8/2/2019 Topic 6 Option Market
1/27
Option Markets Chapter 9
Topic 6
8/2/2019 Topic 6 Option Market
2/27
Important Concepts
Definitions and examples of call and putoptions
Options available for trading Mechanics of trading options
Payoff profiles
Accessing option price quotations Time Value and Intrinsic Value
Margins
8/2/2019 Topic 6 Option Market
3/27
Options
An option gives the holder the:
rightto buy or to sell a certain amount of anunderlying asset
at a specified price
at a particular time (or for a specified period of time)
Examples:
the right to buy or to sell a share the right to buy or to sell a commodity
the right to convert a convertible preference share or aconvertible bond
8/2/2019 Topic 6 Option Market
4/27
Option Terminology
Option Premium/Price
the amount paid by the option buyer to theoption seller (referred to as the option writer)
Strike (Exercise) price
the price at which the holder of the option hasthe right to buy or to sell.
Expiration date
the right to buy or to sell exists up to a specifiedexpiry date
8/2/2019 Topic 6 Option Market
5/27
Types of Options
CALLOPTION:
Gives the holder the right to buythe
underlying asset at the exercise priceExamples of who might buy a call option
Hedger: might buy a Call to hedge against arise in the price of an underlying asset that it
intends to buy in the future Speculator: might buy a Call based on the
view that the underlying asset price wouldincrease
8/2/2019 Topic 6 Option Market
6/27
Types of Options (cont.)
PUTOPTION:
Gives the holder the right to sellthe underlying
asset at the exercise priceExamples of who would buy a put option
Hedger: might buy a Put to hedge against a fallin the price of an asset held, or on asset itexpects to have/produce in the future.
Speculator: might buy a Put based on the viewthat the underlying asset price would decrease;
8/2/2019 Topic 6 Option Market
7/27
Remember !!!
Buy Sell
Call Put
8/2/2019 Topic 6 Option Market
8/27
Types of Options (cont)
European option: an option that can only be exercised on a
particular date (at expiry).
American option: an option that can be exercised at any time
up to its expiry date
Most exchange tradedoptions are Americanstyle but it is not common to exercise beforeexpiry date (for reasons discussed later)
OTC options are usually European options
8/2/2019 Topic 6 Option Market
9/27
Over-the-Counter Options Market
Worldwide
Customized - terms such as exercise price,expiry date and amount are customised
Private transactions
Unregulated market
Credit risk counterparties exposed to each
others credit risk
OTC options on bonds, interest rates ¤cies are the most common
8/2/2019 Topic 6 Option Market
10/27
Organized Options Trading on
Exchanges Listing Requirements
Contract Size specified Exercise Prices set by market makers
Expiration Dates determined by exchange
Margins who writes options Clearing House guarantees that the options
writes will fulfill their obligations
8/2/2019 Topic 6 Option Market
11/27
8/2/2019 Topic 6 Option Market
12/27
Types of options
Share Options and Share Price IndexOptions
Currencies
Interest Rates
Commodities eg. oil
Options on futures contracts * Other Types of Traded Options
options attached to bonds
warrants, callable bonds, convertible bonds
8/2/2019 Topic 6 Option Market
13/27
Option Positions
There are two sides to every option contract.
On one side is the investor who buysthe callor the put option
On the other side is the investor who sells orwritesthe call or the put option
The buyer of a call or put must pay the option
premium (effectively to the option writer) The writerof an option receives the option
premium up front for accepting risk but haspotential liabilities later.
