Title 3

Chapter
Date
Mechanics of Options Markets
Lifetime Learning… Building Success… Towards Globalization
 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 in the contract is known as the
expiration date or the maturity date.
• The price specified in the contract is known as the exercise
price or the strike price.
• American options can be exercised at any time up to the
expiration date
• European options can be exercised only on the expiration
date itself
Comparison
Forwards
Both the parties –buyer and
seller have the commitment
to do the trade
They are traded on Over the
Counter
No premium has to be paid
Options
Buyer of the option has the
right to trade and writer has
the obligation
They are traded in both –
Exchange and Over the
Counter
Option premium has to be
paid
Call Option
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months

30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130

Figure 1
Call Option………(Contd.)
• Consider the situation of an investor who buys a
European call option with a strike price of $100 to
purchase 100 shares of a certain stock.
• Suppose that the current stock price is $98, the
expiration date of the option is in 4 months, and the
price of an option to purchase one share is $5.
• The initial investment is $500.
• If the stock price on this date is < $100, the investor
will choose not to exercise. So, investor’s loss will be
$500.
• If the stock price is above $100 on the expiration
date, the option will be exercised.
Call Option………(Contd.)
• Assuming stock price is $115. By exercising the
option, the investor is able to buy 100 shares for $100
per share.
• Now, if the shares are sold immediately, the investor
makes a gain of $15 per share, i.e. $1,500 (ignoring
transactions costs).
• Considering initial investment ($500),net profit to the
investor is $1,500 - $500 =$1000
• It is important to realize that an investor sometimes
exercises an option and makes a loss overall.
Call Option………(Contd.)
• Let’s assume stock price as $102 on the maturity
date. The investor would exercise the option for a
gain of 100* ($102-$100) = $200 and realize a loss
overall of $300
• However, not exercising would lead to an overall loss
of $500, which is worse than the $300 loss when the
investor exercises.
• In general, call options should always be exercised at
the expiration date if the stock price is above the
strike price.
Put Options
• Profit from buying a European put option: option
price = $7, strike price = $70

30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7
Figure 2
Put Options………(Contd.)
• Whereas the purchaser of a call option is hoping that
the stock price will increase, the purchaser of a put
option is hoping that it will decrease.
• Consider an investor who buys a European put option
with a strike price of $70 to sell 100 shares of a certain
stock.
• Assume that the current stock price is $65, the
expiration date of the option is in 3 months, and the
price of an option(option premium) to sell one share is
$7. The initial investment is $700.
• As option is European, it will be exercised only if the
stock price is below $70 on the expiration date.
Put Options………(Contd.)
• Suppose that the stock price is $55 on this date. The
investor can buy 100 shares for $55 per share and,
under the terms of the put option, sell the same
shares for $70 to realize a gain of $15 per share, or
$1,500. (Again, transactions costs are ignored.)
• When the $700 initial cost of the option is taken into
account, the investor’s net profit is $800.
• There is no guarantee that the investor will make a
gain. If the final stock price is above $70, the put
option expires worthless, and the investor loses $700.
Option Positions
• There are two sides to every option contract. On one
side is the investor who has taken the long position
(i.e., has bought the option). On the other side is the
investor who has taken a short position (i.e., has sold
or written the option).
• The writer of an option receives cash up front, but
has potential liabilities later. The writer’s profit or loss
is the reverse of that for the purchaser of the option.
• Figures 3 and 4 show the variation of the profit or
loss with the final stock price for writers of the
options considered in the earlier examples
Option Positions………(Contd.)

• There are four types of option positions:

1. A long position in a call option
2. A long position in a put option
3. A short position in a call option
4. A short position in a put option.
Option Positions………(Contd.)
Profit from writing one European call option: option
price = $5, strike price = $100

Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30
Figure 3: Short Call
Option Positions………(Contd.)
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
Figure 4: Short Put
Payoffs -positions in European Options
The initial cost of the option is then not included in the
calculation. K = Strike price, ST = Price of asset at
maturity
Payoff: Long Call Payoff: Short Call

K
K ST ST

Payoff: Long Put Payoff: Short Put

K
K ST ST
Let’s Test Our Understanding
Q1.This graph represents the payoff for which position
a) b)

