Mechanics of Options Markets Chapter 8 Options Futures

Review of Option Types A call is an option to buy A put is

Option Positions Long call Long put Short call Short put Options, Futures, and Other

Long Call (Figure 8. 1, Page 180) Profit from buying one European call option:

Short Call (Figure 8. 3, page 182) Profit from writing one European call option:

Long Put (Figure 8. 2, page 181) Profit from buying a European put option:

Short Put (Figure 8. 4, page 182) Profit from writing a European put option:

Payoffs from Options What is the Option Position in Each Case? K = Strike

Assets Underlying Exchange-Traded Options Page 183 -184 Stocks Foreign Currency Stock Indices Futures Options,

Specification of Exchange-Traded Options Expiration date Strike price European or American Call or Put

Expiration Dates Example: a January call Expiration date: Saturday immediately following the third Friday

Expiration Dates Stock options are on January, February, and March cycle. January cycle: January,

Expiration Dates If the expiration date for the current month has not yet been

Strike Prices Strike prices are normally spaced $2. 50, $5, or $10 apart. $2.

Terminology Moneyness : ◦ At-the-money option ◦ In-the-money option ◦ Out-of-the-money option Options, Futures,

Terminology (continued) Option class: call or put Option series: IBM 175 Oct. calls Intrinsic

Dividends & Stock Splits (Page 186 -188) Suppose you own N options with a

Dividends & Stock Splits (continued) Consider a call option to buy 100 shares for

Market Makers Most exchanges use market makers to facilitate options trading A market maker

Commissions Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull

Commissions, Example Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John

Example, continued Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John

Margins (Page 190 -191) Margins are required when options are sold When a naked

Margins When a naked put option is written the margin is the greater of:

Margins, Example Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John

Warrants are options that are issued (or written) by a corporation or a financial

Executive Stock Options Executive stock options are a form of remuneration issued by a

Convertible Bonds Convertible bonds are regular bonds that can be exchanged for equity at

Warrants, employee stock options, and convertibles, compared to exchange traded options A predetermined number

Warrants, employee stock options, and convertibles, compared to exchange traded options By contrast, when

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Review of Option Types 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 Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 2

Long Call (Figure 8. 1, Page 180) Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months 30 Profit ($) 20 10 0 -5 70 80 90 100 Terminal stock price ($) 110 120 130 Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 4

Short Call (Figure 8. 3, page 182) Profit from writing one European call option: option price = $5, strike price = $100 Profit ($) 5 0 -10 120 130 70 80 90 100 Terminal stock price ($) -20 -30 Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 5

Long Put (Figure 8. 2, page 181) Profit from buying a European put option: option price = $7, strike price = $70 30 Profit ($) 20 10 0 -7 Terminal stock price ($) 40 50 60 70 80 90 100 Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 6

Short Put (Figure 8. 4, page 182) Profit from writing a European put option: option price = $7, strike price = $70 Profit ($) 7 0 40 50 Terminal stock price ($) 60 70 80 90 100 -10 -20 -30 Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 7

Payoffs from Options What is the Option Position in Each Case? K = Strike price, ST = Price of asset at maturity Payoff K K ST ST Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 8

Specification of Exchange-Traded Options Expiration date Strike price European or American Call or Put (option class) Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 10

Expiration Dates Example: a January call Expiration date: Saturday immediately following the third Friday of January Last trading day: The third Friday Until 4: 30 pm on Friday, time for investor to instruct the broker to exercise the option Until 10: 59 p. m. on Saturday, time for broker to complete the paperwork Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 11

Expiration Dates Stock options are on January, February, and March cycle. January cycle: January, April, July, October February and March cycle similarly Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 12

Expiration Dates If the expiration date for the current month has not yet been reached, options trade with expiration dates in the current month, the following month, and the next two months in the cycle. If the expiration date has passed, options trade with expiration dates in the next month, the next-but-one month, and the next two months of the expiration cycle. Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 13

Strike Prices Strike prices are normally spaced $2. 50, $5, or $10 apart. $2. 5, when the stock price is between $5 and $25 $5, when the stock price is between $25 and $200 $10, for stock prices above $200 Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 14

Terminology (continued) Option class: call or put Option series: IBM 175 Oct. calls Intrinsic value: a) call: max(S-K, 0) b) put: max(K-S, 0) Time value Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 16

Dividends & Stock Splits (Page 186 -188) 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 m. K/n the no. of options is increased to n. N/m ◦ Stock dividends are handled in a manner similar to stock splits Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 17

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 5% stock dividend? Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 18

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 Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 19

Margins (Page 190 -191) Margins are required when options are sold When a naked call option is written the margin is the greater of: 1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money 2. A total of 100% of the proceeds of the sale plus 10% of the underlying share price Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 24

Margins When a naked put option is written the margin is the greater of: 1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money 2. A total of 100% of the proceeds of the sale plus 10% of the exercise price Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 8. 2 5

Warrants are options that are issued (or written) by a corporation or a financial institution At the same time of a bond issue, the corporation issues call warrants on its own stock and then attaches them to the bond issue to make it more attractive to investors Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 8. 2 7

Executive Stock Options Executive stock options are a form of remuneration issued by a company to its executives They are usually at the money when issued When options are exercised the company issues more stock and sells it to the option holder for the strike price Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 28

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 Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 2008 30

Warrants, employee stock options, and convertibles, compared to exchange traded options A predetermined number of options are issued, whereas the number of exchange traded options outstanding is not predetermined. When warrants and … are exercised, the company issues more shares of its own stock and sells them to the option holder. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 8. 3 1

Warrants, employee stock options, and convertibles, compared to exchange traded options By contrast, when an exchangetraded call is exercised, the party with the short position buys in the market shares that have already been issued and sells them to the party with the long position. The company whose stock underlies the option is not involved in any way. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 8. 3 2