Chapter 14

Options Markets

1
Chapter Outline
 Background on options
 Speculating with stock options
 Determinants of stock option premiums
 Explaining changes in option premiums
 Hedging with stock options
 Using options to measure a stock’s risk

2
Chapter Outline (cont’d)
 Options on ETFs and stock indexes
 Options on futures contracts
 Hedging with options on futures
(->FDI

 Institutional use of options markets

 Globalization of options markets

3
 What is an option? -

Similar to futmes butie

e e

 An option is a financial instrument that gives the

holder (buyer) the right to buy or sell an underlying asset
from or to writer (seller) by a certain date for a certain price
 The buyer pays the premium (price of the option) to the seller
(writer) for the right to buy or sell the underlying asset.
• If the buyer chooses to exercise his right to buy or sell the asset,
the seller of the option has the obligation to deliver or take delivery
of the underlying asset.
• Exercise price, or strike price: the fixed or certain price at which the
underlying asset can be bought or sold.
• At expiration: if the option is not exercised, the option will expire.

4
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Background on Options
 A call option grants the owner the right to purchase a
specified financial instrument for a specified price (exercise
or strike price) within a specified period of time
 Grants the right, but not the obligation, to purchase the specified
investment
 The writer of a call option is obligated to provide the instrument at
the price specified by the option contract if the owner exercises the
option
 A call option is:
 In the money when the market price of the underlying security exceeds
the strike price -> S>X *( )

 At the money when the market price is equal to the strike price -> S X=

 Out of the money when the market price is below the strike price ->SX
MPrice <Exercise
5 plice
Long Call the light
O
- to
buy
Payoff and profit from buying one European call a

option: option price = $5, strike price = $100, option

- -

life = 2 months "P X k/X -

=
100

C/P
30 Profit ($)
= 5

N =
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Payoff

20 Profit

10 Terminal
70 80 90 100 stock price ($)
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-5 110 120 130
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+ Payoff = Max (0, ST-K)

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+ Profit = Max (0, ST-K) - c

Do not
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Short Call
Profit from writing one European call option: option
price = $5, strike price = $100
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)
Payoff
Profit
-20
PIL= 54
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+ Payoff = - Max (0, ST-K) loss

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+ Profit = - Max (0, ST-K) + c

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Background on Options (cont’d)
 A put option grants the owner the right to sell a
specified financial instrument for a specified price
within a specified period of time
 Grants the right, but not the obligation, to sell the
specified investment
 A put option is: ↳ITM (exencisel
 In the money when the market price of the underlying security is
below the strike price ->

K> Si

 At the money when the market price is equal to the strike price -kS
,

 Out of the money when the market price is above the strike
price ↓
OTM (no exercise (
k S

8
Long Put
-
-
-> seft the
nighte
-> C

k
=
7

78
-
=

Profit fromCbuying a European put option: option

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price = $7, strike price = $70

if S+ 80 -> Do not
exercise, Pay
30 Profit ($) [ St
=

-> self & strike

I =

67 -> Exercise K-S+

= payoff

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=

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K-St =
C

70 +

Do
exercise
= not -
Payoff

20
=

,
P/ =
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10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7
↳ Long Put Decision

+ Payoff = Max (0, K-ST) L

if STY , K -
No exercise
[
Payoff
=
G

L if St<K P/L =
-

+ Profit = Max (0, K-ST) - p Exercise

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Profit from writing a European put option: option
price = $7, strike price = $70

Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10

-20

-30
+ Payoff = - Max (0, K-ST)
+ Profit = - Max (0, K-ST) + p 10
 Background on Options (cont’d)
 Call and put options specify 100 shares for stocks
 Premiums paid for call and put options are determined
through open outcry on the exchange floor
 Participants can close out their option positions by taking
an offsetting position
 The gain or loss is determined by the premium paid when
purchasing the option and the premium received when selling the
option
 American-style options can be exercised at any time prior
to expiration
 European-style options can be exercise only just before
expiration

11
Background on Options (cont’d)
 Markets used to trade options
 The CBOE:
 Is the most important exchange for trading options
 Serves as the market for options on more than 1,500
different stocks
 Lists standardized options
 Accounts for about 51 percent of all option trading
 Options are also traded on the AMEX, Philadelphia
Stock Exchange, Pacific Stock Exchange, and the
International Securities Exchange

