1. Financial Derivatives
Options

2. Definition
An option is a contract between two parties – a buyer (holder) and a seller (writer)- that gives the right to the buyer (holder), but not the obligation, to purchase or sell something at a later date, at a price agreed upon today.
The option buyer pays the seller a sum called price or premium.
The option seller stands ready to sell or to buy according to the contract term, if and when the buyer desires.
An option is a financial instrument which gives the holder of the option the right to do something, but the holder does not have to exercise this right.

3. Classification By the right given to the holder (buyer)
Call options – gives the holder of the option the right to buy an asset at a certain date for a certain price.
Put options - gives the holder of the option the right to sell an asset at a certain date for a certain price.
By the moment when the holder can exercise his right:
European option – the option can be exercise only at the expiration date.
American option - the option can be exercise at anytime up to the expiration date.

4. By the possibility to negotiate the option:
Simple – this can not be sold by the holder (OTC options)
negotiable – this are traded on exchange and the holder can sell it on the market.
By the underlying asset
Stock options
Foreign currency options – most are traded on OTC
Index options – most are European type
Futures options – normally matures just before the delivery period in the futures contract.

5. Terminology
Option class – all options of the same type (call or put). Ex. IBM call class.
Option series – all the options of a given class with the same expiration date and strike price.

6. Specifications Contract size Exercise Prices (Strike prices)
For options on indexes the contract size is specified as a multiple.
For options on stocks usually the contract size is equal with 100 shares of stock. An exception occurs when either a stock splits or the company declares a stock dividend. The contract size is adjusted to reflect the change in company capitalization.
Exercise Prices (Strike prices)
is the price agreed by the holder to respect when he exercise his right. The exchange normally chooses the strike prices at which options can be written.
The strike prices are spaced (for shares):
2.5$ if the stock price is between 5$ and 25$
5$ if the stock price is between 25$ and 200$
10$ if the stock price is higher then 200$.
For index options – the strike price are spaced at 5$

7. Expiration dates:
Expiration Month – the month in which expiration date occurs.
Ex. A March call trading on SG is a call option on SG with an expiration date on March.
The precise expiration date is the Saturday immediately following the third Friday of the expiration month.
The last day in which options trade – the third Friday of the expiration month.
The cycles: January, February, March
January cycle consist of the months of January, April, July, and October.
The February cycle consist of the months of February, May, August and November.
The March cycle consist of the months of March, June, September and December.

8. Position limits and Exercise limits
Position limit - the maximum number of options contract that an investor can hold on one side of the market. On the same side of the market are considered to be:
long call and short puts;
short call and long puts.
Exercise limits – the maximum number of contracts that can be exercised by an investor (or group of investors acting together) in any period of five consecutive business days. Usually the exercise limits equals position limits.

9. FLEX and LEAPS
FLEX – are options on equities and equity indices where the traders on the floor of the exchange agree to nonstandard terms.
The exchange specifies a minimum size for FLEX option trades.
LEAPS – long term equity anticipation securities, are options on long term, with the expiration date up to 3 years in the future.
The expiration dates of LEAPS are always in January.

10. Newspaper Quotes
option/strike – the underlying asset of the option, the expiration months, the strike price and the type of option (p – put).
Vol – the total number of contracts traded.
Exch –the exchange where is traded
Last – the prime or the price per one unit of the underlying asset at which was traded at the end of the trading day.
Net Chg – the change of the price in respect with the previous day.
Close – the closing price of the underlying asset.
Open int – the number of contracts outstanding

11. How can be referred options
If S – is the stock price,
K – is the strike price
In the money
Call option if S>K
Put option if S< K
At the money if S=K
Out of Money
Call option if S< K
Put option if S>K
An option will be exercised only when it is in the money.

12. The total value of an option
= the intrinsic value + the time value
Intrinsic value = the maximum of zero and the value the option would have if it were exercised immediately.
Call option: max (S-K, 0)
Put option: max (K-S, 0)
An ITM American option must be worst at least as much as its intrinsic value because the holder can realize a positive intrinsic value by exercising immediately.
Often it is optimal for the holder of an ITM American option to wait rather to exercise the option. Is the said that the option have time value.

13. Market Makers They are used for the majority of options exchanges.
A market maker for a certain option is an individual who, when asked to do so, will quote both bid and ask price.
Bid – the price at which he is prepared to buy
Ask - the price at which he is prepared to sell.
Ask > Bid
The exchange set upper limits for the bid-ask spread.
The existence of market makers ensures that buy and sell orders can always be executed without any delays.
The market makers add liquidity to the market.

14. Offsetting orders
An investor who has purchased an option can close out the position by issuing an offsetting order to sell the same option.
An investor who has written (sold) an option can close out the position by issuing an offsetting order to buy the same option.
The effect on the Open Interest
it will increase - by one contract if when an option is traded none of the investors is closing an existing position.
stay the same - if one investor is closing a position an the other is not.
It will decrease with one contract if both investors are closing existing positions.

15. Margins
When call and put options with maturities less then 9 months are purchased the option price must be paid in full.
For options with maturities grater then 9 months investors can buy on margin, borrowing up to 25% of the option value.
An investor who writes options is required to maintain funds in a margin account.

16. The options clearing corporation (OCC)
it guarantees that the writers will fulfill their obligations under the term of the option contract
Keeps a record of all long and short positions.
Has a number of members.
If a brokerage house is not itself a member of OCC, it must arrange to clear its trade with an OCC member.

17. Exercising an option
When an investor notifies a broker to exercise an option, the broker notifies the OCC member that clears its trade, and this places an exercise order with OCC.
OCC select randomly a member with an outstanding short position in the same option.
The OCC member selects an investor who has written the option. This is said to be assigned.
If the option is call, the selected investor must sell stock at the strike price.
If the option is a Put the investor must buy stock at strike price.
When the option is exercised, the open interest diminish with one.

18. Trading Strategies Involving Options
They are four types of participants in options market:
Buyers of Calls
Seller of Calls
Buyers of Put
Sellers of Put

19. Loss
LONG CALL
Long Call
Profit
K+C
- C K S
OTM
ATM
ITM

20. Short Call SHORT CALL Profit C K+C S K Loss
„Competenţe avansate – profesionale şi de cercetare – în managementul riscului internaţional” POSDRU/86/1.2/S/53202
Proiect cofinanţat din Fondul Social European prin Programul Operaţional Sectorial Dezvoltarea Resurselor Umane 2007­-2013

21. LONG PUT
Profit
Loss S
Long Put
(K-P)n
K-P K -P

22. SHORT PUT
Profit
Loss S
Short Put P K
K-P
-(K-P)n

23. Stock Price and Strike Price
If a Call option is exercised at some futures time, the payoff will be the amount by which the stock price (S) exceeds the strike price (K).
Is more valuable as the stock price increases.
Is less valuable as the stock price decreases.
For a put option, the payoff of exercise is the amount by which the strike price (K) exceeds the stock price (S).
Is more valuable as the stock price decreases.
Is less valuable as the stock price increases.
Put options behave in the opposite way then the call options.

24. Time to expiration
Both put and call American options become more valuable as the time to expiration increases.
The owner of the long life options has all the exercise opportunities open to the short life options and more.
The long life options must always be worth at least as much as the short life options.