8/2/2019 Topic 6 Option Market
14/27
Option Positions (cont)
The writers profit or loss on an option
transaction is the reverse of that for the option
buyer (ignoring transaction costs such a
brokerage)
8/2/2019 Topic 6 Option Market
15/27
Notation for the followingpayoff diagrams
Ct = price (option premium) of callPt = price (option premium) of putK = exercise (strike) priceT = time to expiry of the optionST = price of the underlying asset (shares in the
following illustrations)
Option payoff at maturity (long position)CT = Max (0, ST K)PT = Max (0, K ST)
8/2/2019 Topic 6 Option Market
16/27
Payoff Profile: Long (Bought) CallAssume: Ct = $1.50 So = $10; K = $11; T = 6m
Price (ST)$0
Profit($)
-$1.50
$11 $12.50 $15
+$2.50
Maximum Loss = $1.50
Break Even @ $12.50Unlimited Upside
$10
8/2/2019 Topic 6 Option Market
17/27
Payoff Profile: Short (Written) CallAssume: Ct = $1.50 So = $10; K = $11; T = 6m
Price (ST)$0
Profit ($)
+$1.50
$11 $12.50 $15
Maximum Gain = $1.50
Break even @ $12.50
Unlimited Downside
$10
8/2/2019 Topic 6 Option Market
18/27
Payoff Profile: Long (Bought) PutAssume: Pt = $0.90 So = $10; K = $9 ; T = 4m
Price (ST)$0
Profit ($)
-$0.90$10$8.10
Break Even @ $8.10Unlimited Upside
Maximum Loss = $0.90
$9
8/2/2019 Topic 6 Option Market
19/27
Payoff Profile: Short (Written) PutAssume: Pt = $0.90 So = $10; K = $9; T = 4m
Price (ST)$0
Profit ($)
$10$8.10
Break Even @ $8.10Unlimited Downside
Maximum Gain = $0.90
$9
+$.90
8/2/2019 Topic 6 Option Market
20/27
Comparison of Bought Call with Long FuturesAssume: Ct = $1.50 So = $10; K = $10; T = 6m
Price (ST)$0
Profit ($)
-$1.50
$11.50 $15
+$3.50
$10
Bought Call
Long Futures
Bought Call: Unlimited Upside; Limited RiskLong Futures: Unlimited upside; unlimited risk
$5.00
8/2/2019 Topic 6 Option Market
21/27
Option Price Quotations
For ASX share options refer www.asx.com.au andfollow the prompts for options
Options exchanges websites
Newspapers
For quotes on futures options go tohttp://www.futuresource.com and click on theoption icon to the right of screen of futures quotes
Problems
Delayed information
Non-synchronized prices
http://www.asx.com.au/http://www.futuresource.com/http://www.futuresource.com/http://www.asx.com.au/8/2/2019 Topic 6 Option Market
22/27
22
E l BHP Billit C ll & P t
8/2/2019 Topic 6 Option Market
23/27
Example: BHP-Billiton Call & PutPrices 28/8/08; Share Price (S) =$40.90
Option C/P Expiry Exercise Margin Open Contract
Code Date Price Price* Interest SizeBHP11 C 30/10/08 40.00 3.16 956 1000BHP13 C 30/10/08 41.00 2.65 294 1000
BHP18 C 30/10/08 42.00 2.16 476 1000BHP19 C 30/10/08 43.00 1.77 866 1000BHPV6 C 30/10/08 44.00 1.40 1486 1000BHPWE C 30/10/08 45.00 1.10 284 1000
BHP1E P 30/10/08 37.00 1.20 691 1000
BHP1R P 30/10/08 38.00 1.49 187 1000BHP1W P 30/10/08 39.00 1.85 304 1000BHP1Y P 30/10/08 40.00 2.34 339 1000BHP14 P 30/10/08 41.00 2.73 96 1000
*The theoretical fair value of the option calculated by the Australian Clearing
House (ACH) which is used to calculate the value of any margin obligations
8/2/2019 Topic 6 Option Market
24/27
Reading Option Quotes
Calls Option premium (price) decreases as strike
price increases. For example: Oct $41 C = $2.65;
Oct $43 C = $1.77(margin prices used in this illustration are indicative
only of bid-ask spread)
Option premium increases as time toexpiration increases. For example: Oct $41 C = $2.65
Dec $41 C = $3.70 (not shown in example)
8/2/2019 Topic 6 Option Market
25/27
8/2/2019 Topic 6 Option Market
26/27
More Terminology
At-the-money option
share price (S0) = strike price (K)
In-the-money optionS0 > K for a long call
S0 < K for a long put
Out-of-the-money option
S0 < K for a long call
S0 > K for a long put
8/2/2019 Topic 6 Option Market
27/27
More Terminology (cont)
Intrinsic value The amount by which an option is in the money
For example, theintrinsic valueof a BHP Oct
$40 Call = $40.90 - $40= $0.90
Time value
Option premium (price) less intrinsic value For example, the time valueof a BHP Oct $40
Call = $3.16 - $0.90
$2 26