Unit 3: Derivatives Flashcards
Basic Options
1) What are Derivatives? What are some examples of Derivative securities?
2) What are Futures?
3) What are the 2 different types of basic options contracts? How do they work?
1) Derivatives are contracts that derive value from that of another underlying asset. They track the value of other assets and are priced accordingly. An example of derivative securities are Options Contracts.
2) Futures are derivative contracts that track the commodity markets. So, the value of futures contracts are based on the price of commodities such as gas, oil, gold etc. Futures are a type of derivative that have commodities as the underlying asset, Futures are not securities.
3) There are 2 types of basic options contracts. There are Calls and there are Puts, and you can buy and sell options and puts.
a) Long Put : An investor who purchases a Long Put, is purchasing the right to sell shares of a stock at a strike price that is below the current market price. A Long-Put investor is a bearish investor who expects the price to fall.
b) Short Put : An investor who purchases a Short put, is getting in return an obligation to buy a certain number of shares at a strike price below the current market price. They are a bullish investor.
c) Long Call : An investor who purchase a Long Call, is purchasing the right to buy shares of stock at a strike price above the current market price. They are bullish on the stock.
d) Short Call : An investor who purchases a Short Call, is in return getting an obligation to buy a certain number of shares at a specified strike price above the market price. This investor is bearish on the stock.
In/Out/At The Money, Intrinsic & Time Value and Option Premium
1) When are call options described as IN, AT, and OUT of the money.
2) When are call options described as IN, AT, and OUT of the money.
3) What is intrinsic value? How is it calculated? When are Calls and Puts considered to have intrinsic value? When are options considered to be at parity?
4) What is time value and what is dependent on? What is the formula for it?
1)
a) call options are described to be in the money when the current market price of the underlying stock is above the strike price. buyers of call options Want to be in the money and sellers do not.
b) options are described to be at the money when the current share price of the underlying asset is equal to the strike price. The buyer of the option will not exercise the contract when he’s at the money buyers don’t want to be at the money sellers want to be at the m.
c) call options are described to be out of the money when the current market value of the underlying asset is below the strike price. The buyer of the option will not exercise the contract as he does not want to be out of the money and the seller wants to be out of money.
2)
a) put options are described to be in the money when the share price of the current underlying asset is below the strike price. Buyers of put options. Want to be in the money and sellers are put options don’t want to be in the money.
b) put options on described at the money when the market value of the underlying asset is equal to the strike price. The buyer of the put option will not exercises contract. Buyers do not.
c) put options are described to be out of the money when the stock price of the underlying asset is above the strike price. Buyers don’t want out-of money puts, sellers want out-of money puts.
3) Intrinsic value = Strike Price - Current Market Price. Intrinsic value can only be a positive number or zero.
- A call option has intrinsic value when the market price is above the strike price of a call option. Buyers want calls with intrinsic value, sellers do not.
- A put option has intrinsic value when the market price is below the strike price. A put option buyer wants a contract with intrinsic value, a seller does not.
- An options contract is considered to be at parity when the premium of an options contract is equal to the intrinsic value.
4) Time Value is a subjective number based on the supply and demand of the underlying asset, as well as the price volatility. The Time Value of an options contract is any premium in excess of intrinsic value. There are 2 factors that intrinsic value is based on:
- Time until expiration : The more time till expiration, the higher the time value the option will have
- Volatility of the price of underlying asset : The more volatile the price, the more time value in the premium
Non Equity Options
1) What are Non-Equity Options? What are the different kinds of non-equity options?
2) What are the American Style options exercise rules vs the European style options exercise rules?
1) Non equity options don’t have stocks as their underlying asset. Although, they function the same way as equity options.
- Index Options
- Index options allow investors to
- Interest Rate Options
- Are yield based.
- Currency Options
- Currency options allow investors to hedge against currency inflation and deflation risk. Exporters who believe the value of a foreign currency will fall, will buy puts of the foreign currency. Importers who believe a foreign currency will fall, will buy calls of the foreign currency.
2) American style exercise options rules allow option contracts to be exercised on or before the expiration date. Nearly all equity and equity index options trade American style.
European style exercise options allows you to only exercise contracts on the expiration date. Most foreign currency and yield based options trade European style.
Option Calculations: MG, ML, BE
1) How is BE, MG, ML calculated for Long Calls and Short Calls?
2) How is BE, MG, ML calculated for Long Puts and Short Puts?
Hedging Risk with Options
1) What are Protective Puts? How is B/E calculated for these?
2) What are Protective Calls? How is B/E calculated for these?
1) Protective put options allow investors to hedge against any risk against the stock falling in value. A protective put is usually used by investors who are long a stock, as it locks in a minimum share price the investor can sell his shares for in case the stock falls.
- When calculating B/E on protective puts, remember that there are two parts: The long stock, and the protective put.
- B/E for protective put w/long stock = Original Stock Price + Premium.
- In order to breakeven on the position, the stock price must rise above the B/E price.
2) protective calls are usually utilized by investors who are short of stock. They use protective calls to hedge against any risk against the stock rising and value in which they would lose money. so they purchase protective calls, Long Calls, which locks in a maximum share price in which they can sell their shares for in case the share price of the stock continues to rise past the strike price.
- remember that a short position on a stock has unlimited risk
- B/E for a protective put on a short position is calculated as the original stock price minus the premium.
Generating Premium Income
1) What are covered calls? Uncovered Calls?
2) What are covered Puts? Uncovered Puts?
1) an investor can write covered calls when they already own shares of the underlying stock and are looking to generate income without selling those shares. When the buyer of the call option exercises the contract, the writer of the call option will be able to execute the transaction. Covered Calls allow investors to generate income without selling those shares
Uncovered Calls our calls sold by investors in which they don’t own any shares of the underlying stock. When the buyer exercises the option the seller would have to buy the shares in order to deliver the shares to the buyer. This is considered extremely risky as it is impossible to know what the market price of a stock will be.
2) covered puts are sold by investors who have the Cash that is necessary to buy the shares from the buyer of the put option and so the transaction can be done and the cash can be delivered to the buyer
Uncovered Puts are when the writer of the uncovered put option doesn’t have the cash to purchase the shares at the strike price if the buyer exercises his contract. The writer has to come up with the cash elsewhere.
Administration and Compliance
1) What two entities are responsible for regulating Options Trading?
2) What is the process for setting up an Options Trading Account?
1) The Chicago Board of Options Exchange (CBOE) and the Options Clearing Corporation (OCC) are responsible for regulating options trading
2) - An investor will notify their interest of trading options
- A BD will assess their financial standing to trade options
- The OCC issues an Options Disclosure Document (ODD) to the investor.
- The account is approved by a Registered Options Principal (ROP) from accredited firm
- Any opening transactions take place.
- The investor must return the sinned ODD within 15 days, or any opening transactions are closed and account is deactivated.
