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##### Options and Options Markets

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**Options and Options Markets**Supplemental Chapter 2**Options**Derivative Assets – assets whose value is derived by the value of another assets (the underlying asset). Call Option - the right to buy an asset at a pre-specified price and time.**Options**Options are a contract between two parties: a buyer and a seller. Two types of options: • Calls • Puts**Options**Call Options – grant the buyer (holder) the right to buy the underlying asset at a pre-specified price. Put Options – grant the buyer (holder) the right to sell the underlying asset at a pre-specified price. Long vs. short positions Strike (exercise) price – pre-specified price stated in the option contract.**Options**Options: Limited life – typically expire within 1 year of the initial trading date. Exchange traded equity options expire on the third Friday in the expiration month. European Options can be exercised on their maturity date only. American Options can be exercised at any time prior to expiration. Note: The terms European and American describe to excise options, and not where they are traded.**Call Options**On 3/29/01 IBM closed at 96.18, a call option expiring in May with a strike of 115 traded at $1.40 premium on that same day. As IBMs price increases so does the premium on the option. Options purchased on organized exchanges can be sold for a profit. If the call buyer holds until the maturity date, she can elect to exercise the option or let it expire. That decision will depend on the selling price of IBM on the options maturity date.**Call Option**At maturity, the buyer’s payoff will equal: CT=Max(ST-X,0) Where: T = Option expiration date CT = Call’s Value on the expiration date ST = Selling Price of the underlying stock on T X = Option’s Strike**Call Option**Profits / Payoff for the Call Buyer Profit ($) Payoff ($) ST-X ST-X 115 115 116.40 116.40 -1.40 -1.40 Stock Price Stock Price At the Money Out-of-the Money In-the Money**Call Option**Profits / Payoff for the Call Seller Profit ($) Payoff ($) Stock Price 1.40 115 Stock Price 115 116.40 -1.40 X-ST X- ST**Put Options**A put option grants the buyer the right to sell stock at the exercise price prior to maturity. On 3/29/01 IBM closed at 96.18, a put option expiring in May with a strike of 115 traded at $18.90 premium on that same day. Buying a put option will allow an investor to set the floor on a stocks selling price. If the put buyer holds until the maturity date, she can elect to exercise the option or let it expire. That decision will depend on the selling price of IBM on the options maturity date. However, when exercising her option the put buyer must deliver the shares to the put seller.**Put Option**At maturity, the buyer’s payoff will equal: PT=Max(X- ST,0) Where: T = Option expiration date PT = Put’s Value on the expiration date ST = Selling Price of the underlying stock on T X = Option’s Strike**Put Option**Profits / Payoff for the Put Buyer Profit ($) Payoff ($) 115 X- ST 96.10 X- ST 115 115 -18.90 Stock Price Stock Price At the Money In-the Money Out-of-the Money $115-$18.90 = $96.10**Put Option**Profits / Payoff for the Put Seller Profit ($) Payoff ($) 18.90 115 Stock Price 96.10 115 Stock Price ST-X ST- X -96.10 -115**Options Markets**Chicago Board Options Exchange (CBOE) Contract maturities and strikes are determined by the exchange (for options traded on organized exchanges), not the individual buyers and sellers. Benefits of trading on the options market: • Protection against default risk – For CBOE, insured by Options Clearing Corp (OCC). • Liquidity