Chapter 9 Options

Chapter 9Mechanics of Options Markets

Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 1

Review of Option TypesA call is an option to buyA put is an option to sellA European option can be exercised only at the end of its lifeAn American option can be exercised at any time


Option PositionsLong callLong putShort callShort put


Long Call (Figure 9.1, Page 195)

Profit from buying one 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 ($)

Short Call (Figure 9.3, page 197) Profit from writing one European call option: option

price = $5, strike price = $100


-30

-20

-10

05

70 80 90 100

110 120 130

Profit ($)


Long Put (Figure 9.2, page 196)

Profit from buying a European put option: option price = $7, strike price = $70


30

20

10

0

-770605040 80 90 100

Profit ($)


Short Put (Figure 9.4, page 197)

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


-30

-20

-10

70

70

605040

80 90 100

Profit ($)Terminal

stock price ($)

Payoffs from OptionsWhat is the Option Position in Each Case?

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


Payoff Payoff

ST STKK

PayoffPayoff

ST STKK

Assets UnderlyingExchange-Traded Options

StocksForeign CurrencyStock IndicesFutures


Specification ofExchange-Traded Options

Expiration dateStrike priceEuropean or AmericanCall or Put (option class)


Terminology Moneyness :

At-the-money optionIn-the-money optionOut-of-the-money option


12

13

14

15

16

17

18

Dividends & Stock Splits

Suppose you own N options with a strike price of K :No adjustments are made to the option terms for cash dividendsWhen there is an n-for-m stock split,

• the strike price is reduced to mK/n • the no. of options is increased to nN/m

Stock dividends are handled similarly to stock splits. A stock dividend involves a company issuing more shares to its existing shareholders. For example,1 20% stock dividend means that investors receive one new share for each five already owned. The 20% stock dividend is essentially the same as a 6-for-5 split.


ExamplesExample 1:

Consider a call option to buy 100 shares of a company for $30 per share. Suppose the company makes a 2-for-1 stock split. The terms of the option contracts are then changed so that it gives the holder the right to purchase 200 shares for $15 per shares.

Example 2:

Consider a put option to sell 100 shares of a company for $15 per share. Suppose the company declares a 25% stock dividend. This is equivalent to a 5-for-4 stock split. The terms of the option contract are changed so that it gives the holder the right to sell 125 shares $12.


Market MakersMost exchanges use market makers to facilitate options tradingA market maker quotes both bid and ask prices when requestedThe market maker does not know whether the individual requesting the quotes wants to buy or sell


WarrantsWarrants are options that are issued by a corporation or a financial institutionThe number of warrants outstanding is determined by the size of the original issue and changes only when they are exercised or when they expire


Warrants(continued)

The issuer settles up with the holder when a warrant is exercisedWhen call warrants are issued by a corporation on its own stock, exercise will usually lead to new treasury stock being issued


Employee Stock Options (see also Chapter 15)

Employee stock options are a form of remuneration issued by a company to its executivesThey are usually at the money when issuedWhen options are exercised the company issues more stock and sells it to the option holder for the strike priceExpensed on the income statement


Convertible BondsConvertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratioUsually a convertible is callableThe call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose


Documents

Chapter 9 Options