1. Chapter 15 Options Markets
Describes the financial instruments traded in primary and secondary markets.
Discusses Market indexes. Discusses options and futures.
McGraw-Hill/Irwin
Copyright © by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. 15.1 The Option Contract

3. Option Terminology What is a listed call option?
A contract giving the holder the right to buy 100 shares of stock at a preset price called the exercise or strike price.
Expirations of 1,2,3,6,& 9 months and sometimes 1 year are normal contract periods. Contracts expire on the Saturday following the third Friday of the expiration month.
Contracts may be sold prior to maturity.
(Friday is the last day you can exercise)

4. Option Terminology What is a listed Put option?
A contract giving the holder the right to sell 100 shares of stock at a preset price

5. Option Characteristics
If a call option holder wishes to purchase the stock, he or she will exercise the option. The option holder must pay the exercise price to the option writer.
The cost of an option is called the premium and it is a small percentage of the cost of the underlying asset. The option buyer pays the cost; the option writer receives the cost at the time of sale of the option.
The underlying company is not involved in the option market.

6. American vs. European Options
the option can be exercised at any date after purchase before the expiry date.
American: European:
the option can only be exercised only on expiry date
European: Only on that last Friday.

7. Figure 15.1 Options on IBM

8. Option Terminology Uses of options: To hedge changes in stock price.
Change your risk and return profile
For example, buying a call is analogous to buying stock on margin.
Short sale constraints can be avoided with puts.

9. Option Clearing Corporation (OCC)
OCC is jointly owned by option exchanges
OCC backs performance of both counterparties
To limit OCC’s risk, option seller (or writer) must post margin. Margin varies with option price and whether the option position is covered or exposed.
When an option is exercised an option seller is randomly selected.
If a call is exercised the selected call writer must deliver 100 shares of stock in exchange for receiving the strike price.
If a put is exercised the selected put writer must purchase 100 shares of stock at the strike price.
Covered or exposed: A covered call writer can post the stock to satisfy the margin requirement, a naked call writer must post cash.

10. Types of Options 4. Types of options Listed Options OTC Options
Index Options
Options on Futures
Foreign Currency Options
Interest Rate Options
Exotic Options
OTC (over-the-counter) options are custom contracts that may be created by financial institutions to meet a customer’s requirements.

11. 15.2 Values of Options at Expiration

12. Option Terminology Symbols & Valuation
Ct = Price paid for a call option at time t. t = 0 is today,
T = Immediately before the option's expiration.
Pt = Price paid for a put option at time t.
St = Stock price at time t.
X = Exercise or Strike Price
A call is “in the money” if St ____ X.
A call is “out of the money” if St ____ X.
A put is “in the money” if St ____ X.
A put is “out of the money” if St ____ X.
>
An option is in the money if you could profitably exercise it right now.
>
>
>
Both are “at the money” when?

13. Basics of Option Pricing
6. The basics of option pricing
a) Price boundaries
Just before expiration at time T:
If ST < X then if ST > X then
Ct ≥ 0, Why?
Pt  0
Pt  X - St
Ct ≥ St – X, Why?
$5 $60 $50
If Ct < St – X How could you take advantage of this?
Thus Ct  Max (0, St – X)
Pt  Max (0, X – St)
CT = 0
CT = ST – X

14. IBM Option Quotes Note: Jul 100 call is out of the money.
Q: What does "Open Int" mean?
A: "Open Int" stands for Open Interest. The "Open Int" column displays the open interest, based upon opening and closing transaction data and exercise notices tendered from the previous day.
(Source CBOE)

15. Profit at expiration from buying a call option
7. Option strategies and profits at expiration
BUYING A CALL
Profit Table
ST < X
ST > X
– C0
– C0
– C0
+CT
ST – X
= Profit
– C0
– C0 + ST – X
Breakeven
ST = X + C0
Constructing a profit table is an excellent method to model and understand the payoffs of any option strategy. This is an excellent teaching tool. It is set up with the animation so that you can ask students to fill in the blanks. After the table is complete it is very easy to see the way the profit graph should look.

