Transcript Mechanics of Options Markets Chapter 8 8.1

8.1
Mechanics of
Options Markets
Chapter 8
8.2
Types of Options
• A call is an option to buy
• A put is an option to sell
• A European option can be exercised
only at the end of its life
• An American option can be exercised at
any time
8.3
Option Positions
•
•
•
•
Long call
Long put
Short call
Short put
8.4
Long Call on Microsoft
Profit from buying a Microsoft European call option:
option price = $5, strike price = $100, option life = 2
months
30 Profit ($)
20
10
70
0
-5
80
90
100
Terminal
stock price ($)
110 120 130
8.5
Short Call on Microsoft
Profit from writing a Microsoft European call option:
option price = $5, strike price = $100
Profit ($)
5
0
-10
-20
-30
110 120 130
70
80
90 100
Terminal
stock price ($)
8.6
Long Put on Oracle
Profit from buying an Oracle European put option:
option price = $7, strike price = $70
30 Profit ($)
20
10
0
-7
Terminal
stock price ($)
40
50
60
70
80
90 100
8.7
Short Put on Oracle
Profit from writing an Oracle European put option: option
price = $7, strike price = $70
Profit ($)
7
0
-10
-20
-30
40
50
Terminal
stock price ($)
60
70
80
90 100
8.8
Payoffs from Options
What is the Option Position in Each Case?
X = Strike price, ST = Price of asset at maturity
Payoff
Payoff
X
X
ST
Payoff
ST
Payoff
X
X
ST
ST
8.9
Assets Underlying
Exchange-Traded Options
•
•
•
•
Stocks
Foreign Currency
Stock Indices
Futures
8.10
Specification of
Exchange-Traded Options
•
•
•
•
Expiration date
Strike price
European or American
Call or Put (option class)
8.11
Terminology
Moneyness :
–At-the-money option
–In-the-money option
–Out-of-the-money option
8.12
Terminology
(continued)
•
•
•
•
Option class
Option series
Intrinsic value
Time value
8.13
Time Value and Intrinsic Value
for a Call
In
Out
Time Value
Intrinsic Value
X
S
8.14
Time and Intrinsic Value
for Put Option
Out
In
Time Value
X
S
8.15
Dividends & Stock Splits
• Suppose you own N options with a strike
price of X :
– No adjustments are made to the option
terms for cash dividends
– When there is an n-for-m stock split,
• the strike price is reduced to mX/n
• the no. of options is increased to nN/m
– Stock dividends are handled in a manner
similar to stock splits
8.16
Dividends & Stock Splits
(continued)
• Consider a call option to buy 100
shares for $20/share
• How should terms be adjusted:
– for a 2-for-1 stock split?
X* = 20/2 = 10
N* = 2x100 = 200
– for a 5% stock dividend?
X* = 20/1.05 = 19.05
N* = 1.05x100 = 105
8.17
Market Makers
• Most exchanges use market makers to
facilitate options trading
• A market maker quotes both bid and
ask prices when requested
• The market maker does not know
whether the individual requesting the
quotes wants to buy or sell
Margins
• Margins are not required when options are
bought
• Margins are required when options are sold
and position is uncovered
• Smaller margin is required for when written
option is out of the money.
• Margins are not required when written
options is fully covered
• See pages 174-175 for details (if interested)
• General rule: margin is required only when
strategy creates a future obligation
8.18
8.19
Convertible Bonds
• Convertible bonds are regular bonds
that can be exchanged for equity at
certain times in the future according to
a predetermined exchange ratio
8.20
Convertible Bonds
(continued)
• Very often a convertible is callable
• The call provision is a way in which
the issuer can force conversion at a
time earlier than the holder might
otherwise choose
8.21
Over-the-Counter Markets
• Options are frequently negotiated in the
over-the-counter market
• The strike price and time to maturity do
not then have to correspond to those
specified by an exchange
8.22
Exotic Options
Nonstandard options trading
over-the counter include:
• Barrier options
• Asian options
• Binary options
• Chooser options
• Compound options