Chapter 14Options MarketsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter OutlineBackground on optionsSpeculating with stock optionsDeterminants of stock option premiumsExplaining changes in option premiumsHedging with stock optionsUsing options to measure a stocks risk

Chapter Outline (contd)Options on ETFs and stock indexesOptions on futures contractsHedging with options on futuresInstitutional use of options marketsGlobalization of options markets

Background on OptionsA call option grants the owner the right to purchase a specified financial instrument for a specified price (exercise or strike price) within a specified period of timeGrants the right, but not the obligation, to purchase the specified investmentThe writer of a call option is obligated to provide the instrument at the price specified by the option contract if the owner exercises the optionA call option is:In the money when the market price of the underlying security exceeds the strike priceAt the money when the market price is equal to the strike priceOut of the money when the market price is below the strike price

Background on Options (contd)A put option grants the owner the right to sell a specified financial instrument for a specified price within a specified period of timeGrants the right, but not the obligation, to sell the specified investmentA put option is:In the money when the market price of the underlying security is below the strike priceAt the money when the market price is equal to the strike priceOut of the money when the market price is above the strike price

Background on Options (contd)Call and put options specify 100 shares for stocksPremiums paid for call and put options are determined through open outcry on the exchange floorParticipants can close out their option positions by taking an offsetting positionThe gain or loss is determined by the premium paid when purchasing the option and the premium received when selling the optionAmerican-style options can be exercised at any time prior to expirationEuropean-style options can be exercise only just before expiration

Background on Options (contd)Markets used to trade optionsThe CBOE:Is the most important exchange for trading optionsServes as the market for options on more than 1,500 different stocksLists standardized optionsAccounts for about 51 percent of all option tradingOptions are also traded on the AMEX, Philadelphia Stock Exchange, Pacific Stock Exchange, and the International Securities Exchange

Background on Options (contd)Markets used to trade options (contd)Listing requirementsEach exchange has its own requirementsOne key requirement is a minimum trading volume of the underlying stocksRole of the Options Clearing Corporation (OCC)The OCC serves as a guarantor on option contracts traded in the U.S.Regulation of options tradingThe SEC and the various option exchanges regulate option tradingRegulations:Are intended to ensure fair and orderly trainingAttempt to prevent insider tradingAttempt to prevent price fixing among floor brokers

Background on Options (contd)How option trades are executedFloor brokers execute transactions desired by investorsSome orders are executed electronically without a floor brokerMarket-makers:Can execute stock option transactions for customersTrade options on their own accountMay facilitate a buy order for one customer and a sell order for a different customerEarn the difference between the bid price and the ask price for the option

Background on Options (contd)Types of ordersA market order results in the immediate purchase or sale of an option at the prevailing market priceWith a limit order, the transaction will occur only if the market price is no higher or lower than a specified price limitOnline tradingMany online brokerage firms, like E*Trade and Datek, facilitate options orders

Background on Options (contd)Stock option quotationsFinancial newspapers and some local newspapers publish quotations for stock options (see next slide)Options with higher exercise prices have lower call premiums and higher put premiumsOptions with a longer maturity have higher call option premiums and higher put option premiums

Background on Options (contd)Stock option quotations (contd)

Speculating with Stock OptionsSpeculating with call optionsCall options can be used to speculate on the expectation of an increase in the price of the underlying stockAssuming that the buyer of the option sells the stock when exercising the option and that the writer will obtain the stock only when the option is exercised, the writers net gain is the buyers net loss, assuming zero transaction costsThe maximum loss for the buyer of a call option is the premium, while the maximum gain is unlimitedThe maximum gain for the writer of a call option is the premium, while the maximum loss is unlimited

Speculating with Call Options

Pete expects ABC stock to increase from its current price of $90 per share. He purchases a call option on ABC stock with an exercise price of $92 for a premium of $4 per share. ABC stock rises to $97 prior to the options expiration date. If Pete exercises the option and immediately sells the shares in the market, what is his net gain from the transaction?

Speculating with Call Options (contd)

Draw the contingency graph for the buyer of the call option and the writer of the call option.

-40049696Buyers PerspectiveWriters PerspectiveProfitStock PriceAt Expiration

Speculating with Stock Options (contd)Speculating with call options (contd)Assume that ABC stock has three call options available:Call option 1: Exercise price = $87; Premium = $7Call option 1: Exercise price = $90; Premium = $5Call option 1: Exercise price = $92; Premium = $4The risk-return potential varies among the several options that are availableThe contingency graph for all three options is shown on the next slideThe graph can be revised to reflect returns for each possible price per share of the underlying stock

Speculating with Stock Options (contd)-4096Call option 3Call option 295-5-794Call option 1Profit or LossPer ShareStock Price of ABC Stock

Speculating with Stock Options (contd)Speculating with put optionsPut options can be used to speculate on the expectation of a decrease in the price of the underlying stockThe maximum gain for the buyer of a put option is the exercise price less the premium, while the maximum loss is the premiumThe maximum loss for the writer of a put option is the exercise price less the premium, while the maximum gain is the premium

Speculating with Put Options

Mary expects XYZ stock to decrease from its current price of $54. Thus, she purchases a put option on XYZ stock with an exercise price of $53 and a premium of $2. If the stock price of XYZ stock is $47 when the option expires, what is Marys net gain?

