Mechanics of Options Markets Chapter 8 1 Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Review of Option Types 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

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Option Positions Long call Long put Short call Short put

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Long Call (Figure 8.1, Page 180) Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months Profit ($) Terminal stock price ($)

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Short Call (Figure 8.3, page 182) Profit from writing one European call option: option price = $5, strike price = $ Profit ($) Terminal stock price ($)

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Long Put (Figure 8.2, page 181) Profit from buying a European put option: option price = $7, strike price = $ Profit ($) Terminal stock price ($)

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Short Put (Figure 8.4, page 182) Profit from writing a European put option: option price = $7, strike price = $ Profit ($) Terminal stock price ($)

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Payoffs from Options What is the Option Position in Each Case? K = Strike price, S T = Price of asset at maturity Payoff STST STST K K STST STST K K

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Assets Underlying Exchange-Traded Options Page Stocks Foreign Currency Stock Indices Futures

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Specification of Exchange-Traded Options Expiration date Strike price European or American Call or Put (option class)

Expiration Dates Example: a January call Expiration date: Saturday immediately following the third Friday of January Last trading day: The third Friday Until 4:30 pm on Friday, time for investor to instruct the broker to exercise the option Until 10:59 p.m. on Saturday, time for broker to complete the paperwork Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull

Expiration Dates Stock options are on January, February, and March cycle. January cycle: January, April, July, October February and March cycle similarly Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull

Expiration Dates If the expiration date for the current month has not yet been reached, options trade with expiration dates in the current month, the following month, and the next two months in the cycle. If the expiration date has passed, options trade with expiration dates in the next month, the next-but-one month, and the next two months of the expiration cycle. Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull

Strike Prices Strike prices are normally spaced $2.50, $5, or $10 apart. $2.5, when the stock price is between $5 and $25 $5, when the stock price is between $25 and $200 $10, for stock prices above $200 Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Terminology Moneyness : ◦ At-the-money option ◦ In-the-money option ◦ Out-of-the-money option

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Terminology (continued) Option class: call or put Option series: IBM 175 Oct. calls Intrinsic value: a) call: max(S-K,0) b) put: max(K-S,0) Time value

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Dividends & Stock Splits (Page ) Suppose you own N options with a strike price of K : ◦ 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 mK/n  the no. of options is increased to nN/m ◦ Stock dividends are handled in a manner similar to stock splits

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 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? ◦ for a 5% stock dividend?

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 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

Commissions Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull

Commissions Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull

Commissions, Example Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004

Example, continued Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Margins (Page ) Margins are required when options are sold When a naked call option is written the margin is the greater of: 1.A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money 2.A total of 100% of the proceeds of the sale plus 10% of the underlying share price

Margins When a naked put option is written the margin is the greater of: 1.A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money 2.A total of 100% of the proceeds of the sale plus 10% of the exercise price Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull

Margins, Example Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull

Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull Warrants Warrants are options that are issued (or written) by acorporation or a financial institution At the same time of a bond issue, the corporation issues call warrants on its own stock and then attaches them to the bond issue to make it more attractive to investors

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Executive Stock Options Executive stock options are a form of remuneration issued by a company to its executives They are usually at the money when issued When options are exercised the company issues more stock and sells it to the option holder for the strike price

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Executive Stock Options continued They become vested after a period of time (usually 1 to 4 years) They cannot be sold They often last for as long as 10 or 15 years Accounting standards now require the expensing of executive stock options

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull 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

Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull Warrants, employee stock options, and convertibles, compared to exchange traded options A predetermined number of options are issued, whereas the number of exchange traded options outstanding is not predetermined. When warrants and … are exercised, the company issues more shares of its own stock and sells them to the option holder.

Warrants, employee stock options, and convertibles, compared to exchange traded options By contrast, when an exchange-traded call is exercised, the party with the short position buys in the market shares that have already been issued and sells them to the party with the long position. The company whose stock underlies the option is not involved in any way. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull