Investments: Analysis and Behavior Chapter 18- Options Markets and Strategies ©2008 McGraw-Hill/Irwin.

Investments: Analysis and Behavior

Chapter 18- Options Markets

and Strategies

©2008 McGraw-Hill/Irwin

18-2

Learning Objectives

Understand the characteristics of call and put options Know the uses of index options Be able to implement covered call and protective put

strategies Utilize Black-Scholes option pricing

18-3

Options Markets

Derivative securities: value is derived or stems from changes in the value of some other assets.

Call option: the right (but not obligation) to buy Put option: the right (but not obligation) to sell

Total volume - 1.5 billion contracts (2005)

The most popular options - equity options

18-4

Figure 18.1 Trading Activity in Equity Options Contracts Has Risen Sharply

0

200,000,000

400,000,000

600,000,000

800,000,000

1,000,000,000

1,200,000,000

1,400,000,000

1,600,000,000

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

OC

C T

otal

Yea

rly

Cle

ared

Con

trac

t V

olum

e Total Contract Volume

Equity Options

Non-Equity Options

Source: Options Clearing Corporation

18-5

Characteristics of Exchange Traded Options

Four types of underlying assets Equity securities Stock indexes government debt securities foreign currencies

Have standardized terms Trading activity is determined by supply and demand Option interest: number of outstanding options

18-6

Exercise price (or Strike price): Promised or predetermined price for underlying assets

At-the-money: when option price equals current market price of underlying assets

In-the-money: when the strike price is less (more) than the market price of the underlying asset for a call (put)

Out-of-money: when the strike price is more (less) than the market price of the underlying asset for call (put)

18-7

Figure 18.2 Call and Put Options Quotes and Volume on Microsoft, CBOE

MSFT   26.93   -0.04

Mar 05, 2006 @ 18:27 ET (Data 15 Minutes Delayed) Bid 26.93   Ask 26.93   Size 14x146   Vol 45234151

CallsLast Sale

Net Bid Ask VolOpen

IntPuts

Last Sale

Net Bid Ask VolOpen

Int

06 Mar 22.50 (MSQ CX-E)

4.60 pc 4.40 4.50 0 667 06 Mar 22.50 (MSQ OX-E)

0.05 pc 0 0.05 0 110

06 Mar 25.00 (MSQ CJ-E)

2.15 +0.10 1.95 2.00 47 14613 06 Mar 25.00 (MSQ OJ-E)

0.05 pc 0 0.05 0 17347

06 Mar 27.50 (MSQ CY-E)

0.10 -- 0.05 0.15 2578 79580 06 Mar 27.50 (MSQ OY-E)

0.65+0.1

00.60 0.70 883 16534

06 Mar 30.00 (MSQ CK-E)

0.05 pc 0 0.05 0 23610 06 Mar 30.00 (MSQ OK-E)

2.90-

0.203.00 3.20 2 785

06 Apr 22.50 (MSQ DX-E)

4.60 pc 4.50 4.60 0 1367906 Apr 22.50 (MSQ PX-E)

0.05 pc 0 0.05 0 35081

06 Apr 25.00 (MSQ DJ-E)

2.15 -- 2.10 2.20 30 5769606 Apr 25.00 (MSQ PJ-E)

0.10 pc 0.05 0.10 0 49933

06 Apr 27.50 (MSQ DY-E)

0.35 -0.05 0.35 0.40 461 14730506 Apr 27.50 (MSQ PY-E)

0.80+0.0

50.75 0.85 128 34125

06 Apr 30.00 (MSQ DK-E)

0.05 pc 0 0.05 0 11536506 Apr 30.00 (MSQ PK-E)

3.08 pc 3.00 3.10 0 670

18-8

18-9

Option premium: price at which the contract trades (the amount paid for the option)

Long-term Equity AnticiPation Securities (LEAPS): expiration dates up to three years.

Trading symbol for stock options – combination of the stock ticker symbol, plus a letter to indicate the month of the year, plus a final letter to indicate strike price

18-10

Expiration Months Code

JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC

Calls A B C D E F G H I J K L

Puts M N O P Q R S T U V W X

Strike Price Codes

A B C D E F G H I J K L M

5 10 15 20 25 30 35 40 45 50 55 60 65

105 110 115 120 125 130 135 140 145 150 155 160 165

205 210 215 220 225 230 235 240 245 250 255 260 265

305 310 315 320 325 330 335 340 345 350 355 360 365

405 410 415 420 425 430 435 440 445 450 455 460 465

505 510 515 520 525 530 535 540 545 550 555 560 565

605 610 615 620 625 630 635 640 645 650 655 660 665

705 710 715 720 725 730 735 740 745 750 755 760 765

N O P Q R S T U V W X Y Z

70 75 80 85 90 95 100 7.50 12.50 17.50 22.50 27.50 32.50

170 175 180 185 190 195 200 37.50 42.50 47.50 52.50 57.50 62.50

270 275 280 285 290 295 300 67.50 72.50 77.50 82.50 87.50 92.50

370 375 380 385 390 395 400 97.50 102.50 107.50 112.50 117.50 122.50

470 475 480 485 490 495 500 127.50 132.50 137.50 142.50 147.50 152.50

570 575 580 585 590 595 600 157.50 162.50 167.50 172.50 177.50 182.50

670 675 680 685 690 695 700 187.50 192.50 197.50 202.50 207.50 212.50

770 775 780 785 790 795 800 217.50 222.50 227.50 232.50 237.50 242.50

18-11

Options Clearing Corporation (OCC)

Sole issuer of all securities options listed on exchanges and NASD

All option transactions are ultimately cleared through OCC

OCC takes the opposite side of every option traded Guarantees contract performance and reduces the

credit risk.

