options Flashcards
Covered Call
formed by the simultaneous purchase of stock and writing a call option
you have the stock and you can deliver it in case the call owner decided to exercise his call
Straddle
A long straddle is established by the simultaneous purchase of a call and a put option on the same
stock, with the same maturity and the same exercise price
Investor in a straddle believes that stock price will move up or down but she/he does not know the exact direction the stock will follow
An investor in straddle views the stock to be more volatile than the market is viewing it
A long straddle investor has to pay two premium: that of a call and that of a put. As a result, for him to make a profit, the stock price should drastically move up or down
Spreads
formed by the simultaneous purchase and sale of more than one call or put options on the same stock with different strike price or different maturities
A money spread
formed by the simultaneous purchase of one option and the sale (writing) of another option with different strike price
if the option are Call Options, then we are forming a bullish money spread
If the option are Put Options, then we are forming a bearish money spread
A time spread
involves the simultaneous purchase and sale of options with different maturities
A Collar
involves the simultaneous purchase of a put and sale (or to write) of a call on the same underlying (security) with different strike prices
formed to provide insurance against exposure to a specific security (stock) with the minimum costs
why do a collar
Purchasing the put, will give the downside protection in case the stock price decreases
In order to cover the price of the put, we write a call
–> writing a call, will also put a limit on the profit of our portfolio in case the stock price increases
–> like putting an upper and lower bound on the return of our investment in stocks
Put-Call Parity
establishes a relationship between the cost of a call option (C), the cost a put option (P), the stock price (S), and the strike price (X)
C – P = S – PV(X)
For the Put-Call Parity to work in the format stated: C – P = S – PV(X)
what do we need
Call and Put options have the same strike price (X)
Call and Put options have the same expiration (T) Call
Put options are European options
The stock does not pay dividend
PV(X): the present value of X
Intrinsic Value (IV)
the value of an option at expiration
IV is positive when, @ expiration, the option is in the money and zero when the option is at the money and out of the money
Option Premium formula
TV + IV
factors of the call option which will affect its price
higher asset price = call price increase
higher exercise price = call price decrease
Longer expiration = call price increase
increased volatile = call price increase
higher interest rate = call price increase
higher dividends = call price decrease
factors of the put option which will affect its price
higher asset price = call price decrease
higher exercise price = call price increase
Longer expiration = call price decrease
increased volatile = call price decrease
higher interest rate = call price decrease
higher dividends = call price increase
replication approach or the perfect hedging approach
finding value of option with discounting a bunch of stuff and whatnot
Binomial Option Pricing: Multi-State Approach
What if our stock may have more than two values by the end of our period?
In such case, we divide our period into several sub-periods
–> This will lead to multi-branch binomial tree and then we apply the replication approach to each branch starting from the extremities (end branches) and moving gradually towards the call option price
