Chapter 9: Mechanics of

Options Markets
 Types Of Options
Call versus Put Options:
• A call option gives the owner of the option the right to buy an assets at a certain price by a
certain time.
• A put option gives the owner of the option the right to sell an assets at a certain price by a
certain time.

• The certain time is known as the expiration date or the maturity date.
• The certain price is known as the strike price or exercise price.
• The owner of the option is long and the seller of the option is short.

American versus European Options:

• An American option can be exercised at any time up to and including the expiration date.
• A European option can be exercised only on the expiration date.
 Types Of Options
Consider the situation of an investor who buys European call options with a strike price of $100 to
purchase 100 shares of a certain stock. Suppose that the current stock price is $98, the expiration
date of the option is in four months, and the price of an option to purchase one share is $5.

The initial investment when the investor is purchasing 100 shares at $5 (total costs = $500).
If the stock price on this date is less than $100, the investor will clearly choose not to exercise.
(There is no point in buying for $100 a share that has a market value of less than $100.) In these
circumstances, the investor loses the whole of the initial investment of $500.

If the stock price is above $100 on the expiration date, the option will be exercised. Investor will
buy stock for $100 a share that has a market value above $100. For example, the stock price is
$115. By exercising the option, the investor is able to buy 100 shares for $100 per share. If the
shares are sold immediately at $115, the investor makes a gain of $115 - $100 = $15 per share, or,
$1500 in total ignoring transaction costs. When the initial cost of the option is taken into account,
the net profit to the investor is $1500 - $500 = $1000.
 Profit from Long Position of Call Option
An investor buys call options to purchase 100 shares. Strike price = $100. Current stock price = $98. Price
of a call option to buy one share = $5. What is the net gain by exercising the option if stock price is $99 on
expiration day? What is the net gain by exercising the option if stock price is $115 on expiration day?
Answer:
Call premium (C) = Price of a call option to buy one share (C) = $5
Initial investment = 5*100 = $500
If stock price is $99 on expiration day, call option will not be exercised as investor will not buy stock at
$100 while market price is $99. Investor will lose $500 initial investment. Net gain = -$500
Call option will not be exercised when stock price (S T)<=exercise price (K).
when ST <= K, net gain per share= - C and total $ net gain = - C*number of shares

If stock price is $115 on expiration day, call option will be exercised because stock price (S T) > exercise
price (K). Investor can buy stock at K while the market price is at a higher price (S T). So investor earn a
profit of ST -K per share ignoring the call premium, and S T -K-C per share considering the initial
investment.
when ST > K, net gain per share= ST - K- C and total $ net gain = (ST - K- C)*number of shares
 Profit from Long Position of Call Option
Payoff Per Share from Long Position of Call Option Considering Call Premium = max (S T - K, 0) - C
• when ST <= K, net gain per share = - C
• when ST > K, net gain per share = ST - K- C
 Profit from Long Position of Put Option
An investor buys a put option to sell 100 shares. Strike price = $70. Current stock price = $65. Price of a
put option to sell one share = $7. What is the net gain by exercising the option if stock price is $80 on
expiration day? What is the net gain by exercising the option if stock price is $55 on expiration day?
Answer:
Put premium = Price of a put option to sell one share (P) = $7
Initial investment = 7*100 = $700
If stock price is $80 on expiration day, investor will not exercise put option and sell stock at $70. Investor
will lose $700 put premium . Net gain = -$700
Put option will not be exercised when stock price at maturity (S T)>= exercise price (K).
when ST >=K, net gain per share= - P and total $ net gain = - P*number of shares