18-12

Option concept

Option contracts are a zero sum game before commissions and other transaction costs.

Hedged position: option transaction to offset the risk inherent in some other investment (to limit risk)

Speculative position: option transaction to profit from the inherent riskiness of some underlying asset.

18-13

Option style and settlement

Option holder: long the option position Option writer: short the option position Style

American style option: exercised at any time (All stock options in the US)

European style option: only exercised on the expiration date. Delivery

Physical delivery option: actual delivery of the underlying asset takes place

Cash-settle option: cash payment based on difference between exercise price and current determined price of the underlying asset

Contract size: usually for 100 shares of stock

18-14

Option types Stock Options: generally cover 100 shares of

underlying securities. Adjustment made for stock dividend, stock split, merger, etc.

Index options: Standard and Poor’s 100 Index (OEX) are the most actively traded.

Debt Options Physical delivery price-based options: right to

purchase (sell) a debt security Cash settled price-based options: right to receive

cash based on the value of debt security Yield based options: cash settled based on the

difference between the exercise price and value of an underlying yield.

18-15

Call Option strategies

Long position: the right (but not obligation) to buy the underlying asset at a strike price for a limited period of time. The right to buy stock at a fixed price becomes more

valuable as price of stock increases (in the money when current stock price > exercise price)

Risk for buyer is limited to the call premium and potential is unlimited

Short position: payoff mirror image of long position (zero sum game)

Covered call: sale of a call option on a stock that is owned.

18-16

18-17

18-18

Put option strategies

Long position: the right, but not obligation, to sell an underlying asset at strike price. The right to sell stock at a fixed price becomes valuable as

price of the stock decreases (in the money when current price < exercise price)

Risk for buyer is limited to the premium and profit is also limited (price cannot be below zero)

Short position: mirror image of long position Protective put: insurance against a sharp correction.

Purchase of a stock and put option

18-19

18-20

18-21

Combinations Spread: both buyer and writer of the same type

of option on the same underlying asset Price spread: purchase or sale of options on the same

underlying asset but different exercise price Time spread: purchase or sales of options on the

same underlying asset but different expiration dates

Bull call spread: purchase of a low strike price call and sale of a high strike price call.

Bull put spread: sale of high strike price put and purchase or a low strike price put

18-22

Payoff Long call

Short call

Bull call spread

PayoffLong put

Short put

Bull put spread

Payoff

Long call Short put

Straddle

Straddle : purchasing a call andWriting a put on the same asset,

exercise price, and expiration date

18-23

Option pricing Factors contributing value of an option

price of the underlying stock time until expiration volatility of underlying stock price cash dividend prevailing interest rate.

Intrinsic value: difference between an in-the-money option’s strike price and current market price

Time value: speculative value. Call price = Intrinsic value + time value

18-24

18-25

Black-Scholes Option Pricing Model

Where C: current price of a call option S: current market price of the underlying stock X: exercise price r: risk free rate t: time until expiration N(d1) and N (d2) : cumulative density functions for d1 and d2

)()( 21 dNe

XdNSC

rt

funds invested of

cost yOpportunit

potential upside

of Value

price

Call

t

trXSd

2

1

5.0ln tdd 12

18-26

Example Current stock price: 50 exercise price : 55

Risk free rate: 6.25% time to expiration: 6 months

Volatility: 40% What is the call price?

Solution

0851.02828.0

0713.00953.05.04.0

5.04.05.00625.05550lnd

2

1

3679.0

5.04.00851.0d 2

N(d1) = 0.4661 N(d2) = 0.3564

30.4$]3564.0[55

]4661.0[50

)()(price Call

)5.0)(0625.0(

21

e

dNe

XdNS

rt

18-27

Put call parity Relationship between the price of a put

option and the price of a call option on the same underlying equity.

Using the same values before,

CS rte

XpricePut

61.7$30.450e

55pricePut

.5)(0.0625)(0

18-28

Option risks

Delta: the sensitivity of option value to a unit change in the underlying asset (hedge ratio)

Gamma: The responsiveness of delta to unit changes in the value of the underlying asset

Theta: The sensitivity of option value to change in time

Vega: The sensitivity of option value to change in volatility

Rho: The sensitivity of option value to changes in interest rate

18-29

Such values are presented in CBOE Option Calculator ( www.cboe.com )