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Chapter 17 Options

Options Marks and Strategies. 17.1Options Markets17.2Options Basics17.3Option Types17.4Option Strategies17.5Option Pricing. The Origin of Options Markets. Chicago Board Options Exchange (CBOE) pioneered standardized options in 1973.Option Contract: right to buy or sell a given amount or v

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Chapter 17 Options

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    1. Chapter 17 Options

    2. Options Marks and Strategies 17.1 Options Markets 17.2 Options Basics 17.3 Option Types 17.4 Option Strategies 17.5 Option Pricing

    3. The Origin of Options Markets Chicago Board Options Exchange (CBOE) pioneered standardized options in 1973. Option Contract: right to buy or sell a given amount or value of a particular asset at a fixed price until a given expiration date Call Option: right to buy or “call from” the market Put Option: right to sell or “put on” the market Derivative Securities: financial instruments with value stemming from changes in the value of some other asset

    4. Characteristics of Exchange-Traded Options Four types of underlying assets or interests: Equities Stock Indexes Government Debt Securities Foreign Currencies Options exchanges provide for orderly, efficient and liquid markets.

    5. Option Terms Standardized terms: nature and amount of underlying asset expiration date exercise price option type manner of contract fulfillment or settlement Open Interest: Number of outstanding options – it depends on the # of interested buyers and sellers

    6. Options Exercise (Strike) Price: promised price for underlying asset At-the-Money: when option strike price equals current market price of underlying asset In-the-Money: when call (put) strike price is less (more) than current market price of underlying asset Out-of-the-Money: when call (put) strike price is more (less) than the current market price of underlying security Option Series: options that have the same terms except for different strike prices Option Holder: buyer Option Writer: seller

    7. Options Q: What happens to call prices as the strike price increases? Q: What happens to call prices as the maturity increases? Q: What happens to put prices as the strike price increases? Q: What happens to put prices as the maturity increases?

    8. Options Contract Period: time between when an option contract is established and when it expires

    9. Actively Traded Options Most actively traded stock and index options: calls with short period until expiration ______________________________________ Short term calls more sensitive to near-term price changes. LEAPS: longer term puts and calls—up to three years before expiration; allows leverage for buy-and-holders

    10. OCC & Market Reform OCC (Options Clearing Corporation): issuer of all listed security options; clears all option transactions Multiply Traded Options: traded on more than one options market at the same time: opportunities for arbitrage On CBOE market makers provide liquidity; take opposite side of public orders.

    11. Option Basics Hedged Position: use of options to offset risk inherent in some other investment

    12. Transaction Type and Option Style American-Style Option: can be exercised any time between purchase date and expiration date European-Style Option: can only be exercised on expiration date Expiration Date: last day of an American-style option, or the single exercise date of a European-style option

    13. Option Settlement Terms Physical Delivery Option: physical delivery of an asset Cash-Settled Option: promise of a cash payment based on the difference between market and exercise price Contract Size: trading unit of underlying asset Exercise: holders execute their rights to buy or sell Triple Witching Hour: expiration date of stock & index options & futures on indexes at calendar quarters; associated with wild price swings Double Witching Hour: expiration of stock and index options and futures on indexes on other eight months’ third Fridays

    14. Option Types: Stock Options Describes options on common stocks, limited partnership interests, ADRs, preferred stocks Issuers of underlying securities do not “sign up” for option issuance Share similarities with common stocks re: trading, settlement, and ready information Stock options generally cover round lot of underlying stock

    15. Option Types: Stock Options, cont. Differences from stocks: Options have limited life (wasting asset) No ownership rights like voting or dividends

    16. Call Purchases: simple,popular strategy for bulls Buying calls gives right, but not obligation, to purchase underlying stock at specified strike price for set time. Risk limited to call premium plus commissions Profit potential unlimited

    17. Call Options Are Popular with Bullish Investors

    18. Options Strategies: Covered Calls Covered Call Strategy: simultaneous purchase of a stock and sale of a call option on same security—offsets purchase costs Because covered call writer owns underlying stock, risk is limited. Naked Short Seller: uncovered short seller—sells call for premium; faces unlimited risk

    19. Call Options Are Popular with Bullish Investors

    20. Buying Put Options: simple, popular strategy for bears Gives right, but not obligation, to sell underlying stock at specified price Risk limited to put premium plus commissions Profit limited only because stock price may not fall below zero Selling puts—expect to profit from stagnant prices; profit limited to put premium Writer of puts has obligation to buy underlying stock at predetermined price—risk limited to range of exercise price and zero

    21. Put Options Are Popular with Bearish Investors

    22. Options Strategies: Protective Puts Protective Put Strategy: simultaneous purchase of stock and purchase of put option on same security—a hedge

    23. Put Options Are Popular with Bearish Investors

    24. Option Combinations Combination: complementary option positions Spread: combination of buying and writing the same type of option (call or put) on same underlying asset Straddle: buying put and call on same security Price Spread: simultaneous purchase or sale of options on same underlying stock but with different exercise prices Time Spread: simultaneous purchase or sale of options on same stock with different exp. dates

    25. Option Combinations Bull Call Spread: purchase of low-strike-price call and the simultaneous sale of another high-strike-price call on same stock with same expiration date Bull Put Spread: sale of high-strike-price put and the simultaneous purchase of another low-strike-price put on same stock with same expiration

    26. Option Pricing Concepts Two components to option premium: Option Price = Intrinsic Value + Time Value Intrinsic Value: difference between in-the-money option’s strike price and current market price of underlying security Example: Time Value: speculative value—possibility that option may have intrinsic value at some point

    27. Black-Scholes Option Pricing Model Formula used to calculate economic values for options

    28. Black-Scholes Option Pricing Model Formula used to calculate economic values for options

    29. To Learn More About Options… Read Characteristics and Risks of Standardized Options from OCC CBOE: <http://www.cboe.com> Options Industry Council @ <www.optionscentral.com>

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