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