Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.1 Options Markets

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.2 Assets Underlying Exchange-Traded Options Stocks ( CBOE PHLX AMEX PSE) Foreign Currency ( Philadelphia Exch, OTC) Stock Indices ( SP100, SP500, CBOE ) Futures ( Treasury Bond and Eurodollar, CBOT CME )

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.3 Specification of Exchange-Traded Options Expiration date Strike price European or American Call or Put (option class)

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.4 Terminology Option class (same type call/put) Option series (class with similar expiration dates and strike price) Intrinsic value (call : PRICE - STRIKE) Time value (added to intrinsic value to value an option)

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.5 Terminology Moneyness : –At-the-money option –In-the-money option –Out-of-the-money option (relation to the premium)

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.6 Dividends & Stock Splits Suppose you own N options with a strike price of X : –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 mX/n the no. of options is increased to nN/m –Stock dividends are handled in a manner similar to stock splits

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.7 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?

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.8 Right to purchase 200 shares at $ % stock dividend : Equivalent to a 5-for-4 stock split. The terms of the option contract are changed so that it gives the holder the right to buy 125 shares at $16

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.9 Organization of Trading Types of traders: –Market makers –Floor brokers Alternative systems for limit orders –Order book officials –Specialists

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.10 Margins 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

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.11 EXAMPLE A trader writes (shorts) 4 naked call options on a stock. The option price is 5, the strike price is $40, and the stock price is $38. Because the option is $2 out of the money, the first calculation gives : 400 (5 + (0.2 x 38) - 2) = $4,240 The second calculation gives 400 ( x 38) = $3,520 The trade ends up paying a margin of $4,240

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.12 EXAMPLE A trader writes 5 naked PUT options on a stock. The option price is $2, the strike price is $30, and the stock price is $36. Because the option is $6 out of the money, the first calculation gives : 500 (2 + (0.2 x 36)- 6) = $1,600 The second calculation gives : 500 ( x 36) = $2,800 The trade ends up paying a margin of $2,800

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.13 EXAMPLE A trader buys 5 calls options on a stock. The option price is $6, the strike price is $30, and the stock price is $26. What is the margin requirement ? No margins, he’s buying !!!!!!!

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.14 Whenever you sell short a derivative (call, put…), It must be done in what is called a margin account

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.15 WRITING COVERED CALLS BUYING SHARES AND SELLING CALLS A trader decides to buy 200 shares on margin at $63. He writes (sells) 2 calls 65 for $7 (out of the money) Minimum cash required : $ $ $1400 = $4900

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.16 Warrants Warrants are options that are issued (or written) by acorporation or a financial institution The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.17 Warrants (continued) Warrants are traded in the same way as stocks 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 lead to new treasury stock being issued

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.18 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

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.19 Executive Stock Options continued They become vested after a period of time They cannot be sold They often last for as long as 10 or 15 years

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.20 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

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull 6.21 Convertible Bonds 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