Chapter 14

Options Markets

1
Chapter Outline
 Background on options
 Speculating with stock options
 Determinants of stock option premiums
 Explaining changes in option premiums
 Hedging with stock options
 Using options to measure a stock’s risk

2
Chapter Outline (cont’d)
 Options on ETFs and stock indexes
 Options on futures contracts
 Hedging with options on futures
 Institutional use of options markets
 Globalization of options markets

3
OPTIONS
 An option is the right, but not obligation, to buy/sell an
underlying asset at or before a specific date for a pre-
specified price

 With options, one pays money to have a choice in the

future

 Essence of options is not that I buy the ability to

vacillate, or to exercise free will. The choice one makes
actually depends only on the underlying asset price

4
Background on Options
 A call option grants the owner the right to purchase a
specified financial instrument for a specified price
(exercise or strike price) within a specified period of
time
 Grants the right, but not the obligation, to purchase the specified
investment
 The writer of a call option is obligated to provide the instrument
at the price specified by the option contract if the owner
exercises the option
 A call option is:
 In the money when the market price of the underlying security
exceeds the strike price
 At the money when the market price is equal to the strike price
 Out of the money when the market price is below the strike price
5
Background on Options (cont’d)
 A put option grants the owner the right to sell a
specified financial instrument for a specified
price within a specified period of time
 Grants the right, but not the obligation, to sell the
specified investment
 A put option is:
 In the money when the market price of the underlying
security is below the strike price
 At the money when the market price is equal to the strike
price
 Out of the money when the market price is above the strike
price

6
Exercise styles, Key elements and Notation
 European Option: Gives owner the right to exercise the option only
on the expiration date.
 American Option: Gives owner the right to exercise the option on
or before the expiration date.
Key elements in defining an option
 Underlying asset and its price
 Exercise price (strike price)
 Expiration date (maturity date) T (today is 0)
 European or American.

Notation
S0 : Price of stock now
ST : Price of stock at T
K : Strike Price or Exercise Price
C : Price of a European call with strike price K and maturity T
P : Price of a European put with strike price K and maturity T
7
Contd..
 The holder of the option has the right to exercise the option →
nonlinear payoffs

 Let K be the strike price of a European option and S the

T

underlying asset price at maturity

◦ The payoff of a long position of a call option is max[S - K, 0]

T

◦ The payoff of a short position of a call option is –max[S - K, 0]

T

◦ The payoff of the long position of a put option is: max (K-S ,0)
T

◦ The payoff from a short position of a put option is –max[K-S ,0] T

8
Background on Options (cont’d)
 Markets used to trade options
 The CBOE:
 Is the most important exchange for trading options
 Serves as the market for options on more than 1,500
different stocks
 Lists standardized options
 Accounts for about 51 percent of all option trading
 Options are also traded on the AMEX, Philadelphia
Stock Exchange, Pacific Stock Exchange, and the
International Securities Exchange

9
Background on Options (cont’d)
 How option trades are executed
 Floor brokers execute transactions desired by
investors
 Some orders are executed electronically without a floor
broker
 Market-makers:
 Can execute stock option transactions for customers
 Trade options on their own account
 May facilitate a buy order for one customer and a sell order
for a different customer
 Earn the difference between the bid price and the ask price
for the option

10
Background on Options (cont’d)
 Stock option quotations
 Financial newspapers and some local
newspapers publish quotations for stock
options (see next slide)
 Options with higher exercise prices have
lower call premiums and higher put premiums
 Options with a longer maturity have higher
call option premiums and higher put option
premiums
11
Options Payoff
The payoff of an option on the expiration date is determined by the price of
the underlying asset.
 Example. Consider a European call option on IBM with exercise price $100.

This gives the owner (buyer) of the option the right (not the obligation) to
buy one share of IBM at $100 on the expiration date. Depending on the
share price of IBM on the expiration date, the option owner’s payoff looks
as follows:

 The payoff of an option is never negative.

