20 DERIVATIVE SECURITIES, OR  more simply
derivatives, play a large and increasingly
important role in financial markets. These
are securities whose prices are determined
by, or “derive from,” the prices of other
securities.
Options and futures contracts are both
derivative securities. Their payoffs depend on
Options Markets:
Introduction
the value of other securities. Swaps, which we
will discuss in Chapter 23, also are derivatives.
Because the value of derivatives depends
on the value of other securities, they can be
powerful tools for both hedging and specula-
tion. We will investigate these applications in
the next four chapters, starting in this chapter
with options.
Trading of standardized options contracts
on a national exchange started in 1973 when
the Chicago Board Options Exchange (CBOE)
began listing call options. These contracts
were almost immediately a great success,
PART VI
CHAPTER TWENTY
crowding out the previously existing over-
the-counter options market.
Option contracts are traded now on several
exchanges. They are written on common stock,
stock indexes, foreign exchange, agricultural
commodities, precious metals, and interest
rate futures. In addition, the over-the-counter
market has enjoyed a tremendous resurgence
in recent years as trading in custom-tailored
options has exploded. Popular and potent
tools in modifying portfolio characteristics,
options have become essential tools a port-
folio manager must understand.
This chapter is an introduction to options
markets. It explains how puts and calls work
and examines their investment characteris-
tics. Popular option strategies are considered
next. Finally, we examine a range of securities
with embedded options such as callable or
convertible bonds, and we take a quick look
at some so-called exotic options.
 CHAPTER 20 Options Markets: Introduction 679

20.1 The Option Contract

A call option gives its holder the right to purchase an asset for a specified price, called
the exercise, or strike, price, on or before some specified expiration date. For example,
a February call option on IBM stock with exercise price $195 entitles its owner to
purchase IBM stock for a price of $195 at any time up to and including the expiration
date in February. The holder of the call is not required to exercise the option. She will
choose to exercise only if the market value of the underlying asset exceeds the exercise
price. In that case, the option holder may “call away” the asset for the exercise price.
Otherwise, the option may be left unexercised. If it is not exercised before the expira-
tion date of the contract, a call option simply expires and becomes valueless. Therefore,
if the stock price is greater than the exercise price on the expiration date, the value of
the call option equals the difference between the stock price and the exercise price; but
if the stock price is less than the exercise price at expiration, the call will be worthless.
The net profit on the call is the value of the option minus the price originally paid to
purchase it.
The purchase price of the option is called the premium. It represents the compensation
the purchaser of the call must pay for the right to exercise the option only when exercise
is desirable.
Sellers of call options, who are said to write calls, receive premium income now as pay-
ment against the possibility they will be required at some later date to deliver the asset in
return for an exercise price less than the market value of the asset. If the option is left to
expire worthless, the writer of the call clears a profit equal to the premium income derived
from the initial sale of the option. But if the call is exercised, the profit to the option writer
is the premium income minus the difference between the value of the stock that must be
delivered and the exercise price that is paid for those shares. If that difference is larger than
the initial premium, the writer will incur a loss.

Example 20.1 Profits and Losses on a Call Option

Consider the February 2013 expiration call option on a share of IBM with an exercise
price of $195 selling on January 18, 2013, for $3.65. Exchange-traded options expire on
the third Friday of the expiration month, which for this option was February 15. Until the
expiration date, the call holder may buy shares of IBM for $195. On January 18, IBM sells
for $194.47. Because the stock price is only $194.47, it clearly would not make sense at
the moment to exercise the option to buy at $195. Indeed, if IBM remains below $195
by the expiration date, the call will be left to expire worthless. On the other hand, if IBM
is selling above $195 at expiration, the call holder will find it optimal to exercise. For
example, if IBM sells for $197 on February 15, the option will be exercised, as it will give
its holder the right to pay $195 for a stock worth $197. The value of each option on the
expiration date would then be
Value at expiration 5 Stock price 2 Exercise price 5 $197 2 $195 5 $2
Despite the $2 payoff at expiration, the call holder still realizes a loss of $1.65 on the
investment because the initial purchase price was $3.65:
Profit 5 Final value 2 Original investment 5 $2.00 2 $3.65 5 2$1.65
680 PART VI Options, Futures, and Other Derivatives

Nevertheless, exercise of the call is optimal at expiration if the stock price exceeds the
exercise price because the exercise proceeds will offset at least part of the purchase
price. The call buyer will clear a profit if IBM is selling above $198.65 at the expiration
date. At that stock price, the proceeds from exercise will just cover the original cost of
the call.