12
Background on Options (cont’d)
 Markets used to trade options (cont’d)
 Listing requirements
 Each exchange has its own requirements
 One key requirement is a minimum trading volume of the
underlying stocks
 Role of the Options Clearing Corporation (OCC)
 The OCC serves as a guarantor on option contracts traded in
the U.S.
 Regulation of options trading
 The SEC and the various option exchanges regulate option
trading
 Regulations:
 Are intended to ensure fair and orderly training
 Attempt to prevent insider trading
 Attempt to prevent price fixing among floor brokers
13
Background on Options (cont’d)
 How option trades are executed
 Floor
-
brokers execute transactions desired by
investors
 Some orders are executed electronically without a floor
broker
-

↳
 Market-makers:
 Can execute stock option transactions for customers

 Trade options on their own account

 May facilitate a buy order for one customer and a sell order
for a different customer
 Earn the difference between the bid price and the ask price
for the option

14
Background on Options (cont’d)
 Types of orders
A market order results in the immediate
purchase or sale of an option at the prevailing
market price
 With a limit order, the transaction will occur
only if the market price is no higher or lower
than a specified price limit
 Online trading
 Many online brokerage firms, like E*Trade and
Datek, facilitate options orders

15
Background on Options (cont’d)
 Stock option quotations
 Financial newspapers and some local
newspapers publish quotations for stock
options (see next slide)
 Options with higher exercise prices have
lower call premiums and higher put premiums
 Options with a longer maturity have higher
call option premiums and higher put option
premiums
16
Background on Options (cont’d)
 Stock option quotations (cont’d)
Strike Exp. Vol. Call Vol. Put

McDonald’s 45 Jun 180 4 1/2 60 2 3/4

45 Oct 70 5 3/4 120 3 3/4

50 Jun 360 1 1/8 40 5 1/8

50 Oct 90 3 1/2 40 6 1/2

17
Speculating with Stock Options
 Speculating with call options
 Call options can be used to speculate on the expectation of an
increase in the price of the underlying stock
 Assuming that the buyer of the option sells the stock when
exercising the option and that the writer will obtain the stock
only when the option is exercised, the writer’s net gain is the
buyer’s net loss, assuming zero transaction costs
 The maximum loss for the buyer of a call option is the premium,
while the maximum gain is unlimited
 The maximum gain for the writer of a call option is the premium,
while the maximum loss is unlimited

18
 Speculating with Call Options
Pete expects ABC stock to increase from its current price of
$90 per share. He purchases a call option on ABC stock
-

with an exercise price of $92 for a premium of $4 per

- - -

share. ABC stock rises to $97 prior to the option’s

n -

expiration date. If Pete exercises the option and

immediately sells the shares in the market, what is his
net gain from the transaction?

$97 $92 $4 $1 per share

19
 Speculating with Call Options
(cont’d)
Draw the contingency graph for the buyer of the call option
and the writer of the call option.

Buyer’s Perspective Writer’s Perspective

Profit

96 4
0 0
-4 Stock Price 96
At Expiration

20
Speculating with Stock Options (cont’d)
 Speculating with call options (cont’d)
 Assume that ABC stock has three call options available:
Call option 1: Exercise price = $87; Premium = $7

(FPM


 Call option 1: Exercise price = $90; Premium = $5

 Call option 1: Exercise price = $92; Premium = $4
 The risk-return potential varies among the several options that are
available
 The contingency graph for all three options is shown on the next
slide
 The graph can be revised to reflect returns for each possible price per
share of the underlying stock

21
Speculating with Stock Options
(cont’d) Call option 1
Call option 2
Profit or Loss
Per Share Call option 3

94 95
0
96 Stock Price of ABC Stock
-4
-5

-7

22
 Speculating with Stock Options (cont’d)
 Speculating with put options
night
 Put options can be used to speculate on the
Long <
pur
expectation of a decrease in the price of the underlying
-

only stock
 The maximum gain for the buyer of a put option is the
exercise price less the premium, while the maximum
loss is the premium
 The maximum loss for the writer of a put option is the
exercise price less the premium, while the maximum
gain is the premium

23
 Speculating with Put Options
Mary expects XYZ stock to decrease from its current price of
$54. Thus, she purchases a put option on XYZ stock
with an exercise price of $53 and a premium of $2. If the
un
-
-

stock price of XYZ stock is $47 when the option expires,

-

what is Mary’s net gain?

