Options Markets: Introduction Chapter 20 Options Markets: Introduction

Option Terminology Buy - Long Sell - Short Call Put Key Elements Exercise or Strike Price Premium or Price Maturity or Expiration

Market and Exercise Price Relationships In the Money - exercise of the option would be profitable. Call: market price>exercise price Put: exercise price>market price Out of the Money - exercise of the option would not be profitable. Put: exercise price>market price At the Money - exercise price and asset price are equal.

American vs European Options American - the option can be exercised at any time before expiration or maturity. European - the option can only be exercised on the expiration or maturity date.

Different Types of Options Stock Options Index Options Futures Options Foreign Currency Options Interest Rate Options

Payoffs and Profits on Options at Expiration - Calls Notation Stock Price = ST Exercise Price = X Payoff to Call Holder (ST - X) if ST >X 0 if ST < X Profit to Call Holder Payoff - Purchase Price

Payoffs and Profits on Options at Expiration - Calls Payoff to Call Writer - (ST - X) if ST >X 0 if ST < X Profit to Call Writer Payoff + Premium

Profit Profiles for Calls Call Holder Call Writer Stock Price

Payoffs and Profits at Expiration - Puts Payoffs to Put Holder 0 if ST > X (X - ST) if ST < X Profit to Put Holder Payoff - Premium

Payoffs and Profits at Expiration - Puts Payoffs to Put Writer 0 if ST > X -(X - ST) if ST < X Profits to Put Writer Payoff + Premium

Profit Profiles for Puts Profits Put Writer Put Holder Stock Price

Equity, Options & Leveraged Equity - Text Example Investment Strategy Investment Equity only Buy stock @ 100 300 shares $10,000 Options only Buy calls @ 10 1000 options $10,000 Leveraged Buy calls @ 10 100 options $1,000 equity Buy T-bills @ 2% $9,000 Yield

Equity, Options & Leveraged Equity - Payoffs IBM Stock Price $95 $105 $115 All Stock $9,500 $10,500 $11,500 All Options $0 $5,000 $15,000 Lev Equity $9,270 $9,770 $10,770

Equity, Options & Leveraged Equity - Rates of Return IBM Stock Price $95 $105 $115 All Stock -5.0% 5.0% 15% All Options -100% -50% 50% Lev Equity -7.3% -2.3% 7.7%

Protective Put Use - limit loss Position - long the stock and long the put Payoff ST < X ST > X Stock ST ST Put X - ST 0

Protective Put Profit Profit Stock Protective Put Portfolio ST -P

Covered Call Use - Some downside protection at the expense of giving up gain potential. Position - Own the stock and write a call. Payoff ST < X ST > X Stock ST ST Call 0 - ( ST - X)

Covered Call Profit Profit Stock Covered Call Portfolio ST -P

Option Strategies Straddle (Same Exercise Price) Long Call and Long Put Spreads - A combination of two or more call options or put options on the same asset with differing exercise prices or times to expiration. Vertical or money spread: Same maturity Different exercise price Horizontal or time spread: Different maturity dates

Put-Call Parity Relationship ST < X ST > X Payoff for Call Owned 0 ST - X Put Written -( X -ST) 0 Total Payoff ST - X ST - X

Payoff of Long Call & Short Put Combined = Leveraged Equity Stock Price Short Put

Arbitrage & Put Call Parity Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal. C - P = S0 - X / (1 + rf)T If the prices are not equal arbitrage will be possible.

Put Call Parity - Disequilibrium Example Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 10.25% Maturity = .5 yr X = 105 C - P > S0 - X / (1 + rf)T 17- 5 > 110 - (105/1.05) 12 > 10 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative.

Put-Call Parity Arbitrage Immediate Cashflow in Six Months Position Cashflow ST<105 ST> 105 Buy Stock -110 ST ST Borrow X/(1+r)T = 100 +100 -105 -105 Sell Call +17 0 -(ST-105) Buy Put -5 105-ST 0 Total 2 0 0

Optionlike Securities Callable Bonds Convertible Securities Warrants Collateralized Loans

Exotic Options Asian Options Barrier Options Lookback Options Currency Translated Options Binary Options

Chapter 20 Weblinks http://www.amex.com/options/education This site contains online option education material. It has extensive programs to learn about the use of options, options pricing, and option markets. http://www.options.about.com/money/options This site has extensive links to many other sites. It contains sections on education, exchanges, research, quotes, as well as extensive sources related to futures markets.

Chapter 20 Weblinks http://www.optionscentral.com The Options Industry Council site contains extensive educational material including access to the freely available Options Toolbox. The toolbox is an excellent source that allows you to simulate different options positions and examine the pricing on options. http://www.numa.com Links to numerous options and other derivative websites. http://www.phlx.com Links to numerous options and other derivative websites.

Chapter 20 Weblinks Exchange sites: http://www.cme.com http://www.amex.com http://www.cboe.com http://www.nasdaq.com http://www.cbt.com

Home Assignment Required: • problems 1, 2, 7 (3rd ed). • problems 2, 3, 7 (5th ed). • visit the recommended web sites • closely follow financial news!