3. Options

Question 1

What is an option? What are the six elements

Answer 1

1. Gives the buyer the right (but not the obligation, to buy (or sell)
2. A specified quantity of
3. A specified asset on/before
4. A specified future date at
5. A specified price for
6. A premium agreed today

Question 2

Options terminology - what are the three names given to the buyer of an option?

Answer 2

1. The buyer
2. The holder
3. The long

Question 3

Options terminology - what are the three names given to the seller of an option?

Answer 3

1. The seller
2. The writer
3. The short

Question 4

Summarise a call option from both sides?

Answer 4

The buyer/holder/long has bought the right (but not the obligation) to buy the underlying from the seller/writer/short. If they exercise the option, the seller/writer/short has an obligation to sell the underlying.

Question 5

Summarise a put option from both sides?

Answer 5

The buyer/holder/long has bought the right (but not the obligation) to sell the underlying to the seller/writer/short. If they exercise the option, the seller/writer/short has an obligation to buy the underlying.

Question 6

Explains how options are like insurance?

Answer 6

The buyer/holder/long has bought an insurance for a premium, giving them a right (eg policy holder) to exercise. If exercised, the writer (eg underwriter) has an obligation to settle.

Question 7

Explain what is an option on a future?

Answer 7

An option contract where the underlying is a futures contract. They are a derivative of a derivative.

Question 8

What is a European style option?

Answer 8

Where the holder has the right to exercise the option only on the expiry date.
(Think E for European and Expiry only)

Question 9

What is an American style option?

Answer 9

Where the holder has the right to exercise the option anytime up to expiry.
(Think A for American & Anytime)

Question 10

What is a Bermudan style option?

Answer 10

Where the holder has the right to exercise the option at certain fixed dates up to expiry (think hybrid of European and American style).

Question 11

European, American and Bermudan style options are sometimes referred to as what?

Answer 11

Plain vanilla options

Question 12

In addition to plain vanilla options, what are the other category of options called?

Answer 12

Exotic options

Question 13

Why are exotic options called this?

Answer 13

Because the payoffs are based on how the underlying assets price moves over whole/part of the options life.

Question 14

What is a lookback option?

Answer 14

Where the holder has the right to buy/sell the underlying at its lowest/highest price over the preceding period.

Question 15

What is a barrier option? What are the two types?

Answer 15

Where options existence and payoff depends on whether or not the underlying has reached a predetermined price.
1. Knock in - option is activated once the underlying has reached the predetermined price.
2. Knock out - option is deactivated once the predetermined price has been reached.

Question 16

What is a binary option? What is it also known as?

Answer 16

Also known as a ‘digital option’. Pays a fixed amount or nothing at all, depending on the price of the underlying at maturity or stated times prior to maturity.

Question 17

What is an Asian option? What are the two types?

Answer 17

An averaging pricing option.
1. Where strike price is set at the beginning and settlement price is the average price over the life of the option.
2. Where the strike price is the average traded price over the life of the option - “average strike option”.

Question 18

What is a choser option?

Answer 18

An option that allows the holder to decide whether the option is a call or a put, at a predetermined time during the options life.

Question 19

What is a compound option?

Answer 19

An option that gives the holder the right t purchase another option with specific strike prices at predetermined dates during the options life: calls on calls, calls on puts, puts on calls, puts on puts.

Question 20

What is a rainbow option?

Answer 20

An option on multiple underlying assets, sometimes referred to as; multi-asset options, correlation options or basket options.

Question 21

Draw the following profiles: long call, short call, long put, short put.

Answer 21

Draw

Question 22

Complete the strategy, max loss, max gain, and break even table.

Answer 22

Draw

Question 23

Why can options be called ‘wasting chattels’?

Answer 23

Because if the option is not exercised then it becomes worthless, and it has no value after expiry.

Question 24

Does moneyness of the option consider the premium?

Answer 24

No

Question 25

What is the rule concerning moneyness and intrinsic value? When does one exercise an option?

Answer 25

You exercise if there is ANY intrinsic value in the option, even if not break even.

Question 26

Explain how you hedge with options; if you are long the underlying, what is your concern and how do you hedge?

Answer 26

If you’re long the underlying, you are concerned about prices falling, so you would buy an option to sell a future. A protective put.

Question 27

Explain how you hedge with options; if you are short the underlying, what is your concern and how do you hedge?

Answer 27

If you’re short the underlying, you are concerned about prices rising, so you would buy an option to buy a future. A protective call.

Question 28

What are FLEX options?

Answer 28

They are hybrid instruments; exchange-traded products with some OTC features.

Question 29

What are the benefits of a FLEX option?

Answer 29

You have have an exchange traded product with the strengths of some standardisation, combined with some negotiable OTC options allowing some customisation.

Question 30

In a FLEX option, which three aspects are OTC?

Answer 30

1. The strike price
2. The expiry date
3. The expiry style