 Sometimes, it is positive.
 Actual payoff depends on the price of the underlying asset. The net payoff
from an option must includes its cost. 12
Option Payoff
 Actual payoff depends on the price of the underlying asset. The
net payoff from an option must includes its cost.
Example. A call option on IBM shares with an exercise price of
$100 and maturity of three months is trading at $5. What is the
price of IBM that makes the call break-even? At maturity, the call’s
net payoff is as follows:

 The break even point is given by:

Net payoff = ST − 100 − 5 = 0
Or ST = $105 13
Option Payoff
 The break even point is given by:
Net payoff = ST − 100 − 5 = 0
Or ST = $105
The pay off diagram:
30 Profit ($)

20

10
70 80 90 100 stock price ($)
0
-5 110 120 130
14
15
In-the-money and Out-of-the-Money and at-the-
money Option
 In-the-money options would be worth something if
exercised now. For calls, in-the-money refers to options
where the strike price is less than the current price of the
underlying asset. A put option is in-the-money if its strike
price is greater than the current price of the underlying
asset
 Out-of-the-money options would be worthless if exercised
now. For calls, out-of-the-money refers to options where
the strike price is more than the current price of the
underlying asset. A put option is out-of-the-money if its
strike price is less than the current price of the underlying
asset
 At the money option refers to the option where the strike
price is equal to the current price of the underlying asset16
Options Buyers and Sellers (Writers)
 For every option there is both a buyer and a
seller (writer)
 The buyer pays the writer for the ability to
choose when to exercise, the writer must abide
by buyer’s choice
 Buyer puts up no margin, naked writer must
post margin

17
Option Positions
 Long call: Buyer of a call
 Short call: Seller of a call
 Long put: Buyer of a put
 Short put: Seller of a put

18
Long Call

Profit from buying one call option: option price = $5, strike
price = $100, option life = 2 months; Break-Even stock
Price=100+5 = 105

30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130
19
Long Call

Profit from buying one call option: option price = $5, strike
price = $100, option life = 2 months; Break-Even stock
Price=100+5 = 105

30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130
20
Short Call

Profit from writing one European call option: option price

= $5, strike price = $100; Break-Even stock Price=100+5
= 105
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30

21
Long Put

Profit from buying a European put option: option price =

$7, strike price = $70; Break-Even stock Price=70-7 = 63

30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7

22
 A summary for a call
option
a call option traded between A and B
Investor A (long call) Investor B (short call)
Long a call option on a stock Short a call option on a stock
t=0 Pay call option premium c to B Receive call option premium c from A
t=T Opt to exercise the call, Based on A’s decision, B has to
if ST>K i.e., buy the stock from B at sell the stock to A at K
K
payoff: ST – K (gain) payoff: –(ST – K) (loss)
profit: ST – K– c profit: –(ST – K) +c

t=T Call expires out-of-the- no action from B

if ST<K money, no action
from A
payoff: 0 payoff: 0
profit: 0-c = -c profit: 0+c=c

2
3
 A summary for a put
option
a put option traded between A and B
Investor A (long put) Investor B (short put)
Long a put option on a stock Short a put option on a stock
t=0 Pay option premium p to B Receive option premium p from A
t=T put expires out-of-the- no action from B
if ST>K money, no action
from A
payoff: 0 payoff: 0
profit: 0 - p= - p profit: 0 + p=p
t=T Opt to exercise the put, i.e., Based on A’s decision, B has to
if ST<K sell the stock to B at buy the stock from A at
K K
payoff: K–ST (gain) payoff: –(K–ST ) (loss)

profit: K–ST – p profit: –(K–ST ) +p

2
4
Main differences between futures & options
 Rights & obligations

◦ Traders of a futures contract are obliged to buy/sell

the underlying asset at the delivery price

◦ Buyers of an option can choose whether to buy/sell

the underlying asset at the strike price

◦ Sellers of an option have potential liability to sell/buy

the underlying asset at the strike price based on
buyer’s decision
Background on Options (cont’d)
 Stock option quotations (cont’d)
Strike Exp. Vol. Call Vol. Put

McDonald’s 45 Jun 180 4 1/2 60 2 3/4

45 Oct 70 5 3/4 120 3 3/4

50 Jun 360 1 1/8 40 5 1/8

50 Oct 90 3 1/2 40 6 1/2

26
Speculating with Stock Options
 Speculating with call options
 Call options can be used to speculate on the expectation of an
increase in the price of the underlying stock
 Assuming that the buyer of the option sells the stock when
exercising the option and that the writer will obtain the stock
only when the option is exercised, the writer’s net gain is the
buyer’s net loss, assuming zero transaction costs
 The maximum loss for the buyer of a call option is the premium,
while the maximum gain is unlimited
 The maximum gain for the writer of a call option is the premium,
while the maximum loss is unlimited

