Chapter 15 – Options Markets
CHAPTER FIFTEEN
OPTIONS MARKETS
CHAPTER OVERVIEW
This chapter describes characteristics of options, terminology used in the options’ markets, option
payoffs and profits to both option owners and sellers (called writers), and positions that are
comprised of combinations of options and stock or multiple option contracts. Option-like assets,
such as callable bonds, warrants, and collateralized loans are also described.
LEARNING OBJECTIVES
After studying this chapter, the student should be able to calculate potential profits resulting from
various option trading strategies and to formulate portfolio management strategies to modify the
risk-return attributes of the portfolio. The student should be able to identify the embedded
options in various assets and to determine how these option characteristics affect the prices of
these assets.
CHAPTER OUTLINE
1. The Option Contract
PPT 15-2 through PPT 15-8
A listed call option is a contract giving the holder the right to buy 100 shares of stock at a preset
price called the exercise or strike price. A listed put option is a contract giving the holder the
right to sell 100 shares of stock at a preset price. Expirations of 1,2,3,6, 9 months and sometimes
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. The underlying company is not involved in the option market.
the last Friday before expiration). Most options that are traded in this country are American
options. Foreign currency and stock index options that trade on the Chicago Board Options
Exchange are exceptions. European style options are cheaper, that is the motivation for them.
Note that the style (American vs. European) has nothing to do with where the options are traded.
Options Uses
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bubble burst many option holders lost large sums and option writers defaulted. After this episode
options were banned for several hundred years. Option trading has been the province of the
Chicago markets, but it really didn’t take off until the Black-Scholes model of option pricing was
discovered. Options can be used to hedge changes in stock price, change your risk and return
profile (for example, buying a call is analogous to buying stock on margin, often with a lower
option seller (or writer) must post margin. The margin varies with option price and whether the
option position is covered or exposed. An in the money option requires more margin than an out
of the money option. Margin varies with the exposure of the option seller. A covered call writer
write a call on which they own stock. The writer can post the stock to satisfy the margin
requirement, whereas a naked call writer must post cash. When an option is exercised an option
available on other derivative instruments such as futures contracts. Most of the pricing and payoff
examples that are built in the text are stock options.
2. Values of Options at Expiration
PPT 15-9 through PPT 15-26
This section requires the use of some terminology:
Symbols & Valuation
Ct = Price paid for a call option at time t. t = 0 is today,
A call is “out of the money” if St < X. A put is “out of the money” if St > X.
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Chapter 15 – Options Markets
An option is in the money if you could profitably exercise it right now. Basic option pricing
Constructing a profit table is an excellent method to model and understand the payoffs of any
option strategy and having students work though some of these tables is an excellent teaching
exercise. For example the profit at expiration of buying a call if ST < X is –C0, therefore profit is
a straight line at the level equal to –C0. If ST > X then profit = –C0 + ST – X. Since the
horizontal axis on the profit graph (see below) is ST and the profit equation in this region has a +1
Chapter 15 – Options Markets
The breakeven can be found as X + C0 or $100 + $7.35 = $107.3 Buying this option is placing a
bet that the stock price will climb above $107.35 by July. It is a bullish (price rising), high
volatility strategy. The strategy benefits from having high stock price volatility and benefits from
Chapter 15 – Options Markets
Option traders use Greek symbols to characterize strategies. A +∆ strategy is bullish, a bearish
strategy is said to be negative delta or –∆. A delta neutral strategy is unaffected by a stock price
change or is equally affected by the same amount for a given price increase or decrease. Negative
positions that open downward are positive τ. Positions that increase in value if volatility increases
are said to be positive vega or +. Negative vega positions increase in value if perceived stock
volatility declines.
The put writer has unlimited loss potential if the stock price falls. The profit for a put writer is
limited to a premium of the option. The text has an excellent boxed item entitled, “The Black
and the purchase of puts on an equivalent number of shares. The strategy reduces upside potential
if the stock price rises by the cost of the put but it limits the loss if the stock declines in price.
A covered call involves ownership of stock and writing a call option. It is referred to as covered
since the stock is owned if the option buyer exercised their option. The position has limited
upside potential and offers some protection to the owner of the stock if the stock price declines.
A collar is an options strategy that brackets the value of a portfolio between two bounds and may
be appropriate for an investor who has a target wealth goal but is unwilling to risk losses beyond a
certain level.
Warnings about Option Strategies
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feature makes options appear safer than they are. You have to compare equal dollar investments in
stocks and options to truly see the higher risk of the option position. Options are traded in a
highly competitive market and are priced according to expected volatility of the underlying asset.
To profit in options you must be able to forecast price or volatility better than the competition and
your gains must exceed your transactions costs. This is a tall order in a competitive market.
writer’s gain to the call premium but exposes the writer to unlimited loss, and this is a poor
strategy in volatile markets.
3. Optionlike Securities
PPT 15-27 through PPT 15-34
Many securities are complex products that include imbedded options. The payoffs and profits
associated with securities that contain imbedded options will present payoffs that are similar to
no recourse (other than the collateral posted) and there can be no reputation loss or other costs.
4. Exotic Options
PPT 15-35
15–6
options, lending and levels of stock ownership. The second spreadsheet allows students to
examine the changes in payoffs and rates of returns for various spread and straddle strategies.
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