Tag Archives | financial instrument

Stock Options Basics

Stock Options Definition

A stock option is a financial instrument that gives its holder the right but not the obligation to buy or sell a security for a set price on or before a set date. Stock options are traded on financial bonuses. A stock option contract typically consists of no less than 100 options. A trader can enter into a stock option contract to profit from or protect against volatility in the underlying security without actually having to invest in the underlying security. A stock option is exercised when the stock option holder decides to buy or sell the underlying security. If a stock option is not exercised by its expiration date, the stock option expires.

A stock option contract has an option premium, a strike price, and an expiration date. The option premium is the price of the stock option contract. The strike price refers to the price of the underlying security at which the stock option can be exercised. The expiration date is the date on which the option contract expires.

There are two basic types of options: calls and puts. A call option gives its holder the right to buy the underlying security. A put option gives its holder the right to sell the underlying security.

Call Option Contract

A call option gives its holder the right to buy the underlying security at a set price on or before a set date. If a trader expects a security to rise in value, the trader can buy a call option on that security.

Put Options Contract

A put option gives its holder the right to sell the underlying security at a set price on or before a set date. If a trader expects a security to fall in value, the trader can buy a put option on that security.

Stock Options Examples

Call Option Example

A stock is currently trading at $10. A trader expects the stock to rise in value so he buys a call option. The premium is $1, the strike is $12, and the option expires in 1 month. For the option to make a profit, the stock must rise above $13 before the contract expires. Let’s say the stock rises to $15 within a month. The trader can then exercise the option and make $2 profit. He buys the stock at $12 when it is worth $15, so he gains $3. But the cost of the option was $1, so his profit is $2.

Put Option Example

A stock is currently trading at $10. A trader expects the stock to fall in value so he buys a put option. The premium is $1, the strike is $8, and the option expires in 1 month. For the option to make a profit, the stock must fall below $7 before the contract expires. Let’s say the stock falls to $5 within a month. The trader can then exercise the option and make $2 profit. He sells the stock at $8 when it is worth $5, so he gains $3. But the cost of the option was $1, so his profit is $2.

Black Scholes Model

The value of an option consists of time value and intrinsic value. Option values can be determined using the Black-Scholes formula, or other option valuing formulas.

European Options vs American Options

American options can be exercised at any time during the life of the option contract. You can only exercise European options on the expiration date. Both types of contract trade in markets all over the world.

In-the-Money Call Option

An option is in-the-money if exercising it immediately would result in a profit.

At-the-Money Call Option

An option is at-the-money if exercising it immediately would result in no profit or loss.

Out-of-the-Money Call Option

An option is out-of-the money if exercising it immediately would result in a loss. (A trader would not exercise an out-of-the money option, but instead would simply let it expire.)

Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.

stock options

Strategic CFO Lab Member Extra

Access your Projections Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

stock options

See Also:
Intrinsic Value – Stock Options
Initial Public Offering (IPO)
Black Scholes Option Calculation
Binomial Options Pricing Model
Subscription (Preemptive) Rights

0

Hedge Funds

See Also
Currency Exchange Rates
Hedging Risk
Currency Swap
Transaction Exposure
Exchange Traded Funds

Hedge Funds Defined

What is a hedge fund? A hedge fund is a private investment portfolio that makes aggressive speculative investments. Because hedge funds often have a very high minimum investment requirement, hedge fund investors are typically only institutional investors and wealthy individuals. The hedge fund manager manages the hedge fund investments. Because hedge funds are private – often structured as private partnerships – they are not subject to the same SEC regulations as other funds, such as mutual funds.

Hedge Fund Investing

Hedge fund investing is fairly illiquid. This is because hedge funds often require investors to commit their invested capital for a certain period of time, sometimes a year or longer. During this period the investor’s capital is locked into the hedge fund. Therefore, the investor cannot pull out the invested funds. Hedge funds often require investors to lock in their funds so the hedge fund manager can engage in complicated investments without worrying about having the capital pulled out from under him.

Costs of Hedge Funds

The costs of hedge funds include management fees and a percentage of any profit that goes to the hedge fund manager. Call this percentage of profit that goes to the hedge fund manager the hedge fund carry. Hedge fund investments often include combinations of exotic financial instruments, such as credit default swaps, leverage, options contracts, forward contracts, futures contracts, long positions, short positions, and other financial derivatives.

Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.

hedge funds

Strategic CFO Lab Member Extra

Access your Projections Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

hedge funds

0

Covariance

See Also:
Direct Labor Variance Formulas
Direct Material Variance Formulas
Variance Analysis
Financial Instruments
Common Stock Definition

Covariance Definition

The covariance in finance is the degree or amount that two stocks or financial instruments move together or apart from each other.

Meaning of Covariance

The covariance means that investors have the opportunity to seek out different investments based upon their respective risk adversity. If the covariance is negative then this means that the two instruments move opposite one another depending on the economy. This then becomes a way for investors to diversify some of their risks away.

If an investor were to buy two stocks with a negative covariance then in a boom period one would earn more than the other and vice versa for a recession.

If an investor were to care solely about the return and no risk then an investor might choose two stocks that have a positive covariance based solely on their expected returns. This means that this particular investor has the chance to make a big gain, but also a bad loss. This is because the two instruments will move with each other and there is no diversification in the portfolio of two stocks.

Covariance Example

Tim has been doing some research in the market and has narrowed his search down to three stocks. However, Tim only has enough money to invest in two of the stocks. The covariances are as follows:

A and B Stock = -100
A and C Stock = 100
B and C Stock = 0

Depending on Tim’s risk adversity he will make different decisions. If he is simply looking solely at the returns he will choose stocks A and C because they have the highest potential returns but also the highest potential loss. If he were very risk averse he would choose stocks A and B because the amount of risk has been diversified away. The final option would not be chosen because stocks B and C have no covariance or correlation between each other. The two stocks simply move independently and there is not as much potential to diversify or maximize the risk and return.

Note: The result assumes weights of 50% will be put into each stock for each investment opportunity.

covariance

0

Basis Points

See Also:
Accounts Payable
Margin vs Markup
Collateralized Debt Obligations
Are You Collecting Business Data?
Benchmarking

A basis point is one hundredth of a percentage point. A single basis point would look like this: 0.01%. Fifty basis points is a half a percentage point: 0.50%. 100 basis points equal one percentage point: 1.00%.

When To Use Basis Points

In finance, changes in the values of financial instruments or interest rates may be denoted in basis point. They are used to describe quantities less than one percent. When the Federal Reserve lowers its fed funds rate by a half a percent, the media may report that the fed funds rate was lowered by 50 basis points.

Similarly, the interest rate on a loan or debt instrument that is based on a reference rate, such as LIBOR or the Prime Rate, may have a spread quoted using the term basis point. The rate may be described as Prime Rate plus 50 basis point. If Prime Rate is 5%, then the rate on that loan or debt instrument would be 5.5%.

basis points

 

0

LEARN THE ART OF THE CFO