$53 $47 $2 $4 per share

24
Speculating with Put Options (cont’d)

Draw the contingency graph for the buyer of the put option
and the writer of the put option.

Buyer’s Perspective Writer’s Perspective

Profit
51

2
51 51
0 0
-2 Stock Price
At Expiration
51

25
 Speculating with Stock Options (cont’d)
 Excessive risk from speculation
 Firms should closely monitor the trading of derivative contracts by
their employees to ensure that derivatives are being used within
the firm’s guidelines
 Firms should separate the reporting function from the trading
function so that traders cannot conceal trading losses
 When firms receive margin calls on derivative positions, they
should recognize that there may be potential losses on their
derivative instruments

26
Determinants of Stock Option Premiums
p's
 The option premium must be sufficiently high to equalize
the demand by buyers and the supply that sellers are
willing to sell
 Determinants of call option premiums St>K
 Influence of the market price
 The higher the existing market price of the underlying financial
instrument relative to the exercise price, the higher the call option
premium
 Influence of the stock’s volatility ->
Higher price fluctuation -> ↑ opportunition to exencise
-> ITM - P4
 The greater the volatility of the underlying stock, the higher the call
option premium
 Influence of the call option’s time to maturity N +
opportunitie
-> PA

 The longer the call option’s time to maturity, the higher the call
option premium
27
Determinants of Stock Option
Premiums (cont’d)
 Determinants of put option premiums
-
) StK +K-St : FiM
 Influence of the market price STY - IV Put
-> = K -

Sit
 The higher the existing market price of the underlying PA ->

financial instrument relative to the exercise price, the lower

the put option premium
 Influence of the stock’s volatility -> ↑fluctuation ->
 The greater the volatility of the underlying stock, the higher
the put option premium
 Influence of the put option’s time to maturity -> N4 ->
↑
nation -> PM

 The longer the call option’s time to maturity, the higher the
put option premium

⑪ 28
Explaining Changes in Option Premiums
 Economic conditions and market conditions can cause
abrupt changes in the stock rice or in the anticipated
volatility of the stock price
 This would have a major impact on the stock option premium
 Indicators monitored by participants in the option market
 Option market participants closely monitor the indicators that
are monitored for stocks:
 Economic indicators, industry-specific conditions, firm-specific
conditions

29
Hedging with Stock Options
 Mutual funds, insurance companies, and
pension funds manage large stock portfolios
and use options on stocks and stock indexes to
hedge
 Hedging with call options
A covered call involves the sale of a call option with
a simultaneous long position in the stock

30
 Writing A Covered Call
Philly Mutual Fund owns 100 shares of ABC stock. Philly
believes that the stock price will decline temporarily from
its current price of $90, but does not want to liquidate its
position because of transaction costs. Consequently, Philly
writes one call option on ABC stock with an exercise price
of $88 and a premium of $6. Construct a contingency
graph showing Philly’s position with covered call writing
and without covered call writing.

31
Writing A Covered Call (cont’d)
Without Covered Call
Writing

3
With Covered Call Writing

0
85 88 90

32
Hedging with Stock Options (self-
reading)
 Hedging with put options
 Ifan institution with a long position in a stock is
concerned about a decline in the stock price, it could
hedge against a temporary decline by purchasing put
options on that stock
 Put options are typically used to hedge when portfolio
managers are concerned about a temporary decline in
a stock’s value

33
 Using Options to Measure a Stock’s
Risk
 Stock options can be used to drive the market’s
anticipation of a stock’s standard deviation over the life of
the option
 The option-pricing model can be used to derive the
implied standard deviation of a stock
 The implied standard deviation increases when a firm
experiences an event that creates more uncertainty

34
Options on ETFs and Stock Indexes

 An ETF option provides the right to trade a

specified ETF at a specified price by a
specified expiration date
 Since ETFs are traded like stocks, options on ETFs
are traded like options on stocks
 Investors who exercise a call option on an ETF
would receive delivery of the ETF in their account

