MBF1243 Derivatives

L5: Mechanics of Options Markets

Review of Option Types

A call option gives the holder of the option the right to
buy an asset by a certain date for a certain price
A put option gives the holder the right to sell an asset by
a certain date for a certain price
The date specified is know as expiration date or
maturity date.
Price specified is known as exercise price or the strike
price
A European option can be exercised only at the end of its
life
An American option can be exercised at any time up to the
expiration date
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Option Positions
Long position - investor has bought the option
Short position investor has sold or written the option.

Long call
Long put
Short call
Short put

Option Positions

Long call
Long put
Short call
Short put

Long Call

(Figure 10.1, Page 214)

Scenario : European call option: option price = $5,

strike price = $100, option life = 2 months. Initial investment is $500

If stock price is $102, the investor will make 100 x ($102-$100) = $200 (and realize a loss of
$300). Will the investor exercise this option?

A call option should always be exercised at the expiration date of the stock price is above the
strike price

30 Profit ($)
20
10
70
0
-5

80

90

100

Terminal
stock price ($)
110 120 130
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Short Call

(Figure 10.3, page 216)

Profit from writing one European call option: option price = $5,
strike price = $100

Profit ($)
5
0
-10

110 120 130

70

80

90 100

Terminal
stock price ($)

-20
-30
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Long Put (Figure 10.2, page 215)

Scenario: European put option: option price = $7, strike price = $70, option life = 3
months. Initial investment is $700

If stock price is $55, the investor will make 100 x ($70-$55) = $1,500 (and realize a profit of
$800). Will the investor exercise this option if the stock price is above$70? Above $70 the
option is worthless and the investor losses $700
A put option should always be exercised at the expiration date of the stock price is below
the strike price

30 Profit ($)
20
10
0
-7

Terminal
stock price ($)
40

50

60

70

80

90 100
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Short Put (Figure 10.4, page 216)

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
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Payoffs from Options

What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
(A) - Long call
(B) - Short call
(C) - Long put
(D) - Short put
>>> Option will be exercised of ST > K
>>> Option will be not exercised of ST < K
Payoff

(A)

(B)

Payoff

K
K
Payoff

ST
(C)

ST
(D)

Payoff

K
K

ST

ST
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Assets Underlying Exchange-Traded Options

Page 217-218

Stocks
Foreign Currency
Stock Indices
Futures

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Specification of Exchange-Traded Options

Expiration date
Strike price
European or American
Call or Put (option class)

>>>>Refer handouts

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Terminology
Moneyness:
If S is the stock price, and K is the strike price
A call option is

In-the-money option when S > K

At-the-money option S = K

Out-of-the-money option S < K

If S is the stock price, and K is the strike price
A put option is

In-the-money option when S < K

At-the-money option S = K

Out-of-the-money option S > K

An option will be exercised only when it is in the money

In the absence of transactions costs, an in-the-money option will always be
exercised on the expiration date if it has not been exercised previously.
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Terminology (continued)
Option class - All options of the same type (calls or puts) are
referred to as an option class. Eg, IBM calls are one class, while
IBM puts are another class.
Option series - An option series consists of all the options of a
given class with the same expiration date and strike price.
Eg. IBM 70 October calls would constitute an option series.
Intrinsic value An intrinsic value of an option is defined as the
maximum of zero and the value the option would have if it were
exercised immediately. For a call option, the intrinsic value is
therefore max(S - K, 0). For a put option, it is max(K S, 0). An inthe money American option must be worth at least as much as its
intrinsic value became the holder can realize the intrinsic value by
exercising immediately.
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Ways the CBOE Is Trying to Take Market Share

from the OTC Market
Flex options options on equities and equity indices
These are options where the traders on the floor of the
exchange agree to nonstandard terms. These
nonstandard terms can involve a strike price or an
expiration date that is different from what is usually
offered by the exchange

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Dividends & Stock Splits

(Page 221-222)
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 mK/n
the no. of options is increased to nN/m
Stock dividends are handled similarly to stock splits
* Eg 3-for-1 stock split, 3 new shares are issued to replace each
existing share

Does stock split have effect on the assets or the earning ability
of the company? An shareholders wealth? What effect will it
have on stock price.
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Dividends & Stock Splits (continued)

Consider a call option to buy 100 shares for $30/share
How should terms be adjusted:
for a 2-for-1 stock split?

The terms of the options contract is then changed so that

it gives the holder the right to purchase 200 shares for
$15/share
for a 20% stock dividend?
one new share for each 5 already owned. Essentially same as
6-for-5 stock split. It should cause the stock prie to decline by
5/6 of its previous value.
The terms are adjusted to reflect the expected price decline
arising from a stock dividend in the same way as they are for
that arising from a stock split.
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Market Makers
Most exchanges use market makers to facilitate options
trading
A market maker quotes both bid and ask (offer) prices
when requested
The bid is the price at which the market maker is prepared
to buy,
The offer or asked is the price at which the market maker
is prepared to sell.

At the time the bid and offer prices are quoted and the
market maker does not know whether the individual
requesting the quotes wants to buy or sell
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Margins (Page 224-226)

Margins are required when options are sold
When a naked option is written the margin is the greater
of:
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
A total of 100% of the proceeds of the sale plus 10%
of the underlying share price (call) or exercise price
(put)
For other trading strategies there are special rules

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Margins (Page 224-226)

Margins are required when options are sold

When shares are purchased in the US, an investor can borrow up to 50% of the
price from the broker. This is known as buying on margin.
If the share price declines so that the loan is substantially more than 50% of
the stock's current value, there is a "margin call", where the broker requests
that cash be deposited by the investor. If the margin call is not met, the
broker sells the stock.

When call and put options with maturities less than 9 months are purchased, the
option price must be paid in full.

For options with maturities greater than 9 months investors can buy on margin,
borrowing up to 25% of the option value.

A trader who writes options is required to maintain funds in a margin account.

Both the trader's broker and the exchange want to be satisfied that the investor
will not default if the option is exercised. The amount of margin required depends
on the trader's position.
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Margins (Page 224-226)

Writing Naked Options
A naked option is an option that is not combined with an
offsetting position in the underlying stock.
The initial margin required by the CBOE for a written naked
call option is the greater of the following 2 calculations:
When a naked option is written the margin is the greater of:
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
A total of 100% of the proceeds of the sale plus 10% of the
underlying share price (call) or exercise price (put)
For other trading strategies there are special rules

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Warrants
Warrants are options that are issued by a corporation or a
financial institution
The number of warrants outstanding is determined by the
size of the original issue and changes only when they are
exercised or when they expire
The issuer settles up with the holder when a warrant is
exercised
When call warrants are issued by a corporation on its own
stock, exercise will usually lead to new treasury stock
being issued
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Employee Stock Options

Employee 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
Expensed on the income statement

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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
Usually 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

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