CSC Chapter 10

Strategies for buying Call options

1. Buying Calls to Speculate 2. Buying Calls to Manage Risk

Buying Futures Strategies

1. Buying Futures to Speculate (expectation of rising prices) 2. Buying Futures to manage Risk (lock in a buying price)

Buying Put Options Strategies

1. Buying puts to speculate 2. Buying puts to manage risk

Writing Put Options Strategies

1. Cash Secured Put Writing 2. Naked Put Writing

Strategies for Writing Call options

1. Covered call Writing 2. Naked Call Writing

Selling Futures Strategies

1. Selling Futures to Speculate (expectation of lower prices) 2. Selling futures to manage risk (to lock in a selling price)

warrant

A certificate giving the holder the right to purchase securities at a stipulated price within a specified time limit. Warrants are usually issued with a new issue of securities as an inducement or sweetener to investors to buy the new issue. Investors buy these because of their leverage potential. The price of a ___ is lower than the price of the underlying security, but moves in the same price and the percentage basis of capital appreciation can greatly exceed that of the underlying security.

futures contract

A contract in which the seller agrees to deliver a specifi ed commodity or fi nancial instrument at a specifi ed price sometime in the future. A futures contract is traded on a recognized exchange. Unlike a forward contract, the terms of the futures contract are standardized by the exchange and there is a secondary market.

sweetner

A feature included in the terms of a new issue of debt or preferred shares to make the issue more attractive to initial investors. Examples include warrants and/or common shares sold with the issue as a unit or a convertible or extendible or retractable feature.

forward

A forward contract is similar to a futures contract but trades on an OTC basis. The seller agrees to deliver a specified commodity or financial instrument at a specified price sometime in the future. The terms of a forward contract are not standardized but are negotiated at the time of the trade. There may be no secondary market.

offsetting transaction

A futures or option transaction that is the exact opposite of a previously established long or short position.

hedging

A protective manoeuvre; a transaction intended to reduce the risk of loss from price fluctuations. ex. An example of a this would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the ____).

naked writer

A seller of an option contract who does not own an offsetting position in the underlying security or a suitable alternative.

rights

A short-term privilege granted to a company's common shareholders to purchase additional common shares, usually at a discount, from the company itself, at a stated price and within a specified time period. Rights of listed companies trade on stock exchanges from the ex-rights date until their expiry

commodity futures

A type of futures contract that are commonly used by producers, merchandisers and processors to protect themselves against fluctuating commodity prices. Most are exchange traded contracts. (Commodities/a physical asset are the underlying assets here). Most common: Gold, Crude Oil, Grains and Oilseeds, Dairy, Livestock, Forest.

call option

An agreement between a buyer (long position/holder) and a seller (short position/writer) that gives an investor the RIGHT (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period and the seller the OBLIGATION to sell. The buyer of the call option pays a premium for the right to buy the underlying security at a designated price. The writer of the call option receives a premium for the obligation to sell the underlying security at a designated price.

put option

An option contract giving the owner the RIGHT, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time and the buyer the OBLIGATION. This is the opposite of a call option, which gives the holder the right to buy shares. protection in case prices fall. The buyer of the put option pays a premium for the right to sell the underlying security at a designated price. he writer of the put option receives a premium for the obligation to buy the underlying security at a designated price.

opening transaction

An option transaction that is considered the initial or primary transaction. An opening transaction creates new rights for the buyer of an option, or new obligations for a seller. On the expiration date one of 3 things can happen. (offset, exercise, let the option expire).

cum rights

Between the day of the announcement that rights will be issued and the ex rights date, the stock is trading _____, meaning that anyone who buys the stocks is entitled to receive the rights if they hold the stock to the records date

financial futures

Futures that have financial assets as the underlying asset. Most common: stocks, bonds, currencies, interest rates, stock indexes.

cash secured put write

Involves writing a put option and setting aside an amount of cash equal to the strike price. If the writer is assigned, the cash is used to buy the stock from the exercising put buyer.