27
Speculating with Call Options
Pete expects ABC stock to increase from its current price of
$90 per share. He purchases a call option on ABC
stock with an exercise price of $92 for a premium of $4
per share. ABC stock rises to $97 prior to the option’s
expiration date. If Pete exercises the option and
immediately sells the shares in the market, what is his
?net gain from the transaction

$97  $92  $4  $1 per share

28
 Speculating with Call Options
(cont’d)
Draw the contingency graph for the buyer of the call option
.and the writer of the call option

Buyer’s Perspective Writer’s Perspective

Profit

96 4
0 0
-4 Stock Price 96
At Expiration

29
Speculating with Stock Options
(cont’d)
 Speculating with call options (cont’d)
 Assume that ABC stock has three call options available:
 Call option 1: Exercise price = $87; Premium = $7
 Call option 1: Exercise price = $90; Premium = $5
 Call option 1: Exercise price = $92; Premium = $4
 The risk-return potential varies among the several options that
are available
 The contingency graph for all three options is shown on the
next slide
 The graph can be revised to reflect returns for each possible price
per share of the underlying stock

30
Speculating with Stock Options
(cont’d) Call option 1
Call option 2
Profit or Loss
Per Share Call option 3

94 95
0
96 Stock Price of ABC Stock
-4
-5

-7

31
Speculating with Stock Options
(cont’d)
 Speculating with put options
 Put options can be used to speculate on the
expectation of a decrease in the price of the
underlying stock
 The maximum gain for the buyer of a put option is
the exercise price less the premium, while the
maximum loss is the premium
 The maximum loss for the writer of a put option is
the exercise price less the premium, while the
maximum gain is the premium

32
Speculating with Put Options
Mary expects XYZ stock to decrease from its current price
of $54. Thus, she purchases a put option on XYZ stock
with an exercise price of $53 and a premium of $2. If
the stock price of XYZ stock is $47 when the option
?expires, what is Mary’s net gain

$53  $47  $2  $4 per share

33
 Speculating with Put Options
(cont’d)
Draw the contingency graph for the buyer of the put option
.and the writer of the put option

Buyer’s Perspective Writer’s Perspective

Profit
51

2
51 51
0 0
-2 Stock Price
At Expiration
51

34
Speculating with Stock Options
(cont’d)
 Excessive risk from speculation
 Firms should closely monitor the trading of derivative contracts
by their employees to ensure that derivatives are being used
within the firm’s guidelines
 Firms should separate the reporting function from the trading
function so that traders cannot conceal trading losses
 When firms receive margin calls on derivative positions, they
should recognize that there may be potential losses on their
derivative instruments

35
Determinants of Stock Option
Premiums
 The option premium must be sufficiently high to
equalize the demand by buyers and the supply that
sellers are willing to sell
 Determinants of call option premiums
 Influence of the market price
 The higher the existing market price of the underlying financial
instrument relative to the exercise price, the higher the call option
premium
 Influence of the stock’s volatility
 The greater the volatility of the underlying stock, the higher the
call option premium
 Influence of the call option’s time to maturity
 The longer the call option’s time to maturity, the higher the call
option premium

36
Determinants of Stock Option
Premiums (cont’d)
 Determinants of put option premiums
 Influence of the market price
 The higher the existing market price of the underlying
financial instrument relative to the exercise price, the lower
the put option premium
 Influence of the stock’s volatility
 The greater the volatility of the underlying stock, the higher
the put option premium
 Influence of the put option’s time to maturity
 The longer the call option’s time to maturity, the higher the
put option premium

37
Explaining Changes in Option
Premiums
 Economic conditions and market conditions can cause
abrupt changes in the stock rice or in the anticipated
volatility of the stock price
 This would have a major impact on the stock option premium
 Indicators monitored by participants in the option
market
 Option market participants closely monitor the indicators that
are monitored for stocks:
 Economic indicators, industry-specific conditions, firm-specific
conditions

