chapter 15 options markets copyright © 2010 by the mcgraw-hill companies, inc. all rights...
TRANSCRIPT
Chapter 15
Options Markets
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
15-2
Option Terminology1. What is a listed stock call option?
– A contract giving the holder the right to buy 100 shares of stock at a preset price called the exercise or strike price.
– Expirations of 1,2,3,6,& 9 months and sometimes 1 year are normal contract periods. Contracts expire on the third Saturday of the expiration month.
– Contracts may be resold prior to maturity.– Listed => traded on the exchanges (e.g., CBOE). OTC options market is larger
then exchanges– Rain check: a real life call option example
2. What is a listed stock put option?
- A contract giving the holder the right to sell 100 shares of stock at
a preset price
- Ray Lewis contract with Ravens: a real life example of a put option
- Farmers interested in put options as they are concerned about low crop prices.
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Option Characteristics
• If a call option holder wishes to purchase the stock using options, he or she will exercise the option. The option holder must pay the exercise price to the option writer.
• Exercise prices are adjusted for stock splits and stock dividends, but not cash dividends.
• The cost of an option is called the premium and it is a small percentage of the cost of the underlying asset. The option buyer pays the cost; the option writer receives the cost at the time of sale of the option.
• Options are a zero sum game.
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American vs. European Options
American:
European:
the option can be exercised any time, but no
Later than the expiration date
the option can only be exercised at the
expiration date
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Figure 15.1 Options on IBM
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3. Uses of options:a. To hedge changes in stock price.
b. Change your risk and return profile• For example, buying a call is analogous to buying stock on
margin.
c. Options give two prices (either to pay for a call or to get paid for a put) to the holder to choose from, the market price and the exercise price. The holder is free to compare and choose the one which is more favorable!
d. Seller (writer) has only obligations as the holder makes a decision whether to exercise (use) it or not..
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Option Clearing Corporation (OCC)
• OCC is jointly owned by option exchanges• OCC backs performance of both counterparties
– To limit OCC’s risk, option seller (or writer) must post margin. Margin varies with option price and whether the option position is covered or exposed.
• When an option is exercised an option seller is randomly selected. – If a call is exercised the selected call writer must deliver 100
shares of stock in exchange for receiving the strike price.– If a put is exercised the selected put writer must purchase 100
shares of stock at the strike price.
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4. Types of options
o
o
o
o
o
Listed Options vs OTC Options
Index Options
Options on Futures
Foreign Currency Options
Interest Rate Options
Exotic Options
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5. Symbols & Valuation
Ct = Price paid for a call option at time t. t = 0 is today,
T = option's expiration date.
Pt = Price paid for a put option at time t.
St = Stock price at time t.
Xc, Xp = Exercise or Strike Price for a call, or a put
In the money=> profitable to exercise, Out of the money =>?
A call is “in the money” if St ____ Xc.
A call is “out of the money” if St ____ Xc.
A put is “in the money” if St ____ Xp.
A put is “out of the money” if St ____ Xp.
>
>
>>
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6. The basics of option pricing
a) Price boundarieso o
– o
o Pt 0o Pt X - St
o Pt Max (0, X – St)
If Ct < St – X How could you take advantage of this?$5 $60 $50
Thus Ct Max (0, St – X)
Ct ≥ 0, Why?
Ct ≥ St – X, Why?
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7. Option strategies and profits at expiration
ST = X + C0Breakeven
– C0 + ST – X– C0= Profit
ST – X0+CT
– C0– C0– C0
ST > XST < XProfit Table
BUYING A CALL
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Call profit at expiration (fig 15.1)
IBM Jul 100 call option
Stock Price = $96.14
Exercise = $100
Call premium = $735=$7.35*100
Contract Size 100 shares
Ex = $100
Stock PriceT
Profit
$0
-$735
Bullish or bearish? Bullish High or low volatility strategy? High
-C0
-C0 + ST – X
ST = X + C0
$100 $107.35$92.65
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Writing a naked call
ST = X + C0Breakeven
+C0 – ST + X+C0= Profit
–(ST – X)0– CT
+C0+C0+C0
ST > XST < XProfit Table
WRITING A NAKED CALL
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Writing a naked call
Stock PriceT
Profit
$0
+C0 +C0 – ST + X
X
Bullish or bearish? Bearish High or low volatility strategy? Low
ST = X + C0
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Buying a put option
ST = X – P0Breakeven
– P0X – ST – P0= Profit
0X – ST+PT
– P0– P0– P0
ST > XST < XProfit Table
BUYING A PUT
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X – ST – P0
Buying a put option (fig 15.1)IBM Dec 100 put option
Stock price = $96.14
Exercise = $100
Put premium = $1,166=$11.66*100
Contract Size 100 shares
Ex = $100
Stock Pricet
Profit
$0
-$1,166Put
$100$88.34
$8,834
Bullish or bearish? Bearish High or low volatility strategy? High
– P0B.E.: ST = X – P0
$111.66
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Writing a put option
ST = X – P0Breakeven
+P0 ST – X + P0= Profit
0–(X – ST )– PT
+P0+P0+P0
ST > XST < XProfit Table
Writing A Put
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Writing a put optionWriting a put option
Xx = $100Xx = $100
Stock Stock PricePricett
ProfitProfit
$0$0
$1,166$1,166
$100$100 $111.66$111.66$88.34$88.34
- $8,834- $8,834
Bullish or bearish? BullishBullish or bearish? Bullish High or low volatility strategy? LowHigh or low volatility strategy? Low
SST T –– X + P X + P00 +P+P
00
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Buy stocks and at the money puts: Protective Put
Stock Pricet
Profit
$0
Hedged profit equals sum of profits of put and stock at each stock price.
