Options Flashcards
(22 cards)
Define an optinon and in and out of the money
-An option is a finalncial derivative contract hat gives its buyer the right, but not the obligation, to buy or sell an asset at a predetermined price (called the exercise/strike price) on or before a specified date (called the expiration date).
If it is profitable to exercise the option at the current price,–> “in the money option”
If it is unprofitable to exercise the option at the currentprice -> “out of the money option”
Define a call option, (european and american call) + value
-Call option gives the holder the right, not obligation, to buy the underlyng asser at a specified strike price on or ebfore the experation date.
European option refers to ptions that can only be executed on a specific day whereas american options refer to options that can be exercised on or before the experiation date
-Ct = Max(0, St - X), profit when St - X - a >0
Define the following terms: Strike/exercise price, experiation date, premium, buyer/holder and seller/writer
-Premium, price paid buy the option buyer to the seller/writer for the option contract. Contract has value.
-Buyer/holder: person/party holding the option contract and paying the premium
-Seller/writer, party/person recieving the premium and must sell/buy the asset at the strike price.
-Strike/exercise price, fixed price in which the buyer/option holder can execute the option and either buy/call or sell/put the asset.
-Experiation date, date which the contract expires and can no longer be executed
show call option graphically
show put option graphically
Define a put option + value
-Put option contracts give the holder the right, not obligation, to sell an asset as a specified strike price on or before the experiation date.
-Value of put option Pt with asset price S and strike price X is given by:
-Pt = max(0, X - St)
-The put is worth the difference between current asset price and strike price, profit depends on whether Pt > a, premium.
Main purpose of options for investtors and how are options used to hedge risk briefly
Options allow investors to transfer risk—one party pays a premium to reduce risk, while another takes on that risk.
-Options can protect against interest rate, currency, or stock price movements.
describe protective puts (option strategies)
-investors buy/own stock and hedge against price drops by buying a put option.
-Can be seen as insurance against a stock with the price of insurance being the premium.
describe spreads option (strategie) + bullish call spread option
-Refers to the purchasing of one option and selling another, typically same type with different strike prices (money spread) or different experiations (time spreda)
-This strategy aims to limit risk and cost and profit off price moves/mispricing.
-Bullish call spread refers to when you expect stock to go up but not by a large amount.
-Bullish call spread: buy call option at low strike price and sell call option at high strike price, same experiation darte.
describe covered call options (option strategies)
-Refers to buying stock/owning and selling a call option against it.
-Goal is to generate additoanl income from premiums(a) if you expect price to rise moderatly.May miss out on gains greater than the strike price if prices rise.
-If experation price st rises above strike price, buyer of call will rationally exerecise call and you’re the seller required to sell shares at strike price.
-If experation price st falls below X strike price, seller/you keep premium and buyer doesnt execute.
describe straddle options (option strategies)
refers to buying OR selling BOTH a put and call option at identical strike prices X and experiation dates.
Long straddles profit from large volitlle changes in price
Short straddles profit from small changes in prices.
-Profit is made when experation price St moves above or below strike price by the value of the total premiums paid.
net value
-Total payoff at experation + premiums recived - premieums paid
define short and long straddle and when both appropriaete
-Long straddle refers to buying a call and a put with same strike price and expperation date. Pay both premiums upfront.
-Long straddle approapite when expected share prices to be volatile
-Short straddle refers to selling a call and a put with same strike price and experation date. Recieve both premiums upfront.
-Suitable whe expect share prices to remain in a trading range. Expect low voitilty.
Calculate payoff/net value of a long straddle
-Refers to buying a call and put optino at same price and expery.
-Calculate put payoff = Max(0, X- St)
-Calcluate call payoff: = max(0,St-X)
-Total payoff = put + call payoff
-net value = Total payoff - total premiums paid
Calculate payoff/et value of a short straddle
-Refers to selling a call and a put option at same strike price x and expiry date.
-Calculate call payoff: = - max(0,St-X)
-Calculate Put payoff= - max (0, X-st)
-negative beacuse paying out option
x strike price, st experiation price.
-Total payoff = put payoff + call payoff (negative)
-Net value = total payoff + total premiums gained from selling contracs
Calculate net payoff/value of a protective put
-buy/own stock and buy put option
Find stock payoff = Stock price at experiation St - initial stock price (may be bought at strike price)
-Find the put payoff: = Max(0, X - St)
x is strike price, st stock price at experiation.
-Total payoff = put payoff + stock payoff
-Net value = Total payoff - put premium
Calculate payoff/net value of a covered call
Refers to buying/owning stock and SELLING a call option against it.
-Find stock payoff: Price at experation St - inital price (maybe bought at strike price)
-Find call payoff = as sold its negative or 0
= - MAX(0, St-X)
-Total payoff = stock payoff+ call payoff
-Net value = total payoff (stock payoff + call payoff) + premium recived from selling option
Calculate payoff/net value of a spread option (Bull call spread)
-Refers to buying a call at a lower strike price and selling a call at a higher strike price.
-Long call payoff (call bought) = max(0, St - X), premium paid
-Short call ( call sold) payoff =
- Max (0, St-X ),
will recived premium, negative payoff
-Total payoff = long call payoff (bought) + short call payoff (sold)
-Value = total payoff - premoum paid for long call + premoium recived for short call
Formula for the put call parity relationship with continuous and discrete compounding
Continous compounding of X
Ct + Xe^-rT = Pt + So
-Discrete compounding of X
Ct + X / (1+r)^T = Pt + So
Ct/Pt - price/value of call and put option, X strike price, r is the interest rate/risk free rate, So is the current stock price
Describe the put call parity relationship and what used for
-refers to relationship between european call option and put option prices of the same underlying stock with the same price and experation date.
-if relationship doesnt hold –> mispricing exists (should have fair prices relative to the other, market prices being different)
- mispricing creates arbitrage opportunities for investors to earn profits.
-USED FOR:
-Calculaying fair option prices based on the price of other type of option.
-Shows relationship between call and puts of same stock
-Check for arbitrage opportunties.
Put call parity relationship formula involving dividends
-Discrete
-Ct + X / (1 + r)^T = Pt + So - D / (1+r)^T
Continous
-Ct + Xe^-rT = Pt + So - De^-rT
