Options Markets

1
 Review of Option Types
• 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

2
 Option Positions

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

3
 Long Call
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

4
 Short Call
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

5
 Long Put
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

6
 Short Put
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

7
 Payoffs from Options
What is the Option Position in Each Case?

K = Strike price, ST = Price of asset at maturity

Payoff Payoff

K
K ST ST
Payoff
Payoff
K
K ST ST

8
 Assets Underlying
Exchange-Traded Options

• Stocks
• Foreign Currency
• Stock Indices
• Futures

9
 Specification of
Exchange-Traded Options

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

10
 Terminology

Moneyness :
– At-the-money option
– In-the-money option
– Out-of-the-money option

11
 Terminology
(continued)
• Intrinsic value
• Time value

12
 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

13
 Margins
• Margins are required when options are sold
• When a naked option is written the margin is the
greater of:
– A total of 100% of the proceeds of the sale plus
20% of the underlying share price less the
amount (if any) by which the option is out of the
money
– A total of 100% of the proceeds of the sale plus
10% of the underlying share price (call) or
exercise price (put)
• For other trading strategies there are special rules

14
 Warrants

• Warrants are options that are issued by a

corporation or a financial institution
• The number of warrants outstanding is
determined by the size of the original issue
and changes only when they are exercised
or when they expire

15
 Warrants
(continued)

• The issuer settles up with the holder when a

warrant is exercised
• When call warrants are issued by a
corporation on its own stock, exercise will
usually lead to new treasury stock being
issued

16
 Employee Stock Options
• Employee stock options are a form of
remuneration issued by a company to its
executives
• They are usually at the money when issued
• When options are exercised the company issues
more stock and sells it to the option holder for
the strike price
• Expensed on the income statement

17
 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
• Usually 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

18
Trading Strategies Involving
Options

19
Positions in an Option & the
Underlying
Profit Profit

K
K ST ST
(a)
(b)
Profit Profit

K
ST K ST

(c) (d)

20
Bull Spread Using Calls

Profit

ST
K1 K2

21
Bull Spread Using Puts

Profit

K1 K2 ST

22
Bear Spread Using Puts

Profit

K1 K2 ST

23
Bear Spread Using Calls
Profit

K1 K2 ST

24
Butterfly Spread Using Calls

Profit

K1 K2 K3 ST

25
Butterfly Spread Using Puts

Profit

K1 K2 K3 ST

26
Calendar Spread Using Calls

Profit

ST
K

27
Calendar Spread Using Puts

Profit

ST
K

28
A Straddle Combination

Profit

K ST

29
 Strip & Strap
Profit Profit

K ST K ST

Strip Strap

30
A Strangle Combination

Profit

K1 K2
ST

31