Chapter 14
Options Markets
Outline
Background on Options
Comparison of Options and Futures
Markets Used to Trade Options
How Option Trades Are Executed
Types of Orders
Stock Option Quotations
Institutional Use of Options
Determinants of Stock Option Premiums
Determinants of Call Option Premiums
Determinants of Put Option Premiums
How Option Pricing Can Derive a Stock’s Volatility
Explaining Changes in Stock Option Premiums
Speculating with Stock Options
Speculating with Call Options
Speculating with Put Options
Excessive Risk from Speculation
Hedging with Stock Options
Hedging with Covered Call Options
Hedging with Put Options
Options on ETFs and Stock Indexes
Hedging with Stock Index Options
Using Index Options to Measure the Market’s Risk
Options on Futures Contracts
Speculating with Options on Futures
Hedging with Options on Interest Rate Futures
Hedging with Options on Stock Index Futures
Options as Executive Compensation
Limitations of Option Compensation Programs
Globalization of Options Markets
Currency Options Contracts
Chapter 14: Options Markets ❖ 2
Key Concepts
1. Explain why speculators take positions in stock options and how the outcome is determined.
2. Explain why institutional investors take positions in stock options and the tradeoff involved.
3. Explain how stock index options are used by institutional investors.
4. Explain how options on financial futures are used by institutional investors.
POINT/COUNTER-POINT:
If You Were a Major Shareholder of a Publicly Traded Firm, Would You
Prefer That Stock Options Be Traded on That Stock?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Options versus Futures. Describe the general differences between a call option and a futures
contract.
2. Speculating with Call Options. How are call options used by speculators? Describe the conditions
under which their strategy would backfire. What is the maximum loss that could occur for a purchaser
of a call option?
3. Speculating with Put Options. How are put options used by speculators? Describe the conditions
under which their strategy would backfire. What is the maximum loss that could occur for a purchaser
of a put option?
4. Selling Options. Under what conditions would speculators sell a call option? What is the risk to
speculators who sell put options?
5. Factors Affecting Call Option Premiums. Identify the factors affecting the premium paid on a call
option. Describe how each factor affects the size of the premium.
6. Factors Affecting Put Option Premiums. Identify the factors affecting the premium paid on a put
option. Describe how each factor affects the size of the premium.
7. Leverage of Options. How can financial institutions with stock portfolios use stock options when
they expect stock prices to rise substantially but do not yet have sufficient funds to purchase more
stock?
8. Hedging with Put Options. Why would a financial institution holding Hinton stock consider buying
a put option on that stock rather than simply selling it?
Chapter 14: Options Markets ❖ 4
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ANSWER: If a financial institution is concerned about a possible temporary decline in ABC stock,
but has favorable long-term expectations for the stock, it may purchase put options on ABC stock
rather than sell its ABC stock.
9. Call Options on Futures. Describe a call option on interest rate futures. How does it differ from
purchasing a futures contract?
10. Put Options on Futures. Describe a put option on interest rate futures. How does it differ from
selling a futures contract?
Advanced Questions
11. Hedging Interest Rate Risk. Assume a savings institution has a large amount of fixed-rate
mortgages and obtains most of its funds from short-term deposits. How could it use options on
financial futures to hedge its exposure to interest rate movements? Would futures or options on
futures be more appropriate if the institution is concerned that interest rates will decline, causing a
large number of mortgage prepayments?
ANSWER: The financial institution could purchase put options on interest rate futures. If interest
12. Hedging Effectiveness. Three savings and loan institutions (S&Ls) have identical balance sheet
compositions: a high concentration of short-term deposits that are used to provide long-term, fixed-
rate mortgages. The S&Ls took the following positions one year ago.
Chapter 14: Options Markets ❖ 5
Name of S&L Position
LaCrosse Sold financial futures
Stevens Point Purchased put options on interest rate futures
Whitewater Did not take any position in futures
Assume that interest rates declined consistently over the last year. Which of the three S&Ls would
have achieved the best performance based on this information? Explain.
