Week 13 Flashcards
What is an option contract?
An option contract provides a party the right to buy or sell an asset at a fixed price on (European) or before (American) a certain time in the future. This fixed price is the exercise or strike price, and using your right to buy or sell is called exercising the option. The future time is called the expiration date / exercise date / maturity date / settlement date. The premium is the purchase price of the option, the compensation the buyer pays for the right to exercise the call option.
What does the options clearing house do?
Facilitates exchanges between option writers and option buyers by buying the option from the option writer and selling to to the buyer.
What type of options are there? When will the buyer exercise them?
Call options (holder has the right to buy, they will exercise if the exercise price is less than the asset price), or put options (the holder has the right to sell, they will exercise this only if the exercise price is greater than the asset price).
What is an in the money option, at the money or out of the money option?
In the money options mean the option is currently profitable (Call with exercise < asset price, put exercise > asset price), at the money means the exercise price is equal to the asset price, an out of the option is currently unprofitable (Call exercise > asset price, put exercise < asset price).
What is the payoff and profit for a call holder and call writer?
Call holder payoff: asset price-exercise price, or 0 if the asset price is less than or equal to the strike price.
Call writer payoff: -(asset price - strike price) or 0 if the asset price is less than or equal to the exercise price.
Call holder profit: payoff - premium.
Call writer profit:
payoff + the premium.
Why can purchasing options be useful for speculation?
Purchasing options can allow us to leverage an investment, by purchasing the right to buy more stock then you can currently afford in the future, because the premium will be far less than the cost of stocks. We will realise profits on all of these stocks if the change is profitable, even though we could not afford them otherwise.
What is a protective put?
A protective put involves purchasing an asset combined with a put option that guarantees minimum proceeds equal to the put’s exercise price. The payoff will be the strike price if the asset price is below or equal to the strike price, or the stock price if the asset price is above the strike price.
What is a covered call?
A covered call involves purchasing an asset together with the sale of a call option in that asset. It is good for someone intending to hold a stock a long time without expecting the price to change much. The payoff will be the stock value if the stock value is less than or equal to the strike price, or the strike price if the stock price is greater than the strike price.
What is a straddle?
A straddle is a combinantion of call and put, with the same exercise price and expiration date. These are good when we expect a large movement, but do not know which direction. The payoff will be the strike price minus the stock price if the stock price is less than the exercise price, or the stock price - the exercise price if the stock price is greater tha or equal to the strike price.
What is a spread?
Look it up dingus.
What is option valuation determined by? Which option type do they increase/decrease in value?
Stock price(call option increases, put decreases)
Exercise price(call option decreases, put option increases)
Volatility (put option and call option increase in value)
Time to expiration (increases call option and put option).
Interest rate(increases call option, decreases put option value).
Dividend payouts (decreases call option value, increases put option value).
What are the assumptions of the Black-Scholes option pricing formula?
- Underlying return is lognormally distributed, with a known, constant risk free rate.
- Volatility known and constant
- No tax and transaction costs
- No cash flow (dividend) on underlying
- Options are European style).
How do we account for dividends?
Substitute S0e^-delta*T for S0.
What is N(d) in the Black-Scholes formula?
The probability that a random draw from a normal distribution is less than d, normdist in excel.
What is the implied volatility?
Implied volatility is the volatility level for the stock implied by the option price, if the stock standard deviation is greater than the implied volatility the option is considered a good buy.
If there are two options on the same stock with the same expiration date but different exercise prices, the option with the higher implied volatility would be considered relatively expensive.
