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9,10,11 - LN0-1

12 - LN2
13 - LN3
14 - LN4-5
16,17 - LN6
18 - LN7
20.6-20.7 - LN8
19 - LN9
21 - LN10
9.1 Types of Options
Call option - holder has the right to buy an asset by a certain date for a certain price.
A call option should always be exercised at maturity if the stock price is above the strike price (this may still
lead to a loss though, depending on stock price and option price).

Break even at stock price 105 (5+100 = 105). Stock price above 105 gives a profit.
Put option - holder has the right to sell an asset by a certain date for a certain price.

Break even at strike price minus option price (70-7=63). Stock price below 63 gives a profit.
American option - can be exercised at any time
European option - can be exercised only at maturity/expiration date
9.2 Option Positions

S
1. Long in a call option. Payoff would be max( T K , 0)

Meaning that the option would be

ST K .
KS
2. Long in a put option. Payoff would be max( T )

exercised if

ST > K

, and not exercised if

S
3. Short in a call option. Payoff would be max( T K , 0)=min(KST , 0)

KS
4. Short in a put option. Payoff would be max(T , 0)=min(ST K , 0)

9.3-9.4 Underlying Assets


Stock Options
Traded on exchange (CBOE, Nasdaq, NYSE, Boston SE) on more than 2500 stocks. One contract gives the
right to buy or sell 100 shares at specified strike price. Convenient because stocks are generally sold in lots of
100.
For expiration dates, the most important day is the third Friday in the expiration month. This is the last day on
which an option is traded, as it matures on Saturday after the third Friday in the month. A long position in has
until 4.30pm to exercise and the broker has until 10.59pm on saturday to complete the paperwork.

The exchange normally sets the strike prices at which options can be written so they are spaced $2.50, $5 or
$10 apart.
Spacing
Stock Price
$2.50
$5-25
$5
$25-200
$10
> $200
Say a stock price $84 has options with strike prices $80, $85 and $90. If the stock price rises above $90 a new
strike price of $95 would be included. Same if stock falls to below $80, then probably a strike price of $75
would be offered.
FX Options
Mostly traded OTC, but some are on exchange. Exchange traded are usually on Nasdaq which offers
European-style contracts. One contract gives the right to buy or sell 10,000 units of foreign currency for U.S
dollars. (1,000,000 if Japanese Yen for USD).
Index Options
Futures Options
If futures are traded on exchange you can usually get an options contract on it as well. A futures option
matures just before delivery period in the futures contract.
When a call is exercised the holders gain equals the excess of the futures price over the strike price.
When a put is exercised the holders gain equals the strike price over the futures price.
Terminology
Option Class - Consisting of all option of the same type (IBM call are one class, IBM puts another class)
Option Series - All options within a class with same expiration date and strike price. (IBM 70 October calls).
In the Money - For calls when S > K, and for puts when S < K
At the Money - For both calls and puts when S = K
Out of the Money - For calls when S < K, and for puts when S > K
Clearly, we will only exercise when in-the-money. In absence of transaction costs, an in-the-money
option will ALWAYS be exercised at maturity if not earlier.
Intrinsic value - defined as the maximum of zero and the value the option would have if it was exercised
immediately.
Intrinsic value of a call: max( SK , 0)
Intrinsic value of a put: max( K S , 0)
Dividends & Stock Splits
Exchange traded options are usually not adjusted for cash dividends. When a dividend is paid the terms of the
options contract remains the same. An exception may be made for large cash dividends.
Exchange traded options are adjusted for stock splits. A stock split of n-for-m should generally cause the stock

n
of its previous value. The terms of the option contracts are adjusted to reflect the expected
m
m
change in stock price. A stock split of n-for-m will reduce the strike price by
of its previous value, and the
n
price to fall to

number of shares covered by one contract increases by

n
of its previous value. So when the stock price
m

falls as expected the positions of both writer and holder are unchanged.
Example:
Call option for 100 shares for $30 a share. Assume 2-for-1 split. The option contract changes so that
the
holder has right to purchase 200 shares for $15 a share.