If stock price is $55 on expiration day, put option will be exercised because stock price (S T) < exercise
price (K). Investor can sell stock at K while the market price is at a lower price (S T). So investor earn a
profit of K-S per share ignoring the put premium, and K-S-P per share considering the initial investment.
when ST <K, net gain per share= K- ST -P and total $ net gain = (K- ST -P)*number of shares
If stock price $55 per share on expiration day, total net gain = (70-55-5)*100=$1000
 Profit from Long Position of Put Option
Profit Per Share from Long Position of Put Option Considering Put Premium= max (K- S T ,0) - P
• when ST >=K, net gain per share = - P
• when ST <K, net gain per share = K- ST -P
 Option Positions
There are two sides to every option contract:
• On one side is the investor who has taken the long position (i.e., has bought the
option).
• On the other side is the investor who has taken a short position (i.e., has sold or
written the option).
The writer of an option receives cash up front, but has potential liabilities later.
The writer’s profit or loss is the reverse of that for the purchaser of the option.
Profit from Short Position of Call Option
Profit from Short Position of Put Option
 Payoffs from Options
Payoffs from positions in European options ignoring initial cost: (a) long call, (b) short call, (c) long put,
(d) short put. K = Strike price, ST = Price of asset at maturity
 Summary of Option Payoffs and Profits
Option Payoffs Ignoring Initial Cost:
• Payoff of a long call is MAX(ST – K, 0)
• Payoff of a short call is –MAX(ST – K, 0)
• Payoff of a long put is MAX(K – ST, 0)
• Payoff of a short put is –MAX(K – ST, 0)

Option Payoffs Considering Initial Cost:

• Payoff of a long call is MAX(ST – K, 0) - premium
• Payoff of a short call is –MAX(ST – K, 0) + premium
• Payoff of a long put is MAX(K – ST, 0) - premium
• Payoff of a short put is –MAX(K – ST, 0) + premium

MAX(ST – K, 0) = the larger number between (ST – K) and 0.

The breakeven asset price causes the payoff to equal zero. The breakeven asset price occurs
when MAX(S – K, 0) = S – K for call option
 Payoffs and Profits
Option Payoff Example 1:
You paid $5 for a call option has a strike price of $45. At expiration the stock price is $49. What
is the payoff and profit?
Answer: Investor pay premium to buy call option. This is a long call situation.
Payoff of a long call = MAX(ST – K, 0) – premium = MAX($49 – $45, 0) -$5 = $4 - $5 = -$1

Option Payoff Example 2:

You paid $4 for a put option has a strike price of $20. At expiration the stock price is $14. What is
the payoff and profit?
Answer: Investor pay premium to buy put option. This is a long put situation.
Payoff of a long put = MAX(K – ST, 0) – premium = MAX($20 – $14, 0) - $4 = $6 - $4 = $2
 Payoffs and Profits
Option Payoff Example 3:
You received $6 for a call option has a strike price of $65. At expiration the stock price is $67.
What is the payoff and profit?
Answer: You receive premium because you are writing and selling the call option. This is a short
call situation.
Payoff of a short call = –MAX(ST – K, 0) + premium = -MAX($67 – $65, 0) + $6 = -2 + 6= $4

Option Payoff Example 4:

You received $3 for a put option has a strike price of $65. At expiration the stock price is $63.
What is the payoff and profit?
Answer: You receive premium because you are writing and selling the put option. This is a short
put situation.
Payoff of a short put = –MAX(K – ST, 0) + premium = -MAX($65 – $63, 0) + $3 = -2 + 3= $1
 Payoffs and Profits
Breakeven Stock Price Example 1:
You went long a call with an exercise price of $25.00 per share for a premium of $4.00. What is
the breakeven stock price?
Answer:
Payoff of a long call = MAX(ST – K, 0) – Premium
The breakeven asset price causes the payoff to equal zero.
The breakeven asset price occurs when MAX(ST – K, 0) = ST – K for call option

Payoff of a long call = MAX(ST – K, 0) – Premium = ST – K – Premium = ST – 25 – 4 = 0

ST = 29 is the breakeven stock price.
 Payoffs and Profits
Breakeven Stock Price Example 2:
You bought a put with a strike price of $10.00 per share for a premium of $0.80. What is the
breakeven stock price?
Answer:
Payoff of a long put is MAX(K – ST, 0) - premium
The breakeven asset price causes the payoff to equal zero.
The breakeven asset price occurs when MAX(K – ST, 0) = K – ST for put option.