38
Hedging with Options : Protective Put
(owning stock and buying a put)

 A protective put is a risk-management

strategy that investors can use to guard against
the loss of unrealized gains. The put option
acts like an insurance policy — it costs money,
which reduces the investor's potential gains
from owning the security but also reduces his
risk of losing money if the security declines in
value.
 Protective put = Long (Own) Asset + Long
(Own) a put
39
Hedging with Options (Protective
Put)

Example: Rock Solid has a stock portfolio worth

$100 million, which tracks closely with the S&P
500. The portfolio manager fears that a decline
is coming and want to completely hedge the
value of the portfolio against any downside risk.
If the S&P is currently at 1,000, how is this
accomplished?
Hedging with Options
 Value of the S&P 500 Option Contract = 100 
index
 Currently 100 x 1,000 = $100,000
 To hedge $100 million of stocks that move 1 for 1
(perfect correlation) with S&P currently selling at
1000, you would:
 buy $100 million of S&P put options =
1,000 contracts
Hedging with Options

 The premium would depend on the strike price.

For example, a strike price of 950 might have
a premium of $200 / contract, while a strike
price of 900 might have a premium of only
$100.
 Let’s assume Rock Solid chooses a strike price
of 950. Then Rock Solid must pay $200,000
for the position. This is non-refundable and
comes out of the portfolio value (now only
$99.8 million).
Hedging with Options
 Suppose after the year, the S&P 500 is at 900 and
the portfolio is worth $89.8 million.
 options position is up $5 million (since 950
strike price)
 in net, portfolio is worth $94.8 million
 If instead, the S&P 500 is at 1100 and the portfolio
is worth $109.8 million.
 options position expires worthless, and portfolio
is worth $109.8 million
Hedging with Options
 Note that the portfolio is protected from any
downside risk (the risk that the value in the
portfolio will fall ) in excess of $5 million.
However, to accomplish this, the manager has
to pay a premium upfront of $200,000.
Income Strategy: Covered Call (owning stock
and writing a call)

 A covered call is an options strategy A covered call is a

popular options strategy used to generate income for
investors who think stock prices are unlikely to rise much
further in the near term.
 A covered call is constructed by holding a long position in a
stock and then selling (writing) call options on that same
asset, representing the same size as the underlying long
position.
 A covered call will limit the investor's potential upside profit
and may not offer much protection if the stock price drops.

45
Covered Call Example
 When you sell a covered call, you get paid in exchange
for giving up a portion of future upside. For example,
assume you buy XYZ stock for $50 per share, believing
it will rise to $60 within one year. You're also willing to
sell at $55 within six months, giving up further upside
while taking a short-term profit. In this scenario, selling a
covered call on the position might be an attractive
strategy. Expalin how?

46
 Put-Call
Parity
 Portfolio A: one European call option plus an amount of cash equal to
Ke-rT

 Portfolio B: one European put option plus one share.

 At time T

◦ Portfolio A is worth max (S , K)

T

◦ Portfolio B is worth max (S , K)

T
 Now (0) Maturity (T)
Portfolio A c + Ke-rT Max(ST – K, 0) + K = Max(ST, K)
Portfolio B p + S0 Max(K – ST, 0) + ST = Max(ST, K)
Result c + Ke-rT = p + S0 Max(ST, K) = Max(ST, K)

 As at maturity portfolio A= B, the same must be true

today

 Thus c + Ke-rT = p + S0

4
8
 Example

◦ Suppose the stock price is £31, the strike price is £30,

the risk free is 10%, three-month call worth 3 and three-
month put worth £2.25. Thus

c+ K e−rT =3+30
e−0.1⋅0.25=32.26 p+S
0 =2.25+31=33.25

−rT
0 >c+ K e

◦ This indicates that the put option and the stock are
relatively overpriced and the call option is relatively
underpriced
4
9
How can we exploit this?
 Action Now

◦ Buy call for £3

◦ Short put to realize £2.25
◦ Short the stock to realize
£31
◦ Invest £30.25 for 3 months

Action in 3 months if ST > Action in 3 months if ST <

£30 £30

Receive £31.02 from Receive £31.02 from

investment investment
Exercise call to buy stock for Put exercised, buy stock for
£30 Net profit: £1.02 £30 Net profit: £1.02
5
0