INVESTMENTS FINAL EXAM Chapter 15 The option contract expiration date o Call option The right to buy an asset at a specified exercise price on or before a specified Exercise or strike price price set for calling buying an asset or putting selling an asset EX a September call option on IBM stock with exercise price 170 entitles its owner to purchase IBM stock for a price of 170 at any time up to and including the expiration date in September The holder of the call is not required to exercise the option they will only choose to exercise it if the market value of the asset exceeds the exercise price If it is not exercised before the expiration date of the contract a call option simply expires and becomes valueless In this case all you lose is the premium Net profit of a call is the value of the option minus the price originally paid to purchase it Premium purchase price of an option EX you pay 5 dollars for the right to buy a call at the specific exercise or strike price Sellers of calls who write calls receive the premium income now EX someone pays you a 5 dollar premium so that the can purchase a call from you at a specific price If the option is left to expire the writer of the call seller clears a profit from the premium income But if it is exercised the profit to the option writer is the premium minus the difference between the value of stock and the exercise price Keep in mind that even thought a call is the right to buy a stock at a certain price you can also sell a call meaning you can sell the right to buy So you either 1 Buy or 2 Someone buys from you FOR A CALL o Put option the right to sell an asset at a specified exercise price on or before a specified expiration date EX a September put on IBM with exercise price 170 entitles its owner to sell IBM stock to the put writer at a price of 170 at any time before expiration in September even if the market price is less than 170 While 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 asset You don t need to own shares of IBM to exercise the IBM put option as soon as they re exercised the broker will purchase them and deliver them o In the money An option where exercise would generate a positive cash flow EX call option is in the money when the asset price exceeds the strike price EX put option is in the money when asset price is less than the exercise price o Out of the money An option which if exercised would produce negative cash flow so are therefore never exercised o At the money An option where the exercise price equals asset price o Options trading Some options trade on OTC markets over the counter because it offers an advantage that the terms of the option contract can be tailored to the traders needs The cost of OTC options are high so most options trade on organized exchanges Each stock option contract provides for the right to buy or sell 100 shares of stock except when stock splits occur after the contract is listed and the contract is adjusted for the terms of the split Options trading in the US use to take place on the Chicago board options exchange but now the international securities exchange electronic displaced the CBOE as the largest Options trading in Europe is uniformly transacted in electronic exchanges If the stock price moves outside of the rang of exercises prices offered on the exchange new options may be offered The value of a call is lower when the exercise price is higher because the right to purchase a share is not as valuable when the purchase price is higher EX The September expiration of IBM call option with the strike price of 160 sells for 9 15 while the 170 strike price sells for only 3 LEAPS long term equity anticipation securities for larger firms and several stock indexes longer term options are traded with expirations ranging up to three years o American and European options American option can be exercised on or before its expiration date American style options because they allow more leeway than European style counterparts European options can be exercised only at expiration Most traded options in the U S are American Except for foreign currency options and some generally will be more valuable stock index options o The option clearing corporations The option clearing corporation OCC the clearinghouse for options trading is jointly owned by the exchanges on which stock options are traded It places itself between options traders becoming the effective buyer of the option from the write and the effective writer of the option to the buyer All individuals deal only with the OCC which guarantees contract performance When an option holder exercises an option the OCC arranges for a member firm with clients who have written that option to make good on the option obligation Because the OCC guarantees contract performance it requires option writers to post margin to guarantee that they can fill contract obligations Margin is a certain amount of money that needs to be in your broker account to prove that you can go through with the trade When the required margin exceeds the posted margin the write will receive a margin call The holder of the options doesn t need to post margin because they re only going to exercise if its profitable for them A call option writer seller who already owns the stock against which the option is written can just let the broker hold that stock as margin o Other listed options Index Options a call or put based on a stock market index such as the S P 500 Traded on several broad based indexes and industry specific indexes as well as foreign stock indexes In contrast to stock options index options do not require that the call writer actually deliver the index upon exercise or that the put writer purchase the index instead a cash settlement procedure is used The payoff is equal to the difference between the exercise price of the option and the value of the index EX if the S P index is at 1 280 when a call option with a strike price of 1 270 is exercised then the holder receives cash payment equal to the difference 1 280 1 270 times the multiplies of 100 or 1 000 per contract Options on the major indexes are the most actively traded on the CBOE Futures Options Futures options give their holders the right to buy or sell a specified futures contract using a futures price as the exercise price The terms of the futures options