Chapter 17 Options

1
Chapter 17Options
2
Options Marks and Strategies

• 17.1 Options Markets
• 17.2 Options Basics
• 17.3 Option Types
• 17.4 Option Strategies
• 17.5 Option Pricing

3
The Origin of Options Markets

• Chicago Board Options Exchange (CBOE) pioneered
  standardized options in 1973.
• Option Contract right to buy or sell a given
  amount or value of a particular asset at a fixed
  price until a given expiration date
• Call Option right to buy or call from the
  market
• Put Option right to sell or put on the market
• Derivative Securities financial instruments with
  value stemming from changes in the value of some
  other asset

4
Characteristics of Exchange-Traded Options

• Four types of underlying assets or interests
• Equities
• Stock Indexes
• Government Debt Securities
• Foreign Currencies
• Options exchanges provide for orderly, efficient
  and liquid markets.

5
Option Terms

• Standardized terms
• nature and amount of underlying asset
• expiration date
• exercise price
• option type
• manner of contract fulfillment or settlement
• Open Interest Number of outstanding options it
  depends on the of interested buyers and sellers

6
Call Options Are Popular with Bullish Investors
A. Extremely Bullish Investors Buy Calls to
Leverage Upside Potential
Long Call
Strike Price 50.0
Short Call
17-6
7
Options

• Exercise (Strike) Price promised price for
  underlying asset
• At-the-Money when option strike price equals
  current market price of underlying asset
• In-the-Money when call (put) strike price is
  less (more) than current market price of
  underlying asset
• Out-of-the-Money when call (put) strike price is
  more (less) than the current market price of
  underlying security
• Option Series options that have the same terms
  except for different strike prices
• Option Holder buyer
• Option Writer seller

8
Options

• Q What happens to call prices as the strike
  price increases?
• Q What happens to call prices as the maturity
  increases?
• Q What happens to put prices as the strike price
  increases?
• Q What happens to put prices as the maturity
  increases?

9
Options

• Contract Period time between when an option
  contract is established and when it expires

• Option Premium nonrefundable payment at current
  option price

10
Actively Traded Options

• Most actively traded stock and index options
  calls with short period until expiration
• Short term calls more sensitive to near-term
  price changes.
• LEAPS longer term puts and callsup to three
  years before expiration allows leverage for
  buy-and-holders

11
OCC Market Reform

• OCC (Options Clearing Corporation) issuer of all
  listed security options clears all option
  transactions
• Multiply Traded Options traded on more than one
  options market at the same time opportunities
  for arbitrage
• On CBOE market makers provide liquidity take
  opposite side of public orders.

12
Option Basics

• Hedged Position use of options to offset risk
  inherent in some other investment

• Speculative Position use of options to profit
  from the inherent riskiness of some underlying
  asset takes advantage of options significant
  leverage
• Zero Sum Game buyers gain is sellers loss, and
  vice versa.

13
Transaction Type and Option Style

• American-Style Option can be exercised any time
  between purchase date and expiration date
• European-Style Option can only be exercised on
  expiration date
• Expiration Date last day of an American-style
  option, or the single exercise date of a
  European-style option

14
Option Settlement Terms

• Physical Delivery Option physical delivery of an
  asset
• Cash-Settled Option promise of a cash payment
  based on the difference between market and
  exercise price
• Contract Size trading unit of underlying asset
• Exercise holders execute their rights to buy or
  sell
• Triple Witching Hour expiration date of stock
  index options futures on indexes at calendar
  quarters associated with wild price swings
• Double Witching Hour expiration of stock and
  index options and futures on indexes on other
  eight months third Fridays

15
Option Types Stock Options

• Describes options on common stocks, limited
  partnership interests, ADRs, preferred stocks
• Issuers of underlying securities do not sign up
  for option issuance
• Share similarities with common stocks re
  trading, settlement, and ready information
• Stock options generally cover round lot of
  underlying stock

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Option Types Stock Options, cont.

