Exam 4 Part 5 Derivative Markets Chapter 15 Options Markets 1 2 4 5 6 7 Chapter 16 Options Valuation 3 8 9 10 Chapter 17 Futures Markets and Risk Management 11 12 13 14 15 16 17 1 Elements of to an option Chapter 15 Terminology o Exercise strike price the specified price of option contract o Premium purchase price of the option Small percentage of the cost of underlying asset Option buyer pays the cost Option writer receives the cost o Stock price current market value of the stock o Exercise prices are adjusted for stock splits and stock dividends not cash dividends o Underlying company is not involved in the option market o Options are a zero sum game each participants gain loss is exactly balanced by losses gains of other participants Call option before some specified expiration date gives its holder the right to purchase an asset for specified strike price on or o The holder will choose to exercise the option only if the stock price is greater than the exercise price the option holder will call away the asset for exercise price Value of call option stock price exercise price o If not exercised before the expiration date the option will simply expire no value gives its holder the right to sell an asset for specified strike price on or before Put option some expiration date o The holder will choose to exercise the option only if the exercise price is greater than the price of the underlying asset o Profits on put options increase when the asset value falls 2 Option issuer maker responsibilities interests Chapter 15 Today most option trading occurs in organized exchanges Option contracts traded on exchanges are standardized by o Allowable expiration dates for each listed option o Allowable exercise prices for each listed option Each stock option contract provides for the right to buy or sell 100 shares of stock except when stock splits occur All market participants trade in a limited and uniform set of securities o Increases depth of trading lowers trading costs and increases competition Exchanges offer two important benefits o Ease of trading o A liquid secondary market where buyers and sellers of options can transact quickly and cheaply While exercise prices generally are set at five point intervals for stocks larger intervals may be set for stock selling above 100 and intervals of 2 50 for stocks selling below 30 3 Influences to value valuation of options Chapter 16 If this variable increases Stock Price S Exercise Price X Volatility Time to expiration T Interest Rate r Dividend Payouts The value of a Call Option Increases Decreases Increases Increases Increases Decreases The value of a Put Option Decreases Increases Increases Increases Decreases Increases Current Stock Price S and Exercise Price X o Call Option payoff S X therefore as stock price increases the value of the option increases since it would increase the payoff of the option and as the exercise price increases the value of the option would decrease since it would decrease the payoff of the option o Put Option payoff X S therefore as stock price increases the value of the option decreases since it would decrease the payoff of the option and as the exercise price increases the value of the option would increase since it would increase the payoff of the option Volatility o Call Option and Put Option As possible stock prices at expiration are more volatile the expected option payoff is higher than if these prices were not as volatile Bottom line higher value under high volatility scenario Extremely good stock outcomes can improve the option payoff without limit but extremely poor outcomes cannot worsen the payoff below zero Time Value Time to expiration o Call Option and Put Option The more time an option has until it expires the greater the chance it will end up being profitable or in the money Interest Rate o Call Option Higher interest rates reduce present value of the exercise price benefiting the call option holder o Put Option Higher interest rates reduce present value of the exercise price not benefiting the put option holder because what they are receiving in exchange for the asset will be worth less Dividend Payouts o Because the stock price is expected to drop by the amount of the dividend high cash dividends imply lower call premiums and higher put premiums 4 In out of the money options Chapter 15 In the money when an option s exercise would produce a positive payoff o A call option is in the money when the stock price exercise price Because buying it for less than the current market value o A put option is in the money when the stock price exercise price Because selling it for more than the current market value Out of the money when an option s exercise is not profitable o A call option is out of the money when the stock price exercise price Because buying it for more than the current market value o A put option is out of the money when the stock price exercise price Because selling it for less than the current market value At the money when an option s exercise price and stock price are equal 5 Strategies for profiting on long short positions Chapter 15 Protective Put Long position Buying or holding a call put option owns the right to buy sell Short position Selling or writing a call put option owes the right to buy sell equal to the put s exercise price An asset combined with a put option that guarantees minimum proceeds o AKA investing in a stock and purchasing a put option on that stock o Whatever happens to the stock price you are guaranteed a payoff equal to the put option s exercise price because the put gives you the right to sell the share for the exercise price even if the stock price is below that value If Strike Price X 90 and Stock Price S 87 Sell at 90 Value 90 87 3 If Strike Price X 90 and Stock Price S 94 Don t exercise option sell at 94 o Win Win Situation o It offers some insurance against stock price declines in that it limits losses Covered Call Writing selling a call on an asset together with buying the asset o Written option is covered because the potential obligation to deliver the stock is covered by the stock held in the portfolio o In essence the sale of the call option means the call writer has sold the claim to any stock value above X strike price in return for the initial premium call option price o At expiration the position is worth at most X o To boost income by the premiums collected o The written call guarantees the stock sale will occur as planned 6 Long short