1. Chapter 20
Options
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2. Learning objectives
Understand the structure and operation of option contracts and the types available
Explain the profit and loss payoff profiles of call and put option contracts
Describe the structure and organisation of international and Australian options markets
Explain the factors affecting the price of options
Develop options strategies for hedging price risk
Discuss the advantages and disadvantages of option contracts in managing risk

3. Chapter organisation
20.1 The nature of options 20.2 Option profit and loss payoff profiles 20.3 Organisation of the market 20.4 Factors affecting an option contract premium 20.5 Option risk management strategies 20.6 Conclusion 20.7 Summary

4. 20.1 The nature of options (cont.)
Options differ from futures because they provide asymmetric cover against price movements
Options limit the effects of adverse price movements without reducing profits from favourable price movements
Options involve the payment of a premium by the buyer to the seller (writer)
(cont.)

5. 20.1 The nature of options (cont.)
An option gives the buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a predetermined price (exercise or strike price), on or before a specified date (expiration date)
An option will be exercised only if it is in the buyer’s best interests
(cont.)

6. 20.1 The nature of options (cont.)
Types of options
Call options
Give the option buyer the right to buy the commodity or instrument at the exercise price
Put options
Give the buyer the right to sell the commodity or instrument at the exercise price
Options can be exercised either:
only on expiration date (European); or
any time up to expiration date (American)
(cont.)

7. 20.1 The nature of options (cont.)
Premium
The price paid by an option buyer to the writer (seller) of the option
Exercise price or strike price
The price specified in an options contract at which the option buyer can buy or sell

8. Chapter organisation
20.1 The nature of options 20.2 Option profit and loss payoff profiles 20.3 Organisation of the market 20.4 Factors affecting an option contract premium 20.5 Option risk management strategies 20.6 Conclusion 20.7 Summary

9. 20.2 Option profit and loss payoff profiles
Call option profit and loss payoff profiles
Example: a call option for shares in a listed company at a strike or exercise price (X) of $12, and a premium (P) of $1.50
Figure 20.1 indicates the profit and loss profiles of a call option for (a) the buyer or holder (long call) and (b) the writer or seller (short call)
The critical break points of the market price of the share (S) at expiration date are <$12, $12 to $13.50 and >$13.50
If S (market price of asset) > X (i.e. > $12) , option is ‘in the money’
(cont.)

10. 20.2 Option profit and loss payoff profiles (cont.)

11. 20.2 Option profit and loss payoff profiles (cont.)

12. 20.2 Option profit and loss payoff profiles (cont.)
Call option profit and loss payoff profiles (cont.)
The value of the option to the buyer or holder (long call party) is:
V = max(S - X, 0) - P
The value of the option to the writer (short call party) is:
V = P - max(S - X, 0)
(cont.)

13. 20.2 Option profit and loss payoff profiles (cont.)
Put option profit and loss payoff profiles
Example: a put option for shares in a listed company at a strike or exercise price (X) of $12, and premium (P) of $1.50
Figure 20.2 indicates the profit and loss profiles of a put option for (a) the buyer or holder (long put) and (b) the writer or seller (short put)
The critical break points of the market price of the share (S) at expiration date are <$10.50, $10.50 to $12 and >$12
Buyer exercises option if S < X (i.e. < $12)
(cont.)
Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney
Slides prepared by Anthony Stanger

14. 20.2 Option profit and loss payoff profiles (cont.)

15. 20.2 Option profit and loss payoff profiles (cont.)

16. 20.2 Option profit and loss payoff profiles (cont.)
Put option profit and loss payoff profiles (cont.)
The value of the option to the buyer or holder (long put party) is:
V = max(X - S, 0) - P
The value of the option to the writer (or short put party) is:
V = P - max(X - S, 0)
(cont.)

17. 20.2 Option profit and loss payoff profiles (cont.)
Covered and naked options
Unlike the case with futures, the risk of loss for a buyer of an option contract is limited to the premium
However, sellers (writers) of options have potentially unlimited risk and may be subject to margin requirements unless they write a covered option
I.e. the writer of an option holds the underlying asset or provides a financial guarantee
(cont.)