ANSWER: Whitewater would have achieved the best performance because its long-term, fixed-rate
13. Change in Stock Option Premiums. Explain how and why the option premiums may change in
response to a surprise announcement that the Fed will increase interest rates even if stock prices are
not affected.
14. Speculating with Stock Options. The price of Garner stock is $40. There is a call option on Garner
stock that is at the money, with a premium of $2.00. There is a put option on Garner stock that is at
the money, with a premium of $1.80. Why would investors consider writing this call option and this
put option? Why would some investors consider buying this call option and this put option?
ANSWER: If the investors expected that the stock price would remain somewhat stable, they could
15. How Stock Index Option Prices May Respond to Prevailing Conditions. Consider the prevailing
conditions that could affect the demand for stocks, including inflation, the economy, the budget
deficit, and the Fed’s monetary policy, political conditions, and the general mood of investors. Based
on prevailing conditions, would you consider purchasing stock index options at this time? Offer some
logic to support your answer. Which factor do you think will have the biggest impact on stock index
option prices?
ANSWER: This question is open-ended. It requires students to apply the concepts that were presented
16. Backdating Stock Options. Explain what backdating stock options entails. Is backdating consistent
with rewarding executives who help to maximize shareholder wealth?
Chapter 14: Options Markets ❖ 6
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ANSWER: Some firms also allowed the CEO to backdate options that they were granted to an earlier
period when their stock price was lower. This enabled the CEOs to exercise the options at a lower
exercise price. This activity occurred in the late 1990s and early 2000s but was not recognized until
2006. Backdating is completely inconsistent with the idea of granting options to encourage greater
focus on maximizing the stock price. Instead, CEOs benefit when the options are backdated to some
period in which the stock price was weak.
17. CBOE Volatility Index. How would you interpret a large increase in the CBOE volatility
index (VIX)? Explain why the VIX increased substantially during the credit crisis. The CBOE
volatility index (VIX) represents the implied volatility derived from options on the S&P 500 index
(an index of 500 large stocks). An increase in the index suggests that market fear has increased, as
investors who sell stock index options demand a high premium to incur the risk that the stock index
might move substantially above or below the exercise price.
The VIX increased substantially during the credit crisis because there was much uncertainty
surrounding the economy and stock valuations.
CRITICAL THINKING QUESTION
18. Strategy for Investing in CBOE Volatility Index An investment newsletter suggests that because
the prevailing stock market conditions are subject to much uncertainty, investors should purchase call
options on the CBOE volatility index. Write a short essay on the logic behind how the valuation of
this index is influenced by market uncertainty. Also support or refute the advice provided by the
newsletter, and offer a strategy for investing in call options on the CBOE volatility index based on
expectations of changes in market uncertainty.
ANSWER
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “Our firm took a hit because we wrote put options just before the stock market crash.”
Chapter 14: Options Markets ❖ 7
b. “Before hedging our stock portfolio with options on index futures, we search for the index that is
most appropriate.”
c. “We prefer to use covered call writing to hedge our stock portfolios.”
Managing in Financial Markets
As a stock portfolio manager, you have investments in many U.S. stocks and plan to hold these stocks
over a long-term period. However, you are concerned that the stock market may experience a temporary
decline over the next three months, and that your stock portfolio will probably decline by about the same
degree as the market. You are aware that options on S&P 500 index futures are available. The following
options on S&P 500 index futures are available and have an expiration date about three months from now:
Strike Price Call Premium Put Premium
1372 40 24
1428 24 40
The options on S&P 500 index futures are priced at $250 times the quoted premium. Currently, the S&P
500 index level is 1400. The strike price of 1372 represents a 2 percent decline from the prevailing index
level, and the strike price of 1428 represents an increase of 2 percent above the prevailing index level.
a. Assume that you wanted to take an options position to hedge your entire portfolio, which is
currently valued at about $700,000. How many index option contracts should you take a position
in to hedge your entire portfolio?
b. Assume that you want to create a hedge so that your portfolio will lose no more than 2 percent
from its present value. How could you take a position in options on index futures to achieve this
goal? What is the cost to you as a result of creating this hedge?
