Options Trading

Question 1

Option

Answer 1

An option gives the buyer the right to buy or sell a specified quantity of a specified underlying asset at a fixed price on or before a specified future date

Question 2

Call

Answer 2

The right to buy the underlying

Question 3

Put

Answer 3

The right to sell the underlying

Question 4

Holder

Answer 4

The buyer

Question 5

Writer

Answer 5

The seller

Question 6

Exercise price

Answer 6

The price at which the holder of a call option can buy the underlying (or the holder of a put option can sell)

Question 7

When describing an option what must be included?

Answer 7

Underlying asset name
Expiry date
Exercise/strike price
Whether the option is a call or a put
Notional size of trade

Question 8

European style

Answer 8

May only be exercised in the expiration date

Question 9

Bermuda style

Answer 9

May be exercised only on predetermined dates, or the expiration date

Question 10

American style

Answer 10

May be exercised at any time up fo and including the expiration date. More expensive due to extra flexibility

Question 11

Buying options advantages

Answer 11

• risk is limited to the option premium
• unlimited potential for profit
• you can select the strike price and expiry date
• can be used for speculation or hedging

Question 12

Buying options disadvantages

Answer 12

• 90% of FX options expire worthless
• option premiums can be very expensive
• pricing is not transparent
• potential credit/ counterparty risk

Question 13

Selling options advantages

Answer 13

• 90% of options expire worthless
• premiums can be lucrative and are likely to be retained
• you can select the strike price and expiry date
• can be used for speculation or hedging

Question 14

Disadvantages of selling options

Answer 14

• unlimited potential for loss

* potential credit/ counterparty risk

Question 15

Basic option positions

Answer 15

• long call: right to buy the underlying
• short call: potential obligation to sell the underlying
• long put: right to sell the underlying
• short put: potential obligation to buy the underlying

Question 16

American style options pricing

Answer 16

Premium= intrinsic value + time value

Question 17

Intrinsic value

Answer 17

Intrinsic value= underlying price -strike price

Intrinsic value is the inherent value of an option were it to be exercised now

Question 18

Time value

Answer 18

The extra amount of premium that a buyer must pay due to potentially favourable price move in underlying between now and expiry

Question 19

General rules of option pricing

Answer 19

The more chance of an option being in the money (ITM) at expiry, the higher the option premium

Question 20

What increases the chances of being ITM?

Answer 20

Longer time to maturity
Higher implied volatility
Strike price being increasingly in the money relative to the forward outright (higher DELTA)

Question 21

Time value decay

Answer 21

Time value decreases as the life of the option progresses. Means longer dated options are generally more expensive than shorted dated options. More time to expiry= higher premium

Question 22

Backwardation

Answer 22

When longer dated options are cheaper than shorter dated options

Question 23

Who does time decay act in favour of?

Answer 23

It acts in favour of the option writer and against the option holder

Question 24

Hedging with options

Answer 24

The process of reducing the uncertainty due to changing prices

Question 25

Hedging a long

Answer 25

To reduce the risk with owning an asset (e.g. if you are long the underlying, you should buy a put option)

Question 26

Complex option strategies

Answer 26

•Directional strategies - call spreads- moderately bullish - put spreads- moderately bearish •Volatility (you don’t need to know which direction the market is moving in, you’re banking on volatility increasing or decreasing) - straddle - strangle

Question 27

Call spread

Answer 27

Strategy: moderately bullish Buy call options at a specific strike price. Sell the same number of call options with the same asset, same expiry and higher strike.

Question 28

Benefits of call spread

Answer 28

* lower cost (since the short call premium helps pay for the long call) * spot doesn’t need to move far for the trade to become profitable

Question 29

Disadvantages of call spread

Answer 29

•gains are capped at the difference between the two strike prices minus the net premium

Question 30

Put spread

Answer 30

Buy an OTM put | Sell a put (same asset, same maturity, lower strike, hence lower premium)

Question 31

Benefits of put spread

Answer 31

* Lower cost hence lower downside | * spot doesn’t have to move far for trade to be profitable

Question 32

Disadvantages of put spreads

Answer 32

Gains are capped

Question 33

Straddle

Answer 33

You expect spot volatility to increase but you don’t know which direction the price will move in. Buy a put Buy a call (same strike as put, typically close to ATM)

Question 34

Benefits and drawbacks of straddle

Answer 34

You profit of spot moves significantly up or down. | You lose if spot doesn’t move far either way

Question 35

Strangle

Answer 35

You expect spot volatility to increase but you don’t know which direction the price will move in. Buy a put Buy a call (with a higher strike than the put)

Question 36

Benefits and drawbacks of strangle

Answer 36

+cheaper than a straddle +profit if spot moves significantly up or down -loss if spot doesn’t move far either way -spot has to move quite far to generate profit