16. Call profit at expiration
B.E.: ST = X + C0
Stock PriceT $0
$100
$107.35
$92.65
-C0 + ST – X
-C0
-$735
Ex = $100
IBM Jul 100 call option
Stock Price = $96.14
Exercise = $100
Call premium = $735
Contract Size 100 shares
The breakeven can be found: $100 + $7.35 = $107.35,
Buying this option is placing a bet that the stock price will climb above $ by July
Bullish, & High volatility (see the Instructor’s Manual for more detail)
Bullish or bearish?
High or low volatility strategy?

17. Writing a naked call WRITING A NAKED CALL Profit Table ST < X
– CT
–(ST – X)
= Profit
+C0
+C0 – ST + X
Breakeven
ST = X + C0

18. Writing a naked call Stock PriceT X Bullish or bearish?
Profit
+C0
+C0 – ST + X
Stock PriceT $0
B.E.: ST = X + C0 X
Bearish; Low Volatility
Bullish or bearish?
High or low volatility strategy?

19. Buying a put option BUYING A PUT Profit Table ST < X ST > X – P0
= Profit
X – ST – P0
– P0
Breakeven
ST = X – P0

20. IBM Option Quotes

21. Buying a put option Stock Pricet
Short position in IBM
Profit
IBM Dec 100 put option
Stock price = $96.14
Exercise = $100
Put premium = $1,166
Contract Size 100 shares
$8,834
X – ST – P0
Stock Pricet $0
$88.34
$100
$111.66
B.E.: ST = X – P0
– P0
-$1,166
Ex = $100
Put
Breakeven can be found as: $100 – $11.66 = $88.34
Bearish, High Volatility
Maximum gain is found as 100 shares x $100 = $10,000 - $1,166 option cost = $8,834
Bullish or bearish? Alternative Stock Strategy?
High or low volatility strategy? 22

22. Writing a put option Writing A Put Profit Table ST < X ST > X
= Profit
ST – X + P0
+P0
Breakeven
ST = X – P0

23. Writing a put option Stock Pricet
Profit
Long Position in IBM
$1,166
ST – X + P0
+P0
Stock Pricet $0
$100
$111.66
$88.34
IBM Jul 100 put option
Stock price = $96.14
Exercise = $100
Put premium = $1,166
Contract Size 100 shares
Xx = $100
Breakeven can be found as: $100 – $11.66 = $88.34
Bullish; Low Volatility, Max gain $1,166 but Max loss $8,834
- $8,834
Bullish or bearish? Alternative Stock Strategy?
High or low volatility strategy?

24. Buy stocks and at the money puts: Protective Put
All examples that include both stocks and options assume usage of at the money options.

25. Buy stocks and at the money puts: Protective Put
Profit
Long position in IBM
Hedged Position X
Stock Pricet $0
Put
For this one see if the students can think their way through the combination. The profit table is on the next slide.
Hedged profit equals sum of profits of put and stock at each stock price.

26. Buy stocks and at the money puts: Protective Put
Bullish or bearish?
High or low volatility strategy?
LONG STOCK, LONG PUT
Profit Table
ST < X
ST > X
ST – S0
ST – S0
ST – S0
– P0
– P0
– P0
+PT
X – ST
= Profit
ST – S0 + X – ST – P0
ST – S0 – P0
= X – S0 – P0
Breakeven
ST = S0 + P0
If at the money X - S0 = 0 and max loss = -P0, use out of the money, your max loss is more.

27. Writing Covered Calls Covered Call Stock Pricet Bullish or bearish?
Profit
Long position in IBM
Written call
Covered Call
Stock Pricet $0
ST = S0 - C0 S0
Very popular strategy, particularly when markets are trading sideways. Note breakeven occurs when ST = S0 – C0
Bullish or bearish?
High or low volatility strategy?

28. Writing Covered Calls WRITING COVERED CALLS Profit Table ST < X
ST – S0
ST – S0
ST – S0
+C0
+C0
+C0
– CT
–(ST – X)
= Profit
ST – S0 + C0
X – S0 + C0
Breakeven
ST = S0 – C0
If at the money, X = S0 and max gain is +C0. If use out of the money max gain is more, but price has to rise more to get there and you have tighter breakeven with more loss.
hide this slide if you don’t want to fill out the profit table.

29. Bullish Price Spread
Bull perpendicular or price spread with calls; write (sell) the high exercise price call and buy the low exercise price call. All other option terms identical. L=low exercise price, H=high exercise price
Bullish so buy an in the money call, but to help defray the cost you write an out of the money call.

