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Questions and Answers
What is a key distinction between options and forwards/futures?
What is a key distinction between options and forwards/futures?
Which statement correctly describes a call option?
Which statement correctly describes a call option?
What is the total initial investment for buying a long call option if the strike price is $100, current stock price is $98, and the price of the option is $5 per share?
What is the total initial investment for buying a long call option if the strike price is $100, current stock price is $98, and the price of the option is $5 per share?
Which type of option can be exercised at any time before expiration?
Which type of option can be exercised at any time before expiration?
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At expiration, if the stock price of an asset is $115 and the strike price of a long call option is $100, what is the intrinsic value of the option?
At expiration, if the stock price of an asset is $115 and the strike price of a long call option is $100, what is the intrinsic value of the option?
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What is adjusted during a stock split in relation to an option contract?
What is adjusted during a stock split in relation to an option contract?
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What defines the maximum number of option contracts that an investor can hold on one side of the market?
What defines the maximum number of option contracts that an investor can hold on one side of the market?
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How is a long position in options typically closed?
How is a long position in options typically closed?
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What indicates the market's liquidity and trader interest in options?
What indicates the market's liquidity and trader interest in options?
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What is the effect of increasing open interest on market trends?
What is the effect of increasing open interest on market trends?
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What does a market maker do in the options market?
What does a market maker do in the options market?
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How is the bid-offer spread defined?
How is the bid-offer spread defined?
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What is a naked option?
What is a naked option?
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What is the margin requirement for options with maturities greater than nine months?
What is the margin requirement for options with maturities greater than nine months?
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What happens when an option is out of the money?
What happens when an option is out of the money?
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What is the risk associated with over-the-counter market options?
What is the risk associated with over-the-counter market options?
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Which of the following best describes an exercise limit?
Which of the following best describes an exercise limit?
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In the context of naked call options, what does $2 out of the money mean?
In the context of naked call options, what does $2 out of the money mean?
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What is the maximum loss for an investor who exercises a call option when the initial cost of the option is $500?
What is the maximum loss for an investor who exercises a call option when the initial cost of the option is $500?
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At what stock price would the investor break even if they have a call option with a strike price of $100 and the option cost $5?
At what stock price would the investor break even if they have a call option with a strike price of $100 and the option cost $5?
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What does it mean for a call option to be 'in the money'?
What does it mean for a call option to be 'in the money'?
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If a put option has a strike price of $70 and the current stock price is $65, what would be the intrinsic value of the put option?
If a put option has a strike price of $70 and the current stock price is $65, what would be the intrinsic value of the put option?
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What is the primary risk for an investor who takes a short position in an options contract?
What is the primary risk for an investor who takes a short position in an options contract?
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An option that can be exercised at any time is known as what type of option?
An option that can be exercised at any time is known as what type of option?
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How often do strike prices typically vary as the stock price increases?
How often do strike prices typically vary as the stock price increases?
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Which scenario describes an 'out of the money' call option?
Which scenario describes an 'out of the money' call option?
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What adjustment is made to OTC options when a dividend is declared?
What adjustment is made to OTC options when a dividend is declared?
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When a put option is exercised, under what condition does the holder benefit?
When a put option is exercised, under what condition does the holder benefit?
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What does the intrinsic value of an option represent?
What does the intrinsic value of an option represent?
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If a call option is priced at $5 and the stock price is $98, what price must the stock reach for the option to be in the money?
If a call option is priced at $5 and the stock price is $98, what price must the stock reach for the option to be in the money?
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What is the consequence of a stock split on an options contract?
What is the consequence of a stock split on an options contract?
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Which of the following describes the function of a European option?
Which of the following describes the function of a European option?
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Study Notes
Options vs. Forwards/Futures
- Options allow the holder to choose whether to exercise the right, but require an upfront payment.
- Forwards/futures obligate parties to a specific action; there's no initial cost (except margin/collateral).
Types of Options
- Call option: Right to buy an asset at a specific price (strike price) by a specific date (expiration).
- Put option: Right to sell an asset at a specific price by a specific date.
- European options: Can only be exercised on the expiration date.
- American options: Can be exercised at any time.
