Understanding Options Markets: Types, Positions, Profits

Mechanics of Options MarketsChapter 8

Types of Options • A call is an option to buy • A put is an option to sell • A European option can be exercised only at the end of its life • An American option can be exercised at any time

Option Positions • Long call • Long put • Short call • Short put

Profit ($) 30 20 10 Terminal stock price ($) 70 80 90 100 0 110 120 130 -5 Long Call on Microsoft Profit from buying a Microsoft European call option: option price = $5, strike price = $100, option life = 2 months

Profit ($) 110 120 130 5 0 70 80 90 100 Terminal stock price ($) -10 -20 -30 Short Call on Microsoft Profit from writing a Microsoft European call option: option price = $5, strike price = $100

Profit ($) 30 20 10 Terminal stock price ($) 0 40 50 60 70 80 90 100 -7 Long Put on Oracle Profit from buying an Oracle European put option: option price = $7, strike price = $70

Profit ($) Terminal stock price ($) 7 40 50 60 0 70 80 90 100 -10 -20 -30 Short Put on Oracle Profit from writing an Oracle European put option: option price = $7, strike price = $70

Payoff Payoff X X ST ST Payoff Payoff X X ST ST Payoffs from OptionsWhat is the Option Position in Each Case? X = Strike price, ST= Price of asset at maturity

Assets UnderlyingExchange-Traded Options • Stocks • Foreign Currency • Stock Indices • Futures

Specification ofExchange-Traded Options • Expiration date • Strike price • European or American • Call or Put (option class)

Terminology Moneyness : • At-the-money option • In-the-money option • Out-of-the-money option

Terminology(continued) • Option class • Option series • Intrinsic value • Time value

Time Value and Intrinsic Valuefor a Call In Out Time Value Intrinsic Value S X

Time and Intrinsic Value for Put Option Out In Time Value S X

Dividends & Stock Splits • Suppose you own N options with a strike price of X : • No adjustments are made to the option terms for cash dividends • When there is an n-for-m stock split, • the strike price is reduced to mX/n • the no. of options is increased to nN/m • Stock dividends are handled in a manner similar to stock splits

Dividends & Stock Splits(continued) • Consider a call option to buy 100 shares for $20/share • How should terms be adjusted: • for a 2-for-1 stock split? X* = 20/2 = 10 N* = 2x100 = 200 • for a 5% stock dividend? X* = 20/1.05 = 19.05 N* = 1.05x100 = 105

Market Makers • Most exchanges use market makers to facilitate options trading • A market maker quotes both bid and ask prices when requested • The market maker does not know whether the individual requesting the quotes wants to buy or sell

Margins • Margins are not required when options are bought • Margins are required when options are sold and position is uncovered • Smaller margin is required for when written option is out of the money. • Margins are not required when written options is fully covered • See pages 174-175 for details (if interested) • General rule: margin is required only when strategy creates a future obligation

Convertible Bonds • Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio

Convertible Bonds(continued) • Very often a convertible is callable • The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose

Over-the-Counter Markets • Options are frequently negotiated in the over-the-counter market • The strike price and time to maturity do not then have to correspond to those specified by an exchange

Exotic Options Nonstandard options trading over-the counter include: • Barrier options • Asian options • Binary options • Chooser options • Compound options

Understanding Options Markets: Types, Positions, Profits