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Mechanics of Options Markets Types of Options Mechanics of Options Markets A call is an option to buy A put is an option to sell Chapter 9 A European option can be exercised only at the end of its life An American option can be exercised at any time Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 1 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 2 Option Positions Long Call (Figure 9.1, Page 207) Profit from buying one European call option: option price = $5, strike price = $100. Long call Long put 30 Profit ($) Short call 20 Short put 10 Terminal 70 80 90 100 stock price ($) 0 -5 110 120 130 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 3 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 4 Short Call Long Put (Figure 9.3, page 208) (Figure 9.2, page 208) Profit from writing one European call option: option price Profit from buying a European put option: option price = = $5, strike price = $100 $7, strike price = $70 Profit ($) 30 Profit ($) 5 110 120 130 0 20 70 80 90 100 Terminal -10 stock price ($) 10 Terminal stock price ($) -20 0 4050 60 70 80 90 100 -7 -30 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 5 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 6 Short Put Payoffs from Options (Figure 9.4, page 209) What is the Option Position in Each Case? K = Strike price, S = Price of asset at maturity Profit from writing a European put option: option price = T $7, strike price = $70 Payoff Payoff Profit ($) K Terminal 7 K S S 40 50 60 stock price ($) T T 0 70 80 90 100 Payoff Payoff -10 K -20 K ST ST -30 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 7 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 8 Assets Underlying Specification of Exchange-Traded Options Exchange-Traded Options Page 210-211 Expiration date Stocks Strike price Foreign Currency European or American Stock Indices Call or Put (option class) Futures Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 9 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 10 Terminology Terminology (continued) Moneyness : Option class At-the-money option Option series In-the-money option Intrinsic value Out-of-the-money option Time value Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 11 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 12 Dividends & Stock Splits Dividends & Stock Splits (continued) (Page 213-214) Suppose you own options with a strike price of K to buy (or sell) N shares: Consider a call option to buy 100 No adjustments are made to the option shares for $20/share terms for cash dividends How should terms be adjusted: When there is an n-for-m stock split, for a 2-for-1 stock split? the strike price is reduced to mK/n the no. of shares that can be bought (or for a 5% stock dividend? sold) is increased to nN/m Stock dividends are handled in a manner similar to stock splits Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 13 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 14 Margins (Page 217-218) Market Makers Margins are required when options are sold Most exchanges use market makers to For example, when a naked call option is written in facilitate options trading the US, the margin is the greater of: 1 A total of 100% of the proceeds of the sale plus A market maker quotes both bid and ask 20% of the underlying share price less the prices when requested amount (if any) by which the option is out of the money The market maker does not know whether 2 A total of 100% of the proceeds of the sale plus the individual requesting the quotes wants 10% of the underlying share price to buy or sell Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 15 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 16 Warrants Warrants (continued) Warrants are traded in the same way as Warrants are options that are issued (or stocks written) by a corporation or a financial The issuer settles up with the holder institution when a warrant is exercised The number of warrants outstanding is When call warrants are issued by a determined by the size of the original corporation on its own stock, exercise issue & changes only when they are will lead to new treasury stock being exercised or when they expire issued Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 17 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 18 Convertible Bonds Executive Stock Options Option issued by a company to executives When the option is exercised the company Convertible bonds are regular bonds issues more stock that can be exchanged for equity at Usually at-the-money when issued certain times in the future according to a predetermined exchange ratio Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 19 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 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 Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright © John C. Hull 2010 21.
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