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1 CHAPTER 14 Options Markets

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Call Option vs. Put Option A Call Option gives its owner for a specified time the right to purchase an underlying good at a specified price (exercise price/strike price). A Put option gives its owner for a specified time the right to sell an underlying good at a specified price (exercise/strike price).

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Examples At March 1, XYZ stock’s spot price = $110. A trader buys a call option to buy 100 share of XYZ at strike (exercise) price = $100/share. The right lasts until August 15, and the price (option premium) of this call option is $15/share. At March 1, ABC stock’s spot price = $100. A trader buys a put option to sell a share of ABC at strike (exercise) price = $120/share. The right lasts until August 15, and the price (option premium) of this put option is $22/share.

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Options Features There are always two positions in each option contract: Long for the buyer vs. Short for the seller (1)Buying a Call → Long a Call (2)Selling a Call → Short a Call (3) Buying a Put → Long a Put (4) Selling a Put → Short a Put

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Options Features The buyer of an option has to pay a “price”, option premium. The seller of an option receives the option premium. The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the owner (buyer) ever exercises the option.

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Buyer (Long)Seller (Short) Call - Right to buy the underlying (i.e. to exercise the option) - Pays the premium - Obligation to deliver the underlying, if buyer exercises the option - Receives the premium Put - Right to sell the underlying (i.e. to exercise the option) - Pays the premium - Obligation to buy the underlying, if buyer exercises the option - Receives the premium

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American vs. European Option An American Option permits the owner to exercise (buy/sell the underlying) at any time before or at expiration day. A European Option can be exercised only at expiration day.

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Options Markets Different types of options: Stock options, Index options, Options on Futures (like Commodity Futures, Stock Index Futures, Interest rate Futures, Currency Futures) Traded on Option Exchanges (CBOE, CBOT, PHLX, AMEX, …) Options are traded in highly standardized contracts (standardized sizes, expiration dates, exercise prices)

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9 Options trading (2) OTC 1. Option contract can be customized to needs of trader. 2. Difficult to trade. Secondary market illiquid. Exchanges 1. Option contracts are standardized by maturity dates and exercise price. 2. Easy to trade. Secondary market is liquid.

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Options Markets Reasons for trading: Speculation, Hedging Clearinghouse Margin Requirements No margin requirements for long positions Specific margin requirements for short positions

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Moneyness In-the-money For a call option the spot price of the underlying exceeds the exercise price. For a put option the spot price of the underlying is below the exercise price. At-the-money For a call/put option the spot price of the underlying equals the exercise price. Out-of-the-money For a call option the spot price of the underlying is below the exercise price. For a put option the spot price of the underlying exceeds the exercise price.

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Moneyness CallPut In-the-money (ITM) Exercise price < price of underlying Exercise price > price of underlying At-the-money (ATM) Exercise price = price of underlying Exercise price = price of underlying Out-of-the-money (OTM) Exercise price > price of underlying Exercise price < price of underlying

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Stock Option Price Quotation Exhibit 14.1

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14 Payoff and Profit/Loss Line of a Call Option Long Call at $20 with premium of $7 Short Call at $20 with premium of $7

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15 Payoff and Profit/Loss Line of a Put Option Long Put at $20 with premium of $5 Short Put at $20 with premium of $5

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16 Example A trader short a Call at X=20 with a premium of $5/share. At maturity, the stock price is 30. What is the profit/loss to this trader? Payoff= 20-30=-10 Profit/Loss = 5 + (-10) = -5/share A trader long a Put at X=30 with a premium of $5/share. At maturity, the stock price is 15. What is the profit/loss to this trader? Payoff=30-15=15 Profit/Loss = 15 + (-5) = 10/share

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17 Determinants of Stock Option Premiums 1. Determinants of Call Option Premiums a) Influence of the Market Price b) Influence of the Stock’s Volatility c) Influence of the Call Option’s Time to Maturity Higher current stock market price, higher stock’s volatility, and longer time to maturity, leads to higher call option premiums.

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18 Determinants of Stock Option Premiums 2. Determinants of Put Option Premiums a) Influence of the Market Price b) Influence of the Stock’s Volatility c) Influence of the Put Option’s Time to Maturity Lower current stock market price, higher stock’s volatility, and longer time to maturity, leads to higher put option premiums.

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Long a Call Options (p367) Pat Jackson expects Steelco stock to increase from its current price of $113 per share but does not want to tie up her available funds by investing in stocks. She purchases a call option on Steelco with an exercise price of $115 for a premium of $4 per share. Before the option’s expiration date, Steelco’s price rises to $121. At that time, Jackson exercises her option, purchasing shares at $115 per share. She then immediately sells those shares at the spot market price of $121 per share. What is her net gain/loss? 19 Amount received when selling shares$121 per share -Amount paid for shares-$115 per share -Amount paid for the call option-$4 per share =Net gain$2 per share or $200 for one options contract

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Continue If the price of the Steelco stock had not risen above $115 before the option’s expiration date, what will Jackson do? She would have let the option expire. Her net loss would have been the $4 per share she initially paid for the option, or $400 for one option contract. 20

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Exhibit 14.2 Potential Gains or Losses on a Call Option: Exercise Price = $115, Premium = $4

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Long a Put Option (p368) A speculator bought a put options on Steelco with an exercise price of $110 and a premium of $2. The speculator exercised the option when the market price is $104. How much is his net gain? 22 Amount received when selling shares$110 per share -Amount paid for shares-$104 per share -Amount paid for the put option-$2 per share =Net gain$4 per share

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Exhibit 14.6 Potential Gains or Losses on a Put Option: Exercise Price = $110, Premium = $2

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Short a Put Option A speculator sold a put options on Steelco with an exercise price of $110 and a premium of $2. The purchaser exercised the option when the market price is $104. How much is the option writer’s net gain? 24 Amount paid when buying shares-$110 per share -Amount received for selling shares$104 per share -Amount received for the put option$2 per share =Net gain-$4 per share

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Hedging with Put Options Assume that Portland Pension fund purchased Steelco stock at the market price of $112 per share. To hedge against a decline in stock price, Portland bought a put option on that stock at a price of $112 with a $2 premium. 1. If Steelco’s stock price decline to $x, Portland will generate a gain on its option position, 112-x-2, which would help offset the reduction in the stock’s price. 2. If Steelco’s tock price does not decline, Portland would not exercise its put option. 25

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Hedging with Call Options Page 375. 26

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Homework Assignment 9 Chapter 14: Questions and Applications: 14 Problems: 1, 2, 3, 4, 5, 9. 27

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