35
Options on ETFs and Stock
Indexes (cont’d)
 A stock index option provides the right to trade a specified
stock index at a specified price by a specified expiration
date
 Options are offered on the S&P 100 index, the S&P 500 index,
S&P SmallCap 600 Index, Dow Jones Industrial Average, Nasdaq
100 Index, Goldman Sachs Internet Index, among others
 If an index option is exercised, the cash payment is equal to a
specified dollar amount multiplied by the difference between the
index level and the exercise price
 Speculators who anticipate a sharp increase in the stock market
would purchase call options on an index
 Speculators who anticipate a decrease in the stock market would
purchase put options on an index

36
 ETFs for Which Options Are Traded Indexes for Which Options Are Traded
iShares Nasdaq Biotechnology Asia 25 Index

iShares Goldman Sachs Technology Index Euro 25 Index

iShares Goldman Sachs Software Index Mexico Index

iShares Russell 1000 Index Fund Dow Jones Industrial Average

iShares Russell 1000 Value Index Fund Dow Jones Transportation Average

iShares Russell 1000 Growth Index Fund S&P 100 Index

Energy Select Sector SPDR S&P 500 Index

Financial Select Sector SPDR S&P SmallCap 600 Index

Utilities Select Sector SPDR Nasdaq 100 Index

Health Care Select Sector SPDR Russell 1000 Index, etc.

37
Options on ETFs and Indexes
(cont’d)
 Hedging with stock index options
 Portfolio managers consider purchasing put options on a stock
index to protect against stock market declines
 The put options should be purchased on the stock index that
most closely mirrors the portfolio to be hedged
 The greater the market downturn, the greater the decline in the
market value of the portfolio, but the greater the gain from
holding put options on a stock index
 Hedging with long-term stock index options
 Long-term equity anticipations (LEAPs) have expiration dates
at least two years ahead with a lower premium

38
Options on ETFs and Indexes
(cont’d)
 Dynamic asset allocation with stock index options
 Dynamic asset allocation involves switching between risky and
low-risk investment positions over time in response to
changing expectations
 e.g., portfolio managers purchase call options under favorable
conditions and put option under unfavorable conditions
 e.g., write call options when the stock market is expected to be
very stable
 Portfolio managers can select the exercise price that provides
the desired protection
 e.g., buy put options with an exercise price of 380 if the current
level of the index is 400 and a 5 percent loss is acceptable

39
Options on ETFs and Indexes
(cont’d)
 Using index options to measure the market’s
risk
A stock index’s implied volatility can be derived from
information about options on that stock index
 Impact of the September 11 Crisis on the implied
volatility of stock indexes
 The attacks caused more uncertainty about the future
value of stocks
 Implied volatility increased when the markets reopened on
September 17

40
Options on Futures Contracts
 An option on a futures contract allows the right
to purchase or sell that futures contract for a
specified price within a specified period of time
 Options on futures grant the power to take the
futures position if favorable conditions occur but the
flexibility to avoid the future position if unfavorable
conditions occur
 Options are available on stock index futures and on
interest rate futures

41
Options on Futures Contracts
(cont’d)
 Speculating with options on futures
 Speculation based on an expected decline in
interest rates
 Speculators may consider purchasing a call option on
Treasury bond futures
 When interest rates decline, buyers of call options would
sell the option just before expiration
 If interest rates rise, buyers of call options will let the
options expire
 Speculators who expect interest rates to remain stable or
decline could sell put options on Treasury bond futures

42
Speculating on a Decrease in
Rates with Options on Futures
Kevin Phelps expects interest rates to decline and purchases a
call option on Treasury bond futures with an exercise price
of 92–40. The option has a premium of 2–00. Shortly before
the expiration date, the price of Treasury bond futures rises
to 95–00. Kevin exercises the option and closes out the
position by selling an identical futures contract. What it is net
gain from this strategy?