Payoff of a long put = MAX(K – ST , 0) – Premium = K – ST – Premium = 10 – ST – 0.8 = 0

ST = $9.2 is the breakeven stock price.
 Specification of Stock Options
• Expiration dates are set by the exchange
• Strike prices are set by the exchange
• The exchange normally chooses the strike prices at which options can be written so that
they are spaced $2.5, $5, or $10 apart. Typically the spacing is $2.50 when the stock price
is between $5 and $25, $5 when the stock price is between $25 and $200, and $10 for
stock prices above $200.
• Stock splits and stock dividends can lead to nonstandard strike prices.
• Option Class: All options of the same type (calls or puts) on a stock.
• For example, IBM calls are one class, whereas IBM puts are another class.
• Option Series: All the options of a given class with the same expiration date and strike price.
• For example, IBM 180 October 2015 calls are an option series. (strike price =$180;
maturity=Oct 2015; Call)
 Specification of Stock Options
• Moneyness:
• A call is in-the-money if S > K, a put is in-the-money if K > S
• A call is out-of-the-money if S < K, a put is out-of-the-money if K < S
• A call is at-the-money if S = K, a put is at-the-money if K = S
• Intrinsic value: the maximum of zero and the payoff from the option if it were
exercised immediately.
• The intrinsic value of a call option is MAX(S – K, 0)
• The intrinsic value of a put option is MAX(K – S, 0)
• Total value of an option = Option’s intrinsic value + Option’s time value
 Specification of Stock Options
Option Intrinsic Value Example 1:
A call option has a strike price of $45 and the it value is $5 when the stock price is $49. What is its moneyness,
intrinsic value, and time value?
Answer:
Call option is in-the-money as S($49)>K($45)
Intrinsic value of call option = MAX($49 – $45, 0) = $4
Time value = option value – option’s intrinsic value = $5 - $4 = $1

Option Intrinsic Value Example 2:

A put option has a strike price of $15 and the it value is $2 when the stock price is $17. What is its moneyness,
intrinsic value, and time value?
Answer:
Put option is out-the-money as S($17)>K($15)
Intrinsic value of put option= MAX($15 – $17, 0) = $0
Time value = option value – option’s intrinsic value = $2 - $0 = $2
 Specification of Stock Options
Option Intrinsic Value Example 3:
A put option has a strike price of $30.00, 67 days until expiration, and a value of $2.37. If the underlying asset
value is $28.67, what is the option’s intrinsic value and time value?
Answer:
Intrinsic value of put option = MAX(30.00 – 28.67, 0) = 1.33
Time value = option value – option’s intrinsic value = 2.37 – 1.33 = 1.04

Option Intrinsic Value Example 4:

A call option has an exercise price of $65.00, 223 days until expiration, and a value of $4.62. If the underlying
asset value is $67.85, what is the option’s intrinsic value and time value?
Answer:
Intrinsic value = MAX(67.85 – 65.00, 0) = 2.85
Time value = option value – option’s intrinsic value = 4.62 – 2.85 = 1.77
 Specification of Stock Options
Option Intrinsic Value Example 5:
A put has a strike price of $80.00 and 217 days to expiration. The risk-free interest rate is 3.6% per year. If the
asset price is $82.39, then the option is ____.
Answer:
S=$82.39 and K=$80.
S > K, put option is out-of-the-money.

Option Intrinsic Value Example 6:

A call has a strike price of $75.00 and 93 days to expiration. The risk-free interest rate is 4.7% per year. If the
asset price is $72.93, then the option is ____.
Answer:
S=$72.93 and K=$75
S < K, call option is out-of-the-money.
 Dividends and Stock Splits
Stock Splits:
• A stock split occurs when the existing shares are “split” into more shares. For
example, in a 3-for-1 stock split, three new shares are issued to replace each
existing share.
• 3-for-1 stock split should cause the stock price to go down to 1/3 of its previous
value, and number of shares tripled.
• After a n-for-m stock split:
• Stock Price Decreases: Pafter = m/n*Pbefore
• Total Number of Shares Outstanding Increase: Nafter = n/m*Nbefore
• Strike Price Decreases: Kafter = m/n*Kbefore
• Number of shares covered by one contract increases: N after = n/m*Nbefore
 Dividends and Stock Splits
Stock Split Example 1:
Consider a call option to buy 100 shares of a company for $30 per share. Suppose the company
makes a 2-for-1 stock split. How does stock split affect number of shares the company has and the
strike price.
Answer:
Strike Price Decreases: Kafter = m/n*Kbefore = 1/2*30 = $15
Number of shares: Nafter = n/m*Nbefore = 2/1*100 = 200 shares

