Options Markets and Contracts

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Options markets are specialized segments of the financial markets where options contracts are bought and sold. An option is a derivative instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) before or at a …

Options Markets and Contracts - A Comprehensive Guide for CFA Level 1 Exam

Why Options Markets and Contracts are Important:
Options markets provide investors with a powerful tool for managing risk, speculating on price movements, and generating income. Understanding options is essential for CFA candidates as they are widely used in investment strategies and portfolio management.

What are Options Markets and Contracts?
An option is a financial derivative that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) on or before a specific date (expiration date). Options contracts are standardized and traded on exchanges.

How Options Markets and Contracts Work:
1. Call options: Buyers of call options believe the price of the underlying asset will rise, allowing them to purchase the asset at a lower strike price and sell it at a higher market price for a profit.
2. Put options: Buyers of put options believe the price of the underlying asset will fall, allowing them to sell the asset at a higher strike price and buy it back at a lower market price for a profit.
3. Option pricing: Option prices (premiums) are determined by factors such as the current price of the underlying asset, strike price, time to expiration, volatility, and interest rates.
4. Option strategies: Investors can use various strategies, such as covered calls, protective puts, straddles, and spreads, to manage risk and generate income.

Exam Tips: Answering Questions on Options Markets and Contracts
1. Understand the basic terminology and concepts related to options, such as call and put options, strike price, expiration date, and option premiums.
2. Know the factors that influence option prices, such as the underlying asset price, time to expiration, volatility, and interest rates.
3. Be familiar with common option strategies and their risk-return profiles.
4. Practice calculating option payoffs and profits for different scenarios.
5. Read each question carefully and identify the key information provided before attempting to answer.
6. Manage your time effectively by not spending too much time on any single question.

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CFA Level 1 - Options Markets and Contracts Example Questions

Test your knowledge of Options Markets and Contracts

Question 1

When an investor sells a put option, which of the following best describes their market sentiment?

The investor is bearish on the underlying asset and expects the price to decline in the near future. The investor is neutral on the underlying asset and anticipates minimal price movement in either direction. The investor is bullish on the underlying asset and believes the price will rise.

Correct Answer: The investor is bullish on the underlying asset and believes the price will rise.

When an investor sells a put option, they are bullish on the underlying asset. By selling a put, the investor is obligated to buy the underlying asset at the strike price if the option is exercised. The investor hopes that the price of the underlying asset will rise, making the put option expire worthless and allowing them to keep the premium received for selling the put. The other answers are incorrect because: - If the investor were bearish on the underlying asset, they would buy a put option instead of selling one, as they would expect the price to decline. - If the investor were neutral on the underlying asset, they would not likely engage in selling put options, as there is inherent risk involved with the obligation to purchase the underlying asset if the price falls below the strike price.

Question 2

An investor purchases a call option on a stock with a strike price of $100 and a premium of $5. At expiration, the stock price is $110. What is the profit or loss for the option holder?

The option holder will realize a profit of $1,500, calculated as ($110 - $100 + $5) × 100 shares, incorporating both the intrinsic value and the time value of the option at expiration. The option holder will realize a profit of $1,000, calculated as ($110 - $100) × 100 shares, as the premium paid is not considered in the profit calculation. The option holder will realize a profit of $500, calculated as ($110 - $100) × 100 shares - $500 premium paid.

Correct Answer: The option holder will realize a profit of $500, calculated as ($110 - $100) × 100 shares - $500 premium paid.

The correct answer is that the option holder will realize a profit of $500. Here's why: At expiration, the stock price is $110, which is above the strike price of $100. This means the call option is in-the-money by $10. The profit is calculated as the intrinsic value of the option (difference between stock price and strike price) multiplied by the number of shares per contract (typically 100), minus the premium paid for the option. Profit = ($110 - $100) × 100 shares - $500 premium paid = $1,000 - $500 = $500 The other answers are incorrect because they either do not consider the premium paid or incorrectly add the premium to the intrinsic value.

Question 3

Which of the following is a characteristic of American-style options that distinguishes them from European-style options?

American-style options can be exercised at any time prior to expiration. American-style options are only traded on North American exchanges, while European-style options are traded on European exchanges. American-style options have a higher premium than European-style options with the same strike price and expiration date.

Correct Answer: American-style options can be exercised at any time prior to expiration.

The key characteristic that distinguishes American-style options from European-style options is that American-style options can be exercised at any time prior to expiration, while European-style options can only be exercised at expiration. The other two answers are incorrect: - The premium of an American-style option is typically higher than a European-style option with the same strike price and expiration date due to the additional flexibility, but this is not the defining characteristic. - American-style and European-style options are not restricted to specific geographic regions or exchanges. The terms refer to the exercise style, not the location of the exchange.

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