Chapter 15: Options Flashcards
How is an option a “derivative” security?
its value is “derived” from the value of the underlying asset.
Call Option
a contract that gives buyer the right to buy the underlying asset at strike price before expiration
Put Option
a contract that gives buyer the right to sell the underlying asset at strike price before expiration
Standardized Option Expiration Date
last day that an option can be exercised, this is the 3rd Friday of expiration month
European Options
can only be exercised on expiration day
American Options
can be exercised any time on or before expiation day
What are examples of organized option exchanges for standardized contracts?
CME Group (US) Montreal Exchange (Canada)
Options Clearing Corporation (OCC)
guarantees the option writer’s performance in the US market
Canadian Derivatives Clearing Corporation (CDCC)
the clearing agency for all derivatives exchanges in Canada (Montreal and Winnipeg). Brokerage firms merely act as intermediaries between investors and the CDCC.
In-the-money option
An option that would yield a positive payoff if exercised
Out-of-the-money option
An option that would NOT yield a positive payoff if exercised
At-the-money
stock price (S) and strike price (K) are equal
Option payoff
the value of an option at expiration for an European option. An option buyer can realize the option payoff by exercising the option
Option premium (or option price)
the cost to buy the option.
Option Profits
calculated by subtracting the option premium from the option payoff
Protective Put
Position: buy a stock and at-the-money put (S+P)
Objective: maintain unlimited upside potential with limited downside risk (buy the put as an insurance)
Covered Call
Position: own a stock and write a call (S - C)
Objective: Earn the call premium during low volatility period
Naked Call
Writing a “naked” call means writing a call option without holding the underlying stock.
The loss could be unlimited.
Straddle
Long Straddle: buy at-the-money call and at-the-money put on the same stock, with same expiration date and same strike price (C+P) Objective: buy a straddle when expecting large swings from strike price. The strategy will fail if there is no movement in stock price, and the options expire worthless. The buyer will lose the option premiums.
Short straddle: write a straddle for earning the option premiums when expecting no dramatic stock price movement from strike price -(C+P)
Spreads
A combination of two or more calls or puts with differing strike prices or expiration days
Use when stocks are expected in a trading range on the upside
Bear money spread
buy a put and write a put (further out of money). Use when stocks are expected in a trading range on the downside
Put-Call Parity
the difference between the call price and the put price equals to the difference between the stock price and the discounted strike price.
Stock index option
option on a stock market index
Intrinsic value
the payoff that option holders receive when the option is exercised