Option Positions
- Long call: Buys a call option.
- Long put: Buys a put option.
- Short call: Sells a call option.
- Short put: Sells a put option.
Call Option (Long Position, European)
- Investor buys a call option (e.g., right to buy 100 shares).
- Strike price: $100.
- Current stock price: $98.
- Option price per share: $5.
- Initial investment: $500.
- Expiration: Stock price 115.Profit:115. Profit: 115.Profit:1,000.
- Profit at 108:108: 108:300.
- Break-even at $105.
- Loss at 102:102: 102:300.
- No exercise below 100:Loss100: Loss 100:Loss500.
- Maximum loss: $500.
Profit From a Long Call
- Option price = 5Strikeprice=5 Strike price = 5Strikeprice=100. Underlying must increase to atleast $102 to earn profit
Long Put Option (Long European)
- Investor buys a put option (right to sell 100 shares).
- Strike price: $70.
- Current stock price: $65.
- Option price per share: $7.
- Initial investment: $700.
Option Positions (Long vs. Short)
- Long position (buying): Upfront premium, capped maximum loss.
- Short position (selling): Receives upfront premium, theoretically unlimited loss.
Foreign Currency Options
- Traded over-the-counter (OTC) and on some exchanges.
- Mostly European style.
Index Options
- US options (SPX, OEX, NDX, DJX) can be exercised anytime.
- European options can be exercised only on the last day.
Future Options
- Future contract: Agreement to buy/sell a commodity/currency at a set price/date.
- Future options: Underlying asset is a future contract. Gives right to enter a future contract. Exercise period ends before future contract expiration.
Call Option (Future)
- Exercising a call option on a future: Profit=Futures Price - Strike Price, if futures price > Strike Price.
- Futures > Strike Price: Holder gains the difference into a long position at the strike price
Put Option (Future)
- Exercising a put option on a future: Profit = Strike Price - Futures Price if strike price >futures price
- Strike > Futures Price: Holder gains the difference into a short position at the strike price.
Expiration Dates
- Typical cycles: 1, 2, 3, 6 months.
- Long-term: LEAPS (up to 39 months).
Strike Prices
- Spacing: 2.50(under2.50 (under 2.50(under25), 5(5 (5(25-200),200), 200),10 (over $200).
In/At/Out of the Money
- Call option in the money: Stock price > Strike price.
- Put option in the money: Stock price < Strike price.
- Call option at the money: Stock price = Strike price.
- Put option at the money: Stock price = Strike price.
- Call option out of the money: Stock price < Strike price.
- Put option out of the money: Stock price > Strike price.
Intrinsic Value
- Intrinsic value of option = Maximum(0, payoff if immediately exercised).
- Call: Max (S-K, 0)
- Put: Max (K-S, 0)
- Can't be less than zero.
Dividends
- OTC options: Dividend protected.
- Exchange-traded options: No dividend adjustments; stock price drops by dividend on ex-dividend date.
Stock Splits
- Adjust strike price & # of shares per contract, but maintain contract value.
Position Limit / Exercise Limit
- Limits max # of contracts held or exercised during a specific period.
Market Makers
- Quote bid & ask prices (ask > bid).
- Add market liquidity.
- Profit from bid-offer spread.
Offseting Orders
- Investors can buy back an option position (for example a short call position by buying it).
Open Interest
- Total active contracts not settled. A key metric of market liquidity and interest—increasing/decreasing open interest, strengths/weaknesses of trends.
Commissions
- Hidden cost in option trading.
Margin Requirements
- Options with <9 months maturity: Full price payment.
- Options with >9 months maturity: Buy on margin (up to 25% of option value) Short (write) options: Margin required.
Naked Options
- Seller has no offsetting position in the underlying asset.
- Unlimited potential loss.
Over-the-Counter (OTC) Options
- Direct transactions with other institutions.
- Risk of default.
- Collateral increasingly required.
- Often structured for client needs.
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Description
Test your knowledge on the fundamentals of options and futures trading. Understand the differences between call and put options, as well as the strategic implications of various option positions. This quiz will help you grasp key concepts crucial for operating in financial markets.