Stock Split Example 2:

Consider a call option to buy 100 shares of a company for $30 per share. Suppose the company
makes a 3-for-2 stock split. How does stock split affect number of shares the company has and the
strike price.
Answer:
Strike Price Decreases: Kafter = m/n*Kbefore = 2/3*30 = $20
Number of shares: Nafter = n/m*Nbefore = 3/2*100 = 150 shares
 Dividends and Stock Splits
Cash Dividends:
• For options traded on OTC:
• If a company declared a cash dividend:
• The strike price was reduced on the ex-dividend day by the
amount of the dividend: Kafter = Kbefore- dividends
• The number of shares covered by one contract doesn’t change.
• For options traded on exchanges: They are not usually adjusted for
cash dividends except for very large cash dividends.
 Dividends and Stock Splits
Stock Dividends:
• Stock dividend and share splits have the same effect on stock price and number of
shares change.
• 100% stock dividend means an extra 100% shares will be created. If the investor has 1
share, he will get 2 shares after 100% stock dividend. This is the same as 2-for-1 stock
splits.
• If a company declare a stock dividend, strike price will decrease and number of shares
covered by one contract will increase.
• After X% stock dividend, number of shares will increase and stock price will decrease.
• Stock Price Decreases: Pafter = Pbefore /(1+X%)
• Total Number of Shares Outstanding Increase: Nafter = (1+X%)Nbefore
• Strike Price Decreases: Kafter = Kbefore /(1+X%)
• Number of shares covered by one contract increases: Nafter = (1+X%) Nbefore
 Dividends and Stock Splits
Stock Dividends Example 1:
Consider a put option to sell 100 shares of a company for $15 per share. Suppose the company declares a
25% stock dividend. How does stock dividends affect number of shares the company has and the strike
price.
Answer:
Strike Price Decreases: Kafter = Kbefore /(1+X%) = 15/(1+25%) = $12
Number of shares covered by one contract increases: Nafter = (1+X%) Nbefore = (1+25%)*100 = 125 shares

Stock Dividends Example 2:

Consider a put option to sell 200 shares of a company for $12 per share. Suppose the company declares a
20% stock dividend. How does stock dividends affect number of shares the company has and the strike
price.
Answer:
Strike Price Decreases: Kafter = Kbefore /(1+X%) = 12/(1+20%) = $10
Number of shares covered by one contract increases: Nafter = (1+X%) Nbefore = (1+20%)*200 = 240 shares
 Position Limits and Exercise Limits
Position Limit: the maximum number of option contracts that an investor can hold on one
side of the market.
• Long calls and short puts are on the same side of the market.
• Short calls and long puts are on the same side of the market.
Exercise limit: the maximum number of contracts that can be exercised by any investor in any
period of five consecutive business days.
• Options on the largest and most frequently traded stocks have positions limits of
250,000 contracts.
• Smaller capitalization stocks have position limits of 200,000, 75,000, 50,000, or 25,000
contracts.
 Option Trading
Over 95% of the orders at the Chicago Board Options Exchange are handled electronically. The remainder
are large or complex institutional orders that require the skills of floor traders.

• Market Maker: an individual who, when asked to do so, will quote both a bid and an offer price on the
option.
• Bid Price: the price at which the market maker is prepared to buy
• Offer Price or Ask Price: the price at which the market maker is prepared to sell.
• Offer price is always higher than the bid price.
• Bid–offer Spread = Offer Price – Bid Price. Market makers make their profits from the bid–offer
spread.

• Exchange sets upper limits for the bid–offer spread to ensure the option trading liquidity.
• Market maker ensures that buy and sell orders can always be executed at some price without any delays.
• Market makers add liquidity to the market.
 Commission
Commission Example 1: An investor buys one call contract with strike price of $50 when the stock price is $49. The
option price is $4.5. Later stock price rises to $60 and option is exercised. Using the below table from an option
broker, what is the net profit to an investor if he exercise the option and sell stocks? Assuming the investor pays
0.75% commission to buy and sell stocks. Each option contract includes 100 options.