K
K ST ST

Q2. Buyer of the Call Option is said to be taking __________

position
Q3. Writer of the Call Option is said to be taking __________
position
Q4. Buyer of the Put Option is said to be taking ___________
position
Ans 2) Long Call Ans 3) Short Call Ans 4) Long Put
Let’s Test Our Understanding
Q5. Call options should always be exercised at the
expiration date if the stock price is above the strike
price. (T/F)
Q6. Put options should always be exercised at the
expiration date if the stock price is less than the strike
price. (T/F)
Q7. The date specified in the options contract is known
as the _____________
Q8. The price specified in the options contract is known
as the ______________

Ans 5) True Ans 6) True Ans 7) maturity date Ans 8) strike price
Underlying Assets
Stock Options: One contract gives the holder the right
to buy or sell 100 shares at the specified strike price.
Foreign Currency Options: One contract is to buy or sell
10,000 units of a foreign currency (except Japanese yen)
for US dollars.
Index Options: One contract is usually to buy or sell 100
times the index at the specified strike price. Settlement
is always in cash.
Specification Of Stock Options
1. Expiration Dates - month in which the expiration date
occurs
LEAPS (long-term equity anticipation securities), are
publicly traded options contracts with expiration dates
that are longer than one year
2. Strike Price
3. Terminology
Moneyness :
• At-the-money option
• In-the-money option
• Out-of-the-money option
Moneyness
If S is the stock price and K is the strike price then

Moneyness Call Option Put Option

In-the-money S>K S<K

At-the-money S=K S=K

Out-of-the-money S<K S>K

Specification of Stock Options…..(Contd.)

4. FLEX Options (Flexible Exchange Option)

A non-standard option which can be customized,
allowing both the writer and purchaser to define various
terms such as strike price, expiration date and other
features and benefits.

5. Dividends and Stock Splits

Next slide
Stock Dividends and Stock Splits

• Stock dividends are similar to cash dividends;

however, instead of cash, a company pays out
stock. As a result, a company's shares
outstanding will increase, and the company's
stock price will decrease. For example,
suppose Newco decides to issue a 10% stock
dividend. Each current stockholder will thus
have 10% more shares after the dividend is
issued.
Stock Splits
• Stock splits occur when a company perceives that its
stock price may be too high. Stock splits are usually
done to increase the liquidity of the stock (more
shares outstanding) and to make it more affordable
for investors to buy regular lots (a regular lot = 100
shares). Companies tend to want to keep their stock
price within an optimal trading range
• suppose Newco initiates a 2-for-1 stock split. For
each share they own, all holders of Newco stock will
receive two Newco shares priced at $30 each, and
the company's shares outstanding will double
Dividends and Stock Splits
• 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/n * K
• the no. of options is increased to n/m * N
– Stock dividends are handled in a manner similar to
stock splits
Dividends and Stock Splits…..(Contd.)
• Consider a call option to buy 100 shares for
$30/share. How should terms be adjusted for a 2-for-
1 stock split?

• Terms of the option contract are then changed, it

gives its holder the right to buy 200 shares (100*2) for
$15 ($30/2)
Dividends and Stock Splits…..(Contd.)
• Consider a put option to sell 100 shares of a company
for $15 per share. Suppose the company declares a
25% stock dividend.

• This is equivalent to a 5-for-4 stock split. The terms of

the option contract are changed so that it gives the
holder the right to sell 125 shares (100x5/4) for $12
(15x4/5).
 Let’s Test Our Understanding
Q9. Option contract to buy or sell 100 times the index at
the specified strike price is called_____________
Q10. Non-standard option which can be customized,
allowing both the writer and purchaser to define various
terms is called ______________
Q11 _____________ publicly traded options contracts
with expiration dates that are longer than one year

Ans 9) Index Option Ans 10) FLEX Options Ans 11) LEAPS
 Let’s Test Our Understanding
Q12. If S is the stock price and K is the strike price then,
Put Option is said to be In-the-money when S < K (T/F)
Q13. If S is the stock price and K is the strike price then,
Call Option is said to be In-the-money when S < K (T/F)

Q14. If S is the stock price and K is the strike price then,

Call Option is said to be Out-of-the-money when S < K
(T/F)

Ans 12) True Ans 13) False Ans 14) True