Options and Options Markets

1
Options and Options Markets

• Supplemental Chapter 2

2
Options

• Derivative Assets assets whose value is derived
  by the value of another assets (the underlying
  asset).
• Call Option - the right to buy an asset at a
  pre-specified price and time.

3
Options

• Options are a contract between two parties a
  buyer and a seller.
• Two types of options
• Calls
• Puts

4
Options

• Call Options grant the buyer (holder) the right
  to buy the underlying asset at a pre-specified
  price.
• Put Options grant the buyer (holder) the right
  to sell the underlying asset at a pre-specified
  price.
• Long vs. short positions
• Strike (exercise) price pre-specified price
  stated in the option contract.

5
Options

• Options
• Limited life typically expire within 1 year of
  the initial trading date.
• Exchange traded equity options expire on the
  third Friday in the expiration month.
• European Options can be exercised on their
  maturity date only.
• American Options can be exercised at any time
  prior to expiration.
• Note The terms European and American describe
  to excise options, and not where they are traded.

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Call Options

• On 3/29/01 IBM closed at 96.18, a call option
  expiring in May with a strike of 115 traded at
  1.40 premium on that same day.
• As IBMs price increases so does the premium on
  the option.
• Options purchased on organized exchanges can be
  sold for a profit.
• If the call buyer holds until the maturity date,
  she can elect to exercise the option or let it
  expire. That decision will depend on the selling
  price of IBM on the options maturity date.

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Call Option

• At maturity, the buyers payoff will equal
• CTMax(ST-X,0)
• Where
• T Option expiration date
• CT Calls Value on the expiration date
• ST Selling Price of the underlying stock on T
• X Options Strike

8
Call Option
Profits / Payoff for the Call Buyer
Profit ()
Payoff ()
ST-X
ST-X
115
115
116.40
116.40
-1.40
-1.40
Stock Price
Stock Price
At the Money
Out-of-the Money
In-the Money
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Call Option
Profits / Payoff for the Call Seller
Profit ()
Payoff ()
Stock Price
1.40
115
Stock Price
115
116.40
-1.40
X-ST
X- ST
10
Put Options

• A put option grants the buyer the right to sell
  stock at the exercise price prior to maturity.
• On 3/29/01 IBM closed at 96.18, a put option
  expiring in May with a strike of 115 traded at
  18.90 premium on that same day.
• Buying a put option will allow an investor to set
  the floor on a stocks selling price.
• If the put buyer holds until the maturity date,
  she can elect to exercise the option or let it
  expire. That decision will depend on the selling
  price of IBM on the options maturity date.
  However, when exercising her option the put buyer
  must deliver the shares to the put seller.

11
Put Option

• At maturity, the buyers payoff will equal
• PTMax(X- ST,0)
• Where
• T Option expiration date
• PT Puts Value on the expiration date
• ST Selling Price of the underlying stock on T
• X Options Strike

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Put Option
Profits / Payoff for the Put Buyer
Profit ()
Payoff ()
115
X- ST
96.10
X- ST
115
115
-18.90
Stock Price
Stock Price
At the Money
In-the Money
Out-of-the Money
115-18.90 96.10
13
Put Option
Profits / Payoff for the Put Seller
Payoff ()
Profit ()
18.90
115
Stock Price
96.10
115
Stock Price
ST- X
ST-X
-96.10
-115
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Options Markets

• Chicago Board Options Exchange (CBOE)
• Contract maturities and strikes are determined by
  the exchange (for options traded on organized
  exchanges), not the individual buyers and
  sellers.
• Benefits of trading on the options market
• Protection against default risk For CBOE,
  insured by Options Clearing Corp (OCC).
• Liquidity