1. Mechanics of Options Markets
Chapter 8
Mechanics of Options Markets

2. Assets Underlying Exchange-Traded Options Page 183-184
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

4. 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 2008

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.

6. When S<X buyer lets the call expire When S=X buyer is indifferent
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
Loss=premium c
Gain=S-X-c
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008

7. A Long position in a Call option
Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months
Max(S-X, 0) 30 20 10 -5 70 80 90
100
110
120
130
Payoff ($)
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 = $100.
Min(X-S, 0)
-30
-20
-10 5 70 80 90
100
110
120
130
Payoff ($)
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.

10. Payoffs (Put option) When S>X buyer wont exercise the put
When S=X buyer is indifferent
When S<X buyer exercise the put option
Loss=premium p
Gain=X-S-p
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008

11. A Long position in a Put (Figure 8.2, page 181)
Profit from buying a European put option: option price = $7, strike price = $70
Max(X-S, 0) 30 20 10 -7 70 60 50 40 80 90
100
Payoff ($)
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 = $70
Min(S-X, 0)
-30
-20
-10 7 70 60 50 40 80 90
100
Payoff ($)
Terminal
stock price ($)

13. Zero- sum game Payoff of call option X=190 Price of the assets
Payoff-call buyer
Payoff-call writer
Buy from writer
Sell in the market
Profit/loss
Sell to holder
Buy from market
125
Holders doesn’t exercise the call option, losses premium paid
Obligation of writer doesn’t arise, gains premium received
150
175
200
190 10
-10
225 35
-35

14. Zero- sum game Payoff of put option X=160 Price of the assets
Payoff-put buyer
Payoff-put writer
Sell to writer
Buy from the market
Profit/loss
Pay to holder
Sell in the market
125
160 35
-35
150 10
-10
175
Holders doesn’t exercise the put option, losses premium paid
Obligation of writer doesn’t arise, gains premium received
200
225

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

16. Terminology 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. Intrinsic Value & Time Value
The option premium consists of two components;
the intrinsic value, and
the time value
Two important factors that determine the price are:
the extent to which the option is in-the-money, and
the chances that before expiry the option will become deeper in-the-money or will turn into in- the-money if it is presently out-of-the-money
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008

18. Intrinsic Value
The value attached to the option if it is exercised now is called the intrinsic value of the option. The difference between spot price and exercise price will determine this value. The intrinsic value is:
For call option : max {(S -X), 0}, and
For put option : max {(X -S), 0}
Intrinsic value cannot be negative.
The least intrinsic value is for out-of-the-money option, which is equal to zero.
An option cannot sell below its intrinsic value.
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008

19. Time Value
The time value is the excess of actual value over intrinsic value.
The value attached to the chances that strike price will be pierced in times to come before expiry is called the time value of an option.
Time value of an option = Actual Price –Intrinsic Value
Time value cannot be negative. At best/worst it can have zero value.
Time value of the option is greatest for ATM options. The entire premium paid for ATM options is attributable to the time value as the intrinsic value of the option is zero.
Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008

20. 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/(1+ bonus ratio)
the no. of options is increased to N*(1+bonus ratio)
Stock dividends are handled in a manner similar to stock splits

21. 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?