Chapter 20

Question 1

Financial option contract

Answer 1

Gives its owner the right (but not the obligation) to purchase or sell an asset at a fixed price at some future date

Question 2

Call option

Answer 2

Gives the owner the right to buy the asset

Question 3

Put option

Answer 3

Gives the owner the right to sell the asset

Question 4

Owner of the option

Answer 4

Holder
Has the right
Long position

Question 5

Writer of the option

Answer 5

Seller
Has the obligation
Short position

Question 6

Price at which the option gets exercised

Answer 6

Strike price or exercise price

Question 7

American option

Answer 7

Allow their holders to exercise the option on any date up to and including a final date –> expiration

Question 8

European option

Answer 8

Allow their holders to exercise the option only on the expiration date

Question 9

At the money

Answer 9

Exercise price = current price

Question 10

In the money

Answer 10

Payoff from exercising the option is negative

Call options with strike price < current stock price

Put options with strike prices > current stock price

Question 11

Out of the money

Answer 11

Payoff from exercising the option is negative

Call options with strike price > current sock price

Put options with strike price < current stock price

Question 12

Deep in the money or deep out of the money

Answer 12

Options where the strike price and the stock price are very far apart

Question 13

Hedging

Answer 13

Using an option to reduce risk by using a put option to offset the losses on an investor’s portfolio in a market downturn

Question 14

Speculate

Answer 14

Place a bet on the direction in which they believe the market is likely to move

Question 15

Payoff at expiration

Answer 15

How much money you make or lose from holding an option when it expires

Question 16

Call option payoff

Answer 16

You make money if the stock price > strike price

At expiration short
–> max (K - S, 0)
–> Profit max (K + fee - S, 0 - fee)

At expiration long
–> max (S - K, 0)
–> Profit max (S - K - fee, 0 - fee)

Question 17

Put option payoff

Answer 17

You make money if the stock price < strike price

At expiration short
–> max (S - K, 0)
–> Profit max (S + fee - K, fee)

At expiration long
–> max (K - S, 0)
–> Profit max (K - S - fee, 0 - fee)

Question 18

Call’s value

Answer 18

Maximum of the difference between the stock price and the strike price, and 0

Question 19

Straddle

Answer 19

When you have a long position on a put and call option with the same strike price

Question 20

Strangle

Answer 20

When you have a long position on a put and call option with slightly different prices

Question 21

Butterfly spread

Answer 21

When you buy two call options in long and two call options in short

Question 22

Put call parity for a European Option for a dividend paying stock

Answer 22

C = P + S - PV(Div) - PV(K)

Question 23

Factors affecting option prices –> Stock and Strike Price

Answer 23

Determine if an option will be in or out of the money

Question 24

Factors affecting option prices –> Type of option

Answer 24

An American option can’t be worth less than its European counterpart

A put option can’t be worth less than its strike price

A call option can’t be worth more than the stock itself

Question 25

Intrinsic value of an option

Answer 25

Value it would have if it expired immediately

Question 26

Time value of an option

Answer 26

The difference between the current option price and its intrinsic value

Question 27

American options can't be

Answer 27

Worth less than its intrinsic value - Can't have a negative time value

Question 28

The value of an option increases

Answer 28

With the volatility of the stock