1. Investments: Analysis and Behavior Chapter 18- Options Markets and Strategies ©2008 McGraw-Hill/Irwin

2. 18-2 Learning Objectives Understand the characteristics of call and put options Know the uses of index options Be able to implement covered call and protective put strategies Utilize Black-Scholes option pricing

3. 18-3 Options Markets Derivative securities: value is derived or stems from changes in the value of some other assets. Call option: the right (but not obligation) to buy Put option: the right (but not obligation) to sell Total volume - 1.5 billion contracts (2005) The most popular options - equity options

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5. 18-5 Characteristics of Exchange Traded Options Four types of underlying assets  Equity securities  Stock indexes  government debt securities  foreign currencies Have standardized terms Trading activity is determined by supply and demand Option interest: number of outstanding options

6. 18-6 Exercise price (or Strike price): Promised or predetermined price for underlying assets At-the-money: when option price equals current market price of underlying assets In-the-money: when the strike price is less (more) than the market price of the underlying asset for a call (put) Out-of-money: when the strike price is more (less) than the market price of the underlying asset for call (put)

7. 18-7 Figure 18.2 Call and Put Options Quotes and Volume on Microsoft, CBOE MSFT 26.93 -0.04 Mar 05, 2006 @ 18:27 ET (Data 15 Minutes Delayed) Bid 26.93 Ask 26.93 Size 14x146 Vol 45234151 Calls Last Sale NetBidAskVol Open Int Puts Last Sale NetBidAskVol Open Int 06 Mar 22.50 (MSQ CX-E) 4.60pc4.404.500667 06 Mar 22.50 (MSQ OX-E) 0.05pc00.050110 06 Mar 25.00 (MSQ CJ-E) 2.15+0.101.952.004714613 06 Mar 25.00 (MSQ OJ-E) 0.05pc00.05017347 06 Mar 27.50 (MSQ CY-E) 0.10--0.050.15257879580 06 Mar 27.50 (MSQ OY-E) 0.65 +0. 10 0.600.7088316534 06 Mar 30.00 (MSQ CK-E) 0.05pc00.05023610 06 Mar 30.00 (MSQ OK-E) 2.90 - 0.20 3.003.202785 06 Apr 22.50 (MSQ DX-E) 4.60pc4.504.60013679 06 Apr 22.50 (MSQ PX-E) 0.05pc00.05035081 06 Apr 25.00 (MSQ DJ-E) 2.15--2.102.203057696 06 Apr 25.00 (MSQ PJ-E) 0.10pc0.050.10049933 06 Apr 27.50 (MSQ DY-E) 0.35-0.050.350.40461147305 06 Apr 27.50 (MSQ PY-E) 0.80 +0. 05 0.750.8512834125 06 Apr 30.00 (MSQ DK-E) 0.05pc00.050115365 06 Apr 30.00 (MSQ PK-E) 3.08pc3.003.100670

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9. 18-9 Option premium: price at which the contract trades (the amount paid for the option) Long-term Equity AnticiPation Securities (LEAPS): expiration dates up to three years. Trading symbol for stock options – combination of the stock ticker symbol, plus a letter to indicate the month of the year, plus a final letter to indicate strike price

10. 18-10 Expiration Months Code JANFEBMARAPRMAYJUNJULAUGSEPOCTNOVDEC CallsABCDEFGHIJKL PutsMNOPQRSTUVWX Strike Price Codes ABCDEFGHIJKLM 5101520253035404550556065 105110115120125130135140145150155160165 205210215220225230235240245250255260265 305310315320325330335340345350355360365 405410415420425430435440445450455460465 505510515520525530535540545550555560565 605610615620625630635640645650655660665 705710715720725730735740745750755760765 NOPQRSTUVWXYZ 7075808590951007.5012.5017.5022.5027.5032.50 17017518018519019520037.5042.5047.5052.5057.5062.50 27027528028529029530067.5072.5077.5082.5087.5092.50 37037538038539039540097.50102.50107.50112.50117.50122.50 470475480485490495500127.50132.50137.50142.50147.50152.50 570575580585590595600157.50162.50167.50172.50177.50182.50 670675680685690695700187.50192.50197.50202.50207.50212.50 770775780785790795800217.50222.50227.50232.50237.50242.50

11. 18-11 Options Clearing Corporation (OCC) Sole issuer of all securities options listed on exchanges and NASD All option transactions are ultimately cleared through OCC OCC takes the opposite side of every option traded Guarantees contract performance and reduces the credit risk.

