# Investments: Derivatives Flashcards

1
Q

What is an option?

A

An Option is a derivative security

All transactions are handled through an option clearing house.

2
Q

What determines the value of an option?

A

The value of an option depends on (is derived from) the value of another underlying asset.

3
Q

What is an option contract?

A

Agreement between two parties, the seller (or writer) and the buyer

4
Q

How many shares does one option contract control?

A

100 shares

5
Q

What is a call option?

A

-the right to buy a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American options) or a specified future date (European options)

6
Q

What is a put option?

A

the right to sell a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American options) or at a specified future date (European options).

7
Q

What are the three reasons people invest in options?

A
1. hedging
2. Speculation
3. Income
8
Q

Call & Put Option Diagram

A
9
Q

What does an option premium consist of?

A

It consist of intrinsic value and time premium

10
Q

How is intrinsic value of an option premium calculated?

A

Call option: stock price - strike price

Put option: strike price - stock price

*intrinsic value cannot be less than 0

11
Q

Out, in or at the money?

A
12
Q

Calculating again or loss using options: “StOPS”

A

St: stock gain or loss - if you own the underlying stock

O: Options gain or loss (*intrinsic value)

S: shares controlled or owned

13
Q

Selling call option - example

A
14
Q

Selling Put Options - example

A
15
Q

What is a covered call?

A
• selling call options on a stock that is currently owned by the investor.
16
Q

When is a covered call appropriate?

A
• for a stock that has been trading in a range, and the investor wants to generate some income but continue to own the stock.
• if an investor is considering selling a stock, but wants to generate some additional premium dollars and possibly get called out of the stock.
17
Q

What is a married put?

A

Buying a put option on a stock or index that is currently owned by the investor.

18
Q

A

purchasing a put and a call option on the same stock.

Used if the investor expects volatility but is unsure as to the direction

19
Q

A

An investor sells a put and a call option on the same stock

Investor does not expect volatility and is hoping to keep the premiums with little to no volatility in stock price.

20
Q

What is a Collar or Zero-Cost collar?

A
1. Investor sells a call option at a strike price that is slightly higher than the current strike price. This creates a premium received.
2. Investor buys a put option below the current stock price using the premium received by selling the call.
21
Q

When would you use a collar or zero cost collar?

A

When an investor owns the underlying stock and wants to protect the downside risk without paying the entire cost of the put option.

22
Q

What are the 3 option pricing models?

A
1. Black/scholes
2. Put/Call Parity
3. Binomial Pricing Model
23
Q

What is the Black/Scholes model?

A
• used to determine the value of a CALL option
• considers the following variables:

current price of underlying asset
Time until expiration
Risk free rate of return
Volatility of underlying asset

• all variables have a direct relationship on the price of the option.
• as strike price increases, option price goes down.
24
Q

What is the Put/Call Parity?

A

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

25
Q

Binomial Pricing Model

A

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

26
Q

Taxability of options: call

A
• if contract lapses ( or expires) premium paid is a short term loss and the premium received is a short term gain.
• if contract is exercised, premium is added to stock price to increase basis in stock,
27
Q

Tax ability of options: Put

A
• if contract expires without being exercised, the premium paid is a short-term loss and the premium received is a short term gain
28
Q

What are Long term equity anticipation securities (LEAPS)?

A
• have longer expiration periods than traditional options.
• expirations that last for two or more years.
• premiums are higher due to extended time period
29
Q

What are warrants?

A
• long term call options issued by the corporation.
• expiration usually 5-10 years
• terms are not standardized. Call options are generally standardized in terms of expiration month and number of shares.
30
Q

Option example: client owns the stock

A
31
Q

What are the two types of futures contracts?

A

Commodity futures contracts; underlying asset is copper, wheat, pork bellies, oil.

Financial futures contracts: underlying asset is currency interest rates, and stock indices

32
Q

What are the differences between futures and options contracts?

A
• options give the holder the right to do something; futures obligate the holder to make or take delivery of the underlying asset.
• futures do not state the per unit price of the underlying asset, which is determined by supply and demand.
33
Q

Future contracts are “marked to market”, what does that mean?

A

The gain or loss (in cash) is credited/debited to your account on a daily basis

34
Q

What is the loss potential for selling and buying puts/calls?

A