Speculating with Put Options (contd)

Draw the contingency graph for the buyer of the put option and the writer of the put option.

-20025151Buyers PerspectiveWriters PerspectiveProfitStock PriceAt Expiration5151

Speculating with Stock Options (contd)Excessive risk from speculationFirms should closely monitor the trading of derivative contracts by their employees to ensure that derivatives are being used within the firms guidelinesFirms should separate the reporting function from the trading function so that traders cannot conceal trading lossesWhen firms receive margin calls on derivative positions, they should recognize that there may be potential losses on their derivative instruments

Determinants of Stock Option PremiumsThe option premium must be sufficiently high to equalize the demand by buyers and the supply that sellers are willing to sellDeterminants of call option premiumsInfluence of the market priceThe higher the existing market price of the underlying financial instrument relative to the exercise price, the higher the call option premiumInfluence of the stocks volatilityThe greater the volatility of the underlying stock, the higher the call option premiumInfluence of the call options time to maturityThe longer the call options time to maturity, the higher the call option premium

Determinants of Stock Option Premiums (contd)Determinants of put option premiumsInfluence of the market priceThe higher the existing market price of the underlying financial instrument relative to the exercise price, the lower the put option premiumInfluence of the stocks volatilityThe greater the volatility of the underlying stock, the higher the put option premiumInfluence of the put options time to maturityThe longer the call options time to maturity, the higher the put option premium

Explaining Changes in Option PremiumsEconomic conditions and market conditions can cause abrupt changes in the stock rice or in the anticipated volatility of the stock priceThis would have a major impact on the stock option premiumIndicators monitored by participants in the option marketOption market participants closely monitor the indicators that are monitored for stocks:Economic indicators, industry-specific conditions, firm-specific conditions

Hedging with Stock OptionsMutual funds, insurance companies, and pension funds manage large stock portfolios and use options on stocks and stock indexes to hedgeHedging with call optionsA covered call involves the sale of a call option with a simultaneous long position in the stock

Writing A Covered Call

Philly Mutual Fund owns 100 shares of ABC stock. Philly believes that the stock price will decline temporarily from its current price of $90, but does not want to liquidate its position because of transaction costs. Consequently, Philly writes one call option on ABC stock with an exercise price of $88 and a premium of $6. Construct a contingency graph showing Phillys position with covered call writing and without covered call writing.

Writing A Covered Call (contd)

With Covered Call Writing038885Without Covered CallWriting90

Hedging with Stock Options (contd)Hedging with put optionsIf an institution with a long position in a stock is concerned about a decline in the stock price, it could hedge against a temporary decline by purchasing put options on that stock Put options are typically used to hedge when portfolio managers are concerned about a temporary decline in a stocks value

Using Options to Measure a Stocks RiskStock options can be used to drive the markets anticipation of a stocks standard deviation over the life of the optionThe option-pricing model can be used to derive the implied standard deviation of a stockThe implied standard deviation increases when a firm experiences an event that creates more uncertainty

Options on ETFs and Stock IndexesAn ETF option provides the right to trade a specified ETF at a specified price by a specified expiration dateSince ETFs are traded like stocks, options on ETFs are traded like options on stocksInvestors who exercise a call option on an ETF would receive delivery of the ETF in their account

Options on ETFs and Stock Indexes (contd)A stock index option provides the right to trade a specified stock index at a specified price by a specified expiration dateOptions are offered on the S&P 100 index, the S&P 500 index, S&P SmallCap 600 Index, Dow Jones Industrial Average, Nasdaq 100 Index, Goldman Sachs Internet Index, among othersIf an index option is exercised, the cash payment is equal to a specified dollar amount multiplied by the difference between the index level and the exercise priceSpeculators who anticipate a sharp increase in the stock market would purchase call options on an indexSpeculators who anticipate a decrease in the stock market would purchase put options on an index

Options on ETFs and Indexes (contd)Hedging with stock index optionsPortfolio managers consider purchasing put options on a stock index to protect against stock market declinesThe put options should be purchased on the stock index that most closely mirrors the portfolio to be hedgedThe greater the market downturn, the greater the decline in the market value of the portfolio, but the greater the gain from holding put options on a stock indexHedging with long-term stock index optionsLong-term equity anticipations (LEAPs) have expiration dates at least two years ahead with a lower premium

