9.1 mechanics of options markets chapter 9. 9.2 types of options a call is an option to buy a put is...
TRANSCRIPT
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9.1
Mechanics of Options Markets
Chapter 9
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9.2
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
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9.3
Option Positions
Long callLong putShort callShort put
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Payoff versus Profit
Payoff (or terminal cash flow) is gross of the premium paid or received up-front.
Profit is payoff minus or plus premium:
If purchase option, minus premium.
If write option, plus premium. Purchase Call payoff = Max (0, ST – K) Purchase Call profit = Max (0, ST – K) - c
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9.5
Payoffs from OptionsWhat is the Option Position in Each Case? K = Strike price, ST = Price of asset at maturity
Payoff Payoff
ST STK
K
Payoff Payoff
ST STK
K
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9.6
Long Call
Profit from buying one European call option: option price = $5, strike price = $100.
30
20
10
0-5
70 80 90 100
110 120 130
Profit ($)
Terminalstock price ($)
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9.7
Short Call
Profit from writing one European call option: option price = $5, strike price = $100
-30
-20
-10
05
70 80 90 100
110 120 130
Profit ($)
Terminalstock price ($)
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9.8
Long Put
Profit from buying a European put option: option price = $7, strike price = $70
30
20
10
0
-770605040 80 90 100
Profit ($)
Terminalstock price ($)
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9.9
Short Put
Profit from writing a European put option: option price = $7, strike price = $70
-30
-20
-10
7
070
605040
80 90 100
Profit ($)Terminal
stock price ($)
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9.10
Assets UnderlyingExchange-Traded Options
Stocks Foreign Currency Stock Indices Futures
Distinct variables plotted on X-axis.
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Futures Options
Exercise of a Call results in: Long position in futures contract* + cash (=Futures price – Strike Price)
Exercise of a Put results in: Short position in futures contract* + cash (=Strike Price – Futures Price)
*Futures contract has a value of zero
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9.12
Specification ofExchange-Traded Options
Company Call or Put Expiration date Strike price Option class: company & call or put Option series: IBM 70 Oct’11 Calls
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9.13
Terminology
Moneyness :At-the-money option:
value of underlying asset = exercise price
In-the-money option: immediate exercise generates positive payoff.
Out-of-the-money option: immediate exercise generates negative payoff.
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9.14
Terminology(continued)
Option class: company cum call or put
Option series: all options w/in a class with samestrike price and expiration date
Intrinsic value (nonnegative): extent to which option is in-the-money, positive payoff that can be generated now
Time value Option premium = Intrinsic Value + Time Value
(tautology; dichotomy is valid only for American options)
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Dividends & Stock Splits
Exchange-traded options are not cash dividend protected
Cash dividends: adverse events for call owners and put writers
Exchange-traded options are stock dividend and stock split protected
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9.16
Dividends & Stock Splits
Suppose you own an option on N share 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
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Stock Split adjustments to number of shares and exercise price
n for m stock split:
mnK
K
m
nNN
o
o
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Stock Dividend adjustments to number of shares and exercise price
x% stock dividend:
%)1(
%)1(
x
KK
xNN
o
o
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9.19
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?
N=100(2)=200, K =$20/(2)=$10
for a 5% stock dividend? N=100(1.05)=105, K=$20/1.05=$19.05
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9.20
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
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Margins for Long Position
Option maturity < 9 months: 100% margin Option maturity = or > 9 months: at least
75% margin, i.e., at most 25% financed with debt.
Margin means equity (not debt), as in stock trading.
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9.22
Margins for Short Position Margins are required when options are sold For example when a naked call option is written the
margin is 100% of the proceeds of the sale and then some.
Margin means good faith money (not equity) as in futures trading.
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9.23
(Share Purchase) Warrants
Warrants are options that are issued (or written) by a corporation or a financial institution
The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire
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9.24
Warrants(continued)
Warrants are traded in the same way as stocks
The issuer settles up with the holder when a warrant is exercised
Dilution Effect: When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued.
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9.25
Executive Stock Options
Option issued by a company to executives Dilution Effect: When the option is
exercised the company issues more stock Usually at-the-money when issued
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9.26
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 are changing to
require the expensing of executive stock options
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9.27
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
Dilution Effect is present.
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9.28
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
Company can force conversion by calling when call price is less than conversion value of the convertible bond
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Forced Conversion Example
Conversion ratio = 2 (shares) Call price = $110 Stock price = $60 Conversion value = 2($60) = $120 If convertible is called, conversion will
occur perforce