1. Chapter 15 Options Markets
Describes the financial instruments traded in primary and secondary markets.
Discusses Market indexes. Discusses options and futures.
McGraw-Hill/Irwin
Copyright © by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. Option Terminology What is a listed stock call option?
A contract giving the holder the right to buy 100 shares of stock at a preset price called the exercise or strike price.
Expirations of 1,2,3,6,& 9 months and sometimes 1 year are normal contract periods. Contracts expire on the third Saturday of the expiration month.
Contracts may be resold prior to maturity.
Listed => traded on the exchanges (e.g., CBOE). OTC options market is larger then exchanges
Rain check: a real life call option example
What is a listed stock put option?
- A contract giving the holder the right to sell 100 shares of stock at
a preset price
- Ray Lewis contract with Ravens: a real life example of a put option
- Farmers interested in put options as they are concerned about low crop prices.
(Friday is the last day you can exercise)

3. Option Characteristics
If a call option holder wishes to purchase the stock using options, he or she will exercise the option. The option holder must pay the exercise price to the option writer.
Exercise prices are adjusted for stock splits and stock dividends, but not cash dividends.
The cost of an option is called the premium and it is a small percentage of the cost of the underlying asset. The option buyer pays the cost; the option writer receives the cost at the time of sale of the option.
Options are a zero sum game.

4. American vs. European Options
American: European:
the option can be exercised any time, but no
Later than the expiration date
the option can only be exercised at the
expiration date
European: Only on that last Friday.

5. Figure 15.1 Options on IBM

6. Uses of options: To hedge changes in stock price.
Change your risk and return profile
For example, buying a call is analogous to buying stock on margin.
Options give two prices (either to pay for a call or to get paid for a put) to the holder to choose from, the market price and the exercise price. The holder is free to compare and choose the one which is more favorable!
Seller (writer) has only obligations as the holder makes a decision whether to exercise (use) it or not..

7. Option Clearing Corporation (OCC)
OCC is jointly owned by option exchanges
OCC backs performance of both counterparties
To limit OCC’s risk, option seller (or writer) must post margin. Margin varies with option price and whether the option position is covered or exposed.
When an option is exercised an option seller is randomly selected.
If a call is exercised the selected call writer must deliver 100 shares of stock in exchange for receiving the strike price.
If a put is exercised the selected put writer must purchase 100 shares of stock at the strike price.
Covered or exposed: A covered call writer can post the stock to satisfy the margin requirement, a naked call writer must post cash.

8. Listed Options vs OTC Options Index Options Options on Futures
4. Types of options
Listed Options vs OTC Options
Index Options
Options on Futures
Foreign Currency Options
Interest Rate Options
Exotic Options
OTC (over-the-counter) options are custom contracts that may be created by financial institutions to meet a customer’s requirements.

9. Ct = Price paid for a call option at time t. t = 0 is today,
Symbols & Valuation
Ct = Price paid for a call option at time t. t = 0 is today,
T = option's expiration date.
Pt = Price paid for a put option at time t.
St = Stock price at time t.
Xc, Xp = Exercise or Strike Price for a call, or a put
In the money=> profitable to exercise, Out of the money =>?
A call is “in the money” if St ____ Xc.
A call is “out of the money” if St ____ Xc.
A put is “in the money” if St ____ Xp.
A put is “out of the money” if St ____ Xp.
>
An option is in the money if you could profitably exercise it right now.
>
>
>

10. 6. The basics of option pricing
a) Price boundaries
Ct ≥ 0, Why?
Pt  0
Pt  X - St
Ct ≥ St – X, Why?
$5 $60 $50
If Ct < St – X How could you take advantage of this?
Thus Ct  Max (0, St – X)
Pt  Max (0, X – St)

11. 7. Option strategies and profits at expiration
BUYING A CALL
Profit Table
ST < X
ST > X
– C0
– C0
– C0
+CT
ST – X
= Profit
– C0
– C0 + ST – X
Breakeven
ST = X + C0
Constructing a profit table is an excellent method to model and understand the payoffs of any option strategy. This is an excellent teaching tool. It is set up with the animation so that you can ask students to fill in the blanks. After the table is complete it is very easy to see the way the profit graph should look.

