FINA 471 CH 10
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74 Terms
Q: What is an option?
A: The right, but not the obligation, to buy or sell an asset at a set price.
Q: What is a forward or futures contract?
A: An obligation to buy or sell an asset at a set price.
Q: What is the main difference between an option and a forward/future?
A: An option gives a choice; a forward/future creates an obligation.
Q: Does an option require an upfront payment?
A: Yes. The buyer pays an upfront premium.
Q: Does entering a forward or futures contract require an upfront payment?
A: Generally no; it costs nothing to enter, though futures require margin.
Q: What does “asymmetric payoff” mean for an option?
A: One side has a limited loss (the premium), while the potential gain can be much larger.
Q: What does “symmetric payoff” mean for a forward/future?
A: One party’s gain equals the other party’s loss dollar-for-dollar.
Q: If an option is unfavorable at expiration, does the buyer have to exercise it?
A: No—the buyer can let it expire.
Q: If a forward/futures contract is unfavorable, can the party simply walk away at expiration?
A: No. The contract obligation still applies.
Q: Why might someone choose an option over a forward/future?
A: They want protection against bad price movements while retaining the ability to benefit from favorable movements.
Q: What right does a call option give its buyer?
A: The right to buy the underlying asset.
Q: When does a call option buyer profit?
A: When the stock price rises.
Q: What right does a put option give its buyer?
A: The right to sell the underlying asset.
Q: When does a put option buyer profit?
A: When the stock price falls.
Q: Quick memory trick: Call vs. put?
A: Call = buy = bullish (you want the price to go up).
Put = sell = bearish (you want the price to go down).
Q: When can an American option be exercised?
A: Any time up to and including its expiration date.
Q: When can a European option be exercised?
A: Only on its expiration date.
Q: Are “American” and “European” options defined by where they trade?
A: No. They refer to the timing of the exercise right.
Q: Which type is most exchange-traded stock options?
A: American options.
Q: Which option type is generally easier to analyze mathematically?
A: European options.
Q: What are the four basic option positions?
A: Long call, short call, long put, and short put.
Q: What does it mean to be long an option?
A: You bought the option and paid the premium.
Q: What does it mean to be short an option?
A: You sold/wrote the option and received the premium.
Q: What right does a long call give you?
A: The right to buy the stock at the strike price, K.
Q: What is the maximum gain and loss on a long call?
A: Max gain is unlimited; max loss is the premium paid.
Q: What obligation does a short call create?
A: The obligation to sell the stock at K if the option is exercised.
Q: What is the maximum gain and loss on a short call?
A: Max gain is the premium received; max loss is unlimited.
Q: What right does a long put give you?
A: The right to sell the stock at K.
Q: What is the maximum gain and loss on a long put?
A: Max gain is K if the stock price falls to zero; max loss is the premium paid.
Q: What obligation does a short put create?
A: The obligation to buy the stock at KK if the option is exercised.
Q: What is the maximum gain and loss on a short put?
A: Max gain is the premium received; max loss is KK if the stock price falls to zero.
Q: Why is a short call riskier than a short put?
A: A stock price can rise without limit, making a short call’s potential loss unlimited. A stock price cannot fall below zero, so a short put’s maximum loss is capped at K.
Q: What does ST represent in option payoff formulas?
A: The stock price at maturity (expiration).
Q: What does K represent?
A: The strike price—the price specified in the option contract.
Q: What is the payoff of a long call at expiration?
A: max(ST−K,0)
Q: What is the payoff of a long put at expiration?
A: max(K−ST,0)
Q: What is the payoff of a short call at expiration?
A: −max(ST−K,0)
Q: What is the payoff of a short put at expiration?
A: −max(K−ST,0)
Q: What is the difference between an option’s payoff and its profit?
A: Payoff is the value from exercising at expiration. Profit includes the premium paid or received.
Q: How do you calculate profit for a long option position?
A: Profit=payoff−premium paid
Q: How do you calculate profit for a short option position?
A: Profit=signed payoff+premium received
Q: If the call premium is c, what is short-call profit at expiration?
A: c−max(ST−K,0)
Q: If the put premium is p, what is short-put profit at expiration?
A: p−max(K−ST,0)
Q: When is a call option in the money (ITM)?
A: When S0>K: the stock price is above the strike price.
Q: When is a put option in the money (ITM)?
A: When S0<K: the stock price is below the strike price.
Q: When is an option at the money (ATM)?
A: When S0≈K: the stock price is near the strike price.
Q: When is a call option out of the money (OTM)?
A: When S0<K.
Q: When is a put option out of the money (OTM)?
A: When S0>K
Q: What does ITM mean?
A: The option has intrinsic value.
Q: What does OTM mean?
A: The option has no intrinsic value.
Q: What is the relationship between an option premium, intrinsic value, and time value?
A: Option Premium = Intrinsic Value + Time Value
Q: What is the intrinsic value of a call?
A: max(S0-K,0)
Q: What is the intrinsic value of a put?
A: max(K-S0,0)
Q: How do you calculate time value?
A: Time Value = Option Premium - Intrinsic Value
Q: When is time value typically largest?
A: When the option is near the money (ATM).
Q: Can an option be in the money and still result in a loss?
A: Yes. Its intrinsic value may be less than the premium originally paid.
Q: What is the standard size of one listed stock-option contract?
A: 100 shares of the underlying stock.
Q: If an option is quoted at $3.50 per share, what is the cost of one contract?
A: $3.50 × 100 = $350
Q: What key terms specify an option contract?
A: Expiration date, strike price, style (American or European), and class (call or put).
Q: Where are option strike prices typically listed?
A: Around the current stock price.
Q: What are weekly options?
A: Options with shorter, weekly expiration dates.
Q: What are LEAPS?
A: Long-dated options that offer additional, longer-term maturities.
Q: Are listed stock options adjusted for ordinary cash dividends?
A: No. Listed options are generally not adjusted for ordinary cash dividends.
Q: How do ordinary cash dividends affect option values?
A: The expected ex-dividend stock-price adjustment affects option values; dividends are therefore a pricing factor.
Q: What is a two-sided market in options?
A: A market maker quotes both a bid (buy price) and an ask (sell price).
Q: How do market makers earn compensation for supplying liquidity?
A: They earn the bid–ask spread.
Q: How are option positions usually closed?
A: By an offsetting trade—selling an option you bought or buying back an option you wrote.
Q: Why might an investor close an option position rather than exercise it?
A: Exercising forfeits any remaining positive time value.
Q: What is the OCC’s role in listed options?
A: The Options Clearing Corporation is the central counterparty and supports contract performance through margin, clearing-fund resources, and default management.
Q: Who gets assigned when an option is exercised?
A: A short option writer is assigned at random.
Q: What typically happens to an expiring option that is at least $0.01 in the money?
A: It is generally exercised automatically through exercise by exception, unless contrary instructions are given.
Q: Do buyers of long options post additional margin?
A: No. They pay the premium in full; no additional margin is required on the paid-up long option.
Q: Who must post collateral (margin) for an option position?
A: Uncovered option writers, because their exposure can change as the underlying price changes.
Q: What is a covered call?
A: A short call position backed by ownership of the underlying shares.