Options on ETFs and Indexes (contd)Dynamic asset allocation with stock index optionsDynamic asset allocation involves switching between risky and low-risk investment positions over time in response to changing expectationse.g., portfolio managers purchase call options under favorable conditions and put option under unfavorable conditionse.g., write call options when the stock market is expected to be very stablePortfolio managers can select the exercise price that provides the desired protectione.g., buy put options with an exercise price of 380 if the current level of the index is 400 and a 5 percent loss is acceptable

Options on ETFs and Indexes (contd)Using index options to measure the markets riskA stock indexs implied volatility can be derived from information about options on that stock indexImpact of the September 11 Crisis on the implied volatility of stock indexesThe attacks caused more uncertainty about the future value of stocksImplied volatility increased when the markets reopened on September 17

Options on Futures ContractsAn option on a futures contract allows the right to purchase or sell that futures contract for a specified price within a specified period of timeOptions on futures grant the power to take the futures position if favorable conditions occur but the flexibility to avoid the future position if unfavorable conditions occurOptions are available on stock index futures and on interest rate futures

Options on Futures Contracts (contd)Speculating with options on futuresSpeculation based on an expected decline in interest ratesSpeculators may consider purchasing a call option on Treasury bond futuresWhen interest rates decline, buyers of call options would sell the option just before expirationIf interest rates rise, buyers of call options will let the options expireSpeculators who expect interest rates to remain stable or decline could sell put options on Treasury bond futures

Speculating on a Decrease in Rates with Options on Futures

Kevin Phelps expects interest rates to decline and purchases a call option on Treasury bond futures with an exercise price of 9240. The option has a premium of 200. Shortly before the expiration date, the price of Treasury bond futures rises to 9500. Kevin exercises the option and closes out the position by selling an identical futures contract. What it is net gain from this strategy?

Options on Futures Contracts (contd)Speculating with options on futures (contd)Speculation based on an expected increase in interest ratesSpeculators who expect interest rates to increase could purchase a put option on Treasury bond futuresIf interest rates rise, the speculator can exercise the option to sell futures at the exercise price and purchase futures at a lower price than the price at which they sold futuresIf interest rates decline, the speculators will let the options expireSpeculators who anticipate an increase in interest rates may consider selling call options on Treasury bond futures

Speculating on an Increase in Rates with Options on Futures

Barnie Blythe expects interest rates to increase and purchases a put option on Treasury bond futures with an exercise price of 9800 and a premium of 200. Just prior to the expiration date, the price of Treasury bond futures is valued at 9412. What is Barnies net gain from this strategy if he exercises the option and closes out the position by purchasing an identical futures contract?

Hedging with Options on FuturesHedging with options on interest rate futuresFinancial institutions commonly hedge bond or mortgage portfolios using options on interest rate futuresThe position is designed to create a gain that can offset a loss on the bond or mortgage portfolioPut options on futures offer more flexibility than selling futures but require a premiumInstitutions wishing to hedge against interest rate risk should compare outcomes from selling futures contract versus buying put options on interest rate futures

Hedging with Options on Futures (contd)Hedging with options on stock index futuresThe position taken on the options contract is designed to create a gain that can offset a loss on the stock portfolioDetermining the degree of the hedge with options on stock index futuresThe higher the strike price relative to the prevailing index value, the higher the price at which the investor can lock in the sale of the index, but the higher the premiumSelling call options to cover the cost of put optionsSelling call options can generate some fees to help cover the cost of purchasing put options

Institutional Use of Options MarketsOptions positions are sometimes taken by financial institutions for speculative purposes, but more commonly for hedgingSavings institutions and bond mutual funds use options on interest rate futures to hedge interest rate riskStock mutual funds, insurance companies, and pension funds use stock index options and options on stock index futures to hedge stock portfolios

Institutional Use of Options Markets (contd)Options as compensationSome institutions distribute call options on their own stock to their managers as compensationManagers may have an incentive to make decisions that increase the stocks valueDistortion between performance and option compensationMany option compensation programs do not account for general market conditionse.g., managers who received option during the 20012002 period may have earned low compensation even if their firm performed relatively well

Institutional Use of Options Markets (contd)Options as compensation (contd)How stock option compensation can destroy shareholder valueManagers may be enticed to manipulate the stocks price upward in the near future even if it adversely affects the stock price in the futuree.g., use accounting methods that defer expenses and accelerate revenue reportingReporting option compensation as an expenseThe FASB has been unwilling to require firms to report this expense on the income statementEarnings will appear higher when a firm uses stock options to compensate its managers

Globalization of Options MarketsOptions on stock indexes of various countries are availableThe existence of options on foreign stock indexes allows portfolio managers to hedge or speculate based on forecasts of foreign market conditionsCurrency options contractsA currency call option provides the right to purchase a specified currency for a specified price within a specified period of timeA currency put option provides the right to sell a specified currency for a specified price within a specified period of timeCorporations use currency options to hedge foreign payables and receivablesSpeculators purchase put options on currencies they expect to weaken against the dollar