Option Market

Chapter 17

Why Options Markets?

 Financial derivative securities: derive all or part of their value from another
(underlying) security
 Options are created by investors, sold to other investors
 Why trade these indirect claims?
 Expand investment opportunities, lower cost, increase leverage

Options Terminology
 An option is a right to buy (or sell) a given number (if stock then 100 shares) of units of
a particular security at a particular price before a particular expiration date.
 The buyer may:
 (1) exercise the option
 (2) sell the option
 (3) let the option expire.
 The buyer (holder) of the option pays the writer (seller) of the option for this right.
This is known as the option premium (option price).
 Option premium or price: price paid by buyer to the writer (seller) to get the
“right”
 Buyers of option purchase rights to transact, whereas the seller has
an obligation to transact.
 The Exercise or strike price is standardized. For most stocks with a market price
greater than $25, the strike price is set by the exchange at 5 point intervals nearest to
where the stock is currently trading ( ie. If the stock is trading at $43 then options at
strikes of $40 and $45 may be issued by the exchange). For stocks with a market price
under $25, the strike price is set at increments of $2.50.
 Exercise (strike) price: “fixed price”— the per share price at which the security may
be purchased (call) or sold (put) to a writer
 Expiration (maturity) date: the last date at which an option can be exercised
 Call: Buyer has the right but not the obligation to purchase (call away) a fixed quantity
from the seller at a fixed price (exercise price) before a certain date (expiration date).
 Buyers of calls are protected from price increases
 Buyers expect prices to rise.
 Put: Buyer has the right but not the obligation to sell (put away) a fixed quantity to the
seller at a fixed price (exercise price) before a certain date (expiration date).
 Buyers of puts are protected from price decreases.
 Buyers expect prices to fall.
 How Options Work
 Buyers and sellers of options have opposite expectations about price movements
 Call buyer (seller) expects the price of the underlying security to increase (decrease or
stay steady)
 Put buyer (seller) expects the price of the underlying security to decrease (increase or
stay steady)
 At option maturity
 Option may expire worthless, be exercised, or be sold

Options Terminology
 Option Price is determined on the floor of the exchange
 Option Price has 2 components
 Intrinsic value (equate option price to market & strike)
 Speculative (Time) Premium

Intrinsic Value
 Intrinsic value is the value realized from immediate exercise
 Options premium rarely trade below its intrinsic value (If it did the investor would
realize riskless returns).

 Call options: maximum (S0-E or 0)

ALCOA Jan 70 with option price (premium) of $7; current market price for
ALCOA is $74/share

What is the least you'd sell your option for?

Market is $74
Strike is 70 $4 ($74-$70) Intrinsic value

 Put options: maximum (E-S0 or 0)

ALCOA 75 Jan Put at $6.50 and ALCOA’s market price is $70

What is the least you would sell the right to sell ALCOA to you for $75 when
the market is $70.

Market is $70
Strike is $75 $5 ($75-$70) Intrinsic Value
 Speculative Value
 Prior to option maturity, option premiums exceed intrinsic value
 This excess is referred to as time value.
 If the market price of security does not change, the option is referred to as a wasting
asset.
 The options value approaches the intrinsic value as the expiration date
approaches.
 Before expiration date the buyer of an option will often sell the option rather than
exercise the option in order not to lose the time value of the option.

 Speculative (Time) value =Option price - Intrinsic value

= seller compensation for risk
 Examples:
 Calls:
ALCOA Jan 70 with call option price (premium) of $7 current market price
for ALCOA is $74/share
Speculative Premium:
Option Price - Intrinsic Value

$7 - $4 = $3
 Puts:
ALCOA 75 Jan Put at $6.50 and ALCOA’s market price is $70
Speculative Premium:
Option Price - Intrinsic Value

$6.5 - $5.00 = $1.50

Influences on Premiums (Prices)

 Longer time -- higher premium
 Greater volatility of the underlying stock -- higher premium
 Stock price & exercise price— In the Money options have a greater option price
 In/Out of the Money
 In-the-money options have a positive cash flow if exercised immediately
 Call options: S >E
 Put options: S <E
 Out-of-the-money options should not be exercised immediately
 Call options: S <E
 Put options: S >E

