CHAPTER 14

Options
Markets
Chapter Objectives:
provide a background on options
explain why stock option premiums vary
explain how stock options are used to
speculate
explain how stock options are used by
financial institutions to hedge their
security portfolios
explain the use of options in futures
OPTIONS MARKETS
• An options contract fits the “bill”
 Two types of options:
• Call option-the right but not the obligation
to buy
• Put option- the right but not the obligation
to sell
 It takes two to make a contract
• Buyer of the option
• Seller (writer) of the option
Background on Options
• A call option buyer has right but not the
obligation to buy the underlying asset at a
set exercise or “strike” price for a specified
period of time
• A put option buyer has the right but not
the obligation to sell the underlying asset
at a set “strike” price for a specified period
of time
• Note components of an option: specific
quantity of asset, price, and time period
Background on Options
• Premium is the price the buyer of the put or call
pays to buy an option contract
• Seller or writer of the option contract
▫ Receives the premium up front
▫ Has an ongoing obligation to sell (call) or buy
(put) if the buyer decides to exercise the option
contract
• Current market price of the underlying asset or
financial instrument is called the spot price
Background on Options
• Call options
▫ “In-the-money” means the call option’s strike or
exercise price is lower than the market price for
the underlying financial instrument
 The holder of the call can buy the stock at a price
below the current market price
 The call premium (price) of the option would also be
higher by the “in-the-money”
▫ At-the-money means the strike price equals the
market price of the underlying asset
Background on Options
• Put option
▫ In-the-money means the put option’s strike or
exercise price is higher than the market price for
the underlying financial instrument
▫ Put options give the investor an opportunity to
make money from falling prices
▫ Investor has locked in a sale price, making the
price of the option (premium) higher as the stock
price decreases
▫ At-the-money means the strike price equals the
market price of the underlying asset
Background on Options
• Expiration is the date when the contract matures
• American-style options contracts can be
exercised any time up until they expire
• European-style options can only be exercised
just before their expiration
• Option contracts guaranteed by a clearinghouse
to make sure sellers or writers fulfill their
obligations
• Stock options specify 100 shares of stock
Stock Options
 An option contract grants the buyer, who
has paid a premium to the seller (writer),
the right to buy or sell the underlying asset
at a stated price within a specific period of
time
 The premium paid to the writer is the cost
of the option
 Buyer has the “option,” but not the
obligation, to exercise the option
Kinds of stock options

• American-style stock options

• European-style stock options
Stock Option Quotations
• Options quotations available in the financial
press and on the Internet
▫ Typically more than one option contract for a
company’s stock
▫ Many contracts trade for the same stock but with
different strike prices and expiration dates
▫ Quotes indicate the volume, premium, strike price
and maturity
Speculating with Call Options
• BUY A CALL: Speculator thinks a stock price will
appreciate above a particular strike price
• Buyer of call pays premium for the right but not the
obligation to buy stock at the strike price
• If the stock price appreciates above the strike price
the option contract is in-the-money and buyer of the
call would exercise or sell the option at a price
including the “in-the-money” and a premium
• If the stock price does not appreciate, buyer of the
call does not exercise and losses are limited to the
cost of the premium—buyer able to share in
appreciation without large investment
Speculating with Call Options
• If stock price rises above call’s strike price, buyer
exercises and purchases shares at a price below
their current market price
• Breakeven occurs once stock price is high
enough above strike to cover premium’s cost
• Net gain or loss equals
 + Price received for selling stock (spot price)
 - Amount paid for the shares (call’s strike)
 - Amount of the premium
Speculating with Call Options

Breakeven = Strike + Premium

Call
+ Buyer

Call
- Writer
Strike Price
Speculating with Put Options
• BUY A PUT: Speculator thinks a stock price will
depreciate below a particular strike price
• Buyer of put pays premium for the right but not
the obligation to sell stock at the strike price
• If the stock price depreciates below the strike
price the option contract is in-the-money and
buyer of the put would exercise
• If the stock price does not depreciate, buyer of
the put does not exercise and losses are limited
to the cost of the premium
Speculating with Put Options
• If stock price falls below strike, buyer of a put
exercises and sells shares at a price above their
current market price
• Breakeven occurs once stock price is low enough
below strike to cover premium’s cost
• Net gain or loss equals
 +Price received for selling stock (strike price)
 - Amount paid for the shares (spot market)
 - Amount of the premium
Speculating with Put Options

