User FAQs

1) What is an Option ?
An agreement that gives the investor the right (but not the obligation) to buy (or sell) an asset at a specific price on a particular date in the future.

2) Why would someone buy an Option ?
If you have a commitment to buy something in the future you can buy an option contract to provide some protection against the price that you will have to pay.
When this day comes you can compare the current price with the price stated in the option contract.
If the current price is higher than the option price then you can execute the option which allows you to buy at the lower price.

3) How do you price an Option ?
Price of the Underlying Asset -
Volatility of the Underlying Asset -
Interest Rate - (risk free)
Strike Price - the agreed price the asset can be bought or sold at
Maturity Date -
Dividend information if the asset is an Equity
Coupon rate if the asset is a Bond

4) What is a Call Option ?
A Call Option gives the investor the right (but not the obligation) to buy an asset at a specific price on a particular date in the future.

5) What is a Put Option ?
A Put Option gives the investor the right (but not the obligation) to sell an asset at a specific price on a particular date in the future.

6) What do the following abbreviations means:
Long Call - buying a call option - buyer wants the asset price to increase above the strike price
Long Put - buying a put option - buyer wants the asset price to decrease below the strike price
Short Call - writing a call option - writer wants the asset price to decrease below the strike price
Short Put - writing a put option - writer wants the asset price to increase above the strike price

7) How much money can you make buying a Call Option ?
Profit: If the price of the asset increases above the strike price you can make a lot of money (no limit)
Loss: The most you can lose is the Premium.

8) How much money can you make buying a Put Option ?
Profit: If the price of the asset decreases below the strike price you can make some money (has a limit)
Loss: The most you can lose is the Premium.

9) How much money can you make writing a Call Option ?
Profit: The most you can make is the Premium.
Loss: If the price of the asset increases you could lose a lot of money because you will need to buy the asset.

10) How much money can you make writing a Put Option ?
Profit: The most you can make is the Premium.
Loss: If the price of the asset decreases you can lose some money because you will need to sell the asset.

11) What is the difference between a European Option and an American Option ?
A European option can only be exercised on the maturity date where as an American option can be exercised at any time.
An American style option is always worth at least as much as an equivalent European style option.
Stock Options are generally all American.
Equity Index Options are generally all European.

12) Under what circumstances would you exercise an American Call Option on an Equity that pays no dividend ?
Never. American options are rarely exercised early.
All options have a positive time value and are usually worth more not exercised.
Owners who want to close out of an option position would prefer to sell it and sacrifice "some" time value rather than exercise early and sacrifice "all" the time value.

13) What is the Drift ?
This is a measure of the average rate of growth of the underlying asset.

14) What is the Option Premium ?
This is the price of the option contract.

15) What aspects do you have to consider when buying and selling options ?
Premium - The amount charged for the right
Strike Price - The agreed price the asset can be bought or sold at
Maturity Date - The date when the option can be exercised
Historical Volatility - derived from past data, usually the previous x number of daily closes
Implied Volatility - considers past data and also takes a view on the future

16) What is Historical Volatility ?
This is the annualized standard deviation of past stock price movements.
It measures the daily price changes in the stock over the past year.

17) What is Implied Volatility ?
This is derived from an option's price and shows what the market "implies" about the underlying asset's volatility in the future.
Implied volatility shows the market's opinion of the asset's potential movement in the future.
It does not forecast direction.

18) Why is the Implied Volatility so important ?
The higher the Implied Volatility, the higher the option premium.
When the price of the underlying falls, the implied volatility increases ?
When the price of the underlying increases, the implied volatility decreases ?
Knowing where implied volatility levels are and where they are likely to go, can make a substantial difference to the outcome of a strategy.
Implied volatility offers an objective way to test forecasts and identify strategy entry and exit points.

19) How can you calculate Implied Volatility ?
Implied Volatilty can not be observed in the market and can only be determined by knowing all the other variables and using a model.
The Black Scholes Model is modified so market price becomes an input and volatility is the output.
The most traded options are the ones that are 'at-the-money' so it is these ones that are generally used in a model.