Answer:
Investor pays 4.5*100=$450 to purchase option contract
When purchasing options, commission = 20+0.02*450 = $29
When exercising options, the investor first buys stock and pays commission: 0.75%*60*100=$45
After he purchases the stock, he sells the stock at market price and pays commission: 0.75%*60*100=$45
Investor purchase 100 shares of stocks at strike price of $50 when market price is $60. Profit = (60-50)*100=$1000
Net Profit to the Investor = 1000 – 450 – 45 – 45 – 29 = $431
 Margin Requirement
• When shares are purchased, an investor can either pay cash or borrow using a margin account.
• The initial margin is usually 25% of the value of the shares, and the maintenance margin is
usually 50% of the value of the shares.
• When call or put options with maturities less than nine months are purchased, the option
price must be paid in full. Investors are not allowed to buy options with less than 9-month
maturities on margin because options already contain substantial leverage and buying on
margin would raise this leverage to an unacceptable level.
• For call or put options with maturities greater than nine months, investors can buy on
margin, borrowing up to 25% of the option value.
 Writing Naked Options
Naked option: a type of options trading strategy where the trader sells an options contract without
holding the underlying asset.

Naked Call Option: This occurs when a trader sells a call option without owning the underlying
stock. If the stock price rises above the strike price, buyer will purchase the stock at exercise price.
The seller is obligated to provide the stock at the strike price, potentially incurring significant
losses.

Naked Put Option: This occurs when a trader sells a put option without holding a short position
in the underlying stock or enough cash to buy the stock at the strike price. If the stock price falls
below the strike price, put option holder will exercise the put option and sell stock at exercise price
to option seller. The option writer must buy the stock at the higher strike price, again risking
significant losses.

Covered calls/puts are far less risky than naked calls/puts.

 Writing Naked Options
Initial and maintenance margin requirement for naked option:

For a written naked call option is the greater of:

1. 100% of the proceeds of the sale + 20% of the underlying share price - the amount if
any by which the option is out of the money
2. 100% of the option proceeds + 10% of the underlying share price

For a written naked put option, it is the greater of:

3. 100% of the proceeds of the sale + 20% of the underlying share price - the amount if
any by which the option is out of the money
4. 100% of the option proceeds + 10% of the exercise price.
 Writing Naked Options
Margin calculations for a naked call option Example:
An investor writes four naked call option contracts on a stock (4*100=400 options). The option
price is $5, the strike price is $40, and the stock price is $38. What is the initial margin and
maintenance margin requirement?

Answer:
The option is $2 out of the money.
1. 100% of the proceeds of the sale + 20% of the underlying share price - the amount if any by
which the option is out of the money:
400*(5+0.2*38-2)=$4240
2. 100% of the option proceeds + 10% of the underlying share price:
400*(5+0.1*38) = $3520
The initial and maintenance margin requirement is $4240.
 Writing Naked Options
Margin calculations for a naked put option Example:
An investor writes four naked put option contracts on a stock (4*100=400 options). The option
price is $5, the strike price is $40, and the stock price is $38. What is the initial margin and
maintenance margin requirement?

Answer:
The option is $2 in the money.
1. 100% of the proceeds of the sale + 20% of the underlying share price - the amount if any by
which the option is out of the money
400*(5+0.2*38) = $5040
2. 100% of the option proceeds + 10% of the exercise price.
400*(5+10%*40)=$3600
The initial and maintenance margin requirement is $5040.
 Taxation
• For both the holder and the writer of a stock option, a gain or loss is recognized when (a) the option
expires unexercised, or (b) the option position is closed out.

• If the option is exercised, the gain or loss from the option is rolled into the position taken in the stock and
recognized when the stock position is closed out.
• The party with long call position is deemed to have purchased the stock at (strike price + call price).
• The party with short call position is deemed to have sold the stock at (strike price + call price).
• The party with long put position is deemed to have sold the stock for (strike price - put price).
• The party with short put position is deemed to have bought stock for (strike price - put price)
 Wash Sale Rules
• Wash sale: an investor sells a security at a loss and then repurchases the same or a substantially identical
security within a short period of time, typically 30 days. The primary goal of wash sale is to realize a
tax-deductible loss while maintaining the investment position.

