Finance 300 Financial Markets Lecture 25 © Professor J. Petry, Fall

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3 Options Terminology An options contract is a contract in which the writer grants the buyer the right, but not the obligation to buy from or to sell to the writer a specific asset at a specific strike or exercise price, within a specified period of time. Call Option: Grants the buyer the right to BUY the specified stock at the strike price on or before the expiry date. Put Option: Grants the buyer the right to SELL the specified stock at the strike price on or before the expiry date. Premium: The price of an option is called a premium. Strike Price: The price at which the stock is bought and sold if the option is exercised. American Option: options that can be exercised at any time prior to the expiration date.

4 Options Terminology European Option: options that can be exercised only on the expiration date. Contract: Stock options are defined in lots of 100 shares. Index, Interest Rate and Currency Options are defined by the exchange on which the option is listed. Intrinsic Value: the profit per share if the option were exercised immediately. In-the-Money-Option: An option with a favorable exercise price in relation to the price of the underlying security. The intrinsic value is positive. Deep-in-the-Money-Option: An option with a very favorable exercise price in relation to the underlying security. Out-of-the-Money-0ption: An option with an unfavorable exercise price in relation to the price of the underlying security.

5 Options Terminology At-the-Money-Option: An option with a strike price approximately equal to the price of the underlying security. Near-the-Money: Close, but not quite at-the-money. Examples: If IBM is trading at 50 in the spot market, how would you describe the following options (in-the-money, out-of-the- money, intrinsic value): A $45 put A $45 call A $55 call A $55 put A $50 put A $50 call

6 Options Terminology

7 Things to Do: X-1 Explain the difference between buying a call option and writing a put option.

8 Buy 3 January Call options. 1 at 40, 1 at 50, 1 at 60. What would our P/L look like?

9 Write 3 January Call options. 1 at 40, 1 at 50, 1 at 60. What would our P/L look like?

10 (Similar to) Things to Do:X-2 Assume that in September you wrote ten January IBM call options at a strike price of $40 and a premium of 10 1/8. John Q. Investor was the buyer. Suppose that on the last trading date before expiry IBM was trading at $45. A.Is this an in or an out-of-the money option? B.Will J.Q. exercise these options? C.What is J.Q.s profit on this transaction? D.What would J.Q. profit be on this transaction if he did not exercise these options? E.What is your profit on this transaction?