18. 20.2 Option profit and loss payoff profiles (cont.)
Covered and naked options (cont.)
The writer of a call option has written a covered option if the writer either:
owns sufficient of the underlying asset to satisfy the option contract if exercised; or
is also the holder of a call option on the same asset, but with a lower exercise price
The writer of a put option has written a covered option if the writer is also the holder of a put option on the same asset, but with a higher exercise price

19. Chapter organisation
20.1 The nature of options 20.2 Option profit and loss payoff profiles 20.3 Organisation of the market 20.4 Factors affecting an option contract premium 20.5 Option risk management strategies 20.6 Conclusion 20.7 Summary

20. 20.3 Organisation of the market
Option markets are categorised as:
Over the counter
Exchange-traded
These are recorded through a clearing house
Clearing house acts as counterparty to buyer and seller, thus creating two options contracts through the process of ‘novation’
The clearing house allows buyers and sellers to close out (i.e. reverse) their contracts
(cont.)
Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney
Slides prepared by Anthony Stanger

21. 20.3 Organisation of the market (cont.)
International options markets
An exchange in a particular country will usually specialise in option contracts that are directly related to physical or futures market products also traded in that particular country
Trading on international exchanges varies
The largest exchanges, the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME), retain open-outcry trading on the floor involving 4000 to 5000 people
International links between exchanges allow 24-hour trading
(cont.)

22. 20.3 Organisation of the market (cont.)
The Australian options markets
Types of options traded
Options on futures contracts
Share options
Low-exercise-price options
Warrants
Over-the-counter options
(cont.)

23. 20.3 Organisation of the market (cont.)
The Australian options market (cont.)
Options on futures contracts
Traded on the ASX
Buyer of options contract has the right to buy (call) or sell (put) a futures contract
Options on futures available for:
90-day bank-accepted bills
SPI200 index futures contract
three-year and 10-year Commonwealth Treasury bonds
overnight options on the above Treasury bonds and share price index futures contracts
(cont.)

24. 20.3 Organisation of the market (cont.)
The Australian options market (cont.)
Share options
Traded on the ASX
Based on ordinary shares of specified listed companies
Usually three or more options contracts for each company, each with identical expiration dates but different exercise prices
The options clearing house maintains a system of deposits, maintenance margins and a share scrip depository
(cont.)

25. 20.3 Organisation of the market (cont.)
The Australian options market (cont.)
Low exercise price options (LEPOs)
Traded on the ASX since 2005
A highly leveraged option on individual stocks, with an exercise price between 1 and 10 cents, and a premium similar to the price of the underlying stock
Exercisable only at expiration date (i.e. European)
Available over a range of high-liquidity stocks listed on the ASX
(cont.)

26. 20.3 Organisation of the market (cont.)
Australian options market (cont.)
Warrants
An options contract (i.e. contractual right but not obligation to buy or sell an underlying asset)
Two classes of warrants
Equity warrants attached to debt issues made by companies raising funds through primary market debt issues
Option to convert debt to ordinary shares of the issuing company (discussed in Chapter 5)
(cont.)

27. 20.3 Organisation of the market (cont.)
The Australian options market (cont.)
Warrants (cont.)
Two classes of warrants (cont.)
Warrants issued as financial products for investment and to manage risk exposure to price movements in the market
Issued by financial institutions
American- or European-type contracts
Traded on ASX Trade, the ASX’s electronic trading system
Settlement of contracts through ASX Trade
(cont.)

28. 20.3 Organisation of the market (cont.)
The Australian options market (cont.)
Warrants (cont.)
Warrants issued as financial products
Fractional warrants
Cover only a part or a fraction of a listed share
So may require two or more fractional warrants to be exercised to buy a share
Fully covered warrants
Underlying shares lodged in trust by issuer as guarantee
Shares held as a guarantee of the issuer’s capacity to deliver the stock if the holder exercises warrant
Price involves initial specified instalment and second instalment based on market value of share
(cont.)

