Unit 16: Options

Question 1

3 standardized terms for options:

Answer 1

1. The underlying asset. All options on common stock are for 100 shares.
2. The expiration date. All options that expire in a specific month have the same date
3. The exercise or strike price. Strike prices are set at standardized intervals.

Question 2

A for American means

Answer 2

anytime

Question 3

E for European means

Answer 3

expiration date

Question 4

Length of an option contract

Answer 4

• 1 week (weeklys) to 3 years (LEAPS)
• Most are 9 months
• All options, regardless of their length, are derivative securities

Question 5

Why buy calls?

Answer 5

an investor can profit from the increase in the stock’s price while investing a relatively small amount of money

Question 6

Why write calls?

Answer 6

generate income from the option premium, partially hedge a long stock position by offsetting any loss on the sale of the stock by the premium amount

Question 7

Why buy put?

Answer 7

one who speculates a stock will decline in price, a hedging strategy when the investor is long the stock

Question 8

Why sell puts?

Answer 8

source of income, investor believes the stock’s price will rise or remain stable

Question 9

What is a straddle?

Answer 9

combining of a put and a call on the same stock with the same exercise price and expiration date, when an investor is not sure which direction the market will move but has a strong opinion that there will be dynamic movement

Question 10

When you buy a straddle, you profit from:

Answer 10

volatility

Question 11

When you sell a straddle, you profit from:

Answer 11

stability

Question 12

Are rights and warrants derivatives?

Answer 12

Yes - their value is derived from the common stock

Question 13

Rights:

Answer 13

• Given, not sold, to existing holder of the common stock
• Exercisable at a price below the current market
• Short lifespan - they will expire in 45-60 days
• Can be sold and then the buyer can exercise them
• Can be left to expire

Question 14

Warrants:

Answer 14

• Exercisable at a price above the current market
• Life is considerable longer than rights and longer than call options as well.
• When detached, they can be traded like any other security (they are usually traded on the same exchange as the company’s common stock)
• Most securities professionals view warrants as call options with a very long time to expiration.
• Warrants do not have voting rights, the same as any other derivative.

Question 15

One major difference between call options and rights/warrants is that

Answer 15

options originate on the exchange on which they are traded. Rights/warrants originate with the issuer of the stock.

Question 16

Forward Contracts were developed as a means:

Answer 16

for commodity users and producers to arrange for the exchange of the commodity at a time agreeable to both.

Question 17

A forward contract is a

Answer 17

direct commitment between one buyer and one seller. If the position is held until the closing date, the forward seller is obligated to make delivery and the buyer is obligated to take delivery.

Question 18

Forward contracts are not:

Answer 18

therefore not traded on an exchange bc they are non-standardized

Question 19

Futures:

Answer 19

• Exchange-trade obligations

- gains /losses are computed daily for all open futures

Question 20

Futures are commonly used

Answer 20

by speculators while forwards are used by producers (farmers). That explains why such a small percentage of futures contracts ever end with delivery.

Question 21

Farmers use forwards to

Answer 21

hedge the risk of the price of the commodity falling before it is able to be harvested and sold. To hedge, sell a forward contract on that commodity. However, the producer is giving up any potential gain in the event the prices rise above the agreed upon one.

Question 22

Regulation of Futures and Forwards

Answer 22

• Because they are not securities, they do not come under the jurisdiction of the SEC
• SRO that is in charge of regulating the futures market is the Commodity Futures Trading Commission (CFTC)
• Forward contracts are NOT regulated by any agency