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Options Markets

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Title: Options Markets


1
Options Markets
  • Riccardo Colacito

2
Option Terminology
  • Call right to buy at a specified price
  • Put right to sell at a specified price
  • Key Elements
  • Exercise or Strike Price
  • Premium or Price
  • Maturity or Expiration

3
Call Option example
  • Exercise price 90
  • Premium 1.55
  • Price at expiration 91
  • Would you call away the stock?
  • Yes!
  • How much would you make/lose?
  • Lose .55

4
Market and Exercise Price Relationships
  • In the Money - exercise of the option would be
    profitable
  • Call market pricegtexercise price
  • Put exercise pricegtmarket price
  • Out of the Money - exercise of the option would
    not be profitable
  • Call market priceltexercise price
  • Put exercise priceltmarket price
  • At the Money - exercise price and asset price are
    equal

5
Options Trading
  • Each stock option contract provides for the right
    to buy or sell 100 shares
  • Two main exchanges
  • Chicago Board Option Exchange
  • International Security Exchange
  • Exchange traded options expire on the third
    Friday of the expiration month
  • Option Clearing Corporation (OCC)

6
Figure 14-1 Options on IBM June 7, 2004
7
Notes on previous table
  • Maturity Jun 2004
  • Call premium decreases with strike price
  • Put premium increases with strike price
  • Open interest is the number of outstanding
    contracts
  • If option not traded for one day 3 dots

8
American vs European Options
  • American - the option can be exercised at any
    time before expiration or maturity
  • European - the option can only be exercised on
    the expiration or maturity date

9
Different Types of Options
  • Stock Options
  • Index Options
  • Foreign Currency Options
  • Interest Rate Options
  • Futures Options (will see this later)

10
Payoffs and Profits on Options at Expiration -
Calls
  • Notation
  • Stock Price ST Exercise Price X
  • Payoff to Call Holder
  • (ST - X) if ST gtX
  • 0 if ST lt X
  • Profit to Call Holder
  • Payoff - Purchase Price

11
Payoffs and Profits on Options at Expiration -
Calls
  • Payoff to Call Writer
  • - (ST - X) if ST gtX
  • 0 if ST lt X
  • Profit to Call Writer
  • Payoff Premium

12
Example
  • An IBM call option
  • Exercise price is 80
  • Cost/Premium is 14
  • Can you draw payoffs and profits as a function of
    the price at the exercise date?

13
Figure 14-3 Payoff and Profit to Call at
Expiration
14
Figure 14-4 Payoff and Profit to Call Writers at
Expiration
15
Payoffs and Profits at Expiration - Puts
  • Payoffs to Put Holder
  • 0 if ST gt X
  • (X - ST) if ST lt X
  • Profit to Put Holder
  • Payoff - Premium

16
Payoffs and Profits at Expiration - Puts
  • Payoffs to Put Writer
  • 0 if ST gt X
  • -(X - ST) if ST lt X
  • Profits to Put Writer
  • Payoff Premium

17
Put example
  • An IBM put option
  • Exercise price is 80
  • Cost/Premium is 14
  • Can you draw payoffs and profits as a function of
    the price at the exercise date?

18
Figure 14-5 Payoff and Profit to Put Option at
Expiration
19
Are you bullish or bearish?
  • Purchasing call is bullish gain when market goes
    up
  • Purchasing put is bearish gain when market goes
    down

20
Options vs Stocks
  • Is buying options the same as buying stocks?
  • Why might an option strategy be preferable to
    direct stock trabsactions?
  • Use of options for hedging reasons

21
Equity, Options Options Plus T-Bills - Text
Example
Investment Strategy Investment Equity only Buy
stock _at_ 90 100 shares 9,000 Options only Buy
calls _at_ 10 900 options 9,000 Calls Plus Buy
calls _at_ 10 100 options 1,000 T-Bills Buy
T-bills _at_ 2 8,000 Yield
22
Equity, Options Options Plus T-Bills - Text
Example
23
Equity, Options Options Plus T-Bills - Text
Example
24
Figure 14-6 Returns to Three Strategies
25
Some Popular Option Strategies
  • Protective Put Covered Call
  • Long Stock Long Stock
  • Long Put Short Call
  • Straddle Bullish Spread
  • Long Call Long Call Low Strike
  • Long Put Short Call High Strike

26
Protective put
  • Buy one put
  • Buy one share of stock
  • It guarantees minimum proceeds equal to the puts
    exercise price!

