Chap 8
- 1. Mechanics of Options Markets Chapter 8
- 2. Review of Option Types 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
- 3. Option Positions Long call Long put Short call Short put
- 4. Long Call on eBay (Figure 8.1, Page 18 2 ) Profit from buying one eBay European call option: option price = $5, strike price = $100, option life = 2 months 30 20 10 0 -5 70 80 90 100 110 120 130 Profit ($) Terminal stock price ($)
- 5. Short Call on eBay (Figure 8.3, page 18 4 ) Profit from writing one eBay European call option: option price = $5, strike price = $100 -30 -20 -10 0 5 70 80 90 100 110 120 130 Profit ($) Terminal stock price ($)
- 6. Long Put on IBM (Figure 8.2, page 18 3 ) Profit from buying an IBM European put option: option price = $7, strike price = $70 30 20 10 0 -7 70 60 50 40 80 90 100 Profit ($) Terminal stock price ($)
- 7. Short Put on IBM (Figure 8.4, page 18 4 ) Profit from writing an IBM European put option: option price = $7, strike price = $70 -30 -20 -10 7 0 70 60 50 40 80 90 100 Profit ($) Terminal stock price ($)
- 8. Payoffs from Options What is the Option Position in Each Case? K = Strike price, S T = Price of asset at maturity Payoff Payoff S T S T K K Payoff Payoff S T S T K K
- 9. Assets Underlying Exchange-Traded Options Page 18 5 -18 6 Stocks Foreign Currency Stock Indices Futures
- 10. Specification of Exchange-Traded Options Expiration date Strike price European or American Call or Put (option class)
- 11. Terminology Moneyness : At-the-money option In-the-money option Out-of-the-money option
- 12. Terminology (continued) Option class Option series Intrinsic value Time value
- 13. Dividends & Stock Splits (Page 18 8 -1 90 ) Suppose you own N options with a strike price of K : 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 mK / n the no. of options is increased to nN / m Stock dividends are handled in a manner similar to stock splits
- 14. 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? for a 5% stock dividend?
- 15. 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
- 16. Margins (Page 194-19 5 ) Margins are required when options are sold When a naked option is written the margin is the greater of: A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money A total of 100% of the proceeds of the sale plus 10% of the underlying share price For other trading strategies there are special rules
- 17. Warrants Warrants are options that are issued by a corporation or a financial institution The number of warrants outstanding is determined by the size of the original issue and changes only when they are exercised or when they expire
- 18. Warrants (continued) The issuer settles up with the holder when a warrant is exercised When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued
- 19. Executive Stock Options Executive stock options are a form of remuneration issued by a company to its executives They are usually at the money when issued When option s are exercised the company issues more stock and sells it to the option holder for the strike price
- 20. Executive Stock Options continued They become vested after a period of time (usually 1 to 4 years) They cannot be sold They often last for as long as 10 or 15 years Accounting standards now require the expensing of executive stock options
- 21. 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 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