Options Markets Options Markets  I. The Development of Options Markets 1. History 1. History CBOE was established in 1973 and 18 call options were traded in the same year. CBOE was established in 1973 and 18 call options were traded in the same year. In 1977, put options were traded. In 1977, put options were traded. 2. Organized vs. Over-the-Counter Markets 2. Organized vs. Over-the-Counter Markets Organized Options Trading Organized Options Trading Standardized contractStandardized contract Physical trading floorPhysical trading floor LiquidityLiquidity Over-the-Counter Trading Over-the-Counter Trading Foreign currencies, bonds, interest rate swapsForeign currencies, bonds, interest rate swaps Flexibility, Privacy, unregulatedFlexibility, Privacy, unregulated

II. Who Trade Options & Why? Speculator Hedger Arbitrageur III. Social Benefits of Options Markets Price discovery The ability of options to provide information on current & future cash prices Risk management Hedgers use options to shift unwanted price risk to speculators

 IV. The Option Contract –1. Call Option; Put Option Call OptionCall Option  Exercise (Strike) Price  Call (Put) Premium  Option Buyer (Seller)  In-the-Money; Out-of-the-Money; at-the- Money  Naked Option; Covered Option  Margin Requirement –2. American Option; European Option –3. Option Clearing Corporation –4. Other Listed Options

 Index Options: OEX, SPX  Futures Options  Foreign Currency Options  Interest Rate Options  V. The Mechanics of Trading 1. Option Traders 1. Option Traders Market makers – bid, ask Market makers – bid, ask Floor brokers Floor brokers Exchange membership: CBOE – 931 members Exchange membership: CBOE – 931 members Cost $700,000 as of 8/17/2005Cost $700,000 as of 8/17/ Three ways to execute an option 2. Three ways to execute an option Allow the options to expire Allow the options to expire Exercise right on or before the expiration Exercise right on or before the expiration Execute an offsetting transaction Execute an offsetting transaction 3. Margin Requirement 3. Margin Requirement

 VI. Profit of Call Options (at Expiration) –1. Call Option  Long C=$2; X=$55; S 0 =$50

Profit Profit Stock Price $57

–2. Covered Call  Bought S 0 =$50, short C=$2 with X=$55 STSTSTSTC Call payoffs  Stock value Profit

 Covered Call Payoffs Profit 0 + Stock Price $48

 VII. Profit of Put Options –1. Put Option  Long Put: Buy P=$2, S 0 =$55, X=$50 STSTSTSTP Put Payoffs Profit

Profit + 0 Stock Price $48 Short Put (mirror image)

 2. Protective Put –Bought 0 =$50, long with X=45 STSTSTSTP  S S S S Put Payoffs Profit

 Protective Put Payoffs Profit Stock Price $52 + 0

 3. Straddle Buy a 7.8 and a 11.8 when S 0 =160, X=165 Buy a 7.8 and a 11.8 when S 0 =160, X=165 STPC Put Payoffs Call Payoffs profit

 Profit Stock Price + 0

 IX.Optionlike Securities –Callable bonds –Convertible bonds –Warrants  X. Exotics Options –Asian Options –Barrier Options –Lookback Options