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

20

10

0-5

70 80 90 100

110 120 130

Profit ($)

Terminalstock price ($)

8.5

Short Call on Microsoft Profit from writing a Microsoft European call option:

option price = $5, strike price = $100

-30

-20

-10

05

70 80 90 100

110 120 130

Profit ($)

Terminalstock price ($)

8.6

Long Put on Oracle Profit from buying an Oracle European put option:

option price = $7, strike price = $70

30

20

10

0

-770605040 80 90 100

Profit ($)

Terminalstock price ($)

8.7

Short Put on Oracle

Profit from writing an Oracle European put option: option price = $7, strike price = $70

-30

-20

-10

7

070

605040

80 90 100

Profit ($)Terminal

stock price ($)

8.8Payoffs from OptionsWhat is the Option Position in Each Case?

X = Strike price, ST = Price of asset at maturity

Payoff Payoff

ST STX

X

Payoff Payoff

ST STX

X

8.9

Assets UnderlyingExchange-Traded Options

• Stocks

• Foreign Currency

• Stock Indices

• Futures

8.10

Specification ofExchange-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 Valuefor a Call

SX

Out In

Time ValueIntrinsic Value

8.14

Time and Intrinsic Value for Put Option

SX

In Out

Time Value

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 = 10N* = 2x100 = 200

– for a 5% stock dividend?X* = 20/1.05 = 19.05N* = 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

8.18

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

8.19

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 OptionsNonstandard options trading over-the counter include:

• Barrier options• Asian options• Binary options• Chooser options• Compound options