12. 18-12 Option concept Option contracts are a zero sum game before commissions and other transaction costs. Hedged position: option transaction to offset the risk inherent in some other investment (to limit risk) Speculative position: option transaction to profit from the inherent riskiness of some underlying asset.

13. 18-13 Option style and settlement Option holder: long the option position Option writer: short the option position Style  American style option: exercised at any time (All stock options in the US)  European style option: only exercised on the expiration date. Delivery  Physical delivery option: actual delivery of the underlying asset takes place  Cash-settle option: cash payment based on difference between exercise price and current determined price of the underlying asset Contract size: usually for 100 shares of stock

14. 18-14 Option types Stock Options: generally cover 100 shares of underlying securities. Adjustment made for stock dividend, stock split, merger, etc. Index options: Standard and Poor’s 100 Index (OEX) are the most actively traded. Debt Options  Physical delivery price-based options: right to purchase (sell) a debt security  Cash settled price-based options: right to receive cash based on the value of debt security  Yield based options: cash settled based on the difference between the exercise price and value of an underlying yield.

15. 18-15 Call Option strategies Long position: the right (but not obligation) to buy the underlying asset at a strike price for a limited period of time.  The right to buy stock at a fixed price becomes more valuable as price of stock increases (in the money when current stock price > exercise price)  Risk for buyer is limited to the call premium and potential is unlimited Short position: payoff mirror image of long position (zero sum game) Covered call: sale of a call option on a stock that is owned.

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18. 18-18 Put option strategies Long position: the right, but not obligation, to sell an underlying asset at strike price.  The right to sell stock at a fixed price becomes valuable as price of the stock decreases (in the money when current price < exercise price)  Risk for buyer is limited to the premium and profit is also limited (price cannot be below zero) Short position: mirror image of long position Protective put: insurance against a sharp correction. Purchase of a stock and put option

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21. 18-21 Combinations Spread: both buyer and writer of the same type of option on the same underlying asset  Price spread: purchase or sale of options on the same underlying asset but different exercise price  Time spread: purchase or sales of options on the same underlying asset but different expiration dates Bull call spread: purchase of a low strike price call and sale of a high strike price call. Bull put spread: sale of high strike price put and purchase or a low strike price put

22. 18-22 Payoff Long call Short call Bull call spread Payoff Long put Short put Bull put spread Payoff Long call Short put Straddle Straddle : purchasing a call and Writing a put on the same asset, exercise price, and expiration date

23. 18-23 Option pricing Factors contributing value of an option  price of the underlying stock  time until expiration  volatility of underlying stock price  cash dividend  prevailing interest rate. Intrinsic value: difference between an in-the-money option’s strike price and current market price Time value: speculative value. Call price = Intrinsic value + time value

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25. 18-25 Black-Scholes Option Pricing Model Where C: current price of a call option S: current market price of the underlying stock X: exercise price r: risk free rate t: time until expiration N(d 1 ) and N (d 2 ) : cumulative density functions for d 1 and d 2

26. 18-26 Example Current stock price: 50 exercise price : 55 Risk free rate: 6.25% time to expiration: 6 months Volatility: 40% What is the call price? Solution N(d1) = 0.4661N(d2) = 0.3564

27. 18-27 Put call parity Relationship between the price of a put option and the price of a call option on the same underlying equity. Using the same values before,

28. 18-28 Option risks Delta: the sensitivity of option value to a unit change in the underlying asset (hedge ratio) Gamma: The responsiveness of delta to unit changes in the value of the underlying asset Theta: The sensitivity of option value to change in time Vega: The sensitivity of option value to change in volatility Rho: The sensitivity of option value to changes in interest rate

29. 18-29 Such values are presented in CBOE Option Calculator ( www.cboe.com )www.cboe.com