20) Can you draw the payoff diagram for buying a European call option ?
payoff = max(Current Price - Strike Price, 0)

21) Can you draw the payoff diagram for selling a European call option ?
payoff = -max(Current Price - Strike Price, 0)

22) Can you draw the payoff diagram for buying a European put option ?
payoff = max(Strike Price - Current Price, 0)

23) Can you draw the payoff diagram for selling a European put option ?
payoff = -max(Strike Price - Current Price, 0)

24) What is the Put-Call Parity ?
This is a relationship that must exist between the price of a European Call option and the price of a European Put option that has the same exercise price and maturity date.
It says that: if I buy a call option and an amount of cash equal to the present value of the exercise price then this gives me exactly the same payoff as selling a put option and buying the actual asset.
If this relationship did not exist then there would be an opportunity for risk-less profit (or arbitrage).

25) Can you explain the concept of moneyness ?
This describes whether an option is 'in', 'at' or 'out' of the money.

26) What is the Intrinsic Value ?
This is defined as the difference between the exercise price and the current price.
This is basically the amount that the option is worth.
Defined as the maximum of zero and the value the option would have if it were exercised immediately.
For example, if a call option (100 shares) has an exercise price of £30 and the share price is currently trading at £40 than the call option has an intrinsic value of (40-30) £10 (per share). If the current price is less than the exercise price the call option has no intrinsic value.

27) What is the Intrinsic Value of a Call Option when (Current Price > Strike Price) ?
Intrinsic Value = Current Price - Strike Price
A Call Option is in the money when Current Price > Strike Price
A positive delta between 0.5 and 1 meaning there would be a positive cash flow.

28) What is the Intrinsic Value of a Put Option when (Current Price < Strike Price) ?
Intrinsic Value = Strike Price - Current Price
A Put Option is in the money when Current Price < Strike Price
A negative delta between -0.5 and -1 meaning there would be a positive cash flow.

29) What is an at the money option ?
An option is at the money when the strike price is very close to the current price of the underlying asset.
An option is at the money when Current Price = Strike Price meaning Intrinsic Value = 0

30) What is the Intrinsic Value of a Call Option when (Current Price < Strike Price) ?
Intrinsic Value = Zero
A Call Option is out of the money when Current Price < Strike Price
A positive delta of 1 meaning there would be a negative cash flow if exercised.

31) What is the Intrinsic Value of a Put Option when (Current Price > Strike Price) ?
Intrinsic Value = Zero
A Put Option is out of the money when Current Price > Strike Price
A negative delta of -1 meaning there would be a negative cash flow if exercised.

32) What is the Time Value ?
This is the difference between the premium (price of the option) and the intrinsic value ?

33) Which Call Option would be cheaper ?
One that matures in 3 months or one that matures in 6 months.
3 month call option
The further the expiry date, the more time (or time value) there is for the option to become profitable.

34) What is a deep in the money option ?
An option is described as deep-in-the-money when there is big difference between the strike price and the current price of the underlying asset.
These options trade at (or very close) to their intrinsic values.

35) What type of options are traded the most ?
The most actively traded options are the ones that trade 'at-the-money'.
Deep in the money and deep out of the money rarely trade.

36) What are the risk measurements (sensitivities or greeks) ?
Delta - This is the amount an option price is expected to move for a 1 dollar change in the underlying. Calls have a positive delta. Puts have a negative delta. This is a percentage measure.
Gamma - This is how fast the delta is changing
Vega - How the price of the option changes with volatility
Rho - How the price of the option changes with interest rates
Theta - How the price of the option changes with time
Quoted in terms of 1 day.