12. Call profit at expiration (fig 15.1)
ST = X + C0
Stock PriceT $0
$100
$107.35
$92.65
-C0 + ST – X
-C0
-$735
IBM Jul 100 call option
Stock Price = $96.14
Exercise = $100
Call premium = $735=$7.35*100
Contract Size 100 shares
Ex = $100
The breakeven can be found: $100 + $7.35 = $107.35,
Buying this option is placing a bet that the stock price will climb above $ by July
Bullish, & High volatility (see the Instructor’s Manual for more detail)
Bullish or bearish? Bullish
High or low volatility strategy? High

13. Writing a naked call WRITING A NAKED CALL Profit Table ST < X
– CT
–(ST – X)
= Profit
+C0
+C0 – ST + X
Breakeven
ST = X + C0

14. Writing a naked call Stock PriceT X Bullish or bearish? Bearish
Profit
+C0
+C0 – ST + X
Stock PriceT $0
ST = X + C0 X
Bearish; Low Volatility
Bullish or bearish? Bearish
High or low volatility strategy? Low

15. Buying a put option BUYING A PUT Profit Table ST < X ST > X – P0
= Profit
X – ST – P0
– P0
Breakeven
ST = X – P0

16. Buying a put option (fig 15.1)
Profit
IBM Dec 100 put option
Stock price = $96.14
Exercise = $100
Put premium = $1,166=$11.66*100
Contract Size 100 shares
$8,834
X – ST – P0
Stock Pricet $0
$88.34
$100
$111.66
B.E.: ST = X – P0
– P0
-$1,166
Ex = $100
Put
Breakeven can be found as: $100 – $11.66 = $88.34
Bearish, High Volatility
Maximum gain is found as 100 shares x $100 = $10,000 - $1,166 option cost = $8,834
Bullish or bearish? Bearish
High or low volatility strategy? High 16

17. Writing a put option Writing A Put Profit Table ST < X ST > X
= Profit
ST – X + P0
+P0
Breakeven
ST = X – P0

18. Writing a put option Stock Pricet Bullish or bearish? Bullish
Profit
$1,166
ST – X + P0
+P0
Stock Pricet $0
$100
$111.66
$88.34
Xx = $100
Breakeven can be found as: $100 – $11.66 = $88.34
Bullish; Low Volatility, Max gain $1,166 but Max loss $8,834
- $8,834
Bullish or bearish? Bullish
High or low volatility strategy? Low

19. Buy stocks and at the money puts: Protective Put
Profit
Long position in IBM ($X borrowed)
Hedged Position X
Stock Pricet $0
Put
For this one see if the students can think their way through the combination. The profit table is on the next slide.
Hedged profit equals sum of profits of put and stock at each stock price.

20. Long position in IBM $X borrowed
Writing Covered Calls
Profit
Long position in IBM $X borrowed
Written call
Covered Call
Stock Pricet $0
ST = S0 - C0 X
Very popular strategy, particularly when markets are trading sideways. Note breakeven occurs when ST = S0 – C0
Bullish or bearish? Bullish
High or low volatility strategy? Low

21. Bullish Price Spread
Bull perpendicular or bull price spread with calls; write (sell) the high exercise price call and buy the low exercise price call. All other option terms identical. L=low exercise price, H=high exercise price
Bullish so buy an in the money call, but to help defray the cost you write an out of the money call.

22. Bullish Price Spread – + XH Stock Pricet Profit XL
Profit Table
ST < XL
XL < ST < XH
ST > XH
– C0L
– C0L
– C0L
– C0L
+C0H
+C0H
+C0H
+C0H
+CTL
ST – XL
ST – XL
– CTH
–(ST – XH )
= Profit
C0H – C0L
ST – XL – C0L +C0H
XH – XL – C0L + C0H
Breakeven –
ST = XL + C0L – C0H +
Profit
Only way for the final column to be positive is if the time value on H is greater than the time value on L.
Bullish (mildly)
Low volatility strategy XH
Stock Pricet XL
Bullish or bearish? Bullish
High or low volatility strategy? neutral

23. Straddle
(Bull or Long) Straddle: buy a put and a call with the same T and X. (For bear or short straddle, sell both put and call and just flip the graph upside down.)

24. Straddle Bullish or bearish? _______ Neutral
Profit Table
ST < X
ST > X
– C0
– C0
– C0
– P0
– P0
– P0
+CT
ST – X
+PT
X – ST
= Profit
X – ST – C0 – P0
ST – X – C0 – P0
Breakeven
ST = X – C0 – P0
ST = X + C0 + P0
Profit
Profit
Profit
Profit
X – C0 – P0 X
X + C0 + P0 $0 $0 $0 $0
Stock
Stock
Stock
Stock
Price
Price
Price
Price t t t t
Bullish or bearish? _______
High or low volatility strategy? Very High
Neutral
Max Loss: C0 + P0

25. Strips and Straps
Long or bull strap; buy two calls and one put, more bullish than straddle.
Long or bull strip; buy two puts and one call, more bearish than straddle.
Think about bear versions of each.

26. 8. Warnings about options positions
Options may have to move 10-15% or more in a short time period before an investor recovers the premium and commission.
Options are by definition short term instruments (with expiration dates); an investor can ride out bad times in stock markets but not in options.
The limited loss feature makes options appear safer than they are. But you may lose everything you invested.
You have to compare equal $ investments in stocks and options to really see the higher risk of the option position.