29. 20.3 Organisation of the market (cont.)
The Australian options market (cont.)
Warrants (cont.)
Warrants issued as financial products (cont.)
Index warrants
Issued on a share price index (e.g. S&P/ASX 200, S&P 500 index)
Basket warrants
Capped warrants
Instalment warrants
Capital plus warrants
Endowment warrants
(cont.)

30. 20.3 Organisation of the market (cont.)
The Australian options market (cont.)
Over-the-counter markets
Used to trade options not traded on the exchanges, e.g. semi-government securities and other money-market instruments or securities with unusual maturities
Allows flexibility in terms of:
amount
term
interest rate
price
Used to set interest rate caps, floors and collars

31. Chapter organisation
20.1 The nature of options 20.2 Option profit and loss payoff profiles 20.3 Organisation of the market 20.4 Factors affecting an option contract premium 20.5 Option risk management strategies 20.6 Conclusion 20.7 Summary

32. 20.4 Factors affecting an option contract premium
Option price (or premium) is influenced by four key factors
1. Intrinsic value
2. Time value
3. Price volatility
4. Interest rates
(cont.)

33. 20.4 Factors affecting an option contract premium (cont.)
1. Intrinsic value
The market price of the underlying asset relative to the exercise price
The greater the intrinsic value, the greater the premium, i.e. positive relationship
Options with an intrinsic value
Positive are ‘in the money’ and the buyer is able to exercise contract at a profit
Negative are ‘out of the money’ and the buyer will not exercise
Zero are ‘at the money’
(cont.)

34. 20.4 Factors affecting an option contract premium (cont.)

35. 20.4 Factors affecting an option contract premium (cont.)
2. Time value
The longer the time to expiry, the greater the possibility that the option will be able to be exercised for a profit (‘in the money’); i.e. positive relationship
If the spot price moves adversely, the loss is limited to the premium
(cont.)

36. 20.4 Factors affecting an option contract premium (cont.)
3. Price volatility
The greater the volatility of the spot price, the greater the chance of exercising the option for a profit, or a loss
The option will be exercised only if the price moves favourably
The greater the spot price volatility, the greater the option premium; i.e. positive relationship
(cont.)

37. 20.4 Factors affecting an option contract premium (cont.)
4. Interest rates
Interest rates have opposite impacts on put and call options
Positive relationship between interest rates and the price of a call
Benefit of present value of deferred payment if exercised > lower present value of profit if exercised
Negative relationship between interest rates and the price of a put
Opportunity cost of holding asset
Lower present value of the profit if exercised

38. Chapter organisation
20.1 The nature of options 20.2 Option profit and loss payoff profiles 20.3 Organisation of the market 20.4 Factors affecting an option contract premium 20.5 Option risk management strategies 20.6 Conclusion 20.7 Summary

39. 20.5 Option risk management strategies
Single-option strategies
Example: long asset (i.e. bought) and bearish (negative) about future asset price
Strategy
Limit downside risk by writing (selling) a call option, i.e. short call
Figure 20.5 and Table 20.4 in the textbook illustrate the profit profile of this strategy
(cont.)

40. 20.5 Option risk management strategies (cont.)

41. 20.5 Option risk management strategies (cont.)

42. 20.5 Option risk management strategies (cont.)
Single-option strategies (cont.)
Example: short asset (i.e. sold) and bullish (positive) about future asset price
Strategy
Buy a call in the underlying asset (i.e. take a long-call position)
Figure 20.6 and Table 20.5 in the textbook illustrate the profit profile of this strategy
(cont.)

43. 20.5 Option risk management strategies (cont.)
Combined-options strategies
Example: very bullish about future price of the asset
Strategy: ‘vertical bull spread’—contracts with same expiration dates, different exercise prices
Write (sell) a put option and earn a premium to benefit from fall in spot price
Hold (buy) a call option with exercise price greater than written put
Effect: Offsets high premium associated with call
Figure 20.7 in the textbook illustrates the profit profile
(cont.)

