Mechanics of Options Markets

Chapter 8
1
2
Assets Underlying
Exchange-Traded Options
Page 183-184
Stocks Stock Indices
Futures Foreign Currency
Bond options VIX


3
Options
Options are generally different from forwards &
futures contracts. An options gives the holder
of the option the right to do something
Call options
Put options
Buyer or holder
Seller or writer
Premium
Strike price
Maturity date
Contract Specifications
Market type : N
Instrument Type : OPTSTK
Underlying : Symbol of underlying security
Expiry date : Date of contract expiry
Option Type : CE / PE
Strike Price: Strike price for the contract
Trading cycle: Options contracts have a maximum of 3-month
trading cycle - the near month (one), the next month (two) and the
far month (three).


Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 4
5
Call Option
A call option is a right, but not an obligation to buy
an asset at a predetermined price within a specified
time.
Long call- expect price rise. Holder of the call has
an option to exercise call or not. For this right he
pays premium.

Short Call-The call writer does not believe the price
of the underlying security is likely to rise. The writer
sells the call to collect the premium and does not
receive any gain if the stock rises above the strike
price.

Payoffs (Call option)
When S<X buyer lets
the call expire
When S=X buyer is
indifferent
When S>X buyer
exercise the call
option


Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 6
Loss=premium c

Loss=premium c

Gain=S-X-c
7

A Long position in a Call option

Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months
Max(S-X, 0)
30
20
10
0
-5
70 80 90 100
110 120 130
Payoff ($)
Terminal
stock price ($)
8
A Short position in a Call
(Figure 8.3, page 182)
Profit from writing one European call option: option
price = $5, strike price = $100.
Min(X-S, 0)

-30
-20
-10
0
5
70 80 90 100
110 120 130
Payoff ($)
Terminal
stock price ($)
9
Put option
A put option is a right, but not an obligation to sell
an asset at a predetermined price within a specified
time.
Long put- expect price fall. Holder of the put has an
option to exercise putor not. For this right he pays
premium.

Short put- doesnt receive any gain if SP< Strike Price
The option writer receives a premium and incurs an
obligation to purchase (if a put is sold) the underlying
asset at a stipulated price until a predetermined date.

Payoffs (Put option)
When S>X buyer
wont exercise the put
When S=X buyer is
indifferent
When S<X buyer
exercise the put
option


Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 10
Loss=premium p

Loss=premium p

Gain=X-S-p
11
A Long position in a Put
(Figure 8.2, page 181)
Profit from buying a European put option: option
price = $7, strike price = $70
Max(X-S, 0)

30
20
10
0
-7
70 60 50 40 80 90 100
Payoff ($)
Terminal
stock price ($)
12
A Short position in a Put
(Figure 8.4, page 182)
Profit from writing a European put option: option
price = $7, strike price = $70
Min(S-X, 0)

-30
-20
-10
7
0
70
60 50 40
80 90 100
Payoff ($)
Terminal
stock price ($)
Zero- sum game
Payoff of call option X=190
13
Price of the
assets
Payoff-call buyer Payoff-call writer

Buy
from
writer
Sell in
the
market
Profit/los
s
Sell to
holder
Buy from
market
Profit/los
s
125
Holders doesnt exercise the
call option, losses premium
paid
Obligation of writer doesnt
arise, gains premium received
150
175
200 190 200 10 190 200 -10
225 190 225 35 190 225 -35
Zero- sum game
Payoff of put option X=160
14
Price of the
assets
Payoff-put buyer Payoff-put writer

Sell
to
writer
Buy from
the
market
Profit/los
s
Pay to
holder
Sell in
the
market
Profit/los
s
125 160 125 35 160 125 -35
150 160 150 10 160 150 -10
175
Holders doesnt exercise the
put option, losses premium
paid
Obligation of writer doesnt
arise, gains premium received
200
225
15
Payoffs from Options
What is the Option Position in
Each Case?
K = Strike price, S
T
= Price of asset at maturity
Payoff Payoff
S
T
S
T
K
K
Payoff Payoff
S
T
S
T
K
K
16
Terminology
Moneyness :
At-the-money option would have no cash flows
In-the-money option would have positive CFs to
the buyer
Out-of-the-money option would result in cash
outflow if exercised
Intrinsic value
Time value
Based on the nature of exercise
Based on how they are traded & settled
Based on the underlying asset on which option is
created



Intrinsic Value & Time Value

The option premium consists of two
components;
the intrinsic value, and
the time value
Two important factors that determine the
price are:
the extent to which the option is in-the-money, and
the chances that before expiry the option will
become deeper in-the-money or will turn into in-
the-money if it is presently out-of-the-money
Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 17

Intrinsic Value

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 18
The value attached to the option if it is exercised
now is called the intrinsic value of the option. The
difference between spot price and exercise price will
determine this value. The intrinsic value is:

For call option : max {(S -X), 0}, and
For put option : max {(X -S), 0}

Intrinsic value cannot be negative.

The least intrinsic value is for out-of-the-money
option, which is equal to zero.

An option cannot sell below its intrinsic value.

Time Value

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 19

The time value is the excess of actual value over intrinsic
value.
The value attached to the chances that strike price will be
pierced in times to come before expiry is called the time
value of an option.

Time value of an option = Actual Price Intrinsic Value

Time value cannot be negative. At best/worst it can have
zero value.
Time value of the option is greatest for ATM options.
The entire premium paid for ATM options is attributable to
the time value as the intrinsic value of the option is zero.
20

Dividends & Stock Splits

Suppose you own N options with a strike price
of K :

No adjustments are made to the option terms
for cash dividends
When there is an n-for-m stock split,
the strike price is reduced to K/(1+ bonus
ratio)
the no. of options is increased to N*(1+bonus
ratio)
Stock dividends are handled in a manner
similar to stock splits
21
Dividends & Stock Splits
(continued)
Consider a call option to buy 100
shares for $20/share
How should terms be adjusted:
for a 2-for-1 stock split?
for a 25% stock dividend?