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Options. An option is a contract between two parties, let’s call them the writer and the owner . The key feature of an option is that the owner chooses whether the contract is exercised . Options.

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options
Options

An option is a contract between two parties, let’s call them the writer and the owner.

The key feature of an option is that the owner chooses whether the contract is exercised.

options2
Options
  • Department Store gives customer the option to return merchandise for exchange or store credit.
  • Owner of a health insurance policy has the option to see a doctor.
  • Owner of a convertible bond has the option to convert it into stock.
options3
Options
  • The owner of a Call Option has the option to buy an underlying asset for a specified price. The writer has the obligation to sell if the option is exercised.
  • The owner of a Put option has the option to sell an underlying asset for a specified price. The writer has the obligation to buy if the option is exercised.
options4
Options

Like a future, an exchange-traded option:

  • Has two parties, a buyer and a seller
  • Sets a price today for a transaction later

Called the Exercise Price or Strike Price

  • Has an expiration date
  • Clearinghouse acts as intermediary
options5
Options

Unlike a future, an option

  • Is exercised at the discretion of one party (owner).
  • Requires the buyer (owner) to pay a premium to the writer at the time the contract is initiated.
options6
Options

European-style options can be exercised only on the day they expire.

American-style options can be exercised any time prior to expiration.

options call options
OptionsCall Options

Example: April 55 Microsoft Call

  • Underlying Asset: 100 Shares Microsoft
  • Expiration Date: Third Friday in April
  • Strike Price: 55 American-Style

The owner of this option can buy 100 shares of Microsoft for 55/share anytime prior to expiration.

options call options8
OptionsCall Options

On December 28

  • Microsoft was trading for about 45.25
  • The premium for the April 55 call was about 3.25 per share.

Find out where the market is today

options call options9
OptionsCall Options

You buy 10 April 55 Microsoft calls

Initial Investment =

($3.25/share)

X (100 shares/contract)

X (10 contracts)

= $3,250

options call options10
OptionsCall Options

On the third Friday of April:

If MSFT = 54

You have the right to buy for 55

But you can buy on the market for 54

The options expire Out of the Money

Do not exercise. Loss = $3,250

options call options11
OptionsCall Options

If MSFT = 60

You have the right to buy for 55

The options expire In the Money

Exercise: Buy 1,000 shares at 55

You can sell them at 60

Profit = (60-55)*1,000 – 3,250 = $1,750

options call options12
OptionsCall Options

If MSFT = 56

You have the right to buy for 55

Exercise: Buy 1,000 shares at 55

You can sell them at 56

Exercise: Loss = 1,000-3,250 = -$2,250

If you do not exercise: Loss = -$3,250

options call options13
OptionsCall Options

Payoff Function

The payoff of a call option is equal to:

max(0,S-K)

S = Price of stock at the time the option expires

K = Strike Price

MSFT Example : Payoff = max(0,S-55)

options call options15
OptionsCall Options

Payoff Diagram

Payoff

55

S

options call options16
OptionsCall Options

C = Initial Premium

V = Payoff at Exercise or Expiration

Profit per share = V-C

Return = (V-C) / C

MSFT=54 Profit = -3.25 Return = - 100%

MSFT=56 Profit = -2.25 Return = - 69%

MSFT=60 Profit = 1.75 Return= 54%

options call options17
OptionsCall Options

Profit/Loss Diagram

Profit

55

S

-3.25

options call options18
OptionsCall Options

Breakeven Point

C = Initial Premium K = Strike

S = Stock price when you exercise

You break even if: S = K+C

MSFT Example:

Breakeven point: S = 55 + 3.25 = 58.25

options call options19
OptionsCall Options

Buying a Deep out of the money option is like buying a lottery ticket.

Example:

On December 27, Lucent is at 13.125

The January 40 call is trading at .0625

Buy calls on 16,000 Shares for $1,000

Lose 100% almost certainly

If Lucent goes to 45, Payoff = $80,000

options call options20
OptionsCall Options

Buying a deep in the money call is like buying the stock on margin.

Example:

On December 28, GE is at 48.375

The January 20 call is trading at 28.50

A: Buy calls on 700 Shares for $19,950

B: Buy 700 shares at 59% Margin for $19,950

(Borrow $13,912)

options call options21
OptionsCall Options

On the Third Friday of January

If GE is at 55:

A: (700) (55-20) = $24,500

B: (700) 55 – 13,912 = $24,588 - Interest

If GE is at 40:

A: (700) (40-20) = $14,000

B: (700) 40 – 13,912 = $14,088 - Interest

options call options22
OptionsCall Options

Deep in the Money Call vs. Margin Buy

  • The option position has a small loss of value due to the option premium
  • The margined position has a small loss of value due to interest on the margin loan
  • The option position expires
  • Margined position subject to a margin call
  • Option position will do better in a crash
options put options
OptionsPut Options

Example: June 30 McDonalds Put

  • Underlying Asset: 100 Shares McDonalds
  • Expiration Date: Third Friday in June
  • Strike Price: 30 American Style

The owner of this option can sell 100 shares of McDonalds for 30/share anytime prior to expiration.

options put options24
OptionsPut Options

On December 28

  • McDonalds was at about 34
  • The premium for the June 30 put was about 1.25 per share.

