1 Mechanics of Options Markets Chapter 7

2 Just like forwards, futures and swapS OPTIONS ARE CONTRACTS Two parties A contract An underlying asset

3 Assets Underlying Exchange-Traded Options Page Stocks Foreign Currency Stock Indices Futures

4 OPTIONS A contingent claim: The option’s value is contingent upon the value of the underlying asset Two Types of Options: Calls: THE RIGHT TO BUY Puts: THE RIGHT TO SELL

5 CALL Buyer; holder; long. In exchange for making a payment of money, the premium, the long-has the right to BUY a specified quantity of the underlying asset for the exercise (strike) price before the option’s expiration date.

6 PUT Buyer; holder; long. In exchange for making a payment of money, the premium, the long-has the right to SELL a specified quantity of the underlying asset for the exercise (strike) price before the option’s expiration date.

7 Call Seller, writer or short. In exchange for receiving the premium, the short has the obligation to SELL the underlying asset for the predetermined exercise (strike) price upon being served with an exercise notice during the life of the option, I.e., before the option expires.

8 Put Seller, writer or short. In exchange for receiving the premium, the short has the obligation to BUY the underlying asset for the predetermined exercise (strike) price upon being served with an exercise notice during the life of the option, I.e., before the option expires.

9 Types of Options American Options exercisable any time before expiration European Options exercisable only on expiration date Asian Options European style on the underlying average price during its life

10 OPTIONS NOTATIONS: S– the underlying asset’s market price K- the exercise (strike) price t – the current date T – the expiration date T-t - time till expiration c, p - European call, put premiums C, P –American call, put premiums

11 The BUYER of a call option has the right to buy the underlying at the strike price, K, before the call expires at T. Thus => expects the price of the underlying commodity to increase during the period of the option contract.

12 The SELLER of a call option must sell the underlying asset for K, if the option is exercised by its holder. Thus => expects the price of the underlying asset to remain below or at the exercise price during the option’s life.This way the writer keeps the premium.

13 The BUYER of a put option has the right to sell the underlying for K before the put expires at T. Thus => expects the market price of the underlying asset, S, to decrease during the life of the put.

14 The SELLER of a put must buy the underlying for K if the put is exercised by its holder. Thus => expects the market price of the underlying asset, S, to remain at or above K during the life of the put. This way the put writer keeps the premium.

15 $ K K tTS

16 More terminology The option Market Price  PREMIUM PREMIUM = Intrinsic value + extrinsic value Intrinsic value: CallsMax{0, S-K) PutsMax{0, K-S) The intrinsic value cannot be negative. The extrinsic value = The time value.

17 At-the-money S = K In this case the intrinsic value for both calls and puts is zero: S - K = K - S = 0 and the premium consists of the Extrinsic (time) value only.

18 In-the-money CallsPuts S >K S < K or S – K>0 K – S>0 The Intrinsic value is positive.

19 Out-of-the-money CallsPuts S K or S - K<0 K - S <0 The intrinsic value is zero and the premium consists of the extrinsic (time) value only.

20 Example CALLSPUTS S K FEB MAR MAY FEB MAR MAY Expiration: the Saturday following the third Friday of the expiration month

21 INTEL Thursday, September 21, S = $61.48 CALLS - LAST PUTS - LAST K OCT NOV JAN APROCT NOV JAN APR

22 THE OCC GUARANTEE The exchanges understood that there will exist no efficient options markets without an absolute guarantee to the options’ holders, so they have created the: OPTIONS CLEARING CORPORATION (OCC)

23 CLEARING MEMBERS NONCLEARING MEMEBRS EXCHANGE CORPORATION OPTIONS CLEARING CORPORATION BROKERSCLIENTES THE OPTION CLEARING CORPORATION PLACE IN THE MARKET OCC MEMBER

24 The Options Clearing Corporation (OCC) gives all the LONGS the absolute guarantee You will always be able to exercise your option!!! The OCC’s absolute guarantee provides traders with a default-free market. Thus, any investor who wishes to engage in options buying knows that there will be no operational default.

25 The OCC Clears all options trading. Maintains the list of all long and short positions. Matches all long positions with short positions. Hence, the total sum of all options traders positions must be ZERO at all times. The OCC’s absolute guarantee together with the trading list makes the market very liquid. 1 – traders are not afraid to enter the market 2 – traders can quit the market at any point in time by OFFSETTING their original position.

26 OFFSETTING POSITIONS A trader with a LONG position who wishes to get out of the market must open a SHORT position with equal number of the same options on the same underlying asset for the same month of expiration and for the same exercise price. Example: LONG 5, SEP, $85, IBM puts This position must be offset by SHORT 5, SEP, $85, IBM puts.

27 OFFSETTING POSITIONS A trader with a SHORT position who wishes to get out of the market must open a LONG position with equal number of the same options on the same underlying asset for the same month of expiration and for the same exercise price. Example: SHORT 25, JAN, $75, BA calls This position must be offset by LONG 25, JAN, $75, BA calls.