OPTIONS

1. OPTIONS Introduction Week 2 FIN 4486

2. What is an Option? • A call option is a financial instrument that gives the buyer the right, but not the obligation, to purchase the underlying asset at a pre-specified price on or before a specified date • A put option is a financial instrument that gives the buyer the right, but not the obligation, to sell the underlying asset at a pre-specified price on or before a specified date

3. Option Writer • The person who writes the call or put and receives a premium • Option Buyer • The person who buys the call or put and pays the premium

4. Types of Options • Stock Options • Index Options • Currency Options • Other Types of Traded Options • interest rate options • currency options • options attached to bonds • exotic options • warrants, callable bonds, convertible bonds • executive options • Real Options

5. Option Terminology • Buy - Long • Sell - Short • Call • Put • Key Elements • Exercise or Strike Price • Premium or Price • Maturity or Expiration

6. American vs European Options American - the option can be exercised at any time before expiration or maturity European - the option can only be exercised on the expiration or maturity date

7. Options Exchanges and Trading Activity • See Table 2.1, p. 29 for options exchanges

8. 14 - 8 Option Price Quotes

9. Option Price Quotes • A list of available option contracts and their prices for a particular security arrayed by strike price and maturity is known as an option chain.

10. Specification ofExchange-Traded Options • Expiration date • Strike price • European or American • Call or Put (option class)

11. Option Traders • The Market Maker • Bid, ask, and bid-ask spread • Scalpers, position traders, spreaders • The Floor Broker • Designated primary market makers • Dual trading • The Order Book Official • Limit orders • Electronic order processing

12. Options Traders (continued) • Other Option Trading Systems • Specialists • Registered options traders • Electronic trading systems • Off-Floor Option Traders • Cost and Profitability of Exchange Membership • See Figure 2.1, p. 32 for CBOE seat prices • Leasing a seat • High risk, stressful work

13. The Mechanics of Trading • Placing an Opening Order • Types of orders • The Role of the Clearinghouse • The Options Clearing Corporation (OCC) • Clearing firms • See Figure2.2, p. 34 • Margin (see Appendix 2.A) • Open interest

14. The Mechanics of Trading (continued) • Placing an Offsetting Order • In the exchange-listed options market • In the over-the-counter options market • Exercising an Option • European vs. American style • Assignment • Cash settlement

15. Option Obligations

16. Why Options? • Should you buy 100 IBM shares at $90 each ($9,000 investment), or should you buy a call option with a strike price of $90 expiring in three months at $500 ($5 per share)? • Three months later, Buy Shares Buy Option ProfitReturnProfitReturn Case 1: $100 $1,000 11.11% $500 100% Case 2: $90 $0 0% -$500 -100% Case 3: $80 -$1,000 -11.11% -$500 -100%

17. Option Value The value of an option at expiration is a function of the share price and the exercise price. Example - Option values given an exercise price of $4.50

18. A call option is like a rain check. • You spot an ad in the newspaper for an item you really want.  • By the time you get to the store, the item is sold out.  • the manager offers you a rain check  • You now hold a call option on the product • You do not have to use the rain check. You do so only at your own option. • If the price of the product is lowered further before you return, you would let the rain check expire and buy the item at the lower price.

19. Options are Contracts • The option contract specifies: • The underlying instrument • The quantity to be delivered • The price at which delivery occurs • The date that the contract expires • Three parties to each contract • The Buyer • The Writer (seller) • The Clearinghouse

20. The Option Buyer • The purchaser of an option contract is buying the right to exercise the option against the seller. • Purchasing this right conveys no obligations to the buyer, the buyer can let the option expire if they so desire. • The price paid for this right is the option premium.

21. The Option Writer • The seller of an option contract is accepting the obligation to have the option exercised against her, and receiving the premium in return. • If it is a call, sell the stock to the option buyer at the exercise price • If it is a put, buy the stock from the put buyer at the exercise price

22. Option Values • Intrinsic value - profit that could be made if the option was immediately exercised • Call: stock price - exercise price • Put: exercise price - stock price • Time value - the difference between the option price and the intrinsic value

23. Market and Exercise Price Relationships In the Money - exercise of the option would be profitable Out of the Money - exercise of the option would not be profitable At the Money - exercise price and asset price are equal

24. The Options Clearing Corporation • The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised. • The OCC issues and clears all option contracts trading on U.S. exchanges. • Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC).

25. Option Valuation • The value of an option is the present value of its intrinsic value at expiration. Unfortunately, there is no way to know this intrinsic value in advance. • The most famous option pricing model is the Black-Scholes OPM (covered in our next class)

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29. http://www.21stcenturyinvestor.com/page/education/tco/courses/http://www.21stcenturyinvestor.com/page/education/tco/courses/ A free options education course is offered here by my friend Bill Johnson and 21st Century Investors…it is REALLY helpful