Options

1. Options Professor Brooks BA 444 01/09/08

2. The First Known Option Trader • Philosopher Thales of Milesian. • Used the stars to determine the olive crop would be large that year. • Paid a deposit on all the olive presses in the area for use in the harvest season • Olive crop harvest large • Presses in high demand • Rented presses out a rate higher than he had secured with his deposit…made $$$$$

3. Types of Options • Only Two • Call – Right but not the obligation to buy the underlying asset on or before a set date at a pre-set price (strike or exercise price) • Put – Right but not the obligation to sell the underlying asset on or before a certain date at a pre-set price (strike or exercise price)

4. Categories of Options • American vs. European • Underlying Asset • Equity Option – Stock • Index Option – Financial Index • Futures Option – Futures Contract • FX Option – Foreign Exchange • Interest Rate Option – Treasury Bond

5. Standardized Option Contract • Traded on an Exchange • ISE, CBOE, AMEX, Philly, PSE • Set Size of Underlying Asset • Equities are 100 shares of stock • Futures are the size of futures contract • Specific Expiration Date (Third Friday) • Specific Strike Price (Exercise Price) • Price of Option is current selling/buying price of the financial asset.

6. Options Basics • A basketball ticket… • Owner of the ticket has the right to • Attend the game • Sell the ticket to someone else • “Eat” the ticket, not use or sell the ticket • Original seller must provide the “seats” for the game if exercised by either original buyer or subsequent buyer of the ticket • Price of the ticket will vary through time based on the performance of the teams and the time left before tip-off

7. Four Positions in Options & Risk • Buy a Call – Risk is cost of option • Sell a Call – Risk is rising prices • Buy a Put – Risk is cost of option • Sell a Put – Risk is falling prices • Diagrams of four positions • Hockey Sticks of Options • Reveals potential gains and losses

8. Trading Options • Option Ticker Symbols • Page 23… • Example at ISE, http://www.ise.com/ • Bid Prices and Ask Prices • Bid, price at which one is willing to buy • Ask, price at which one is willing to sell • Market vs. Limit • Order Book Official (Limit order book) • Preference to price and time

9. Trading Options -- Continued • Exercise a Call (holder of option) • Notify OCC • Put up the strike price • Receive the underlying asset • Exercise a Put (holder of option) • Notify OCC • Put up the underlying asset • Receive the strike price • Or Sell the Call or Put

10. Option Values • Price of the option • intrinsic value • Call Max (0, S-K) • Put Max (0, K-S) • Plus time value • Illustrate Intrinsic value…profit from exercising • Illustrate time value of option with binomial tree • Never exercise Call option (lose time value)