44. 20.5 Option risk management strategies (cont.)

45. 20.5 Option risk management strategies (cont.)
Combined-options strategies (cont.)
Example: quite bullish, but with some risk of a price fall
Strategy
Hold (buy) a call option to benefit from fall in spot price
Write (sell) a call option with a higher exercise price than the long call
This ‘call bull spread’ limits the potential loss
Figure 20.8 in the textbook illustrates the profit profile
(cont.)

46. 20.5 Option risk management strategies (cont.)
Combined-options strategies (cont.)
Example: very bearish about the future price of the asset
Strategy
Hold (buy) put option to benefit from fall in spot price
Write (sell) a call option with a higher exercise price than the long put
This ‘vertical bear spread’ limits the potential gain but exposes the writer to unlimited losses
Figure 20.9 in the textbook illustrates the profit profile
(cont.)

47. 20.5 Option risk management strategies (cont.)
Combined-options strategies (cont.)
Example: quite bearish, but with some risk of a price rise
Strategy
Hold (buy) put option to benefit from fall in spot price
Write (sell) a put option with a lower exercise price than the long put
This ‘put bear spread’ limits the potential loss if the price rises
Figure in the textbook illustrates the profit profile
(cont.)

48. 20.5 Option risk management strategies (cont.)
Combined-options strategies (cont.)
Example: expectation of increased price volatility, with no trend
Strategy
Hold (buy) a put option
Hold (buy) a call option with common exercise price
‘Long straddle’ provides positive pay-off for both large upward and downward price movements
If prices remain unchanged, individual makes loss equal to sum of premiums
Figure in the textbook illustrates the profit profile
(cont.)

49. 20.5 Option risk management strategies (cont.)
Combined-options strategies (cont.)
Example: expectation of increased volatility, without trend, with stagnation
Strategy
Hold (buy) call option with out-of-the-money exercise price
Hold (buy) put option with out-of-the-money exercise price
With ‘long strangle’ loss is decreased if price remains unchanged, compared with ‘long straddle’
Figure in the textbook illustrates the profit profile
(cont.)

50. 20.5 Option risk management strategies (cont.)
Combined-options strategies (cont.)
Example: expectation of asset price stability
Strategy
Take opposite position to long straddle and long strangle
Strategy I: Short straddle
Sell call and put options with same exercise price
Strategy II: Short strangle
Sell call and put options, both out of the money
Figure in the textbook illustrates the profit profiles
(cont.)

51. 20.5 Option risk management strategies (cont.)
Combined-options strategies (cont.)
Barrier options: knock-out and knock-in options
Another form of option strategy suited to the management of FX risk exposures
Knock-out option:
is extinguished if a specified spot exchange rate barrier is breached
Knock-in option:
is created if a specified spot exchange rate is achieved
The barrier rate can be set above or below the current spot FX rate
As the barrier limits the exposure of the writer, the premium is not as high as it is with a straight option
(cont.)

52. 20.5 Option risk management strategies (cont.)

53. Chapter organisation
20.1 The nature of options 20.2 Option profit and loss payoff profiles 20.3 Organisation of the market 20.4 Factors affecting an option contract premium 20.5 Option risk management strategies 20.6 Conclusion 20.7 Summary

54. 20.6 Conclusion
The potential gains and losses to buyers and sellers of futures contracts are different from those of options
Options provide one-sided price protection that is not available through futures
The option buyer limits losses and allows profits to accumulate
However, the premium may be quite high

55. Chapter organisation
20.1 The nature of options 20.2 Option profit and loss payoff profiles 20.3 Organisation of the market 20.4 Factors affecting an option contract premium 20.5 Option risk management strategies 20.6 Conclusion 20.7 Summary

56. 20.7 Summary
The holder of an option (long party) has the right to buy (call) or sell (put) the commodity at a specified exercise price
The writer (seller) is the short party
ASX trades standardised options, unlike over-the-counter market
The premium paid to buy an option is affected by its intrinsic value, time value, price volatility, and interest rates
A broad array of option strategies may be adopted by hedgers and speculators