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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
1 year are normal contract periods. Contracts expire on the Saturday following the third Friday
American vs. European options
Chapter 15 - Options Markets
With an American style option the option can be exercised at any date after purchase whereas
with a European style option the option can only be exercised immediately before expiration
Options Uses
Options have a long and checkered history. There are records that show that options were used
in ancient Egypt. They were also used during the tulip bulb mania in Holland and when the tulip
bubble burst many option holders lost large sums and option writers defaulted. After this
The OCC
The option exchanges operate the Option Clearing Corporation (OCC). An option buyer or
seller technically buys or sells from or to the OCC. The OCC backs performance of both
counterparties. This allows liquid anonymous trading to occur. To limit the OCC’s risk the
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
2. Values of Options at Expiration
PPT 15-9 through PPT 15-26
Chapter 15 - Options Markets
This section requires the use of some terminology:
Symbols & Valuation
Ct = Price paid for a call option at time t. t = 0 is today,
T = Immediately before the option's expiration.
Pt = Price paid for a put option at time t.
St = Stock price at time t.
X = Exercise or Strike Price
A call is “in the money” if St > X. A put is “in the money” if St < X.
A call is “out of the money” if St < X. A put is “out of the money” if St > X.
An option is in the money if you could profitably exercise it right now. Basic option pricing
boundaries are developed below:
C and P are greater than zero because the holders have a choice to use them or not. A simple
arbitrage argument (shown above) can be used to demonstrate that the call price must be greater
than or equal to the difference between the stock price and the exercise price. This is the basis
for the price boundary of a call Ct ≥ Max (0, St – X).
Chapter 15 - Options Markets
Using data on IMB calls given in Figure 15.1 in the text for the July 100 call we can construct
the profit graph that illustrates the possible payoff at option expiration that can result at various
stock prices.
The breakeven can be found as X + C0 or $100 + $7.35 = $107.3 Buying this option is placing a
Chapter 15 - Options Markets
This is a bearish and low volatility strategy. Any strategy that opens upward will be a high
volatility strategy and any strategy that opens downward will be a low volatility strategy.
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 theta –τ strategies lose value as the option expiration approaches and are basically bets
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
Hole: How Some Investors Lost All Their Money in the Market Crash.” The example of the risk
involved in writing naked puts surrounding the October 1987 Market Crash points out the
upside potential and offers some protection to the owner of the stock if the stock price declines.
A straddle is constructed by purchasing a call and a put with the same exercise date and maturity
date. A straddle will result in profits if the stock price increases or decreases enough to
overcome the premiums for the options.
Warnings about Option Strategies
Options may have to move 10-15% or more in a short time period before an investor recovers the
price & commission. Most options expire worthless. Options are by definition short term
instruments; an investor can ride out bad times in spot markets but not in options. The limited
loss 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
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
options or groups of options. Examples that demonstrate the impact of embedded options include
callable bonds, convertible bonds, collateralized loans and levered equity and these are covered
4. Exotic Options
PPT 15-35
Discussion of these options is useful in making students aware of the all the various types of
options that are available to construct different desired payoffs. Asian- Payoffs depend on the
average (rather than the final) price of the underlying asset during a portion of the life of the
option. Barrier Options’ value depends on whether the underlying asset price has passed through
Excel Applications