Net gain $95,000 $92,625 $2,000 $375

$375
ROI 18.75%
$2,000

43
Options on Futures Contracts
(cont’d)
 Speculating with options on futures (cont’d)
 Speculation based on an expected increase in
interest rates
 Speculators who expect interest rates to increase could
purchase a put option on Treasury bond futures
 If interest rates rise, the speculator can exercise the option
to sell futures at the exercise price and purchase futures at
a lower price than the price at which they sold futures
 If interest rates decline, the speculators will let the options
expire
 Speculators who anticipate an increase in interest rates
may consider selling call options on Treasury bond futures

44
Speculating on an Increase in
Rates with Options on Futures
Barnie Blythe expects interest rates to increase and purchases a
put option on Treasury bond futures with an exercise price of
98–00 and a premium of 2–00. Just prior to the expiration
date, the price of Treasury bond futures is valued at 94–12.
What is Barnie’s net gain from this strategy if he exercises
the option and closes out the position by purchasing an
identical futures contract?

Net gain $98,000 $94,187.50 $2,000 $1,812.50

$1,812.50
ROI 90.63%
$2,000

45
Hedging with Options on Futures
 Hedging with options on interest rate futures
 Financial institutions commonly hedge bond or mortgage
portfolios using options on interest rate futures
 The position is designed to create a gain that can offset a loss
on the bond or mortgage portfolio
 Put options on futures offer more flexibility than selling futures
but require a premium
 Institutions wishing to hedge against interest rate risk should
compare outcomes from selling futures contract versus buying
put options on interest rate futures

46
Hedging with Options on Futures
(cont’d)
 Hedging with options on stock index futures
 The position taken on the options contract is designed to
create a gain that can offset a loss on the stock portfolio
 Determining the degree of the hedge with options on stock
index futures
 The higher the strike price relative to the prevailing index value,
the higher the price at which the investor can lock in the sale of
the index, but the higher the premium
 Selling call options to cover the cost of put options
 Selling call options can generate some fees to help cover the cost
of purchasing put options

Don' stay co van ther

47
Institutional Use of Options Markets
 Options positions are sometimes taken by financial
institutions for speculative purposes, but more
commonly for hedging
 Savings institutions and bond mutual funds use options
on interest rate futures to hedge interest rate risk Talk
-

 Stock mutual funds, insurance companies, and

pension funds use stock index options and options on
stock index futures to hedge stock portfolios

48
Institutional Use of Options Markets
(cont’d)
 Options as compensation
 Some institutions distribute call options on their own stock to
their managers as compensation
 Managers may have an incentive to make decisions that
increase the stock’s value
 Distortion between performance and option compensation
 Many option compensation programs do not account for general
market conditions
 e.g., managers who received option during the 2001–2002 period
may have earned low compensation even if their firm performed
relatively well

49
Institutional Use of Options Markets
(cont’d)
 Options as compensation (cont’d)
 How stock option compensation can destroy shareholder value
 Managers may be enticed to manipulate the stock’s price upward
in the near future even if it adversely affects the stock price in the
future
 e.g., use accounting methods that defer expenses and accelerate
revenue reporting
 Reporting option compensation as an expense
 The FASB has been unwilling to require firms to report this
expense on the income statement
 Earnings will appear higher when a firm uses stock options to
compensate its managers

50
Globalization of Options Markets
 Options on stock indexes of various countries are available
 The existence of options on foreign stock indexes allows portfolio
managers to hedge or speculate based on forecasts of foreign
market conditions
 Currency options contracts
 A currency call option provides the right to purchase a specified
currency for a specified price within a specified period of time
 A currency put option provides the right to sell a specified currency
for a specified price within a specified period of time
 Corporations use currency options to hedge foreign payables and
receivables
 Speculators purchase put options on currencies they expect to
weaken against the dollar

51
Exercise 1 practice
->

 An investor buys a European put on a share for $3. The

stock price is $42 and the strike price is $40. Under what
circumstances does the investor make a profit? Under
what circumstances will the option be exercised? Draw a
diagram showing the variation of the investor’s profit with
the stock price at the maturity of the option.

52
 Exercise 2
 An investor sells a European call on a share for $4. The
stock price is $47 and the strike price is $50. Under what
circumstances does the investor make a profit? Under
what circumstances will the option be exercised? Draw a
diagram showing the variation of the investor’s profit with
the stock price at the maturity of the option.

53
54
Homework
 Point – counter – point
 QA: 2,3
 Problem: 1, 3

55