Mechanics of Options Markets Chapter 8 1

2 Assets Underlying Exchange-Traded Options Page Stocks Stock Indices Futures Foreign Currency Bond options VIX

3 Options Options are generally different from forwards & futures contracts. An options gives the holder of the option the right to do something Call options Put options Buyer or holder Seller or writer Premium Strike price Maturity date

Contract Specifications Market type : N Instrument Type : OPTSTK Underlying : Symbol of underlying security Expiry date : Date of contract expiry Option Type : CE / PE Strike Price: Strike price for the contract Trading cycle: Options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 20084

5 Call Option A call option is a right, but not an obligation to buy an asset at a predetermined price within a specified time. Long call- expect price rise. Holder of the call has an option to exercise call or not. For this right he pays premium. Short Call-The call writer does not believe the price of the underlying security is likely to rise. The writer sells the call to collect the premium and does not receive any gain if the stock rises above the strike price.

Payoffs (Call option) When S<X buyer lets the call expire When S=X buyer is indifferent When S>X buyer exercise the call option Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull Loss=premium c Gain=S-X-c

7 A Long position in a Call option Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months Max(S-X, 0) Payoff ($) Terminal stock price ($)

8 A Short position in a Call (Figure 8.3, page 182) Profit from writing one European call option: option price = $5, strike price = $100. Min(X-S, 0) Payoff ($) Terminal stock price ($)

9 Put option A put option is a right, but not an obligation to sell an asset at a predetermined price within a specified time. Long put- expect price fall. Holder of the put has an option to exercise putor not. For this right he pays premium. Short put- doesn’t receive any gain if SP< Strike Price The option writer receives a premium and incurs an obligation to purchase (if a put is sold) the underlying asset at a stipulated price until a predetermined date.

Payoffs (Put option) When S>X buyer lets the call expire When S=X buyer is indifferent When S<X buyer exercise the call option Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull Loss=premium p Gain=X-S-p

11 A Long position in a Put (Figure 8.2, page 181) Profit from buying a European put option: option price = $7, strike price = $70 Max(X-S, 0) Payoff ($) Terminal stock price ($)

12 A Short position in a Put (Figure 8.4, page 182) Profit from writing a European put option: option price = $7, strike price = $70 Min(S-X, 0) Payoff ($) Terminal stock price ($)

Zero- sum game Payoff of call option X= Price of the assets Payoff-call buyerPayoff-call writer Buy from writer Sell in the market Profit/los s Sell to holder Buy from market Profit/los s 125 Holders doesn’t exercise the call option, losses premium paid Obligation of writer doesn’t arise, gains premium received

Zero- sum game Payoff of put option X= Price of the assets Payoff-put buyerPayoff-put writer Sell to writer Buy from the market Profit/los s Pay to holder Sell in the market Profit/los s Holders doesn’t exercise the put option, losses premium paid Obligation of writer doesn’t arise, gains premium received

15 Payoffs from Options What is the Option Position in Each Case? K = Strike price, S T = Price of asset at maturity Payoff STST STST K K STST STST K K

16Terminology Moneyness : ◦ At-the-money option would have no cash flows ◦ In-the-money option would have positive CFs to the buyer ◦ Out-of-the-money option would result in cash outflow if exercised  Intrinsic value  Time value  Based on the nature of exercise  Based on how they are traded & settled  Based on the underlying asset on which option is created

17 Dividends & Stock Splits Suppose you own N options with a strike price of K : ◦ 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 K*m/n  the no. of shares in options is increased by N*(1+n/m) ◦ Stock dividends are handled in a manner similar to stock splits

18 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? ◦ for a 25% stock dividend?

Margins (Page ) Margins are required when options are sold When a naked option is written the margin is the greater of: 1A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money 2A total of 100% of the proceeds of the sale plus 10% of the underlying share price For other trading strategies there are special rules 19