Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 36:  Options  Definition and function  Option terms 36cis

The development of options Options had been discussed as a theoretical possibility for many years, but until a method for pricing options was devised, they had no practical use as an investment tool  Two US academics produced the Black-Scholes model in 1973, which is still in use today  The Chicago Board Options Exchange (CBOE) opened the same year, offering standardised option contracts Fischer BlackMyron Scholes

What is an option? An option gives the buyer the right – but not the obligation – to buy or sell a specified quantity of an underlying asset at:  A pre-agreed exercise price  On or before a pre-specified future date The seller, in exchange for the payment by the buyer of a premium, grants the option to the buyer  For exchange-traded options, both buyers and sellers contract with the exchange rather than with each other

Options: exchange-traded Since the initial launch of options on the CBOE, several other options exchanges have been set up, including NYSE Liffe, and there has been an explosion in product innovation  Where options are traded on an exchange, they will be in standardised sizes and terms

Settlement of exchange-traded options The option premium: The option premium is paid by the buyer to the exchange at the start of the option contract  The premium is not refundable Exercising the option: If the buyer (holder) or an option chooses to exercise his / her right to buy or sell the underlying asset, the exchange will match the transaction with a deal placed by an option writer  The exchange does not want to be a buyer or seller of the underlying asset

Options: OTC Not all options are traded on exchanges…  If investors wish to trade outside these standard terms they will do so in the Over-The-Counter (OTC) market  In OTC options, the counterparties use bespoke contract terms Global OTC derivatives: As of the end of 2009, outstanding equity-linked option contracts were valued at US$531bn Source: BIS

The two classes of options Call option: The buyer has the right to buy the asset at the exercise price – if he / she chooses to  The seller of the option is obliged to deliver if the buyer exercises the option Put option: The buyer has the right to sell the asset at the exercise price – if he / she chooses to  The seller of the option is obliged to take delivery and pay the exercise price if the buyer exercises the option Buyers and sellers: The buyers of options are the owners of those options.  Buyers are also referred to as holders. The sellers of options are referred to as the “writers” of those options  When a seller accepts a premium for selling an option, it is referred to as “taking for a call” or “taking for a put”  Depending on whether it is a call or put option

Example of a call option  Shares in Beckenham Ventures Plc are trading at 125p  Investor Smith believes the share price is going to rise sharply over the course of the next three months  Investor Jones thinks the shares are going nowhere  Investor Smith buys a 150p call option for three months  Investor Jones writes (sells) the call  Investor Jones charges investor Smith a non-refundable premium of 20p  If the share price of Beckenham Ventures rise above 170p  Investor Smith will definitely exercise the option, as he has made a profit (he has to pay 150p to buy the share and he has already paid 20p for the option premium)  If the share price of Beckenham Ventures rises to 155p  Investor Smith might exercise the option, as the 5p profit on the purchase of share will defray part of the 20p cost of the option premium  If the share price of Beckenham Ventures rises only slightly to 127p  Investor Smith will not exercise the option and allow it to expire

Example of a put option  Shares in Bromley Megastore Plc are trading at 240p  Investor Smith believes the share price is going to fall sharply over the course of the next three months  Investor Jones thinks the shares are going to rise slightly  Investor Smith buys a 220p put option for three months  Investor Jones writes (sells) the put  Investor Jones charges investor Smith a non-refundable premium of 30p  If the share price of Bromley Megastore falls to 160p  Investor Smith will definitely exercise the option, as he has made a profit (he can sell the share for 220p and has paid 30p for the option premium)  If the share price of Bromley Megastore falls to 210p  Investor Smith might exercise the option, as the 10p profit on the sale of the share will defray part of the 30p cost of the option premium  If the share price of Bromley Megastore falls only slightly to 230p  Investor Smith will not exercise the option and allow it to expire