FNCE 100 FINAL
Terms in this set (27)
A contract giving its owner the right to buy or sell an asset at a fixed price on or before a given date
What do options do?
Options give the buyer the right, but not the obligation, to do something
Exercising the option
The act of buying or selling the underlying asset via the option contract
Strike, exercise, price
The fixed price in the option contract at which the holder can buy or sell the underlying asset
The maturity date of the option; after this date, the option is dead
American / European options
An American option may be exercised anytime up to the expiration date. A European option differs from an American option in that it can be exercised only on the expiration date
Call Option (Most common type of option)
gives the owner the right to buy an asset at a fixed price during a particular period
When do options expire?
They expire on the Saturday after the third Friday of the month
What is the value of a call option contract on common stock at expiration?
The answer depends on the value of the underlying stock at expiration
The right to exercise the call
Suppose the stock price is 130 at expiration. The buyer of the call option has the right to buy the underlying stock at the exercise price 0f $100. In other words, he has the right to exercise the call. Having the right to buy something for $100 when it is worth $130 is obviously a good thing. Value is $30 (130-100) on expiration day.
In what case would call be higher than stock price?
On expiration day. On expiration day, $150 - $100, the call would be worth $50. Call's value increases $1 for every $1 rise in the stock price.
Call is in the money
When stock price is greater than the exercise price
Call is out of money
Value of common stock is less than exercise price. Holder does not exercise
Payoff on Expiration Date
If Stock Price is Less than Exercise Price, then the call option value is 0. (Call is out of the money and worthless)
Is Stock Price is Greater than Exercise Price, then the call option value = stock price - exercise price (Call is in the money and its value rises one-for-one with increases in the stock price).
CALL CAN NEVER HAVE A NEGATIVE VALUE
Limited liability instrument
All the holder can lose is the initial amount you pay for. That is why a call can never have a negative value
Put Option (Think of it as opposite of call option
A put gives the holder the right to sell the stock for a fixed exercise price
Exercise price of put = $50 (Sell it at this price)
Stock price at exp. = $40 (buy at stock mkt price)
Owner of put option has right to sell stock for more than what it is worth, clearly profitable
Buy the stock at market price of $40 and sell it at the exercise price of $50, value of option at expiration is $10.
How would profit increase with put options?
If stock price is lower
Rule of Law
For every $1 that stock price declines at expiration, the value of the put rises by $1
At expiration date, what happens if the price of common stock is greater than exercise price?
The holder will exercise the call and the seller must give the holder shares of stock in exchange for the exercise price. Thus, seller loses difference between stock price and exercise price.
When is the put option worthless?
When share price > exercise price
AND value of combined position = value of common stock
What happens when exercise price > share price?
Decline in value of shares will be offset by rise in value of the pet
Strategy of buying a put and buying the underlying stock (buying insurance for the stock)
Price of Underlying stock + price of put = Price of call + PV of exercise price
Why does Put-Call Parity hold?
It holds only if the put and the call have both the same exercise price and the same expiration date. Maturity date of zero coupon bond (exercise price) must be the same as the expiration date of the option s
Covered Call Strategy
Price of underlying stock - price of call = - price of put + pv of exercise price
Why do a covered call strategy?
Investors like to buy a stock and write a call on the stock simultaneously