Call: Put:
In M.P. > E.P. M.P. < E.P.
Out M.P. < E.P. M.P. > E.P.
At M.P. = E.P. M.P. = E.P.
 Interest rates
 higher rates -- premium increase
 Buy the option and invest the difference between option price and stock price
into an interest bearing investment
 Dividend rate:
 Higher dividend
 Lower Call Price-- become more attractive to own the stock
 Higher Put Price--less attractive to sell short in stock market since short seller
must pay the dividend to the lender of the stock--alternative is buy puts--causing
greater demand for the put

Break-Even Points
 Break Even Points:
Alcoa Put @ 75:
Consider the buyer’s cash flows:
Option Stock
-6.50 +75 +75-6.50=68.50
Stock must fall to below $68.50 before profits can be made.

Alcoa Call @ 70:

Consider the buyer’s cash flows:
Option Stock
-7.00 -70 -70-7= -77
Stock must rise to above $77 before profits can be made.

Should Options be Exercised Early?

 Exercise prior to maturity implies the option owner receives intrinsic value only, not
time value
 For call options, buy stock at below market price
 Would more be earned by selling option?
 For put options, receive cash from selling stock at above market price
 Could cash be reinvested for a higher return?

Option Price Boundaries

 At maturity, option prices are intrinsic values
 Intrinsic value is minimum price prior to maturity
 Maximum option prices prior to maturity
 Call options: price of stock, S0
 Put options: exercise price, E
 Options Trading
 Five exchanges constitutes the secondary market
 Chicago Board of Exchange
 American
 Philadelphia
 Pacific
 New York
 Option exchanges are continuous primary and secondary markets
 Chicago Board Options Exchange largest
 Option market provide liquidity to investors
 Types of orders may be market, limit, and stop orders
 Standardized exercise dates, exercise prices, and quantities
 Facilitates offsetting positions through Options Clearing Corporation
 OCC is guarantor, handles deliveries
 Exercising an option: -- OCC randomly selects a broker on whom it holds the
same written contract and then the randomly chosen broker randomly
selects a customer who has written those options

Put/Short Selling
 Buying a put is somewhat analogous to selling short.
 Short sale - limit on gain but no limit on loss (sell short when you expect the market to
drop).

e.g. sell short GM $50

Broker sells his stock for you 5000
Seller 50% margin 2500
Seller's broker account 7500
Stock drops to 40
You direct broker to purchase at 40
Seller's Broker Account 7500
Purchase <4000>
3500
Your gain:
Return:
What if stock goes to 60
Seller's broker account 7500
Purchase at 60 <6000>
1500
Your loss:
Return:
or
Could meet margin call and bring your $ invested to $3000 (50% of 6000).
 Speculative Strategies

 Attempts to profit if the market price of the underlying securities rises or falls

 Bull Market: rising prices

 Long Call Achieve leverage
 Cost of buying a call option on 100 shares much less than cost of purchasing
100 shares of stock.

You think ABC stock at $50/share will increase - option price on ABC call with a
strike at $50 is $5.

Buy Stock Option at $5 with strike $50

$5000 $500
Stock goes to $58

Can sell option for at least

5800 $800
Gain 800 Gain $300

800 = 16% 300 = 60%

5000 500

 Needs to be correct in
 (1) direction of the price movement
 (2) timing

 Maximum Gain: Unlimited

 Maximum Loss: Premium Paid
 BEP=Strike Price+Option Price

 Short Put: Risk avoiding drop in price -- gain option price

ABC at 50 write ABC 50 put at $3/share for $300

ABC drops to $40 and exercised
buy stock at 5000 sell 4000

<1000>
300 O.P.
< 700>

 Maximum Loss: Strike Price-Option Price

 Maximum Gain: Option Price
 BEP = Strike Price-Option Price
 Bear Market: Falling prices
 Short Call: Receive option price
 Write uncovered call then you have a potential of unlimited loss.

Write ABC 50 call at $4/share ABC price moves to $69.

Cash market lost: <6900> + 5000 + 400 = <1500>

Option market lost (why $1900?)

