options

Question 1

what is a call option?

Answer 1

buy the underlying

Question 2

long options give the buyer the _____ to buy and the short seller the _____ to sell

Answer 2

Right
obligation

Question 3

in options trading who pays and who receives the premium?

Answer 3

buyer pays, seller receives

Question 4

explain the differences between american and european options

Answer 4

American can exercise the option at any time before maturity, whereas european options can only be exercised at maturity

American are mostly exchange-traded, whereas European are mostly OTC

American bid-ask spread is low-high liquidity, whereas european is high-low liquidity

Question 5

in a call optiion, prices going _____ is the adverse direction

Answer 5

up

Question 6

in a put option, prices going ______ is the adverse direction

Answer 6

down

Question 7

why might a hedger buy a call option?

Answer 7

to hedge against a rise in the price of an asset that it intends to buy in the future

Question 8

what is the option premium price?

Answer 8

the amount paid by the buyer to the seller

Question 9

what is the strike price?

Answer 9

the price at which the holder of the option has the right to buy or sell

Question 10

what is the expiration date?

Answer 10

the right to buy or to sell, exists up to a specified expiry date

Question 11

why might a hedger buy a put option>?

Answer 11

to hedge against the fall of an asset it holds, or an asset it expects to have in the future

Question 12

describe the OTC options market

Answer 12

OTC options are worldwide and customised. terms such as exercise price, expiry date and amount are all customised to the buyers requirements. these are private transactions in a largely unregulated market and involve credit risk - counterparties are exposed to each others credit risk. options on bonds, interest rates and currencies are the most common in OTC markets

Question 13

describe organised options trading on exchanges

Answer 13

orgganised options on trading exchanges has listing requirements and the contract size is standardised. exercise prices are set by ‘market makers’; expiration dates are determined by exchange, and margins are required only on short option positions. A clearing house guarantees performance

Question 14

describe exchange traded options

Answer 14

most exchanges use market makers to facilitate trading. a market maker quotes both ‘bid’ (what they are prepared to buy at and ‘ask’ (what price they are prepared to sell at) prices when requested. Bid-ask spread is when the bid price is lower than the ask price, and spreads widen when market liquidity is low

Question 15

what does at the money mean?

Answer 15

when the spot price = the strike price

Question 16

what does in the money mean

Answer 16

S0 > K for a long call
S0<K for a long put

Question 17

what does out of the money mean?

Answer 17

s0<K>K for a long put</K>

Question 18

explain cover call options

Answer 18

the writer owns the underlying asset. this does not require a cash margin deposit but gives the underlying assets as margin

Question 19

explain naked call options

Answer 19

naked option are written options that are not combined with an offsetting position in the underlying asset. written naked options are margined because of the risk of unlimited loss.

Question 20

what happens to options prices if a dividend is paid from the underlying?

Answer 20

no adjustments need to be made as the expected dividend would have been priced into the option premiums

Question 21

what happens to the strike price if the underlying announces a stock split?

Answer 21

the strike price will decrease by the ratio of stock split i.e if a company doubles its share count the strike price will half.

Question 22

what are exchange-traded options on shares?

Answer 22

they are short dated products that allow investors to:
- protect the value of individual shares or a portfolio of shares
- earn income by writing covered calls
- undertake to buy shares for less than their current price by writing out of the money puts - if the option is exercised, the writer acquires shares at a lower price than current spot price and also collects premium
- lock in a buying price with puts or calls.