30. Bullish Price Spread – + XH Stock Pricet Profit XL Bullish or bearish?
Profit Table
ST < XL
XL < ST < XH
ST > XH
– C0L
– C0L
– C0L
– C0L
+C0H
+C0H
+C0H
+C0H
+CTL
ST – XL
ST – XL
– CTH
–(ST – XH )
= Profit
C0H – C0L
ST – XL – C0L +C0H
XH – XL – C0L + C0H
Breakeven –
ST = XL + C0L – C0H +
Profit
Only way for the final column to be positive is if the time value on H is greater than the time value on L.
Bullish (mildly)
Low volatility strategy XH
Stock Pricet XL
Bullish or bearish?
High or low volatility strategy?

31. Long or Bull Straddle
Long or bull straddle: buy a put and a call with the same T and X. (For bear or short straddle, sell both put and call and just flip the graph upside down.)

32. Long or Bull Straddle Bullish or bearish? _____________ Neutral
Profit Table
ST < X
ST > X
– C0
– C0
– C0
– P0
– P0
– P0
+CT
ST – X
+PT
X – ST
= Profit
X – ST – C0 – P0
ST – X – C0 – P0
Breakeven
ST = X – C0 – P0
ST = X + C0 + P0
Profit
Profit
Profit
Profit
X – C0 – P0 X
X + C0 + P0 $0 $0 $0 $0
Stock
Stock
Stock
Stock
Price
Price
Price
Price t t t t
Bullish or bearish? _____________
High or low volatility strategy?
Neutral
Max Loss: C0 + P0

33. Strips and Straps
Long or bull strap; buy two calls and one put, more bullish than straddle.
Long or bull strip; buy two puts and one call, more bearish than straddle.
Think about bear versions of each.

34. Short Strangle: Sell out of the money put and call
Profit Table
ST < XL
XL < ST < XH
ST > XH
+ P0L
+ P0L
+ P0L
+ P0L
+C0H
+C0H
+C0H
+C0H
– PTL
– (XL – ST )
– CTH
–(ST – XH )
= Profit
ST – XL+ P0L + C0H
P0L + C0H
XH – ST + P0L + C0H
Breakeven
ST = XL– P0L– C0H +
ST = XH + P0L + C0H
Profit
Only way for the final column to be positive is if the time value on H is greater than the time value on L.
Bullish (mildly)
Low volatility strategy
Stock Pricet XL XH
ST= XL–P0L–C0H
ST = XH + P0L + C0H

35. 8. Warnings about options positions
Options may have to move 10-15% or more in a short time period before an investor recovers the price & commission.
Options are by definition short term instruments; an investor can ride out bad times in spot markets but not in options.
The limited loss feature makes options appear safer than they are.
You have to compare equal $ investments in stocks and options to really see the higher risk of the option position.
Options are traded in a highly competitive market.

36. 8. Warnings about options positions
What’s wrong with selling options?
Covered calls (writing calls against stock you own)
The investor never gets the occasional large stock price run up and suffers most of the loss of a big price drop. Eliminates any positive skewness of stock returns
Wind up with portfolio of poorer performers
Naked calls (writing calls when you do not own the stock)
Maximum gain is limited to call premium but unlimited loss, poor strategy in volatile markets
Better performers get called away: Opportunity loss, not out of pocket

37. 15.3 Optionlike Securities

38. Optionlike Securities
Callable bonds
Issuing firm has the right to call in the bond and pay call price.
When will the firm want to exercise its call option? 40

39. Figure 15.11 Values of Callable Bonds Compared with Straight Bonds41

40. Optionlike Securities
Convertible Securities
Security holder has the option to convert the bond to a fixed number of shares of common stock.
Bond’s Conversion Value = Conversion Ratio x Common Stock Price
If a bond is convertible to 20 shares of stock, stock is priced at $60 per share. The bond’s conversion value =
$1,200 42

41. Figure 15.12 Value of a Convertible Bond as a Function of Stock Price
The option is issued deep out the money, the ‘option cost’ is a lower coupon. 43

42. Convertibles (cont.) Theoretical value of a convertible bond =
Value straight debt + Value of conversion option
In reality there are three complicating factors:
The conversion price may increase over time effectively increasing the option’s exercise price.
Stocks may pay dividends, this makes it harder to value the option to convert
Virtually all convertible bonds are callable by the firm. The firm may call to force conversion, this makes the maturity of the bond and the option indeterminate.

