Mechanics of Option Markets CHAPTER 9

Types of Options Ability to Exercise According to Positions Derivative Instrument Basic Options Call Options European Call Options American Call Options Put Options European Put Options American Put Options

Types of Options A call option gives the holder of the option the right to buy an asset by a certain date for a certain price. A put option gives the holder the right to sell an asset by a certain date for a certain price. The date specified in the contract is known as the expiration date or the maturity date. The price specified in the contract is known as the exercise price or the strike price. The price of option contract is known as premium or sometimes it is titled as cost of option

Types of Options American options can be exercised at any time up to the expiration date European options can be exercised only on the expiration date itself.

Option Positions There are two sides to every option contract. ◦Investor who has taken the long position (i.e., has bought the option). ◦Investor who has taken a short position (i.e., has sold or written the option).

Option Positions Positions for Call Options: Long Call ◦This party acquires the option to have the right to buy the asset. S/he pays the premium in advance to have that privilege to exercise the option or not. Short Call ◦This party sells the option and agrees to sell underlying asset when the long party decides to exercise the option. s/he holds all the liabilities to the party in which he sold the option. S/he receives the premium in advance before delivering the contract

Option Positions Positions for Put Options: Long Put ◦This party acquires the option to have the right to sell the asset. S/he pays the premium in advance to have that privilege to exercise the option or not. Short Put ◦This party sells the option and agrees to buy underlying asset when the long party decides to exercise the option. s/he holds all the liabilities to the party in which he sold the option. S/he receives the premium in advance before delivering the contract

Call Option Example An investor who buys a European call option with a strike price of $100 to purchase 1 lot of shares of a certain stock. Suppose that the current stock price is $98, the expiration date of the option is in four months, and the price of an option to purchase one share is $5. What will be the initial Investment? The initial investment is 100×$5=$500 What will be the gain if the stocks price is $115 at the maturity? ($115-$100) × 100 = $1500 What will be the net profit at the end of the investment? $1500-$500=$1000

Call Option Example (Continued) Profit from buying one European call option: option price = $5, strike price = $100. LONG POSITION Profit ($) Terminal stock price ($)

Call Option Example (Continued) Profit from writing one European call option: option price = $5, strike price = $100 SHORT POSITION Profit ($) Terminal stock price ($)

Put Option Example Investor who buys a European put option with a strike price of $70 to sell 1 lot of shares of a certain stock. Suppose that the current stock price is $65, the expiration date of the option is in three months, and the price of an option to sell one share is $7. What will be the initial Investment? 100×$7= $700 What will be the gain if the stocks price is $55 at the maturity? ($70-$55)×100=$1500 What will be the net gain at the end of the investment? $1500-$700= $800

Put Option Example (Continued) Profit from buying a European put option: option price = $7, strike price = $70 LONG PUT Profit ($) Terminal stock price ($)

Put Option Example (Continued) Profit from writing a European put option: option price = $7, strike price = $70 SHORT PUT Profit ($) Terminal stock price ($)

Payoffs from Options

Payoffs at Each Position Payoff STST STST K K STST STST K K

Assets Underlying Exchange- Traded Options Stocks ◦Options trade on several thousand different stocks. One contract gives the holder the right to buy or sell 100 shares at the specified strike price. Foreign Currency ◦One contract is to buy or sell 10,000 units of a foreign currency except for Japanese yen Stock Indices ◦One contract is to buy or sell 100 times the index at the specified strike price. Futures ◦ A futures option normally matures just before the delivery period in the futures contract.

Specification of Exchange-Traded Options The most important specifications that has to be mentioned in an option contracts are: ◦Exercise Date ◦Strike Price ◦European or American ◦Option Class

Specification of Exchange-Traded Options: Exercise Date The precise expiration date is the Saturday immediately following the third Friday of the expiration month. The last day on which options trade is the third Friday of the expiration month. Options are traded according to Option Cycles There are 3 Option Cycles: January, February, March

Specification of Exchange-Traded Options: Strike Price Strike prices spaced $2.50, $5, or $10 apart. ◦$2.50 when the stock price is between $5-$25, ◦$5 when the stock price is between $25-$200 ◦$10 for stock prices above $200.

Specification of Exchange-Traded Options: European and American, Option Class Important to specify the options ability to exercise at maturity or before. Has to be specified in the contract before proceeding with the contract. Another important issue is to specify if the contract is put or call. Any specific type can be bundled together. These are called option series. Call and puts are an example for option series.

Some Terminology There are some terminologies that we will focus on while quoting in the option markets. ◦Moneyness ◦In-the-money: Call  S>K and Put  S<K ◦At-the-money : S=K ◦Out-of-money: Call  S K

Terminology (continued) Option class ◦ All options of the same type (calls or puts) Option series ◦all the options of a given class with the same expiration date and strike price. Intrinsic value ◦the maximum of zero and the value the option would have if it were exercised immediately. 23

Dividends & Stock Splits (Page ) Suppose you own options with a strike price of K to buy (or sell) N shares: ◦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 mK/n ◦the no. of shares that can be bought (or sold) is increased to nN/m ◦Stock dividends are handled in a manner similar to stock splits 24

Dividends & Stock Splits (continued) Consider a call option to buy 100 shares for $20 per share How should terms be adjusted: ◦for a 2-for-1 stock split? ◦for a 5% stock dividend? 25

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 26

Warrants Warrants are options that are issued by a corporation or a financial institution The number of warrants outstanding is determined by the size of the original issue and changes only when they are exercised or when they expire 27

Warrants (continued) The issuer settles up with the holder when a warrant is exercised When call warrants are issued by a corporation on its own stock, exercise will usually lead to new treasury stock being issued 28

Employee Stock Options (see also Chapter 14) Employee stock options are a form of remuneration issued by a company to its executives They are usually at the money when issued When options are exercised the company issues more stock and sells it to the option holder for the strike price Expensed on the income statement 29

Executive Stock Options Option issued by a company to executives When the option is exercised the company issues more stock Usually at-the-money when issued 30

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 31

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 32