Introduction to options Flashcards
What is a derivative and an option?
financial assets whose value depends on an underlying asset. if the value of the underlying asset changes so does the value of the derivative.
Derivative markets are like gambling.
Options are a derivative because their prices depend on an underlying asset price. They are more popular due to their liquidity.
relatively cheap to trade and speculate on.
What can traders be categorised as?
hedges - firms, investors funds, managers and central banks looking to offset any losses on a portfolio with a gain in the option contract.
Speculators - are those who are gambling and betting on a future expectation.
Arbitrageurs - are those looking to exploit misprices when market is open (looking to make riskless profit)
What are options?
- unique type of financial contract that have a throwaway feature.
- only used if holder wishes to exercise their right.
give the right but not the obligation to buy or sell an asset at a predetermined price on a specific date in the future that we agree on now.
this means that the feature allows option users to obtain insurance against an adverse movement in the price of an asset whilst retaining the opportunity to benefit from favourable movements.
Maximum risk is the cost of the option.
How can they be bought?
- purchased on an exchange or direct from financial institution.
- exchange traded option are standardised and over the counter can be “tailor made”
- every contract has 2 sides: buyers and sellers.
European call and puts?
European call option - provide the right, but not the obligation to buy an asset at a predetermined price on a specific date.
European put option - provide the right but not the obligation to sell an asset at a predetermined price on a specific date.
exercise and strike price both mean the predetermined price.
What is a call purchase?
- position gives investor unlimited profit potential
- losses are limited to the call premium, C
What is a naked call write?
- for an investor to purchase an option, another investor must have written the contract.
- called a naked call write as we are assuming the writer of the option contract does not own the underlying stock.
- limits the investor to profit equal to C but unlimited loss possibilities.
- might seem unattractive but if you expect the option to never be exercised it can be motivation for writing an option.
if someone sells a call option they are expect the stock price to remain the same or fall.
the individual buying it is expecting the prise to rise.
what is a put purchase?
- put purchase provides the seller with a potential large profit opportunity.
-losses are limited to the premium, P.
- strategy required the stock price to decline.
Naked put write?
- expectation is that stock price not going to fall.
- opposite of put purchase.
how to classify options in terms of ‘their moneyness’ ?
in the money = when a call option exercises price X is less then underlying price and when a put options exercise price X is greater then the underlying asset price.
at the money = when an options exercise price X is equal to underlying price of asset.
out of the money = when a call options exercise price X is above the underlying price. When a put option exercise price X is less then the underlying asset price.
Exotic stratgeies?
An option can be combined with stocks and other options to generate several different investment strategies.
straddle - consists of buying both at the money call and at the money put with exercise price of X.
Strangle - involves buying an out the money call option, an out the money put option.
Strangle is cheaper so in constricted by capital better however breakeven point is further away
hedging?
- firms likely to hedge by buying call options if they are likely to buy the underlying asset at some date in the future
- Firms who anticipate selling an asset in the future would likely buy put options on the underlying asset.