1900 - 400 = 1500

 Maximum Gain: Premium Received

 Maximum Loss: Unlimited
 BEP: Option Price + Strike Price (anything below makes $)

 Long Put: Leverage and limited risk

Buy put on ABC stock which is selling for $100

April/ABC 100 Put at 3

Stock drops to $90

profit $10/share

1000 - 300 = 233%

300

 To profit: market price < ( strike price-option price)

 Maximum Gain: Strike Price -Option Price-Price of Stock
 Maximum Loss: Option Price
 BEP = Strike Price-Option Price
 Income Strategies

 Long Stock/Short Call

 Covered:
 Increased return:
Own 100 shares of ABC current market price at $65. Option price for 3
month call at $65 is $4

Receive $1 dividend per quarter. Increase cash return to $5 from $1 if write

ABC call.

 Limited protection (hedge).

 Limited protection in decline of price of stock.
 Own stock-if you fear price will drop then sell a call on your stock (covered
call).
 If price rises above the BEP of the call, writer receives strike price.
 If price drops then writer will at least partially offset the decline in price
by the option price received.

E.g. purchased stock at $112 sold an option @ $110 on stock for $5

8
6
4 stock with covered call
2
-2 104 106 108 110 112 114
-4
-6 return on stock w/o covered call
-8

Max. gain if exercised:: <112> BEP for stockholder: <112>

110 + 5 o.p.
5 <107>
3

With covered call written for $5 and strike price of $110 original purchase price of
stock at $112.

 Maximum Gain: Option Price+Strike Price-Cost of Stock(if market price >

strike price)
 Maximum Loss: Cost Of Stock - Option Price (if market price< strike price)
 BEP: Cost of Stock - Option Price
 Other Reasons to buy Calls
 Limit Risk
Most lost in purchasing an option is the option price
Buy 60 Call @ 5 $500

 Lock in the cost of Future Stock Purchases

Will have $5000 in future and would like to lock in current price of XYZ you think
XYZ's price will rise.

Buy a call option (4 month)

XYZ 50 call at $3
Cost $300
Maximum cost $53/share

HEDGING WITH STOCK OPTIONS

 Long Stock / Long Put [Protective Put]

 Hedge against a stock decline.
 Own a stock - potential decline in price –
 purchase a put, thereby locking in the price at which could sell stock
 if prices fall, exercise the option.
 Benefit:
 Minimizes loss to purchaser
 No margin calls
 Detriment
 Usually shorter period than holding stock

Example:
Buy 100 shares @ $60
Buy 1 60 Put @ $5
Stock price falls to 50
Options Stock BEP Max Gain/Loss
Buy -$5 Buy -$60 65
Sell +60
-$5 0 -$5

 Maximum Gain/Loss: If market price of stock < strike price

 Strike price-market price of stock-option price
 Maximum Gain: If market price of stock > strike price
 Unlimited
 BEP: Stock Cost + Option Price
 Short Stock/Long Call
 Short Selling Stock-- protect against unlimited loss
Sell Short 100 shares @ 60
Buy 60 Call @ 5
Stock price moves to 95
Option Stock BEP GAIN/LOSS
Buy -5 Sell +60 55
Buy -60
-5 0 -5

Buy stock back if price drops but if prices rise then exercise your call at the strike
price.

 Maximum Loss: Short Sale price- Strike price- Option Price

 If strike price = short sale price of stock then loss is the option price
 Maximum Gain: Short Sale Price-Option Price
 BEP: Short Sale Price-Option Price

Spreads
 Being both the buyer and writer of same type of option on the same underlying stock.
(partial hedge (defines risk) rather than a pure one sided option position

Write XYZ March 35 call > Horizontal (Time Spread)

Buy XYZ June 35 call >

or

Write XYZ June 40 Call > Vertical (Price [money] Spreads)

Buy XYZ June 35 Call >

 Why use a spread?