Long position in IBM ($X borrowed)
Hedged Position
Put
X
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Writing Covered Calls
Stock Pricet
Profit
$0
Long position in IBM $X borrowed
Written call Covered Call
• Bullish or bearish? Bullish• High or low volatility strategy? Low
ST = S0 - C0
X
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Bullish Price Spread
Bull perpendicular or bull price spread with calls; write (sell) the high exercise price call and buy the low exercise price call. All other option terms identical. L=low exercise price, H=high exercise price
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Bullish Price Spread
++ST = XL + C0L – C0H––Breakeven
XH – XL – C0L + C0HST – XL – C0L +C0HC0H – C0L= Profit
–(ST – XH )00– CTH
ST – XLST – XL0+CTL
+C0H+C0H+C0H+C0H
– C0L– C0L– C0L– C0L
ST > XHXL < ST < XHST < XLProfit Table
BULLISH PRICE SPREAD
Stock Stock PricePricett
ProfitProfit
XXLL
XXHH
• Bullish or bearish? BullishBullish or bearish? Bullish
• High or low volatility strategy? High or low volatility strategy? neutralneutral
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Straddle
(Bull or Long) Straddle: buy a put and a call with the same T and X.
(For bear or short straddle, sell both put and call and just flip the graph upside down.)
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Straddle
ST = X + C0 + P0ST = X – C0 – P0Breakeven
ST – X – C0 – P0X – ST – C0 – P0= Profit
0X – ST+PT
ST – X0+CT
– P0– P0– P0
– C0– C0– C0
ST > XST < XProfit Table
STRADDLE
Stock Stock PricePrice tt
ProfitProfit
$0$0 Stock Stock PricePrice tt
ProfitProfit
$0$0X – C0 – P0 X + C0 + P0
• Bullish or bearish? _______ Bullish or bearish? _______
• High or low volatility strategy? Very High or low volatility strategy? Very HighHigh
X
NeutralNeutral
Max Loss: C0 + P0
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Strips and Straps
• Long or bull strap; buy two calls and one put, more bullish than straddle.
• Long or bull strip; buy two puts and one call, more bearish than straddle.
Think about bear versions of each.
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8. Warnings about options positions
o Options may have to move 10-15% or more in a short time period before an investor recovers the premium and commission.
o Options are by definition short term instruments (with expiration dates); an investor can ride out bad times in stock markets but not in options.– The limited loss feature makes options appear safer than they
are. But you may lose everything you invested.– You have to compare equal $ investments in stocks and options
to really see the higher risk of the option position.
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.
What’s wrong with selling options?o Covered calls (writing calls against stock you own)
– The investor never gets the occasional large stock price run up and suffers most of the loss of a big price drop.Eliminates any positive skewness of stock returns
– Wind up with portfolio of poorer performers
o Naked calls (writing calls when you do not own the stock)– Maximum gain is limited to call premium but
unlimited loss, poor strategy in volatile markets
Stock Stock PricePricett
ProfitProfit
$0$0 Stock Stock PricePricett
ProfitProfit
$0$0
Stock Stock PricePricett
ProfitProfit
$0$0 Stock Stock PricePricett
ProfitProfit
$0$0
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Optionlike Securities
1. Callable bonds– Issuing firm has the right to call in the bond
and pay call price. – When will the firm want to exercise its call
option? ~ when the interest rate gets low as this is like a refinancing
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Figure 15.11 Values of Callable Bonds Compared with Straight Bonds
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2. Convertible Securities• Security holder has the option to convert the
bond to a fixed number of shares of common stock.• If a bond is convertible to 20 shares of stock, stock is priced at $60 per share. The bond’s conversion value = $1,200
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Figure 15.12 Value of a Convertible Bond as a Function of Stock Price
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3. Warrants– Call options issued by the firm itself allowing
bond investors to purchase new stock shares in the future at a fixed price.
– Detachable “sweetener” to help sell the bond– Exercise of warrants (and convertibles) can
result in dilution of earnings per share
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4. Collateralized loans– The borrower has an option to repay the loan at maturity if
L > ST, otherwise the borrower can default and give up the value of L. Your home loan is an option!
5. A similar logic can be applied to corporate equity if a firm has debt.– Equity holders effectively have a call option on firm value
as they can choose to pay off the debt if firm value > value of the debt or default otherwise. Why is this happening? Limited liability!
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Exotic Options
Asian Options
Barrier Options
Lookback Options
Payoff depends on the average (rather than the final) price of the underlying asset during a portion of the life of the option.
Example “down-and-out” expires worthless if the stock price drops below a specified barrier.
Payoff depends on minimum or max price during life of option.
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Exotic Options
Currency Translated Options or Quantos
Binary or Digital Options
Allows a variable amount of foreign currency based on the performance of an investment to be translated to dollars at a fixed exchange rate.
Pays a fixed amount if the option is in the money at expiration.
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Problem 1
a.
b.
Purchase a straddle, i.e., buy both a put and a call on the stock. The total cost of the straddle would be: $10 + $7 = $17
$17