Investments: Analysis and Behavior Chapter 18- Options Markets and Strategies ©2008 McGraw-Hill/Irwin

18-2 Learning Objectives Understand the characteristics of call and put options Know the uses of index options Be able to implement covered call and protective put strategies Utilize Black-Scholes option pricing

18-3 Options Markets Derivative securities: value is derived or stems from changes in the value of some other assets. Call option: the right (but not obligation) to buy Put option: the right (but not obligation) to sell Total volume billion contracts (2005) The most popular options - equity options

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18-5 Characteristics of Exchange Traded Options Four types of underlying assets  Equity securities  Stock indexes  government debt securities  foreign currencies Have standardized terms Trading activity is determined by supply and demand Option interest: number of outstanding options

18-6 Exercise price (or Strike price): Promised or predetermined price for underlying assets At-the-money: when option price equals current market price of underlying assets In-the-money: when the strike price is less (more) than the market price of the underlying asset for a call (put) Out-of-money: when the strike price is more (less) than the market price of the underlying asset for call (put)

18-7 Figure 18.2 Call and Put Options Quotes and Volume on Microsoft, CBOE MSFT Mar 05, 18:27 ET (Data 15 Minutes Delayed) Bid Ask Size 14x146 Vol Calls Last Sale NetBidAskVol Open Int Puts Last Sale NetBidAskVol Open Int 06 Mar (MSQ CX-E) 4.60pc Mar (MSQ OX-E) 0.05pc Mar (MSQ CJ-E) Mar (MSQ OJ-E) 0.05pc Mar (MSQ CY-E) Mar (MSQ OY-E) Mar (MSQ CK-E) 0.05pc Mar (MSQ OK-E) Apr (MSQ DX-E) 4.60pc Apr (MSQ PX-E) 0.05pc Apr (MSQ DJ-E) Apr (MSQ PJ-E) 0.10pc Apr (MSQ DY-E) Apr (MSQ PY-E) Apr (MSQ DK-E) 0.05pc Apr (MSQ PK-E) 3.08pc

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18-9 Option premium: price at which the contract trades (the amount paid for the option) Long-term Equity AnticiPation Securities (LEAPS): expiration dates up to three years. Trading symbol for stock options – combination of the stock ticker symbol, plus a letter to indicate the month of the year, plus a final letter to indicate strike price

18-10 Expiration Months Code JANFEBMARAPRMAYJUNJULAUGSEPOCTNOVDEC CallsABCDEFGHIJKL PutsMNOPQRSTUVWX Strike Price Codes ABCDEFGHIJKLM NOPQRSTUVWXYZ

18-11 Options Clearing Corporation (OCC) Sole issuer of all securities options listed on exchanges and NASD All option transactions are ultimately cleared through OCC OCC takes the opposite side of every option traded Guarantees contract performance and reduces the credit risk.

18-12 Option concept Option contracts are a zero sum game before commissions and other transaction costs. Hedged position: option transaction to offset the risk inherent in some other investment (to limit risk) Speculative position: option transaction to profit from the inherent riskiness of some underlying asset.

18-13 Option style and settlement Option holder: long the option position Option writer: short the option position Style  American style option: exercised at any time (All stock options in the US)  European style option: only exercised on the expiration date. Delivery  Physical delivery option: actual delivery of the underlying asset takes place  Cash-settle option: cash payment based on difference between exercise price and current determined price of the underlying asset Contract size: usually for 100 shares of stock

18-14 Option types Stock Options: generally cover 100 shares of underlying securities. Adjustment made for stock dividend, stock split, merger, etc. Index options: Standard and Poor’s 100 Index (OEX) are the most actively traded. Debt Options  Physical delivery price-based options: right to purchase (sell) a debt security  Cash settled price-based options: right to receive cash based on the value of debt security  Yield based options: cash settled based on the difference between the exercise price and value of an underlying yield.

18-15 Call Option strategies Long position: the right (but not obligation) to buy the underlying asset at a strike price for a limited period of time.  The right to buy stock at a fixed price becomes more valuable as price of stock increases (in the money when current stock price > exercise price)  Risk for buyer is limited to the call premium and potential is unlimited Short position: payoff mirror image of long position (zero sum game) Covered call: sale of a call option on a stock that is owned.

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18-18 Put option strategies Long position: the right, but not obligation, to sell an underlying asset at strike price.  The right to sell stock at a fixed price becomes valuable as price of the stock decreases (in the money when current price < exercise price)  Risk for buyer is limited to the premium and profit is also limited (price cannot be below zero) Short position: mirror image of long position Protective put: insurance against a sharp correction. Purchase of a stock and put option

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18-21 Combinations Spread: both buyer and writer of the same type of option on the same underlying asset  Price spread: purchase or sale of options on the same underlying asset but different exercise price  Time spread: purchase or sales of options on the same underlying asset but different expiration dates Bull call spread: purchase of a low strike price call and sale of a high strike price call. Bull put spread: sale of high strike price put and purchase or a low strike price put

18-22 Payoff Long call Short call Bull call spread Payoff Long put Short put Bull put spread Payoff Long call Short put Straddle Straddle : purchasing a call and Writing a put on the same asset, exercise price, and expiration date

18-23 Option pricing Factors contributing value of an option  price of the underlying stock  time until expiration  volatility of underlying stock price  cash dividend  prevailing interest rate. Intrinsic value: difference between an in-the-money option’s strike price and current market price Time value: speculative value. Call price = Intrinsic value + time value

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18-25 Black-Scholes Option Pricing Model Where C: current price of a call option S: current market price of the underlying stock X: exercise price r: risk free rate t: time until expiration N(d 1 ) and N (d 2 ) : cumulative density functions for d 1 and d 2

18-26 Example Current stock price: 50 exercise price : 55 Risk free rate: 6.25% time to expiration: 6 months Volatility: 40% What is the call price? Solution N(d1) = N(d2) =

18-27 Put call parity Relationship between the price of a put option and the price of a call option on the same underlying equity. Using the same values before,

18-28 Option risks Delta: the sensitivity of option value to a unit change in the underlying asset (hedge ratio) Gamma: The responsiveness of delta to unit changes in the value of the underlying asset Theta: The sensitivity of option value to change in time Vega: The sensitivity of option value to change in volatility Rho: The sensitivity of option value to changes in interest rate

18-29 Such values are presented in CBOE Option Calculator ( )