1. Chapter Thirteen Traded Options

2. Professional Users of Derivative Products Speculators: who believe they know what the next price movement is and back their judgment with money Hedgers: who will lose money from a given price movement and seek to protect themselves from this Arbitrageurs: who perceive pricing anomalies and seek to exploit this

3. Traded Options: Equities Traded options are standardized options that grant the buyer the right (but not the obligation) to buy or sell financial instruments at standard prices and dates in the future A premium is charged for this right, and is usually paid when the option is bought. This right to buy a financial product later is the call option. The right to sell a financial product later is the put option

4. Option Writers There are four possibilities in the option game. One can buy calls or puts and one can write calls or puts. The risk profile is quite different for buyers and writers: Maximum loss Maximum gain Buyers of options The premium Unlimited Writers of options Unlimited The premium

5. Trading Options There is a choice of share prices at which calls/puts can be bought/written. They are called exercise or strike prices. There is a choice of dates for expiry of the contract Options must be dealt in set multiples or standard contract sizes Options can be traded, that is, sold back to the market for a later premium. Having bought an option it can be exercised at any time prior to the expiry date. This is called an American option. (It’s nothing to do with America. Most options on European exchanges are American options.)

6. £1.80 and £2.00 Calls for April, July and October Exercise Expiry Intrinsic Time Premium Price value value _______________________________________________ £1.80 April 6 + 10 = 16 July 6 + 18 = 24 October 6 + 26 = 32 £2.00 April 0 + 7 = 7 July 0 + 14 = 14 October 0 + 21 = 21

7. Main European Markets For Equity Options Exchange Country ______________________________________________ Deutsche Termin Börse (DTB), merged with the Swiss Options and Fiunancial Futures Excahnage in 1998 to form EurexGermany (1990) European Options Exchange (EOE ) Netherlands (1978) London Traded Options Market (LTOM) U K (1978) Marché des Options Négociables de Paris(MONEP) part of Euronext Paris France (1987) Swiss Options and Futures Exchange (SOFFEX) merged with Deutsche Termin Börse (DTB) in 1998 to form EurexSwitzerland (1988) ___________________________________________________________________

8. Traded Options: Other Options Currencies Bonds Interest rates

9. Options Strategies: Straddle We might buy both a call and a put on the exercise price of £1.80 for July expiry. If the share price rises we win, if it falls we also win The problem is that two premiums have been paid. The call premium is 24 and the put might be 18 - 42 in total. Having paid 42 for a £1.80 call, the price must go up to £2.22 (£1.80 + 42) to break even and that ignores dealing costs. Having paid 42 for a £1.80 put, the price must fall to £1.38 (£1.80 – 42) to break even In other words, this is a strategy for a volatile situation. A sharp share price movement is expected, either up or down. It might be that there is a takeover bid struggle. The bid will either fail and the victim’s share price fall sharply or the bidder will come back with a higher offer and the opposite will happen The straddle buyer expects a volatile situation; the straddle writer thinks they are wrong

10. Options Strategies: Bull Spread Another strategy might be to buy the July £1.80 calls and write the July £2.20 calls. The premium for the July £1.80 calls is 24p and for the July £2.20 calls, it is 7p. If the share price goes over £2.20 later, we have bought a call and also sold one at this level and so no further gain can be made, the purchase and sale will cancel out However, we have offset the 24p premium for the £1.80 call by receiving the premium of 7p when we wrote the £2.20 call. Our net cost for a 1,000 share contract is 24 – 7 = 17p per share or £170 instead of £240 had we simply bought the £1.80 call alone. We have reduced our possible loss from £240 per contract to £170 per contract and brought the breakeven point down from £1.80 + 24 to £1.80 + 17 What we gave up to achieve this was any profit above a later share price of £2.20.

11. Other Options Strategies Share ratios: is not the share’s absolute price and its movement but how it compares with others Spread trading is similar, and is based on the difference between two prices Calendar spreads are the difference between the option premiums for different expiry dates, for example March and June Exotic options, e.g.; barriers, cheapen the option premium by attaching some condition