1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-1 Chapter 19 Options Websites: www.sfe.com.au www.asx.com.au

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-2 Learning Objectives Examine the nature of options contracts and markets Describe the types of options contracts available Explain the profit and loss payoff profiles of options contracts Explain the factors affecting the price of options Develop options strategies for hedging price risk

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-3 Chapter Organisation 19.1The Nature of Options 19.2Option Profit and Loss Payoff Profiles 19.3Organisation of the Market 19.4Pricing an Option 19.5 Option Risk Management Strategies 19.6 Conclusion 19.7 Summary

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-4 19.1The Nature of Options 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)

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-5 19.1The 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 only be exercised if it is in the buyer’s best interest

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-6 19.1The 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) –Any time up to expiration date (American)

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-7 19.1The 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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-8 Chapter Organisation 19.1The Nature of Options 19.2Option Profit and Loss Payoff Profiles 19.3Organisation of the Market 19.4Pricing an Option 19.5 Option Risk Management Strategies 19.6 Conclusion 19.7 Summary

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-9 19.2Option 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 19.1 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 $13.50  If S (market price of asset) > X (i.e. > $12), option is ‘in-the- money’

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-10 19.2Option Profit and Loss Payoff Profiles (cont.)

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-11 19.2Option Profit and Loss Payoff Profiles (cont.)

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-12 19.2Option 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 (19.1) –The value of the option to the writer (short call party) is V = P - max(S - X, 0) (19.2)

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-13 19.2Option 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 19.2 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 $12  Buyer exercises option if S < X (i.e. < $12)

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-14 19.2 Option Profit and Loss Payoff Profiles (cont.)

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-15 19.2 Option Profit and Loss Payoff Profiles (cont.)

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-16 19.2 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 (19.3) –The value of the option to the writer (or short put party) is V = P - max(X - S, 0) (19.4)

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-17 19.2 Option Profit and Loss Payoff Profiles (cont.) Covered and uncovered options –Unlike 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

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-18 19.2 Option Profit and Loss Payoff Profiles (cont.) Covered and uncovered options (cont.) –The writer of a call option has written a covered option if either  The writer owns sufficient of the underlying asset to satisfy the option contract if exercised, or  The writer 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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-19 Chapter Organisation 19.1The Nature of Options 19.2Option Profit and Loss Payoff Profiles 19.3Organisation of the Market 19.4Pricing an Option 19.5 Option Risk Management Strategies 19.6 Conclusion 19.7 Summary

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-20 19.3 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

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-21 19.3 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 the open outcry trading on the floor involving 4000 to 5000 people –International links between exchanges allow 24-hour trading

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-22 19.3 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

23. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-23 19.3 Organisation of the Market (cont.) The Australian options market (cont.) –Options on futures contracts  Traded on the Sydney Futures Exchange (SFE)  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 SFE/SPI200index futures contract 3-year and 10-year Commonwealth Treasury bonds Overnight options on the above Treasury bond and share price index futures contracts

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-24 19.3 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 3 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

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-25 19.3 Organisation of the Market (cont.) The Australian options market (cont.) –Low exercise price options (LEPOs)  Traded on the ASX since 1995  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

26. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-26 19.3 Organisation of the Market (cont.) The 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)

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-27 19.3 Organisation of the Market (cont.) The Australian options market –Warrants  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 CLICK XT, the ASX’s electronic trading system –Settlement of contracts through ASX options clearing-house

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-28 19.3 Organisation of the Market (cont.) The Australian options market –Warrants (cont.)  Warrants issued as financial products Fractional warrants –Cover only a part or a fraction of a listed share –Thus 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

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-29 19.3 Organisation of the Market (cont.) The Australian options market –Warrants  Warrants issued as financial products (cont.) Index warrants –Issued on a share price index (e.g. S&P/ASX All Ordinaries index, S&P 500 index) Basket warrants Capped warrants Instalment warrants Capital plus warrants Endowment warrants

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-30 19.3 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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-31 Chapter Organisation 19.1The Nature of Options 19.2Option Profit and Loss Payoff Profiles 19.3Organisation of the Market 19.4Pricing an Option 19.5 Option Risk Management Strategies 19.6 Conclusion 19.7 Summary

32. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-32 19.4 Pricing an Option Option price (or premium) is influenced by four key factors –Intrinsic value –Time value –Price volatility –Interest rates

33. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-33 19.4 Pricing an Option (cont.) 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’

34. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-34 19.4 Pricing an Option (cont.)

35. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-35 19.4 Pricing an Option (cont.) 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

36. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-36 19.4 Pricing an Option (cont.) 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 only be exercised if the price moves favourably –The greater the spot price volatility, the greater the option premium, i.e. positive relationship

37. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-37 19.4 Pricing an Option (cont.) 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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-38 Chapter Organisation 19.1The Nature of Options 19.2Option Profit and Loss Payoff Profiles 19.3Organisation of the Market 19.4Pricing an Option 19.5 Option Risk Management Strategies 19.6 Conclusion 19.7 Summary

39. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-39 19.5 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 19.5 and Table 19.4 in textbook illustrate the profit profile of this strategy

40. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-40 19.5 Option Risk Management Strategies (cont.)

41. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-41 19.5 Option Risk Management Strategies (cont.)

42. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-42 19.5 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 19.6 and Table 19.5 in textbook illustrate the profit profile of this strategy

43. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-43 19.5 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 19.7 in textbook illustrates the profit profile

44. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-44 19.5 Option Risk Management Strategies (cont.)

45. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-45 19.5 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 19.8 in textbook illustrates the profit profile

46. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-46 19.5 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 19.9 in textbook illustrates the profit profile

47. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-47 19.5 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 19.10 in textbook illustrates the profit profile

48. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-48 19.5 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 19.11 in textbook illustrates the profit profile

49. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-49 19.5 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 to ‘long straddle’ Figure 19.12 in textbook illustrates the profit profile

50. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-50 19.5Option 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 19.13 in textbook illustrates the profit profiles

51. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-51 19.5 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

52. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-52 19.5 Option Risk Management Strategies (cont.)

53. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-53 Chapter Organisation 19.1The Nature of Options 19.2Option Profit and Loss Payoff Profiles 19.3Organisation of the Market 19.4Pricing an Option 19.5 Option Risk Management Strategies 19.6 Conclusion 19.7 Summary

54. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-54 19.6 Conclusion The potential gains and losses to buyers and sellers of futures contracts are different from that 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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-55 Chapter Organisation 19.1The Nature of Options 19.2Option Profit and Loss Payoff Profiles 19.3Organisation of the Market 19.4Pricing an Option 19.5 Option Risk Management Strategies 19.6 Conclusion 19.7 Summary

56. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 19-56 19.7 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 and SFE trade 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