37) What is Delta ?
The rate of change between the option price and a $1 change in the price of the underlying asset.
It can be thought of as a ratio or a percentage.
It measures the expected probability that an option will end up "in the money" when it expires.
If the delta is 0.5 this means if the price of the underlying asset increases by $1, the price of the option increases by $0.5 (all else being equal).
Call options have a positive delta. The more "in-the-money" the call option is the closer the delta is to 1.
Put options have a negative delta. The more "in-the-money" the put option is the closer the delta is to -1.

38) What would the Delta be for the following types of options at expiry ?
Call Option - In the Money: 1
Call Option - At the Money: 0.5
Call Option - Out of the Money: 0 (zero)
Put Option - In the Money: -1
Put Option - At the Money: -0.5
Put Option - Out of the Money: 0 (zero)

39) If the asset price increases by $1 how would this change the price of the option ?
Call Option - In the Money - (Current Price > Strike Price), the option price would increase by $1.
Call Option - At the Money - (Current Price == Strike Price), the option price would increase by $0.5
Call Option - Out of the Money - (Current Price < Strike Price), the option price would increase by $1.
Put Option - In the Money - (Current Price < Strike Price), the option price would
Put Option - At the Money - (Current Price == Strike Price), the option price would
Put Option - Out of the Money - (Current Price > Strike Price), the option price would

40) What should you do with an American Option that is deep in the money ?
The option should be exercised early or sold.

41) What does it mean if a call option price = $1 and the Delta = 0.5 (or 50, because it is out of 100) ?
This means whatever the change of the underlying asset is, the option price will move by 50% of that change.
If the price of the underlying asset moves from 96 to 97.5 (which is a 1.5 move) the price of the option will change by 0.75 (half of that).
Which means the price of this option would now be $1.75.

42) What does "Position Delta Neutral" mean ?
An at-the-money call option has a delta = 0.5, which means that there is a 50% chance the option will end in the money and a 50% chance it will end out of the money.
This delta tells us that it would take two at-the-money call options to hedge one short contract of the underlying.
In other words, you need two long call options to hedge one short futures contract.
(Two long call options x delta of 0.5 = position delta of 1.0, which equals one short futures position).
This means that a one-point rise in the S&P 500 futures (a loss of $250), which you are short, will be offset by a one-point (2 x $125 = $250) gain in the value of the two long call options.
In this example, we would say that we are position delta neutral.

43) What is Gamma ?
The rate of change of Delta with respect to the change in the price of the underlying.
This is a second order derivative with respect to the 'price of the underlying'.

44) What is Vega ?
The rate of change between the option price and a 1% change in the implied volatility of the underlying asset.
If the vega = 0.5 this means if the volatility of the asset increases by 1%, the price of the option increases by $0.5 (all else being equal)
This means whatever the change in the volatility, the option price will move by 50% of that change.
Options that are long have a positive vega
Options that are short have a negative vega
If the vega of an option is greater than the bid-ask spread, then the option is said to offer a competitive spread.

45) If the asset implied volatility increases by 1% how would this change the price of the option ?
If the vega = 0.5, the price of the option would increase by $0.5

46) What is Rho ?
This is how the price of a derivative changes with interest rates.

47) If the interest rate increases by 1% how would this change the price of the option ?
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48) What is Theta ?
This is how the price of a derivative changes with time.
This is how much the option price decreases every day

49) What is an Uncovered Option ?
This is an option that is not backed by the an offsetting position in the underlying.
Also known as a naked option.

50) What is a Barrier Option ?
Similar to a plain vanilla option but with the presence of one or two trigger prices.
If a trigger price is touched the option is either activated or erased.
A single barrier has one trigger price.
A double barrier has two trigger prices.

51) Can you describe the main types of Barrier Options ?
Up and Out - barrier level is higher than spot (option is erased)
Down and Out - barrier level is lower than spot (option is erased)
Up and In - barrier level is higher than spot (option is activated)
Down and In - barrier level is lower than spot (option is activated)

52) Why would someone buy a Barrier option ?
These are cheaper than vanilla options.