A put option gives its holder the right to sell an asset for a specified exercise or strike
price on or before some expiration date. A February expiration put on IBM with an exer-
cise price of $195 entitles its owner to sell IBM stock to the put writer at a price of $195 at
any time before expiration in February even if the market price of IBM is less than $195.
Whereas profits on call options increase when the asset price rises, profits on put options
increase when the asset price falls. A put will be exercised only if the exercise price is
greater than the price of the underlying asset, that is, only if its holder can deliver for the
exercise price an asset with market value less than that amount. (One doesn’t need to own
the shares of IBM to exercise the IBM put option. Upon exercise, the investor’s broker
purchases the necessary shares of IBM at the market price and immediately delivers, or
“puts them,” to an option writer for the exercise price. The owner of the put profits by the
difference between the exercise price and market price.)

Example 20.2 Profits and Losses on a Put Option

Now consider the February 2013 expiration put option on IBM with an exercise
price of $195, selling on January 18 for $5.00. It entitled its owner to sell a share
of IBM for $195 at any time until February 15. If the holder of the put buys a share of
IBM and immediately exercises the right to sell it at $195, net proceeds will be
$195 2 $194.47 5 $.53. Obviously, an investor who pays $5 for the put has no inten-
tion of exercising it immediately. If, on the other hand, IBM were selling for $188 at
expiration, the put would turn out to be a profitable investment. Its value at expiration
would be
Value at expiration 5 Exercise price 2 Stock price 5 $195 2 $188 5 $7
and the investor’s profit would be $7  2  $5  5  $2. This is a holding period return of
$2/$5  5 .40, or 40%—over only 28 days! Obviously, put option sellers on January 18
(who are on the other side of the transaction) did not consider this outcome very likely.

An option is described as in the money when its exercise would produce a positive
cash flow. Therefore, a call option is in the money when the asset price is greater than
the exercise price, and a put option is in the money when the asset price is less than the
exercise price. Conversely, a call is out of the money when the asset price is less than
the exercise price; no one would exercise the right to purchase for the strike price an asset
worth less than that amount. A put option is out of the money when the exercise price
is less than the asset price. Options are at the money when the exercise price and asset
price are equal.
 CHAPTER 20 Options Markets: Introduction 681

Options Trading
Some options trade on over-the-counter markets. The OTC
market offers the advantage that the terms of the option PRICES AT CLOSE JANUARY 18, 2013
contract—the exercise price, expiration date, and number I B M (IBM) Underlying Stock Price: 194.47
of shares committed—can be tailored to the needs of the Call Put
traders. The costs of establishing an OTC option contract, Open Open
Expiration Strike Last Volume Interest Last Volume Interest
however, are higher than for exchange-traded options.
Jan 185 9.15 307 2431 0.76 302 2488
Options contracts traded on exchanges are standard- Feb 185 10.60 299 2 1.82 710 3645
Apr 185 12.00 41 706 3.60 104 2047
ized by allowable expiration dates and exercise prices for Jul 185 14.35 37 134 6.55 37 1354
each listed option. Each stock option contract provides Jan 190 4.40 815 5697 1.75 507 2496
Feb 190 6.75 402 2808 3.00 3553 10377
for the right to buy or sell 100 shares of stock (except Apr 190 8.85 107 1866 5.20 527 2177
Jul 190 10.95 15 645 8.54 6 1142
when stock splits occur after the contract is listed and Jan 195 0.01 2451 11718 0.70 4090 8862
the contract is adjusted for the terms of the split). Feb 195 3.65 1337 11902 5.00 860 3156
Apr 195 5.90 1785 2928 7.30 934 1141
Standardization of the terms of listed option contracts Jul 195 8.45 13 5773 10.85 22 3419
Jan 200 1.10 1248 2966 5.55 637 6199
means all market participants trade in a limited and uni- Feb 200 1.61 1053 5530 8.09 546 967
Apr 200 3.70 629 3236 10.05 375 1903
form set of securities. This increases the depth of trad- Jul 200 6.10 80 1257 ... ... 1105
ing in any particular option, which lowers trading costs
and results in a more competitive market. Exchanges,
therefore, offer two important benefits: ease of trading,
which flows from a central marketplace where buy- Figure 20.1 Stock options on IBM closing prices
ers and sellers or their representatives congregate; and as of January 18, 2013
a liquid secondary market where buyers and sellers of
Source: The Wall Street Journal Online, January 18, 2013.
options can transact quickly and cheaply.
Until recently, most options trading in the United
States took place on the Chicago Board Options Exchange. However, by 2003 the Inter-
national Securities Exchange, an electronic exchange based in New York, displaced the
CBOE as the largest options market. Options trading in Europe is uniformly transacted in
electronic exchanges.
Figure 20.1 is a selection of listed stock option quotations for IBM. The last recorded
price on the New York Stock Exchange for IBM shares was $194.47 per share.1 The exer-
cise (or strike) prices bracket the stock price. While exercise prices generally are set at
five-point intervals, larger intervals sometimes are set for stocks selling above $100, and
intervals of $2.50 may be used for stocks selling at low prices. If the stock price moves out-
side the range of exercise prices of the existing set of options, new options with appropriate
exercise prices may be offered. Therefore, at any time, both in-the-money and out-of-the-
money options will be listed, as in this example.
Figure 20.1 shows both call and put options listed for each expiration date and exercise
price. The three sets of columns for each option report closing price, trading volume in
contracts, and open interest (number of outstanding contracts). When we compare prices
of call options with the same expiration date but different exercise prices in Figure 20.1,
we see that the value of a call is lower when the exercise price is higher. This makes sense,
because the right to purchase a share at a lower exercise price is more valuable than the
right to purchase at a higher price. Thus the February expiration IBM call option with
strike price $195 sells for $3.65 whereas the $200 exercise price February call sells for
1
Occasionally, this price may not match the closing price listed for the stock on the stock market page. This is
because some NYSE stocks also trade on exchanges that close after the NYSE, and the stock pages may reflect
the more recent closing price. The options exchanges, however, close with the NYSE, so the closing NYSE stock
price is appropriate for comparison with the closing option price.
682 PART VI Options, Futures, and Other Derivatives