43. Optionlike Securities
Warrants
Firm sometimes issue warrants with its bonds. The warrants are call options to purchase new stock at a fixed price.
Detachable “sweetener” to help sell the bond
Exercise of warrants (and convertibles) can result in dilution of earnings per share
The dilution is why firms report ‘fully diluted’ earnings per share in annual reports. It is not necessarily the case that EPS will fall. In the case of the convertible security the interest saved on the conversion may fully offset the extra number of shares outstanding, with warrants, the return on investment on the warrant exercise could do the same. 45

44. Optionlike Securities
Collateralized loans
Suppose a borrower is obligated to pay back L dollars at loan maturity (Time T) and has posted collateral worth St dollars.
The borrower has an option to repay the loan at maturity if L > ST, otherwise the borrower can default and give up the value of L.
A similar logic applies to corporate equity if a firm has debt.
Equity holders effectively have a call option on firm value as they can choose to pay off the debt if firm value > value of the debt or default otherwise.
This would have to be a no recourse loan (other than the collateral posted) for this to work and there can be no reputation loss or other costs. … A bit of a stretch.

45. Collateralized Loan Payoffs

46. 15.4 Exotic Options

47. Exotic Options Asian Options Barrier Options Lookback Options
Payoff depends on the average (rather than the final) price of the underlying asset during a portion of the life of the option.
Asian Options
Barrier Options
Lookback Options
Example “down-and-out” expires worthless if the stock price drops below a specified barrier.
Asian- Payoff depend on the average (rather than the final) price of the underlying asset during a portion of the life of the option.
Barrier Options- Depend on whether the underlying asset price has passed through some barrier during the life of the option. Example “down-and-out” expires worthless if the stock price drops below a specified barrier.
Lookback- Depend on minimum or max price during life of option. Might provide payoff equal to the maximum price in period. (Pay a premium for perfect timing)
Currency-Fixes exchange rates and the amount of money to convert is based on the performance of the currency.
Binary option- Pay a fixed amount if the option is in the money.
Payoff depends on minimum or max price during life of option.

48. Exotic Options Currency Translated Options or Quantos
Binary or Digital Options
Allows a variable amount of foreign currency based on the performance of an investment to be translated to dollars at a fixed exchange rate.
Digital options are being used to make bets on economic data such as # jobless claims or inflation.
Asian- Payoff depend on the average (rather than the final) price of the underlying asset during a portion of the life of the option.
Barrier Options- Depend on whether the underlying asset price has passed through some barrier during the life of the option. Example “down-and-out” expires worthless if the stock price drops below a specified barrier.
Lookback- Depend on minimum or max price during life of option. Might provide payoff equal to the maximum price in period. (Pay a premium for perfect timing)
Currency-Fixes exchange rates and the amount of money to convert is based on the performance of the currency.
Binary option- Pay a fixed amount if the option is in the money.
Pays a fixed amount if the option is in the money at expiration.

49. Selected Problems

50. Problem 1
Purchase a straddle, i.e., buy both a put and a call on the stock. The total cost of the straddle would be:
$10 + $7 = $17
Since the straddle costs $17, this is the amount by which the stock would have to move in either direction for the profit on either the call or the put to cover the investment cost (not including commissions.
$17

51. Joe’s Protective Put Strategy Sally’s Protective Put Strategy
Problem 3
Joe’s Protective Put Strategy
Profit Table
ST < $1,200
ST > $1,200
Sally’s
-$75
$1245
ST – $1,200
ST – $1,200
ST – $1,200
Joe’s
-$60
$1260
– P0
– $60
– $60
+PT
$1,200 – ST
= Profit
– $60
ST – $1,260
Breakeven
ST = $1,260
Use this problem to illustrate the tradeoffs in choosing options with different exercise prices. Note that Sally’s strategy exposes Joe to more potential losses, Joe’s strategy is in effect buying more insurance against losses, since his strategy costs more stock prices have to rise further before his strategy breaks even.
Sally’s Protective Put Strategy
Profit Table
ST < $1,170
ST > $1,170
ST – $1,200
ST – $1,200
ST – $1,200
– P0
– $45
– $45
+PT
$1,170 – ST
= Profit
– $75
ST – $1,245
Breakeven
ST = $1,245 54