Options Professor Brooks BA 444 01/09/08

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 $$$$$

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)

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

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.

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

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

Trading Options Option Ticker Symbols Bid Prices and Ask Prices 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

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) Put up the underlying asset Receive the strike price Or Sell the Call or Put

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)