1Chapter 14 Option Market – Part I5/1/2006 FIN3710 - Investment - Professor Rui Yao 2Introduction Definition¾ Option is the right to buy or sell an underlying asset at a specified price on or before a specified date Key elements of an option¾ Specified price: Exercise price or Strike price (X)¾ Specified date: Expiration date (T) Exercise only on expiration date: European option Exercise on or before expiration: American option¾ Option premium: the price of the option Call: right to buy Put: right to sell25/1/2006 FIN3710 - Investment - Professor Rui Yao 3Example On 10/18/1999, IBM Dec155 Call trades at $8 3/8; IBM stock price is $159 3/8 What does it tell us?¾ Style: American Call¾ Underlying Security: IBM Stock¾ Strike Price: $155 (X)¾ Expiration Month: Dec, 1999¾ Expiration Date: The 3rdFriday¾ Current asset price: $159 3/8 (S)¾ Call price (premium): $8 3/85/1/2006 FIN3710 - Investment - Professor Rui Yao 4Option creation and exercise 10/18/1999: 1 contract of IBM Dec155 call created 12/18/1999 or before: buyer exercises call When to exercise?¾ Decision: exercise if St> $155¾ Payoff per share: St- $155Pay Option Premium = $8 3/8 * 100Option Buyer(Long position)Option Seller (Short position)IBM Dec. 155 CallPay $155 * 100Option Buyer(Long position)Option Seller (Short position)100 shares of IBM stock35/1/2006 FIN3710 - Investment - Professor Rui Yao 5Moneyness of the Options In-the-money (ITM): positive payoff for immediate exercise¾ For call: St– X > 0¾ For put: St– X < 0 At-the-money (ATM): zero payoff for immediate exercise¾ For both call and put: St– X = 0 Out-of-the-money (OTM): negative payoff for immediate exercise¾ For call: St– X < 0¾ For put: St– X > 05/1/2006 FIN3710 - Investment - Professor Rui Yao 6Example of Moneyness of Options Current IBM stock price S=$155¾ Option 1: Dec150 IBM call¾ Option 2: Dec155 IBM call¾ Option 3: Dec160 IBM call¾ Option 4: Dec160 IBM put45/1/2006 FIN3710 - Investment - Professor Rui Yao 7Option Payoff versus Option Profit/Loss Notation¾ Security Price: St¾ Strike (Exercise) Price: X Payoff per share at expiration for a call¾ Payoff = max(ST– X, 0) Payoff = ST–X if ST >X, option is in-the-money Payoff = 0 if ST< X, option is out-of-the-money Profit or loss¾ P/L = Payoff – Option Premium5/1/2006 FIN3710 - Investment - Professor Rui Yao 8An Example of Option Profit/Loss IBM Dec155 call trading at $8 3/8 Decision Time: 12/18/1999Possible Price of ST - X Exercise Option OptionIBM on 12/18/99 (X = $155) Decision Payoff P/L$145 $145-$155 < 0 No Exercise 0 -8.375$150 $150-$155 < 0 No Exercise 0 -8.375$155 $155-$155 = 0 No Exercise 0 -8.375$160 $160-$155 > 0 Exercise $5 -3.375$165 $165-$155 > 0 Exercise $10 1.62555/1/2006 FIN3710 - Investment - Professor Rui Yao 9Payoff vs. P/L for Call Option Payoff Diagram of IBM Dec155 CallValue0-$8 3/8(Premium)Payoff of ACall OptionX = $155ST IBM price at TP/LOTM RegionITM Region5/1/2006 FIN3710 - Investment - Professor Rui Yao 10Leverage Effect of Call Option IBM price $150; IBM Dec150 ATM call price $15; Start with $15,000 in the account Strategy 1 (all equity): buy 100 share of IBM Strategy 2 (all option): buy 10 contract callStrategy 1 Strategy 2STGain at T Return Gain at T Return$180 100*30 20% 10*100*15 100%$120 100*(-30) -20% 10*100*(-15) -100%Options magnify both gains and losses65/1/2006 FIN3710 - Investment - Professor Rui Yao 11ITM Region OTM RegionX = $155Payoff vs. Profit / Loss for Put Option IBM Dec155 PutValue-$3 7/8ST IBM Price at T0$155Payoff of Puts at T: = X - STif ST< X= 0 if ST> XPayoffP/L5/1/2006 FIN3710 - Investment - Professor Rui Yao 12Wrap-up Definition of Call and Put options Difference between American and European options ITM vs. OTM vs. ATM Option payoff vs. option profit/loss Payoff and P/L diagrams for call and