Unit 4 (Derivatives)
What is a covered call?
A covered call option is one where the writer (seller) owns the stock on which the call is sold. There are two reasons to write covered calls. The primary one is that the sale generates income in the form of the premium received from the buyer. A secondary reason is that, at least to the extent of the premium received, there is some downside protection for the long stock. This action has no impact on the amount of the dividends received. It is the uncovered (or naked) call option that has unlimited risk.
What is a derivative?
A financial product that derives its value from the value of underlying assets such as stocks, bonds, or mortgages
What is a warrant?
A warrant is a derivative that gives the holder the ability to acquire shares of common stock at a fixed price. At issuance, that price is always higher than the current market value of the stock, but warrants generally have a long expiration date that gives them great time value. When an issuer attaches warrants to a bond or preferred stock issue, they serve to sweeten the offering resulting in lower interest rates or dividends.
What are not traded on exchanges?
Forward Contracts
What does an option seller want?
Market Stability (makes money from the premium and the purchaser won't exercise if there's not movement)
What does an option buyer want?
Market Volatility (will only act on their option if there is a sharp swing in the price that favors their position)
What is a stradle?
Purchasing a straddle on a stock means going long a put and a call at the same strike price with the same exercise date. If the stock goes up, the investor profits on the call; if the stock goes down, the investor profits on the put. When an investor writes a straddle, a put and a call are sold at the same exercise price and expiration date. Short straddles profit when the stock price remains stable (the opposite of what is presented in this question). Taking a long position in a stock with a long put offers protection to the downside but no profit. Likewise, shorting a stock and taking a long position in a call offers protection to the upside but no profit.
In what option position has the investor created the possible obligation to purchase stock?
Selling a put When you sell (write, go short) an option, you create an obligation. In the case of a put, you are obligated to purchase stock that is put to you. In the case of a call, you are obligated to sell stock that is called away from you. Options buyers have rights. They can choose what they wish to do; there are no obligations.
What two factors influence the price of a derivative?
The two most important factors influencing the price of a derivative are the price movement (volatility) of the underlying asset and the length of time until the contract expires (the longer the time, the greater the time value)
When can warrants be exercised?
When the price is above market value
When are Rights exercisable?
When the price is below market value - must be an existing shareholder.
You have a client who has sold short 100 shares of RIF, a stock listed on the NYSE. If the client wishes to use options to protect against unlimited loss, you would suggest the client?
buy 1 RIF call. Buying a call option on a stock you are short will give you a guaranteed covering cost, thus preventing against unlimited loss. This is the best way to hedge a short position.
