Week 6 - Options

Question 1

Describe an option contract

Answer 1

a contract that gives you the right but not th obligation to buy or sell an asset for a specified price on a specified date

Question 2

Call option

Answer 2

this gives us the right to buy some underlying asset

Question 3

Put option

Answer 3

this gives us the right to sell some underlying asset

Question 4

option premium

Answer 4

the cost that falls on the option holder for the privilege of having the option to buy/sell

Question 5

long position (option contract)

Answer 5

different to futures and forward contracts, the long position in an option contract is the option holder - regardless of whether they buy or sell

Question 6

short position (option contract)

Answer 6

the short position in an option contract is the trader who has no choice in the execution - the option writer

Question 7

at the money

Answer 7

when the strike price = stock price

Question 8

in the money

out the money

Answer 8

when the option can be profitably exercised
when the option cannot be profitably exercised

Question 9

what is a European option

Answer 9

an option that can only be exercised on the maturity date

Question 10

payoff vs profit

Answer 10

the payoff is the value of the option upon maturity
profit takes into account the initial premium paid (the cost of the option)

Question 11

how are option payoff’s zero-sum

Answer 11

Holder and writer payoffs/profits are a trade-off - for one to make a profit the other must make an identical loss
This also means the diagrams are symmetrical

Question 12

Call holder profit/payoff equation

Answer 12

payoff = max (0, St - X)
profit = payoff - premium

Question 13

call writer profit/payoff equation

Answer 13

payoff = max (0, -(St - X)
profit = payoff + premium

Question 14

put holder profit/payoff equation

Answer 14

payoff = max (0, X - St))
profit = payoff - premium

Question 15

put writer profit/payoff equation

Answer 15

payoff = max (0, - (X - St))
profit = payoff + premium