Mechanics of Options Markets Chapter 8

1
Mechanics of Options MarketsChapter 8
2
Types of Options

• A call is an option to buy
• A put is an option to sell
• A European option can be exercised only at the
  end of its life
• An American option can be exercised at any time

3
Option Positions

• Long call
• Long put
• Short call
• Short put

4
Long Call on Microsoft

• Profit from buying a Microsoft European call
  option option price 5, strike price 100,
  option life 2 months

5
Short Call on Microsoft

• Profit from writing a Microsoft European call
  option option price 5, strike price 100

6
Long Put on Oracle

• Profit from buying an Oracle European put
  option option price 7, strike price 70

7
Short Put on Oracle

• Profit from writing an Oracle European put
  option option price 7, strike price 70

8
Payoffs from OptionsWhat is the Option Position
in Each Case?

• X Strike price, ST Price of asset at
  maturity

9
Assets UnderlyingExchange-Traded Options

• Stocks
• Foreign Currency
• Stock Indices
• Futures

10
Specification ofExchange-Traded Options

• Expiration date
• Strike price
• European or American
• Call or Put (option class)

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Terminology

• Moneyness
• At-the-money option
• In-the-money option
• Out-of-the-money option

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Terminology(continued)

• Option class
• Option series
• Intrinsic value
• Time value

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Time Value and Intrinsic Valuefor a Call
In
Out
Time Value
Intrinsic Value
S
X
14
Time and Intrinsic Value for Put Option
Out
In
Time Value
S
X
15
Dividends Stock Splits

• Suppose you own N options with a strike price of
  X
• 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 mX/n
• the no. of options is increased to nN/m
• Stock dividends are handled in a manner similar
  to stock splits

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Dividends Stock Splits(continued)

• Consider a call option to buy 100 shares for
  20/share
• How should terms be adjusted
• for a 2-for-1 stock split?
• X 20/2 10
• N 2x100 200
• for a 5 stock dividend?
• X 20/1.05 19.05
• N 1.05x100 105

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Market Makers

• Most exchanges use market makers to facilitate
  options trading
• A market maker quotes both bid and ask prices
  when requested
• The market maker does not know whether the
  individual requesting the quotes wants to buy or
  sell

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Margins

• Margins are not required when options are bought
• Margins are required when options are sold and
  position is uncovered
• Smaller margin is required for when written
  option is out of the money.
• Margins are not required when written options is
  fully covered
• See pages 174-175 for details (if interested)
• General rule margin is required only when
  strategy creates a future obligation

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Convertible Bonds

• Convertible bonds are regular bonds that can be
  exchanged for equity at certain times in the
  future according to a predetermined exchange ratio

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Convertible Bonds(continued)

• Very often a convertible is callable
• The call provision is a way in which the issuer
  can force conversion at a time earlier than the
  holder might otherwise choose

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Over-the-Counter Markets

• Options are frequently negotiated in the
  over-the-counter market
• The strike price and time to maturity do not then
  have to correspond to those specified by an
  exchange

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Exotic Options

• Nonstandard options trading over-the counter
  include
• Barrier options
• Asian options
• Binary options
• Chooser options
• Compound options