• When the repurchase is within 30 days of the sale, any loss on the sale is not deductible.
• The disallowance also applies where, within the 61-day period, the taxpayer enters into an option or
similar contract to acquire the stock.

• Imagine an investor who buys a stock when the price is $60 and plans to keep it for the long term. If the
stock price drops to $40, the investor might be tempted to sell the stock and then immediately repurchase
it at $40 to realize loss for tax purposes if wash sale rules don’t exist.
• Under Wash Sale Rules, any loss on the sale is not deductible when the repurchase is within 30 days of
the sale.
 Warrants, Employee Stock Options, and Convertibles
Warrant:
• A long-term call option: A certificate issued by a company that gives the holder the
right to buy a stated number of shares of the company’s stock at a specified price
(usually 20%-30% higher than the stock price when warrants are issued) for some
specified length of time
• A long-term call option issued with debt.
• Used to induce investors to buy long-term debt with a lower coupon rate.

Employee Stock Option:

• Call options issued to employees by their company to motivate them to act in the best
interests of the company’s shareholders. They are usually at the money at the time of
issue.
 Warrants, Employee Stock Options, and Convertibles
Convertible bonds:
• Bonds that can be converted into common stock at the option of the holder.
(Convertible bond = Straight bond + Option to convert bond to stock)
• Conversion does NOT provide new capital to the firm (Warrants brings in additional
funds).
• Debt is simply replaced on the balance sheet by common stock.
• Reducing debt the will improve the firm’s financial strength and make it easier to raise
additional capital.
• Because of conversion feature, convertible bonds can be issued at a lower coupon rate
than its comparable straight bond.
 Over-The-Counter Options Markets
• Options can be traded on both exchanges and OTC market.
• The over-the-counter market for options is now larger than the exchange-traded market.
• In the over-the-counter market, derivatives dealers trade directly with other financial
institutions, corporations, and fund managers.
• Disadvantage of options traded on OTC: Option writer may default. So buyer is subject to
some credit risk. To overcome this disadvantage, collateral is increasingly required.
• Advantage of options traded on OTC: Option contracts can be customized to meet the
precise needs of their clients, including choosing exercise dates, strike prices, and contract
sizes.
 Exotic Options
• Rainbow option: an option that that derives its value from the performance of multiple underlying
assets.
• Exchange option: involves two different underlying assets. The holder has the right to exchange one
asset (Asset A) for another asset (Asset B).
• Asian option: payoff is based on the average price of the underlying asset over the life of the option.
• Lookback option: payoff is based on the minimum or maximum price of the underlying asset over the
life of the option.
• Chooser option: allows the owner to decide, within a specific period, whether the option is a put or a
call.
• Bermuda option: can be exercised early only on specific dates or on maturity day.
• Shout option: The holder of a Shout option can choose to "shout" (declare) once during the life of the
option to lock the payoff regardless of future price movements. The option has the higher of a
traditional payoff or the option’s intrinsic value at a time selected by the owner.
 Summary
Calls and Puts:
• A call option gives the holder the right to buy the underlying asset for a certain price by a certain date.
• A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.
Four possible positions in options markets: a long position in a call, a short position in a call, a long
position in a put, and a short position in a put.
Long and Short Positions: Option holders are taking long positions. Option writers (issuer, or seller) are
taking short positions.
An exchange must specify the terms of the option contracts including the size of the contract, the precise
expiration time, and the strike price.
In the United States one stock option contract gives the holder the right to buy or sell 100 shares.
The terms of a stock option (strike price and number of shares covered by an option contract) are not
normally adjusted for cash dividends. However, strike price and number of shares covered by an option
contract are adjusted for stock dividends, stock splits, and rights issues.
Options can be traded on both exchanges and OTC market. An advantage of over-the-counter options
is that they can be tailored by a financial institution to meet the particular needs of a corporate treasurer
or fund manager.