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# Options Strategies

Question | Answer |
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The intrinsic value of a call option is the amount, if any, by which the ... | price of the underlying stock exceeds the strike price of the call |

The intrinsic value of a put option is the amount, if any, by which the ... | strike price of the put exceed the price of the underlying stock |

Maximum Risk, Maximum Reward, Break-Even Stock Price of a Long Stock Position | Maximum Risk = stock price Maximum Reward = unlimited Break-Even Stock Price = stock price |

Maximum Risk, Maximum Reward, Break-Even Stock Price of a Short Stock Position | Maximum Risk = unlimited Maximum Reward = stock price Break-Even Stock Price = stock price |

Maximum Risk, Maximum Reward, Break-Even Stock Price of a Long Call Position | Maximum Risk = Call Premium Paid/Received Maximum Reward = unlimited Break-Even Stock Price = strike price + Call Premium Paid/Received |

Maximum Risk, Maximum Reward, Break-Even Stock Price of a Short Call Position | Maximum Risk = unlimited Maximum Reward = Call Premium Paid/Received Break-Even Stock Price = strike price + Call Premium Paid/Received |

Maximum Risk, Maximum Reward, Break-Even Stock Price of a Long Put Position | Maximum Risk = Put Premium Paid/Received Maximum Reward = strike price - Put Premium Paid/Received Break-Even Stock Price = strike price - Put Premium Paid/Received |

Maximum Risk, Maximum Reward, Break-Even Stock Price of a Short Put Position | Maximum Risk = strike price - Put Premium Paid/Received Maximum Reward = Put Premium Paid/Received Break-Even Stock Price =strike price - Put Premium Paid/Received |

A great deal of fundamental equity valuation involves ... | financial statement analysis |

Option pricing models try to calculate ... | an options time value. Since intrinsic value is certain, an option pricing model measures the uncertainty associated with the other factors. |

Factors affecting options value | Stock Price Strike Price Time to Expiration Expected Volatility Carrying Costs |

Effect of INCREASE in one factor on combined intrinsic value and time value of call and put options: | Stock Price: Call+ Put- Strike Price: Call- Put+ Time to Exp: Call+ Put+ Expected Volatility: Call+ Put+ Carrying Costs: Call+ Put- |

Effect of DECREASE in one factor on combined intrinsic value and time value of call and put options: | Stock Price: Call- Put+ Strike Price: Call+ Put- Time to Exp: Call- Put- Expected Volatility: Call- Put- Carrying Costs: Call- Put+ |

Most option pricing models rely on three principles: 1. At expiration, an option will be worth | its intrinsic value only. |

Most option pricing models rely on three principles: 2. option pricing models are based on the assumption that markets are | efficient and arbitraage opportunities do not exist |

Most option pricing models rely on three principles: 3.options can be combined with stocks and bonds in a portfolio such that | the value of the portfolio over a very short time period is unaffected by changes in stock price. Using option pricing and stock pricing models, it is possible to create portfolios that have no risk over this short time period |

Option pricing models are probability- | probability neutral models. Based on assumed probablilities, not certainties. The value of an option depends on the dispersion of returns associated with the actual stock price. The actual probability function is irrelavent. |

Formulas for u, d, Prd, Pru | u= Su/St d=Sd/St (1+r)-d u-(1+r) Pru= -------- Prd = ------- u-d u-d |

Formula for N | Cu - Cd N = ------- Su - Sd |

Formulas for Ct and Pt | (Pru x Cu) + (Prd x Cd) Ct = ----------------------- 1+r (Pru x Pu) + (Prd x Pd) Pt = ----------------------- 1+r |

As the number of periods is INCREASED and the length of any period is DECREASED, the Single Period Binomial Model ... | begins to resemble reality. |

The binomial model is a DISCRETE TIME MODEL because ... | it assumes that stock prices change over finite time intervals. As the time periods become shorter and shorter, to the point where they are infinitesimally small, the model becomes a CONTINUOUS TIME MODEL. |

In a CONTINUOUS TIME MODEL, stock prices ... | are assumed to change constantly. |

The Black-Scholes Options Pricing Model makes many of the same assumptions used for the Single-Period Binomial Model. It assumes that... | 1. the risk-free rate is constant over life of the option 2. the future volatility of the stock is constant over life of the option 3. money can be borrowed or lent at the risk-free rate 4. the full proceeds from short sale are available for reinvestme |

The key difference between Single-Period Binomial Model and the Black-Scholes Options Pricing Model is that ... | the Black-Scholes Options Pricing Model assumes that the stock prices change randomly and continuously throughout time so that the future distribution of stock prices is a normal distribution. |

The difference between the values calculated using the SPBM and B-S are attributed to two different, but important assumptions: 1. In SPBM, stock can take | only 2 values after a year, while B-S can take on any non-neg value after one year |

