1. Mechanics of Options Markets
Chapter 9

2. Types of Options A call is an option to buy A put is an option to sell
A European option can be exercised only at the end of its life
An American option can be exercised at any time

3. Option Positions
Long call
Long put
Short call
Short put

4. Payoff versus Profit
Payoff (or terminal cash flow) is gross of the premium paid or received up-front.
Profit is payoff minus or plus premium:
If purchase option, minus premium.
If write option, plus premium.
Purchase Call payoff = Max (0, ST – K)
Purchase Call profit = Max (0, ST – K) - c

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

6. Long Call
Profit from buying one European call option: option price = $5, strike price = $100. 30 20 10 -5 70 80 90
100
110
120
130
Profit ($)
Terminal
stock price ($)

7. Short Call
Profit from writing one European call option: option price = $5, strike price = $100
-30
-20
-10 5 70 80 90
100
110
120
130
Profit ($)
Terminal
stock price ($)

8. Long Put
Profit from buying a European put option: option price = $7, strike price = $70 30 20 10 -7 70 60 50 40 80 90
100
Profit ($)
Terminal
stock price ($)

9. Short Put
Profit from writing a European put option: option price = $7, strike price = $70
-30
-20
-10 7 70 60 50 40 80 90
100
Profit ($)
Terminal
stock price ($)

10. Assets Underlying Exchange-Traded Options
Stocks
Foreign Currency
Stock Indices
Futures
Distinct variables plotted on X-axis.

11. Futures Options
Exercise of a Call results in: Long position in futures contract* + cash (=Futures price – Strike Price)
Exercise of a Put results in: Short position in futures contract* + cash (=Strike Price – Futures Price)
*Futures contract has a value of zero

12. Specification of Exchange-Traded Options
Company
Call or Put
Expiration date
Strike price
Option class: company & call or put
Option series: IBM 70 Oct’11 Calls

13. Terminology Moneyness : At-the-money option:
value of underlying asset = exercise price
In-the-money option: immediate exercise generates positive payoff.
Out-of-the-money option: immediate exercise generates negative payoff.

14. Terminology (continued)
Option class:
company cum call or put
Option series: all options w/in a class with same
strike price and expiration date
Intrinsic value (nonnegative): extent to which option is in-the-money, positive payoff that can be generated now
Time value
Option premium = Intrinsic Value + Time Value (tautology; dichotomy is valid only for American options)

15. Dividends & Stock Splits
Exchange-traded options are not cash dividend protected
Cash dividends: adverse events for call owners and put writers
Exchange-traded options are stock dividend and stock split protected

16. Dividends & Stock Splits
Suppose you own an option on N share 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 mK/n
the no. of options is increased to nN/m
Stock dividends are handled in a manner similar to stock splits

17. Stock Split adjustments to number of shares and exercise price
n for m stock split:

18. Stock Dividend adjustments to number of shares and exercise price
x% stock dividend:

19. 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? N=100(2)=200, K =$20/(2)=$10
for a 5% stock dividend? N=100(1.05)=105, K=$20/1.05=$19.05

20. Market Makers
Most exchanges use market makers to facilitate options trading
A market maker quotes both bid and ask prices when requested
The market maker does not know whether the individual requesting the quotes wants to buy or sell

21. Margins for Long Position
Option maturity < 9 months: 100% margin
Option maturity = or > 9 months: at least 75% margin, i.e., at most 25% financed with debt.
Margin means equity (not debt), as in stock trading.

22. Margins for Short Position
Margins are required when options are sold
For example when a naked call option is written the margin is 100% of the proceeds of the sale and then some.
Margin means good faith money (not equity) as in futures trading.

23. (Share Purchase) Warrants
Warrants are options that are issued (or written) by a corporation 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

24. Warrants (continued) Warrants are traded in the same way as stocks
The issuer settles up with the holder when a warrant is exercised
Dilution Effect: When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued.

25. Executive Stock Options
Option issued by a company to executives
Dilution Effect: When the option is exercised the company issues more stock
Usually at-the-money when issued

26. Executive Stock Options continued
They become vested after a period of time (usually 1 to 4 years)
They cannot be sold
They often last for as long as 10 or 15 years
Accounting standards are changing to require the expensing of executive stock options

27. 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
Dilution Effect is present.

28. Convertible Bonds (continued)
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
Company can force conversion by calling when call price is less than conversion value of the convertible bond

29. Forced Conversion Example
Conversion ratio = 2 (shares)
Call price = $110
Stock price = $60
Conversion value = 2($60) = $120
If convertible is called, conversion will occur perforce