 Limit or define risk
 Vertical Spreads
 Short Call Spread: (Bear Spread)
XYZ at $91 expect price to drop before Jan. but not more than 10 points

Write XYZ Jan 80 Call (uncovered) 1300

Buy XYZ Jan 90 Call < 600>
700 Credit ( cash inflow)

 Maximum Gain: Credit700

 Maximum Loss:
 If price increase max. lost?
 Sell at 80 uncovered if called then exercise Jan 90 option and buy at
90

<1000> + 700 = <300>

 Differences between Strike Prices  Credit

 BEP: Short Strike Price + Credit ---87

 Long Put Spread: (Bear Spread)

XYZ at $89 expect price to drop before Jan. but not by more than 10 points
Buy XYZ Jan 90 Put <500>
Write XYZ Jan 80 Put 100
<400> Debit ( cash outflow)

 Maximum Gain: Difference between Strike Prices  Debit ---

Sell at 90 buy at 80 = 10
10-4 = 6
6*100=600
 Maximum Loss: Debit --4
 BEP: Long Strike Price - Debit ---86

 Short Put Spread : (Bull Spread)

XYZ at $91 expect price to rise before Jan. but more than 10 points
Write XYZ Jan 90 Put 500
Buy XYZ Jan 80 Put <100>
400 Credit ( cash inflow)
 Maximum Gain: Credit400
 Maximum Loss:
 If price decreases max. lost?
 Differences between Strike Prices  Credit
Sell at 80 and buy at 90
<1000> + 400 = <600>

 BEP: Short Strike Price - Credit ---86

 Long Call Spread: (Bull Spread)
XYZ at $84 expect price to rise before Jan. but not by more than 10 points
Buy XYZ Jan 80 Call <500>
Write XYZ Jan 90 Call 100
<400> Debit ( cash outflow)

 Maximum Gain: Difference between Strike Prices  Debit ---

Sell at 90 buy at 80 = 10
10-4 = 6
6*100=600
 Maximum Loss: Debit --4
 BEP: Long Strike Price + Debit ---84

Horizontal (Calendar) Spreads

 Tries to take advantage of human nature to make a profit. As the expiration date
approaches, the option price should fall evenly over time. What happens is the price
does not fall evenly, but falls rapidly near the end of the contract.

Write XYZ March 35 Call 400

Buy XYZ June 35 Call <600>
<200> Debit (cash outflow)

Offsetting position---near the expiration date of the March contract

Buy XYZ March 35 Call 0

Write XYZ June 35 Call 500
500 Credit (cash inflow)
 Gain: 500-200 = 300
 Maximum Loss: Debit200
 BEP: Strike + Debit
 Straddles

 Straddles: purchasing or writing both a put and a call on the same stock with options
having same exercise price and same expiration date.
 Buyer: anticipates a relative substantial change in stock price.
 Writer: Anticipates little change in price of stock during life of option.

 Long Straddle: (Speculative strategy that is both bullish and bearish)

Expect XYZ @ $50 to move sharply before Jan, but not sure of movement direction.

Buy Straddle
Buy XYZ Jan 50 Call < 400 >
Buy XYZ Jan 50 Put < 300 >
< 700 > Debit (cash outflow)

If price is above 57 or below 43 profit

Buyer Writer Buyer

57 43

 Maximum Loss: Debit is maximum loss

 BEP:
 Upside BEP: Call price + debit (57)
 Downside BEP: Put price  debit (43)
 Maximum Gain:
 Call—Unlimited
 Put: --Strike Price-Premium

 Short Straddle:( Speculative strategy that is suitable for flat market)

Writer XYZ Jan 50 Call 400

Writer XYZ Jan 50 Put 300
700 Credit (cash inflow)
i.e. If XYZ drops below 47, put will be exercised
suffer maximum loss of strike price- market price (=0)-option strategy price

 Maximum Gain: Credit

 Maximum Loss:
 Call---Unlimited
 Put:---Strike Price-Premium
 BEP:
 Call: Call Strike Price + Credit
 Put: Put Strike Price  Credit
 Writer has double risk (upside and downside)
 Triple Witching Hour:
Third Friday of March, June, September, December
Options and futures on stock indexes expire  heavy trading

Portfolio Insurance
 Hedging strategy that provides a minimum return on the portfolio while keeping upside
potential
 Buy protective put that provides the minimum return
 Put exercise price less or equal to the at expiration or put is exercised.
 Problems in matching risk with contracts