Differences between Options and Forwards

Options give holders the rights, Forward agreements are obliged. Options have a strike price and a premium

strike price

See also Exercise Price.The price, as specified in an option contract, at which the underlying security will be purchased in the case of a call or sold in the case of a put. The difference between the underlying security's current market price and the option's _____ represents the amount of profit per share gained upon the exercise or the sale of the option.

option premium

The buyer of the put option pays a premium for the right to sell the underlying security at a designated price. he writer of the put option receives a premium for the obligation to buy the underlying security at a designated price. The buyer of the call option pays a premium for the right to buy the underlying security at a designated price. The writer of the call option receives a premium for the obligation to sell the underlying security at a designated price.

subscription price

The price at which a right or warrant holder would pay for a new share from the company. With options the equivalent would be the strike price.

marking to market

The process in the futures market in which the daily price changes are paid by the parties incurring losses to the parties earning profits.

default risk

The risk that a debt security issuer will be unable to pay interest on the prescribed date or the principal at maturity. Default risk applies to debt securities not equities since equity dividend payments are not contractual.

arbitrage

The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. (because of tech. advances, less likely to occur now)

ex rights

The two business days before the record date, which means that anyone who buys the stocks are not entitled to receive the rights from the company

covered writer

The writer of an option who also holds a position that is equivalent to, but on the opposite side of the market from the short option position. In some circumstances, the equivalent position may be in cash, a convertible security or the underlying security itself.

exchange traded derivatives

Type of derivative that is: standardized contract; transparent; easy termination prior to expiry; clearinghouse acts as third party guarantor; performance bond required; gains/losses accrue day to day; heavily regulated; commission visible; used by retail investors, corporations and institutional investors

Over the Counter Derivatives

Type of derivative that is: traded through computer/phone lines; customized contracts; private; difficult early termination; no third party guarantor; performance bond not required; less regulated; fee built in; used by corporations and financial insitutions

Financial derivatives

Underlying Assets of this type of derivatives are: Equities (options on individual stocks); Interest Rates (rate sensitive securities, rather than interest rates themselves); Currencies (US dollar)

forward agreement

When a forward is traded over the counter it is generally referred to as a _____

derivative

a financial contract between two parties whose value is derived from, or dependent upon the value of some other asset. (the ___'s underlying asset)

option

contracts between two parties: a buyer and a seller. The buyer of an ___ as the RIGHT but not the obligation to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today. the seller of the ____ is OBLIGATED to completed the transaction if called upon to do so.

Users of Derivatives - Corporations and Businesses

hedging. In particular, these users tend to focus on derivatives that help them hedge interest-rate, currency and commodity price risk.

Why buy options

hey are useful for investors who want to profit or protect themselves from short-term market fluctuations. The exchanges have begun listing options with much longer expirations.

american style option

options that can be exercised at any time up to and including the expiration date are referred to as ____. Exchange traded stock options are this style.

european style option

options that can be exercised only on the expiration date. (index options are this style)

performance bond

or a good faith deposit. A bond issued to one party of a contract as a guarantee against the failure of the other party to meet obligations specified in the contract. (With Forwards, there are not up front payments so this gives both parties a higher level of assurance that the terms will be honoured)

in the money

owners of options will exercise only if it is in their best financial interest, which occurs when an option is ____. Call - when the price of the underlying asset is higher than the strike price. Put - when the underlying asset is lower than the strike price.

out of the money

owners of options will not exercise if they are _____ or at the money. Call - when the underlying asset is lower than the strike price. Put - when the underlying asset is above the strike price.

time value

represents the value of uncertainty. Option buyers want options to be in the money at expiration; option writers want the opposite. The greater the uncertainty about where the option will be at expiration, the greater the options time value.

intrinsic value

the amount that the owner of an in the money option would earn by immediately exercising the option and offsetting any resulting position in the underlying asset. Simply: the value of certainty.

underlying asset

the asset that the option holder has the right to buy or sell. It is also the asset from which an option derives its value. It can be any of the following: an equity, an index,currency, an exchange-traded fund (ETF), a commodity

expiration date

the date by which both parties must fulfill their obligation or exercise their rights under the contract on or before the ______. After this date, the contract is automatically terminated.

record date

the date that is set when a company does a rights offering, the date determines the list of shareholders who will receive the rights.

long term equity anticiPation Securities (LEAPS)

the options are called ____, are simply long term option contracts and offer the same risks are rewards as regular options. (Longer than one year, premiums are higher because because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.)

exercise

the party holding the long position can _____. When this happens, the person in the short position is said to be ASSIGNED the option.

Users of Derivatives - Individual investors

use derivatives as either a risk management strategy or a speculative strategy.

Users of Derivatives - Institutional Investors

use derivatives for both speculation and risk management: Hedging, Speculation. Market Entry and Exit, Yield Enhancement and arbitrage