• Differences from stocks
• Options have limited life (wasting asset)
• No ownership rights like voting or dividends

17
Option Strategies Calls

• Call Purchases simple,popular strategy for bulls
• Buying calls gives right, but not obligation, to
  purchase underlying stock at specified strike
  price for set time.
• Risk limited to call premium plus commissions
• Profit potential unlimited

18
Options Strategies Covered Calls

• Covered Call Strategy simultaneous purchase of a
  stock and sale of a call option on same
  securityoffsets purchase costs
• Because covered call writer owns underlying
  stock, risk is limited.
• Naked Short Seller uncovered short sellersells
  call for premium faces unlimited risk

19
Call Options Are Popular with Bullish Investors
B. Moderately Bullish Investors Sell Calls
against a Stock Position to Increase Income
Covered Call
Strike Price 50.0
17-19
20
Option Strategies Puts

• Buying Put Options simple, popular strategy for
  bears
• Gives right, but not obligation, to sell
  underlying stock at specified price
• Risk limited to put premium plus commissions
• Profit limited only because stock price may not
  fall below zero
• Selling putsexpect to profit from stagnant
  prices profit limited to put premium
• Writer of puts has obligation to buy underlying
  stock at predetermined pricerisk limited to
  range of exercise price and zero

21
Put Options Are Popular with Bearish Investors
A. Extremely Bearish Investors Buy Put Options to
Profit from Declining Share Prices
Short Put
Strike Price 50.0
Long Put
17-21
22
Options Strategies Protective Puts

• Protective Put Strategy simultaneous purchase of
  stock and purchase of put option on same
  securitya hedge

23
Put Options Are Popular with Bearish Investors
B. Moderately Bearish Investors Buy Puts to Give
Price Protection for Portfolio Holdings
Protective Put
Strike Price 50.0
17-23
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Option Combinations

• Combination complementary option positions
• Spread combination of buying and writing the
  same type of option (call or put) on same
  underlying asset
• Straddle buying put and call on same security
• Price Spread simultaneous purchase or sale of
  options on same underlying stock but with
  different exercise prices
• Time Spread simultaneous purchase or sale of
  options on same stock with different exp. dates

25
Option Combinations

• Bull Call Spread purchase of low-strike-price
  call and the simultaneous sale of another
  high-strike-price call on same stock with same
  expiration date
• Bull Put Spread sale of high-strike-price put
  and the simultaneous purchase of another
  low-strike-price put on same stock with same
  expiration

26
Option Pricing Concepts

• Two components to option premium
• Option Price Intrinsic Value Time Value
• Intrinsic Value difference between in-the-money
  options strike price and current market price of
  underlying security
• Example
• Time Value speculative valuepossibility that
  option may have intrinsic value at some point

27
Black-Scholes Option Pricing Model

• Formula used to calculate economic values for
  options

Assuming the ability to continuously and
instantaneously rebalance portfolios, no
transaction costs, and a risk-free asset, the
value of a call option is
where CP is the current price of a call option,
CMP is the current market price of the underlying
common stock (equity), EP is the exercise price
(strike price) for the call option, e is the
natural base e ? 2.718, r is the risk-free rate,
and t is the time remaining before expiration (in
years). N(d1) and N(d2) are the cumulative
density functions for d1 and d2 as defined in the
following equation
28
Black-Scholes Option Pricing Model

• Formula used to calculate economic values for
  options

In these equations, ln(CMP/EP) is the natural log
of (CMP/EP), and is the standard deviation of the
underlying common stocks annual return. In other
words, N(d) is the probability that a random draw
from a standard normal distribution will be less
than d.
29
To Learn More About Options

• Read Characteristics and Risks of Standardized
  Options from OCC
• CBOE lthttp//www.cboe.comgt
• Options Industry Council _at_ ltwww.optionscentral.com
  gt