27. What’s wrong with selling options? .
What’s wrong with selling options?
Covered calls (writing calls against stock you own)
The investor never gets the occasional large stock price run up and suffers most of the loss of a big price drop. Eliminates any positive skewness of stock returns
Wind up with portfolio of poorer performers
Naked calls (writing calls when you do not own the stock)
Maximum gain is limited to call premium but unlimited loss, poor strategy in volatile markets
Better performers get called away: Opportunity loss, not out of pocket

28. Optionlike Securities
Callable bonds
Issuing firm has the right to call in the bond and pay call price.
When will the firm want to exercise its call option? ~ when the interest rate gets low as this is like a refinancing 28

29. Figure 15.11 Values of Callable Bonds Compared with Straight Bonds29

30. Convertible Securities
Security holder has the option to convert the bond to a fixed number of shares of common stock.
If a bond is convertible to 20 shares of stock, stock is priced at $60 per share. The bond’s conversion value =
$1,200 30

31. Figure 15.12 Value of a Convertible Bond as a Function of Stock Price31

32. Warrants
Call options issued by the firm itself allowing bond investors to purchase new stock shares in the future at a fixed price.
Detachable “sweetener” to help sell the bond
Exercise of warrants (and convertibles) can result in dilution of earnings per share
The dilution is why firms report ‘fully diluted’ earnings per share in annual reports. It is not necessarily the case that EPS will fall. In the case of the convertible security the interest saved on the conversion may fully offset the extra number of shares outstanding, with warrants, the return on investment on the warrant exercise could do the same. 32

33. A similar logic can be applied to corporate equity if a firm has debt.
Collateralized loans
The borrower has an option to repay the loan at maturity if L > ST, otherwise the borrower can default and give up the value of L. Your home loan is an option!
A similar logic can be applied to corporate equity if a firm has debt.
Equity holders effectively have a call option on firm value as they can choose to pay off the debt if firm value > value of the debt or default otherwise. Why is this happening? Limited liability!
This would have to be a no recourse loan (other than the collateral posted) for this to work and there can be no reputation loss or other costs. … A bit of a stretch.

34. Exotic Options Asian Options Barrier Options Lookback Options
Payoff depends on the average (rather than the final) price of the underlying asset during a portion of the life of the option.
Example “down-and-out” expires worthless if the stock price drops below a specified barrier.
Asian- Payoff depend on the average (rather than the final) price of the underlying asset during a portion of the life of the option.
Barrier Options- Depend on whether the underlying asset price has passed through some barrier during the life of the option. Example “down-and-out” expires worthless if the stock price drops below a specified barrier.
Lookback- Depend on minimum or max price during life of option. Might provide payoff equal to the maximum price in period. (Pay a premium for perfect timing)
Currency-Fixes exchange rates and the amount of money to convert is based on the performance of the currency.
Binary option- Pay a fixed amount if the option is in the money.
Payoff depends on minimum or max price during life of option.

35. Exotic Options Currency Translated Options or Quantos
Binary or Digital Options
Allows a variable amount of foreign currency based on the performance of an investment to be translated to dollars at a fixed exchange rate.
Digital options are being used to make bets on economic data such as # jobless claims or inflation.
Asian- Payoff depend on the average (rather than the final) price of the underlying asset during a portion of the life of the option.
Barrier Options- Depend on whether the underlying asset price has passed through some barrier during the life of the option. Example “down-and-out” expires worthless if the stock price drops below a specified barrier.
Lookback- Depend on minimum or max price during life of option. Might provide payoff equal to the maximum price in period. (Pay a premium for perfect timing)
Currency-Fixes exchange rates and the amount of money to convert is based on the performance of the currency.
Binary option- Pay a fixed amount if the option is in the money.
Pays a fixed amount if the option is in the money at expiration.

36. Problem 1
Purchase a straddle, i.e., buy both a put and a call on the stock. The total cost of the straddle would be:
$10 + $7 = $17
Since the straddle costs $17, this is the amount by which the stock would have to move in either direction for the profit on either the call or the put to cover the investment cost (not including commissions.
$17

37. Problem 2 + – Stock Pricet Profit XH XL BEARISH PRICE SPREAD
Profit Table
ST < XL
XL < ST < XH
ST > XH
+ C0L
+ C0L
+ C0L
+ C0L
– C0H
– C0H
– C0H
– C0H
– CTL
–(ST – XL)
–(ST – XL)
+ CTH
ST – XH
= Profit
C0L – C0H
XL – ST – C0H +C0L
XL – XH + C0L – C0H
Breakeven +
ST = XL + C0L – C0H –
Profit XH
Stock Pricet XL