27
Table 14-1 Payoff to Protective Put Strategy
28
Figure 14-7 Value of Protective Put Position at
Maturity
29
Figure 14-8 Protective Put Versus Stock
Investment (at-the-money put)
30
Why is this an interesting strategy?
  • Great for risk management limit portfolio risk
  • If holding large position in one stock, it may be
    a good idea to insure against the risk of a sharp
    drop in stocks value!

31
Covered Call
  • Sell one call
  • Buy one share of underlying stock
  • It compensates losses associated to writing a
    naked call

32
Table 14-2 Payoff to a Covered Call
33
Figure 14-9 Value of a Covered Call Position at
Expiration
34
Why is this an interesting strategy?
  • Writing a naked call may result in huge losses,
    if stock price goes up!
  • If holding large position in a stock and have
    planned to sell it if stock exceeds a certain
    barrier, writing a call may help as self
    discipline and generate income in the form of
    options premium.

35
Straddle
  • Buy one call
  • Buy one put
  • Expiration dates must be the same
  • Strike prices must be the same

36
Table 14-3 Payoff to a Straddle
37
Figure 14-10 Payoff and Profit to a Straddle
Position at Expiration
38
Why is this an interesting strategy?
  • You think stock price will move, but are
    uncertain about the direction of the movement
  • E.g. an imminent court case will make or break a
    company you would profir no matter what!
  • Your worst case scenario is that nothing happens!

39
Strips and Straps
  • Strip two puts and one call
  • Strap one put and two calls

40
Strip
41
Strap
42
Why strips and straps?
  • You know that price will move a lot in the near
    future and want to bet on one direction a
    little more than on the other
  • Your worst nightmare is again that nothing
    happens!

43
Butterfly
  • Buy one call at strike X-a
  • Sell two calls at strike X
  • Buy one call at strike Xa
  • Recover part of the cost with the collection of
    the premiums.

44
Butterfly example
45
Spread
  • Buy one call with exercise X1
  • Sell one call with exercise X2gtX1
  • The two calls must have same expiration date
  • You benefit from stocks price increase aka
    bullish spread!

46
Table 14-4 Payoff to a Bullish Spread
47
Figure 14-11 Value of a Bullish Spread Position
at Expiration
48
Why invest in a bullish spread?
  • You benefit from stocks price increase, as you
    would do with a naked call
  • However you can recover part of the costs
    associated with buying the call, by writing one
    yourself.

49
A bearish spread
  • Buy a put at one strike
  • Sell a put at a lower strike
  • Benefit from market drops!

50
An impressive jargon!
  • Collar
  • Fence
  • Cartwheel
  • Strangle
  • Wrangle
  • Calendar Spread
  • Ratio Call Spread
  • Ratio Put Spread

51
Optionlike Securities
  • Callable Bonds
  • Convertible Bonds
  • Warrants
  • Collateralized Loans

52
Figure 14-13 Value of a Convertible Bond as a
Function of Stock Price
53
Warrants
  • An option issued by a firm to purchase shares of
    firms stock
  • Call options issued by a firm
  • If exercised, the option increases number of
    outstanding shares

54
Figure 14-4 Collateralized Loan
55
Exotic Options
56
Exotic Options
  • Asian Options payoff depends on average rather
    than the final price of underlying asset
  • Barrier Options e.g. down and out option
    automatically expires worthless if stock price
    falls below barrier price
  • Lookback Options e.g. an option that provides a
    payoff equal to the maximum stock price during
    the life of the option minus the exercise price
  • Currency-Translated Options either asset or
    exercise price are denominated in foreign
    currency
  • Binary Options fixed payoff that depends on
    whether a condition is satisfied by the price of
    the underlying. E.g. payoff is 100, if price at
    maturity exceeds strike price.
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