53) What is a Lookback option ?
The payoff is the highest or lowest price that the spot trades at over the life of the option.
Lookback Call - right to buy at a strike price equal to the lowest price the spot traded at.
Lookback Put - right to sell at a strike price equal to the highest price the spot traded at.

54) What is an Asian option ?
This type of option has its payoff determined by the average price of the underlying over a defined period.

55) What is a Quanto option ?
The underlying is denominated in one currency but the instrument is settled in a different currency at some fixed interest rate.
Also known as a Fixed Exchange Rate Option or a Foreign Asset Option.

56) What is a Composite option ?
The underlying is denominated in one currency but the instrument is settled in a different currency. The interest rate is not fixed but floating
Also known as a Floating Exchange Rate Option or a Foreign Asset Option.

57) What is a Rainbow option ?
This type of option is exposed to two or more sources of uncertainty.
A normal option is exposed to one, normally the price of the underlying.
A good example might be to value natural resources deposits. Such assets are exposed to two uncertainties - price and Quantity.

58) Can you describe some Option Strategies ?
(Covered Call) - buy asset, sell call option (neutral position)
(Married Put) - own asset, buy put option (bullish, hope price increases)
(Bull Call Spread) - buy call option, sell call option at a higher exercide price (bullish)
(Bear Put Spread) - buy put option, sell put option at a lower exercide price (bearish)
(Protective Collar) - buy 'out of the money' put option, sell 'out of the money' call option (locks in profit after a long position has made gains)
(Long Straddle) - buy call and put simultaneously with same strike (hope price will move in either direction)
(Long Strangle) - buy call and put simultaneously with put strike below call strike (hope price moves significantly in either direction)
(Butterfly Spread) - combination of a bull spread and a bear spead using 3 different strike prices
(Iron Condor) - combination of two different strangle positions
(Iron Butterfly) - combination of a long or short straddle with a buy or a sell of a strangle

59) How many different methods can be used to price a European Option on an Equity ?
Black Scholes - (PDE, analytical closed form solution)
Blacks -
Binomial Tree - (Numerical Method) slow (trinomial trees)
Finite Differences - (Numerical Method)
Monte Carlo - (Numerical Method) extremely slow
Risk Neutral Valuation - (Numerical Method)

60) How many different methods can be used to price an American Option on an Equity ?
Black Scholes -
Binomial Tree (Numerical Method)
Implicit Finite Differences - (Numerical Method)
Monte Carlo - (Numerical Method) - You must obtain the optimal exercise threshold function
Least Square Method -
Whaley -

61) How many different methods can be used to price a European Option on a Bond ?
There are three different approaches which you could use:
Ignore the Term Structure - Black Scholes because it has an assumption that the risk free interest rate is constant
Model the Term Structure - continuous models
Match the Term Structure - discrete models

62) Can you use the Black Scholes model to price an Option on a Bond ?
No. There are three reasons why this is not a suitable model.
*) The model assumes that the volatility of the underlying is constant. As a bond moves closer to maturity the price volatility decreases.
*) The probability distribution assumes lognormal which means the price can take on any positive value. The price of a bond can never exceed the sum of the coupons plus the principle. The black-scholes model can produce a price that exceeds this.
*) The model assumes that the risk free interest rate is constant. A change in the short term interest rate will affect the other interest rates along the yield curve.

63) Can you use Binomial Trees based on Prices to price an Option on a Bond ?
No. This model suffers from the same problems as the Black Scholes model.

64) Can you use Binomial Trees based on Yields to price an Option on a Bond ?
No. This model does not satisfy the put-call parity relationship and therefore allows arbitrage opportunities.

65) What is a Volatility Smile ?
These are implied volatility patterns that arise in pricing options.
Graphing the implied volatility against different strike prices for a given expiry produces a skewed smile instead of the expected constant volatility.
When there are higher prices for 'out-of-money' options this implies a deficiency in the Black Scholes Model which assumes constant volatility.