only $1.61. Conversely, put options are worth more when the exercise price is higher: You
would rather have the right to sell shares for $200 than for $195 and this is reflected in
the prices of the puts. The February expiration put option with strike price $200 sells for
$8.09, whereas the $195 exercise price February put sells for only $5.
If an option does not trade on a given day, three dots will appear in the volume and price
columns. Because trading is infrequent, it is not unusual to find option prices that appear
out of line with other prices. You might see, for example, two calls with different exercise
prices that seem to sell for the same price. This discrepancy arises because the last trades
for these options may have occurred at different times during the day. At any moment, the
call with the lower exercise price must be worth more than an otherwise-identical call with
a higher exercise price.
Expirations of most exchange-traded options tend to be fairly short, ranging up to only
several months. For larger firms and several stock indexes, however, longer-term options
are traded with expirations ranging up to several years. These options are called LEAPS
(for Long-Term Equity AnticiPation Securities).

CONCEPT CHECK 20.1

a. What will be the proceeds and net profits to an investor who purchases the February expiration IBM
calls with exercise price $195 if the stock price at expiration is $205? What if the stock price at expira-
tion is $185?
b. Now answer part (a) for an investor who purchases a February expiration IBM put option with exercise
price $195.

American and European Options

An American option allows its holder to exercise the right to purchase (if a call) or sell (if
a put) the underlying asset on or before the expiration date. European options allow for
exercise of the option only on the expiration date. American options, because they allow
more leeway than their European counterparts, generally will be more valuable. Virtually
all traded options in the United States are American style. Foreign currency options and
stock index options are notable exceptions to this rule, however.

Adjustments in Option Contract Terms

Because options convey the right to buy or sell shares at a stated price, stock splits would
radically alter their value if the terms of the options contract were not adjusted to account
for the stock split. For example, reconsider the IBM call options in Figure 20.1. If IBM
were to announce a 2-for-1 split, its share price would fall from about $195 to about
$97.50. A call option with exercise price $195 would be just about worthless, with virtu-
ally no possibility that the stock would sell at more than $195 before the options expired.
To account for a stock split, the exercise price is reduced by a factor of the split, and the
number of options held is increased by that factor. For example, each original call option
with exercise price of $195 would be altered after a 2-for-1 split to two new options, with
each new option carrying an exercise price of $97.50. A similar adjustment is made for stock
dividends of more than 10%; the number of shares covered by each option is increased in
proportion to the stock dividend, and the exercise price is reduced by that proportion.
In contrast to stock dividends, cash dividends do not affect the terms of an option con-
tract. Because payment of a cash dividend reduces the selling price of the stock without