The difference between the values calculated using the SPBM and B-S are attributed to two different, but important assumptions: 2. SPBM assumes | annual compounding of interest. B-S assumes interest rates compound CONTINUOUSLY |

Volatility is the only variable in an option pricing model that is | unknown and therefor must be estimated. This fact makes the volatility estimate the key variable in the determination of an options value because it essentially determines the price of an option. |

The fair value price by an option pricing model depends on | the future volatility of the stock. |

When historical volatility is used to value options and an event occurs that increases current volatility of a stock (resulting in higher premiums) | options on the stock will appear overpriced. FV price calculated using HISTORICAL volatility figures will be ower (all else being equal) than the currentarket price of the options. |

A second approach to estimate future volatility of a stock is to use | IMPLIED VOLATILITY of the stock, based on the market price of its options. |

With B-S model, there is no formula for computing the implied volatility of a stock. The formula cannot be rearranged to solve for volatility. Instead, an iterative process must be used: | 1.Estimate level of stock's volatility & plug into options pricing formula along with other known factors 2.If result greater than market price of the option, est vol too high. Try lower. 3.If FV price is too low, try higher number 4.Continue til corr |

Why does implied volatility of a stock sometimes differ with different options on same stock? | Most speculators buy out-of-the-money options because they offer highest % returns, pushing up demand, higher prices, implying higher volatility. |

Another reason implied volatility of a stock sometimes differ with different options on same stock? | OPMs do not include all possiible factors that affect a stocks price. Eg, increased demand for out-of-the-money is not an input. Willing sellers may not be as numerous, driving up the price. Anythg othr thn 4 factors affecting price affect implied vol |

An official can declare a "fast market" when: | 1. Price of underlying interest can'tbe determined because of large spread between bid/ask 2. erratic fluctuations in underlying interest 3. Order flow of options too great to ensure orderly trading |

When "fast market" is declared, market makers | are given addtional flexibility when setting option prices. As a result, spread between bid and offer can be quite wide |

"Market orders" which are executed at the best available price at the time, are at risk of | being filled at prices that reflect implied volatility rates that may be unrealistic, reflecting temporary market conditions rather than fair value. |

Another risk of "fast markets" is that quotes are often | delayed. When sending a market order under these conditions investors should be aware that their screen could be significantly different from the price they will receive when the order is actually executed |

Investors must realize that limit buy orders and limit sell orders will not be filled if | buy - limit price lower than market sell- limit price is higher than market |

Distinguish between the price of an option and the value of an option as calculated using an option pricing model | *The price of an option is the price at which the option trades in the market. *The value of an option is the price at which the option is worth according to an option pricing model |

Define and explain the intrinsic value of an option | Intrinsic value is the tanglible value of an option represented by the positive difference between the strike price of the option and the price of the underlying stock |

Define and explain the time value of an option | Time value is the amount by which an option`s price exceeds its intrinsic value. It represents uncertainty about movements in price of the underlying stock over the life of the option. |

Identify and describe the factors that affect the value of an option | Undrlyng stock price, strike price, time to exp, future voltilty of stck price, cost of carry Stock price & Cost of Carryng(financing - divids) determined using current mkt info Future volatility unknown, estimate to determine effect on value of opt |

Describe the three fundamental principles that underlie an option pricing model: 1. At expiration, the value of an option | equals its intrinsic value. Since stock prices can be modelled, the value of an option at expiration over a range of different stock prices can be modelled. |

Describe the three fundamental principles that underlie an option pricing model: 2. the market is | efficient and there are arbitrage opportunities. Therefore, the risk neutral return on an asset is equal to its carrying costs. |

Describe the three fundamental principles that underlie an option pricing model: 3. Options can be | combined with stocks to create risk-free portfolios. If there is no arbitrage opportunities, a risk-free portfolio must earn the risk-free rate of return |

List the assumptions of the single-period binomial model: 1. A stock price can | move up or down only by fixed percentages over the single time period |

List the assumptions of the single-period binomial model: 2. The risk-neutral probability of a stock price increase or decrease | is a function of the risk free rate of return andthe future volatility of the stock price |

List the assumptions of the single-period binomial model: 3. The risk-free rate of return and the volatility of a stock price | are constant over the life of the option |

4. investors can borrow or lend | at the risk-free rate of return |

5. stocks and options can be traded in any | quantities and the proceeds from short sales are available for investment |

6. there are no | transition costs or taxes |

Describe the relationship between the generalized binomial option pricing model and the Black-Scholes option pricing model | The generalized binomial option pricing model is a discrete time model As the length of the time periods in the binomial model gets shorter, to infinite small, the values for the European call and put converge to values produced by Black-Scholes model. |

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WavyGravy