Find out where the market is today

options put options25
OptionsPut Options

You buy 50 June 30 McDonalds Puts

Initial investment: 50*100*1.25= $6,250

At expiration: If MCD = 32

You can sell for 30 if you exercise

You can sell for 32 on the market

Do not exercise.

options put options26
OptionsPut Options

At expiration: If MCD = 28

You can buy for 28 on the market

You can sell for 30 if you exercise

Payoff = (30-28) * 5000 = $10,000

Profit = $10,000 - $6,250 = $3,750

If MCD = 29

Payoff = $5,000 Loss: -$1,250

options put options27
OptionsPut Options

Payoff Function

The payoff of a put option is equal to:

max(0,K-S)

S = Price of stock at the time the option expires

K = Strike Price

MCD Example : Payoff = max(0,30-S)

options put options28
OptionsPut Options

Payoff Table

options put options29
OptionsPut Options

Payoff Diagram

Payoff

30

S

options put options30
OptionsPut Options

Profit/Loss Diagram

Profit

30

S

-1.25

options put options31
OptionsPut Options

Breakeven Point

P = Initial Premium K = Strike

S = Stock price when you exercise

For a put, you break even if:

S = K-P

MCD Example:

Breakeven point: S = 30 - 1.25 = 28.75

options put options32
OptionsPut Options

Deep out of the money Put

Example:

On December 29, IBM is at 85

The January 45 put is trading at 0.125

Buy puts on 10,000 shares for $1,250

Lose 100% almost certainly.

If IBM goes to 40, payoff = $50,000

options put options33
OptionsPut Options

Deep in the money Put

Example:

On December 29, IBM is at 85

The January 160 put is trading at 75.25

A: Buy puts on 100 shares for $7,525

B: $7,525 in cash and short sell 100 shares

options put options34
OptionsPut Options

On the Third Friday of January

If IBM is at 95:

A: (100) (160 - 95) = $6,500

B: (100) (85-95) + 7,525 = $6,525 + Int.

If IBM is at 75:

A: (100) (160 - 75) = $8,500

B: (100) (85-75) + 7,525 = $8,525 + Int.

options put options35
OptionsPut Options

Deep in the Money Put vs. Short Sale

  • The option position has a small loss of value due to the option premium
  • The margined position has a small gain of value due to interest on the margin
  • The option position expires
  • Short position subject to squeeze
  • Option position better if stock skyrockets
markets
Markets

Physical Delivery means that the short party on a futures contract (or the writer of an option) must deliver the underlying asset.

Cash Settlement means that instead of the underlying asset, the short side delivers the cash equivalent of the current value of the underlying asset.

markets physical delivery
CBOT

Grain Futures

Metals Futures

Electricity Futures

CME

Livestock Futures

Currency Futures

CBOE Stock Options

AMEX Stock Options

PCX Stock Options

PHLX Stock Options

MarketsPhysical Delivery
markets cash settlement
MarketsCash Settlement

With cash settlement, the underlying need not be a traded asset.

Stock IndexMortgage Index

Interest RatesWeather

Commodity IndexCatastrophe Index

Muni Bond IndexCrop Yield

Agricultural Index

markets index options
MarketsIndex Options

CBOE Index Options

AMEX Index Options

PHLX Sectors Index Options

markets derivatives exchanges united states
CBOT

CME

NYMEX

NYBOT

KCBT

MIDAM

MGE

CBOE

AMEX

PHLX

PSX

ISE

MarketsDerivatives Exchanges – United States
markets international derivatives exchanges
EUREX

LIFFE

MATIF

MEFF

OM

BSX

AEX

CDE

SAFEX

SFE

TIFFE

OSE

HKFE

KLOFFE

COMMEX

BMF

MarketsInternational Derivatives Exchanges
  • IPE
  • LME
  • TGE
  • TOCOM
  • WCE
  • MONEP
  • SHFE
  • BC
markets over the counter otc
MarketsOver The Counter (OTC)

OTC Derivatives are negotiated directly between the two parties Global Market

  • Swaps
  • Forwards
  • Options
  • Caps/Floors
  • Swaptions
  • Exotics
  • Interest Rates
  • Currencies
  • Equities
  • Commodities
  • Credit