Chapter 14: Options Markets ❖ 8
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
You could purchase two put option contracts on S&P 500 index futures with a strike price of
1372, which reflects a decline of about 2 percent from the present index value. Since the index
was assumed to move in tandem with your portfolio, you are essentially hedging against
movements in the index in order to hedge your portfolio. If the index level declines below 1372
(reflecting a decline of more than 2 percent), you may consider exercising the put options on
index futures, which gives you the right to sell the index futures for a price of 1372. At the
settlement date of the futures contract, you would receive $250 times the differential between the
futures price of 1372 and the index level. This creates the hedge for you, after a 2 percent loss.
There is a cost of creating this hedge. Since the put premium is 224
$250 = $6,000 for one
option contract, your cost is $12,000 for two options on futures contracts.
c. Given your expectations of a weak stock market over the next three months, how can you
generate some fees from the sale of options on S&P 500 index futures to help cover the cost of
purchasing options?
However, by selling the call options, you are obligated to make a payment to the owner of the call
1. Writing Call Options. A call option on Illinois stock specifies an exercise price of $38. Today’s
price of the stock is $40. The premium on the call option is $5. Assume the option will not be
exercised until maturity, if at all. Complete the following table:
Assumed Stock Price at the Time Net Profit or Loss per Share to Be Earned
the Call Option Is About to Expire by the Writer (Seller) of the Call Option
$37
$39
$41
$43
$45
$48
Chapter 14: Options Markets ❖ 9
ANSWER:
Assumed Stock Price at the Time Net Profit or Loss per Share to Be Earned
the Call Option Is About to Expire by the Writer (Seller) of the Call Option
2. Purchasing Call Options. A call option on Michigan stock specifies an exercise price of $55. Today the
stock’s price is $54 per share. The premium on the call option is $3. Assume the option will not be exercised
until maturity, if at all. Complete the following table for a speculator who purchases the call option:
Assumed Stock Price at the Time Net Profit or Loss per Share
the Call Option Is About to Expire to Be Earned by the Speculator
$50
$52
$54
$56
$58
$60
$62
ANSWER:
Assumed Stock Price at the Time Net Profit or Loss per Share
the Call Option Is About to Expire to Be Earned by the Speculator
3. Purchasing Put Options. A put option on Iowa stock specifies an exercise price of $71. Today the
stock’s price is $68. The premium on the put option is $8. Assume the option will not be exercised
until maturity, if at all. Complete the following table for a speculator who purchases the put option
(and currently does not own the stock):
Assumed Stock Price at the Time Net Profit or Loss per Share
the Put Option Is About to Expire to Be Earned by the Speculator
$60
$64
$68
$70
$72
$74
$76
Chapter 14: Options Markets ❖ 10
ANSWER:
Assumed Stock Price at the Time Net Profit or Loss per Share
the Put Option Is About to Expire to Be Earned by the Speculator
4. Writing Put Options. A put option on Indiana stock specifies an exercise price of $23. Today the
stock’s price is $24. The premium on the put option is $3. Assume the option will not be exercised
until maturity, if at all. Complete the following table:
Assumed Stock Price at the Time Net Profit or Loss per Share to Be Earned
the Put Option Is About to Expire by the Writer (Seller) of the Put Option
$20
$21
$22
$23
$24
$25
$26
ANSWER:
Assumed Stock Price at the Time Net Profit or Loss per Share to Be Earned
the Put Option Is About to Expire by the Writer (Seller) of the Put Option
$20 $0
5. Covered Call Strategy.
a. Evanston Insurance Inc. has purchased shares of Stock E at $50 per share. It will sell the stock in
six months. It considers using a strategy of covered call writing to partially hedge its position in
this stock. The exercise price is $53, the expiration date is six months, and the premium on the
call option is $2. Complete the following table.
Profit or Loss per Share Profit or Loss per Share
Possible Price of Stock E If a Covered Call Strategy If a Covered Call Strategy
in 6 Months Is Used Is Not Used
$47
$50
$52
$55
$57
$60
Chapter 14: Options Markets ❖ 11
ANSWER:
Profit or Loss per Share Profit or Loss per Share
Possible Price of Stock E If a Covered Call Strategy If a Covered Call Strategy
in 6 Months Is Used Is Not Used
$47 –$1 –$3
b. Assume that each of the six stock prices in the table’s first column has an equal probability of
occurring. Compare the probability distribution of the profits (or losses) per share when using
covered call writing versus not using it. Would you recommend covered call writing in this
example? Explain.
