- ) place for delivery
- ) price to be paid at delivery
Future Contracts
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.
Buyers of Futures
Goes long and establishes a long position and is obligated to take delivery of the commodity on the future date specificed
Sellers of Futures
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
Close a futures position before delivery
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
