Derivatives (Lesson 8)

Question 1

How many shares does an option contract control

Answer 1

• 100 shares

Question 2

What is call option

Answer 2

• is the right to buy a specified number of shares at a specified price within a specified period of time (American option) or at a specified future date (European option)

Question 3

What is a put option

Answer 3

• is the right to sell a specified number of shares at a specified price within a specified period of time (American option) or at a specified future date (European option)

Question 4

What are the three reasons that people invest in options

Answer 4

• Hedging
• Speculation
• Income

Question 5

What does a buyer of a call option believe

Answer 5

• the price of underlying stock will rise

Question 6

What does a buyer of a put option believe

Answer 6

• the price of underlying stock will fall

Question 7

What does a seller of a call option believe

Answer 7

• the price of underlying stock will fall or stay the same

Question 8

What does a seller of a put option believe

Answer 8

• the price of the underlying stock will rise or stay the same

Question 9

If the investor wants to maximize the gain if the stock price appreciates the investor will

Answer 9

• buy a call

Question 10

If the investor wants to maximize the gain if the stock price falls the investor will

Answer 10

• buy a put

Question 11

What does the option premium consist of

Answer 11

• Intrinsic value
• Time premium

Question 12

What is the intrinsic value of an option

Answer 12

• Call Option: Stock Price - Strike price
• Put Option: Strike Price - Stock Price
• Cannot be less than $0

Question 13

What is the time value of an option

Answer 13

• TV = Premium - Intrinsic Value

Question 14

How do you calculate the gain or loss of an option

Answer 14

• consider two components:
• Intrinsic value and premium paid
• STOPS
• St: Stock Gain or loss - if you own the underlying stock
• O: Options gain or loss
• P: Premium paid or received
• S: Shares controlled or owned

Question 15

(Options Trading Strategies)

Covered Call

Answer 15

• selling call options on stock that is currently owned by the investor
• appropriate for a stock that has been in a trading range and the investor wants to generate some income and continue to own the stock

Question 16

(Options Trading Strategies)

Married Put

Answer 16

• involves buying a put option no a stock or index that is currently owned by the investor
• called portfolio insurance if the investor owns a diversified portfolio of common stocks

Question 17

(Options Trading Strategies)

Long Straddle

Answer 17

• investor buys a put and a call option on the same stock
• investor expects volatility but is unsure as to the direction

Question 18

(Options Trading Strategies)

Short Straddle

Answer 18

• investor sells a put and a call option
• investor does not expect volatility and is hoping to keep the premiums with little to no volatility in the stock price

Question 19

(Options Trading Strategies)

Collar or Zero Cost Collar

Answer 19

• investor owns the underlying stock but wants to protect the downside risk without paying the entire cost of the put option
• Investor sells a call option at a strike price that is slightly higher than the current stock price (Creates the a premium received)
• Investor then buys a put option that is below the current stock price
• Premium dollars received by selling the call are used to buy the put option

Question 20

When an investor wants to protect profits or lock in gains the correct option strategy is

Answer 20

• buying a put

Question 21

What does the Black/Scholes model determine

Answer 21

• the value of a CALL option

Question 22

What are the variables for the Black/Scholes model

Answer 22

• Current price of the underlying asset
• Time until expiration
• Risk free rate of return
• Volatility of the underlying asset

Question 23

All the variables for the Black/Scholes model have a ____ relationship on the ______ of the option except the _____ _____

Answer 23

• Direct relationship
• Price of the option
• Strike Price

Question 24

As the strike price increases the option _____ in value

Answer 24

• Decreases

Question 25

What is the Put/Call parity option pricing model

Answer 25

- Attempts to value a PUT option based on the value of a corresponding call option

Question 26

What is the binomial pricing model for pricing options

Answer 26

- attempts to value an option based on the assumption that a stock can only move in one of two directions

Question 27

Tax consequences of a call or put option expiring

Answer 27

- if contract lapses or expires then the premium paid is a short term loss or premium received is a short term gain

Question 28

Tax consequences of a call option being exercised

Answer 28

- premium is added to the stock price to increase the basis - if underlying stock is held for more than 12 months it will be considered a LT capital gain, if less than or equal to 12 months it is a ST capital gain

Question 29

What are Long Term Equity Anticipation Securities (LEAPS)

Answer 29

- options that have longer expiration periods than traditional options - Premium is higher because of the extended time period

Question 30

What are warrants

Answer 30

- essentially long term call options issued by the corporation - Call options written by investors

Question 31

Are warrant terms standardized

Answer 31

- Not standardized - call options are standardized

Question 32

Which way of purchasing of selling an option has the greatest loss potential

Answer 32

- Selling a naked call

Question 33

What are the two types of future contracts

Answer 33

- Commodity futures - Financial futures

Question 34

What are the differences between futures and options contracts

Answer 34

- option contracts give the holder the right to do something and futures contracts obligate the holder to make or take delivery of the underlying asset - Futures contracts do not state the per unit of the underlying asset which is determined by supply and demand

Question 35

Who are the two primary players in the futures market

Answer 35

- Hedgers and speculators

Question 36

What kind of accounting are futures contracts on and what does it mean

Answer 36

- Marked to Market - the gain or loss is credited to your account on a daily basis

Question 37

Types of hedging using futures: Long the commodity, Short the contract

Answer 37

- Have the commodity and want to lock in profits

Question 38

Types of hedging using futures: Short the commodity, Longthe contract

Answer 38

- Don't have the commodity but have to purchase it to make their own product