Breakeven = Strike - Premium

+ Put Seller

-
Put Buyer

Strike Price or At-The-Money

Determinants of Call Option Premiums

Value of Call Option Market Price of the

Premium Underlying Asset

Volatility of the
Time to Maturity of the
Underlying Asset
Option Contract
Determinants of Call Option Premiums
• The greater the current market price of the
underlying asset compared to the exercise price,
the higher the premium for a call option
▫ As the market price of the underlying asset
approaches or moves above the strike price, there
is increased chance of continued price
appreciation and increased gain from the option
▫ Purchaser is willing to pay more for the option
▫ “Under Water” option has less chance of being
“in-the-money” and the premium is less
Determinants of Call Option Premiums
• Greater volatility of the underlying financial
asset means higher call option premiums
▫ Volatile price means a higher chance price will go
well above strike
▫ That chance makes buyers willing to pay more
• For a call, the longer the time to maturity, the
higher the premium
▫ Owner will have increased chance for the option to
be “in-the-money” with more time available
Determinants of Put Option Premiums
• The lower the current market price of the
underlying asset compared to the exercise price,
the higher the premium for a put option
▫ Better chance of price depreciation well below
strike price if the price of the underlying asset is
already close to or below the exercise price
▫ Stock price appreciation reduces premium as
chance of “in-the-money” decreases
• Volatility and maturity issues the same as for call
options
Explaining Changes in Option
Premiums
• Indicators monitored by participants in the
options market
▫ Premiums influenced by price movements of the
underlying stocks
▫ Monitor economic indicators, industry-specific,
and firm-specific conditions
▫ Speculative options positions limit the downside
risk (the cost of the premium) so options owners
may view some indicators differently
Stock Option Premium Changes Over
Time
International U.S. U.S. U.S. Issuer’s
Economic Fiscal Monetary Economic Industry
Conditions Policy Policy Conditions Conditions

Stock
Market
Conditions

U.S.
Risk-Free
Interest
Rate Market Risk Issuer’s
Premium Risk
Premium

Expected
Required
Cash Flows
Return on
Generated
the Stock
by the Firm
for Investors

Option’s Price
Exercise of Firm’s
Price Stock

Stock Price Option’s Expected

Relative to T ime Volatility of
Option’s until Stock Prices
Exercise Expiration over the
Price Period Prior
to Option
Expiration

Stock Option’s
Premium
Hedging with Stock Options
• Investor hedge against possible adverse stock
price movements
• Downside price insurance for stock investor
▫ Investor can sell/write a call or buy a put if
concerned about a temporary decline in a stock
price
▫ Writer/seller gains premium income from
“covered” option to offset possible stock losses in
exchange for giving up possible upside profit
▫ Buying a put trades premium for downside floor
on stock portfolio
Using Options to Measure a Stock’s
Risk
• Standard deviation is used to measure risk for a
stock
• Stock option premiums commonly are used to
derive the market’s anticipation of a stock’s
standard deviation over the life of the option
• Anticipated volatility of a stock is not observable
but the stock option formula can be used to
derive an estimate
Stock Index Options
• Right to trade a specified stock index at a
specified price by a specified expiration date
• Options on several indexes
▫ S&P 100
▫ Major Market Index
▫ Value Line
▫ National OTC index
▫ NYSE composite
Stock Index Options
• Hedging with stock index options
▫ Pension funds and financial institutions that own
large portfolios of stocks
▫ Buy stock index puts to lock in gain or hedge
downturns in the market
▫ Select index option that matches portfolio
• Hedging with long-term stock index futures
▫ LEAPs or long-term equity anticipations
▫ Expiration dates at least two years into the future,
longer than normal options
Stock Index Options
• Dynamic asset allocation with stock index
options
• As expectations change, switch between risky
and low-risk investment positions
▫ Anticipating stock price increases, portfolio
managers purchase calls and increase their risk
exposure
▫ Hedge if unfavorable conditions expected
▫ Sell calls to insure against market declines
Stock Index Options
• Using index options to measure the market’s risk
• Stock index’s implied volatility can be derived
from options
• Over time standard deviation sometimes
abruptly changes
▫ Review of historical events explain changes
▫ Gulf War, stock market crashes, and global
economic and financial crisis
Options on Futures Contracts
• Options on futures allow the right but not the
obligation to purchase or sell a particular futures
contract for a specified price and for a specified
period of time
• Types of options on futures that are available
▫ Stock index futures
▫ Interest rate futures
• Used for speculation and one-way hedging
Options on Futures Contracts
• Speculating with options on futures if an interest
rate decline is anticipated
• Purchase a call option on Treasury bond futures
• If expectations are correct, T-bond prices and
futures contract increase as interest rate levels
decrease
• Exercise the option to purchase futures at the
strike price which is lower than the value of the
futures contract
• Selling futures offsets futures position at a profit
Options on Futures Contracts
• Speculating with options on futures
• Advantages of using options on futures
▫ Expectations are not always correct
▫ If rates actually rise, speculator loses if in futures
contracts, but just the premium if in options
▫ Loss is reduced using the options on futures
strategy as compared to a futures only speculative
position
▫ If rates rise, do not exercise option on futures
Hedging with Options on Futures
• Used by financial institutions with long-term
mortgages funded by short-term liabilities so the
downside risk is from an interest rate increase
▫ Can use a strategy to gain from futures options if
rates actually increase, offsetting loss of interest
margin in the business
▫ Prepayment risk on loans is important if the
institution loses its offsetting mortgage loans
Hedging with Options on Futures
• A portfolio manager wishes to hedge the
downside risk(one-way insurance) of a stock
portfolio while allowing for the upside potential
• Buy put options on futures to hedge a possible
temporary decline in the market
• Can choose among strike prices available and
decide the degree of risk to hedge
• Can sell call options to cover the cost of buying
put options
• Widespread institutional uses of options