Black-Scholes Valuation

 Black-Scholes values call options of nondividend paying stock

 Five variables needed to value a European call option on a non-dividend paying stock
 Price of underlying stock
 Strike price of the option
 Time remaining to expiration
 Greatest when market price = strike price
 Interest rate
 Higher rate greater value of option
 Volatility of underlying stock
 Greater the volatility, the greater the option value
 The Black-Scholes pricing formula is:
CP=CMP [N(d1)] - (EP/ert) [N(d2)]

Put-Call Parity
 Black-Scholes valuation is for call options
 Put-call parity shows relationship between call and put options so that riskless
arbitrage is not possible
 Price of put =(EP/ert) - CMP +CP

Factors Affecting Prices

Riskless Hedging

 Options can be used to control the riskiness of common stocks

 If stock owned, sell calls or buy puts
 Call or put option prices do not usually change the same dollar amount as the stock
being hedged
 Heding Ratios (delta)
 Shares purchased per calls written =N(d1)
 Shares purchased per puts purchased =N(d1) – 1
 Stock Index Options
 Options available on S&P 100 Index, S&P 500 Index, NYSE Index, others
 Bullish on capital markets implies buying calls or writing puts
 Bearish on capital markets implies buying puts or writing calls
 At maturity or upon exercise, cash settlement of position
 Stock Index Options
 Major Market Index (XMI) --20 stocks that mimics the Dow Jones Industrial
Average (Dow wouldnt allow their name to be placed on an option)
 S/P 100 (OEX)--most actively traded of all indexes (broader than the XMI)
S/P 500 (SPX)
 Settlement is in cash not the actual underlying portfolio. Thus offsetting positions are
used rather than the actual portfolio in exercising the option.
 If buyer exercises then seller pays the buyer the in the money amount
computed upon the closing index option value.

bought at 390 *100 = 39000

exercised- sold at 395.53 * 100 = 39553
Gain: 553
 Settlement-cash next business day

Strategies with Stock Index Options

 Speculation opportunities similar to options on individual stocks
 Hedging opportunities permit the management of market risk
 Well-diversified portfolio of stocks hedged by writing calls or buying puts on stock
index
 What return can investor expect?

OPTIONS ON FUTURES
 Call option on financial futures: grants the right to purchase a futures contract at a
specified price within a specified time period.

 Put option on financial futures: grants the right to sell a particular financial futures
contract at a specified price within a specified time period.

 Why choose options on futures over futures?

 Max loss is O.P. if purchase
 No margin calls if purchase
 Option market (T-bonds) liquid
 Hedge against rising rates
 Futures: Sell T-bond future
 Option: Buy put option

 Pricing of option on future

 % of ($100,000 par value of future - increments of 64th's)

Buy put @ 1-48 with Ex. of 89-16

cost 1.75% (100,000) = 1750

(Future is priced as % of par-increments of 32nd)

Treasury bond future @ 89-16 = (89,500)

Rates rise and price falls to 85

Purchase T-bond future <85,000>

Exercise put 89,500
4,500
Option price 1,750
2,750

Holding Return: 2750/1750 = 157%

BEP: 89-16/32-1 48/64 = 87-24

Rates fall and price rises to 87-16

Purchase T-bond futures <87,750>

Exercise Put 89,500
1,750
Option Price 1,750
-0-
 Warrants
 an option issued by the corporation to purchase within a specified time
period, a stated number of shares of common stock at a specified price
 maturities of at least several years (3-10 years are common)
 terms not always standardized
 Often issued attached to new issues of bonds as sweetners
 Allows lower interest rate on bonds
 Warrants detached and sold separately
 Often used with an acquisition or reorganization
 Characteristics:
 Expiration often 3-10 years
 Expiration date may be extended
 Conversion ratio is often one-one
 Exercise price (per-share amount to be paid) specified at
issuance
 May be callable
 Wasting account
 Valuing warrants
 Maximum value: price of underlying stock
 Minimum value: difference between the market price of the
stock and the warrant’s exercise price if spread is positive
otherwise it is zero
 Intrinsic value
 MP = 0 if CMP < EP
 MP = (CMP-EP) x N if CMP >EP
 Premium = Market Price of warrant – minimum price of
warrant
 Determinants of Premium
 Remaining warrant life
 Price volatility of the stock
 Dividend on the underlying stock
 Potential leverage of the warrant