6. Put Options on Futures. Purdue Savings and Loan Association purchased a put option on Treasury
bond futures with a September delivery date and an exercise price of 91-16. Assume the put option
has a premium of 1-32. Assume that the price of the Treasury bond futures decreases to 88-16. Should
Purdue exercise the option or let the option expire? What is Purdue’s net gain or loss after accounting
for the premium paid on the option?
7. Call Options on Futures. Wisconsin Inc. purchased a call option on Treasury bond futures at a
premium of 2-00. The exercise price is 92-08. If the price of the Treasury bond futures rises to 93-08,
should Wisconsin Inc. exercise the call option or let it expire? What is Wisconsin’s net gain or loss
after accounting for the premium paid on the option?
$2,000 = –$1,000.
8. Call Options on Futures. DePaul Insurance Company purchased a call option on an S&P 500 futures
contract. The option premium is quoted as $6. The exercise price is $1,430. Assume the index on the
futures contract becomes $1,440. Should DePaul exercise the call option or let it expire? What is the
net gain or loss to DePaul after accounting for the premium paid for the option?
9. Covered Call Strategy. Coral Inc. has purchased shares of stock M at $28 per share. It will sell the
stock in six months. It considers using a strategy of covered call writing to partially hedge its position
in this stock. The exercise price is $32, the expiration date is six months, and the premium on the call
option is $2.50. Complete the following table:
Possible Price of Stock M Profit or Loss per Share If a
in 6 Months Covered Call Strategy Is Used
$25
$28
$33
$36
ANSWER:
Possible Price of Stock M Profit or Loss per Share If a
in 6 Months Covered Call Strategy Is Used
10. Hedging with Bond Futures. Smart Savings Bank desired to hedge its interest rate risk. It was
considering two possibilities: (1) sell Treasury bond futures at a price of 94-00, or (2) purchase a put
option on Treasury bond futures. At the time, the price of Treasury bond futures was 95-00. The face
value of Treasury bond futures was $100,000. The put option premium was 2-00, and the exercise
price was 94-00. Just before the option expired, the Treasury bond futures price was 91-00, and Smart
Savings Bank would have exercised the put option at that time, if at all. This is also the time when it
would offset its futures position, if it had sold futures. Determine the net gain to Smart Savings Bank
if it had sold Treasury bond futures versus if it had purchased a put option on Treasury bond futures.
Which alternative would have been more favorable, based on the situation that occurred?
ANSWER:
Chapter 14: Options Markets ❖ 13
Flow of Funds Exercise
Hedging With Options Contracts
Carson Company would like to acquire Vinnet Inc., a publicly traded firm in the same industry. Vinnet’s
stock price is currently much lower than the prices of other firms in the industry, because it is inefficiently
managed. Carson believes that it could restructure Vinnet’s operations and improve its performance. It is
about to contact Vinnet to determine whether Vinnet will agree to an acquisition. Carson is somewhat
concerned that investors may learn of its plans and buy Vinnet stock in anticipation that Carson will need
to pay a high premium (perhaps a 30 percent premium above the prevailing stock price) in order to
complete the acquisition. Carson decides to call a bank about its risk, as the bank has a brokerage
subsidiary that can help it hedge with stock options.
a. How can Carson use stock options to reduce its exposure to this risk? Are there any limitations to
this strategy, given that Carson will ultimately have to buy most or all of the Vinnet stock?
Carson could purchase call options on Vinnet stock so that it would lock in the amount it would
b. Describe the maximum possible loss that may be directly incurred by Carson as a result of
engaging in this strategy.
The maximum loss is the premium paid for the call options.
c. Explain the results of the strategy you offered in the previous question if Vinnet plans to avoid
the acquisition attempt by Carson.
Carson would still have the call options. It may be able to profit from the strategy if it can sell the