1. Options Markets: Introduction
Chapter 20
Options Markets: Introduction

2. Option Terminology Buy - Long Sell - Short Call Put Key Elements
Exercise or Strike Price
Premium or Price
Maturity or Expiration

3. Market and Exercise Price Relationships
In the Money - exercise of the option would be profitable.
Call: market price>exercise price
Put: exercise price>market price
Out of the Money - exercise of the option would not be profitable.
Put: exercise price>market price
At the Money - exercise price and asset price are equal.

4. American vs European Options
American - the option can be exercised at any time before expiration or maturity.
European - the option can only be exercised on the expiration or maturity date.

5. Different Types of Options
Stock Options
Index Options
Futures Options
Foreign Currency Options
Interest Rate Options

6. Payoffs and Profits on Options at Expiration - Calls
Notation
Stock Price = ST Exercise Price = X
Payoff to Call Holder
(ST - X) if ST >X
0 if ST < X
Profit to Call Holder
Payoff - Purchase Price

7. Payoffs and Profits on Options at Expiration - Calls
Payoff to Call Writer
- (ST - X) if ST >X
0 if ST < X
Profit to Call Writer
Payoff + Premium

8. Profit Profiles for Calls
Call Holder
Call Writer
Stock Price

9. Payoffs and Profits at Expiration - Puts
Payoffs to Put Holder
0 if ST > X
(X - ST) if ST < X
Profit to Put Holder
Payoff - Premium

10. Payoffs and Profits at Expiration - Puts
Payoffs to Put Writer
0 if ST > X
-(X - ST) if ST < X
Profits to Put Writer
Payoff + Premium

11. Profit Profiles for Puts
Profits
Put Writer
Put Holder
Stock Price

12. Equity, Options & Leveraged Equity - Text Example
Investment Strategy Investment
Equity only Buy shares $10,000
Options only Buy options $10,000
Leveraged Buy options $1,000
equity Buy 2% $9,000
Yield

13. Equity, Options & Leveraged Equity - Payoffs
IBM Stock Price
$95 $105 $115
All Stock $9,500 $10,500 $11,500
All Options $0 $5,000 $15,000
Lev Equity $9,270 $9,770 $10,770

14. Equity, Options & Leveraged Equity - Rates of Return
IBM Stock Price
$95 $105 $115
All Stock -5.0% 5.0% 15%
All Options -100% % 50%
Lev Equity -7.3% -2.3% 7.7%

15. Protective Put
Use - limit loss
Position - long the stock and long the put
Payoff ST < X ST > X
Stock ST ST
Put X - ST

16. Protective Put Profit
Profit
Stock
Protective Put Portfolio ST -P

17. Covered Call
Use - Some downside protection at the expense of giving up gain potential.
Position - Own the stock and write a call.
Payoff ST < X ST > X
Stock ST ST
Call ( ST - X)

18. Covered Call Profit
Profit
Stock
Covered Call Portfolio ST -P

19. Option Strategies Straddle (Same Exercise Price)
Long Call and Long Put
Spreads - A combination of two or more call options or put options on the same asset with differing exercise prices or times to expiration.
Vertical or money spread:
Same maturity
Different exercise price
Horizontal or time spread:
Different maturity dates

20. Put-Call Parity Relationship
ST < X ST > X
Payoff for
Call Owned ST - X
Put Written -( X -ST)
Total Payoff ST - X ST - X

21. Payoff of Long Call & Short Put
Combined =
Leveraged Equity
Stock Price
Short Put

22. Arbitrage & Put Call Parity
Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal.
C - P = S0 - X / (1 + rf)T
If the prices are not equal arbitrage will be possible.

23. Put Call Parity - Disequilibrium Example
Stock Price = Call Price = 17
Put Price = Risk Free = 10.25%
Maturity = .5 yr X = 105
C - P > S0 - X / (1 + rf)T
17- 5 > (105/1.05)
12 > 10
Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative.

24. Put-Call Parity Arbitrage
Immediate Cashflow in Six Months
Position Cashflow ST<105 ST> 105
Buy Stock ST ST
Borrow
X/(1+r)T =
Sell Call (ST-105)
Buy Put ST
Total

25. Optionlike Securities
Callable Bonds
Convertible Securities
Warrants
Collateralized Loans

26. Exotic Options
Asian Options
Barrier Options
Lookback Options
Currency Translated Options
Binary Options

27. Chapter 20 Weblinks
This site contains online option education material. It has extensive programs to learn about the use of options, options pricing, and option markets.
This site has extensive links to many other sites. It contains sections on education, exchanges, research, quotes, as well as extensive sources related to futures markets.

28. Chapter 20 Weblinks
The Options Industry Council site contains extensive educational material including access to the freely available Options Toolbox. The toolbox is an excellent source that allows you to simulate different options positions and examine the pricing on options.
Links to numerous options and other derivative websites.
Links to numerous options and other derivative websites.

29. Chapter 20 Weblinks
Exchange sites:

30. Home Assignment
Required: • problems 1, 2, 7 (3rd ed).
• problems 2, 3, 7 (5th ed).
• visit the recommended web sites
• closely follow financial news!