8.1 Mechanics of Options Markets Chapter 8

8.2 Types of Options A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time

8.3 Option Positions Long call Long put Short call Short put

8.4 Long Call on Microsoft Profit from buying a Microsoft European call option: option price = $5, strike price = $100, option life = 2 months Profit ($) Terminal stock price ($)

8.5 Short Call on Microsoft Profit from writing a Microsoft European call option: option price = $5, strike price = $ Profit ($) Terminal stock price ($)

8.6 Long Put on Oracle Profit from buying an Oracle European put option: option price = $7, strike price = $ Profit ($) Terminal stock price ($)

8.7 Short Put on Oracle Profit from writing an Oracle European put option: option price = $7, strike price = $ Profit ($) Terminal stock price ($)

8.8 Payoffs from Options What is the Option Position in Each Case? X = Strike price, S T = Price of asset at maturity Payoff STST STST X X STST STST X X

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

8.10 Specification of Exchange-Traded Options Expiration date Strike price European or American Call or Put (option class)

8.11 Terminology Moneyness : –At-the-money option –In-the-money option –Out-of-the-money option

8.12 Terminology (continued) Option class Option series Intrinsic value Time value

8.13 Time Value and Intrinsic Value for a Call S X Out In Time Value Intrinsic Value

8.14 Time and Intrinsic Value for Put Option S X In Out Time Value

8.15 Dividends & Stock Splits Suppose you own N options with a strike price of X : –No adjustments are made to the option terms for cash dividends –When there is an n-for-m stock split, the strike price is reduced to mX/n the no. of options is increased to nN/m –Stock dividends are handled in a manner similar to stock splits

8.16 Dividends & Stock Splits (continued) Consider a call option to buy 100 shares for $20/share How should terms be adjusted: –for a 2-for-1 stock split? X* = 20/2 = 10 N* = 2x100 = 200 –for a 5% stock dividend? X* = 20/1.05 = N* = 1.05x100 = 105

8.17 Market Makers Most exchanges use market makers to facilitate options trading A market maker quotes both bid and ask prices when requested The market maker does not know whether the individual requesting the quotes wants to buy or sell

8.18 Margins Margins are not required when options are bought Margins are required when options are sold and position is uncovered Smaller margin is required for when written option is out of the money. Margins are not required when written options is fully covered See pages for details (if interested) General rule: margin is required only when strategy creates a future obligation

8.19 Convertible Bonds Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio

8.20 Convertible Bonds (continued) Very often a convertible is callable The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose

8.21 Over-the-Counter Markets Options are frequently negotiated in the over-the-counter market The strike price and time to maturity do not then have to correspond to those specified by an exchange

8.22 Exotic Options Nonstandard options trading over-the counter include: Barrier options Asian options Binary options Chooser options Compound options