Derivatives and Options

Question 1

What is a derivative security?

Answer 1

A financial instrument whose value is derived from an underlying asset (stock, bond, commodity, currency, or index)

Question 2

What are the primary uses od derivatives?

Answer 2

Hedging, speculation, and leverage

Question 3

Name the four main types of derivative securities.

Answer 3

Options, futures, forwards, swaps, warrants

Question 4

What is an option contract?

Answer 4

A contract giving the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a set price within a set period.

Question 5

What’s the difference between a call and a put option?

Answer 5

Call: right to buy the asset
Put: Right to sell the asset

Question 6

WHat is an option premium?

Answer 6

The price paid by the option buyer to the seller for the right conferred by the option.

Question 7

What are the main types of option expirations?

Answer 7

Weekly:1-5 weeks
Monthly:1-11 months, stard, expire third Friday
LEAPS: Greater than 1 year (Long-Term Equity Anticipation Securities)

Question 8

When do U.S. options typically expire?

Answer 8

3:00 p.m. CST on expiration Friday (or prior Thursday if Friday is a holiday)

Question 9

What does it mean to be “long” or “short” an option?

Answer 9

Long: You buy the option (right)
Short: You sell/write the option (obligation)

Question 10

What is a long call position?

Answer 10

Buying a call option; bullish outlook; risk limited to the premium, unlimited profit potential.

Question 11

What is a short call position?

Answer 11

Selling a call option; bearish outlook; profit limited to premium, potentially unlimited loss

Question 12

What is a long put position?

Answer 12

Buying a put option; bearish outlook; risk limited to premium, substantial profit if asset falls.

Question 13

What is a short put position?

Answer 13

Selling a put option; bullish outlook; profit limited to premium, potential for large losses if asset falls.

Question 14

WHat does “in the money’” mean for calls and puts?

Answer 14

Call: Strike price < asset price
Put: Strike price > asset price

Question 15

What does “at the money” mean?

Answer 15

Strike price=asset price (for both calls and puts)

Question 16

What does “out of the money” mean?

Answer 16

Call: Strike price > asset price
Put: Strike price < asset price

Question 17

How is an option’s value determined?

Answer 17

Option value=fundamental value+time value

Question 18

If a call option has a strike price of $75, stock price is $76, and premium is $2.75, what are the fundamental and time values?

Answer 18

Fundamental Value: $1 ($76-$75)

Time Value: $1.75 ($2.75-$1)

Question 19

If a put option has a strike price of $60, stock price is $55, and premium is $6.40, what are the fundamental and time values?

Answer 19

Fundamental value: $5 ($60-$55)

Time value: $1.40 ($6.40-$5)

Question 20

Name four bullish strategies.

Answer 20

Long call, short put, bull call spread, bull put spread

Question 21

Name four bearish strategies.

Answer 21

Long put, short call, bear put spread, bear call spread

Question 22

Why is options trading called a “zero-sum game”?

Answer 22

Every gain by one party is matched by a loss to another; net gain/loss is zero

Question 23

What is a futures contract?

Answer 23

A standardized, legally binding agreement to buy/sell a specified quantity of an asset at a set price on a future date.

Question 24

Name three key features of futures contracts

Answer 24

Standardization (asset, quantity, quality, delivery)

Margin Requirements

Mark-to-market daily settlement

Question 25

Who profits in a long futures position?

Answer 25

The buyer, if the asset price rises above the contract price at expiration.

Question 26

Who profits in a short futures position?

Answer 26

The seller, if the asset price falls below the contract price at expiration.

Question 27

Who are hedgers and speculators in the futures market?

Answer 27

Hedgers: Producers/processors protecting against price changes. Speculators: Investors seeking profit from price swings.

Question 28

How do options and futures differ in settlement?

Answer 28

Options: Can expire worthless (buyer loses premium). Futures: Marked to market daily; rarely held to delivery.

Question 29

List three differences between options and futures.

Answer 29

Obligation: Options are rights, not obligations; futures are obligations for both parties. Premium: Option buyers pay a premium; futures require margin, not a premium. Risk: Option buyer’s risk is limited to premium; futures have potentially large risks for both sides.

Question 30

What is a Bull Call Spread?

Answer 30

Market Outlook: Bullish (moderate) Construction: Buy an in-the-money (ITM) call, sell an out-of-the-money (OTM) call (same expiration, same underlying) Risk/Reward: Limited risk, limited profit Explanation: Profits if the underlying rises, but gains and losses are capped by the strikes. Example: Buy $50 call, sell $55 call.

Question 31

What is a Bull Put Spread?

Answer 31

Market Outlook: Bullish (moderate) Construction: Sell a higher-strike put, buy a lower-strike put (same expiration, same underlying) Risk/Reward: Limited risk, limited profit Explanation: Profits if the underlying stays above the higher strike; losses limited by the lower strike. Example: Sell $55 put, buy $50 put.

Question 32

What is a Bear Put Spread?

Answer 32

Market Outlook: Bearish (moderate) Construction: Buy a higher-strike put, sell a lower-strike put (same expiration, same underlying) Risk/Reward: Limited risk, limited profit Explanation: Profits if the underlying falls, but gains and losses are capped by the strikes. Example: Buy $55 put, sell $50 put.

Question 33

What is a Bear Call Spread?

Answer 33

Market Outlook: Bearish (moderate) Construction: Sell a lower-strike call, buy a higher-strike call (same expiration, same underlying) Risk/Reward: Limited risk, limited profit Explanation: Profits if the underlying stays below the lower strike; losses limited by the higher strike. Example: Sell $50 call, buy $55 call.