C. Options Markets

1.  Basic concepts

a.  Call option

• Holder has the right to purchase an asset for a specified price (exercise or strike price) on or before a specified date (expiration date)

• Premium - purchase price of option

• Write - sell option

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• Buy if you expect price to increase, sell if you expect price to decrease

b.  Put option

• Holder has the right to sell an asset for a specified price on or before a specified date

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• Buy if you expect price to decrease, sell if you expect price to increase

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c.  Terminology

• In the money - exercise would yield a positive cash flow

- Asset price > exercise price for calls

- Asset price < exercise price for puts

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• Out of the money - exercise would yield a negative cash flow

- Asset price < exercise price for calls

- Asset price > exercise price for puts

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d.  Options trading

• Standardized expiration dates and exercise prices

• Each option contract involves 100 shares

• Traded on Chicago Board Options Exchange, International Securities Exchange

• European options - can only be exercised on expiration date

• Contract terms adjusted for stock splits

• Options Clearing Corporation - clearing house for options trading

• Other listed options

(1)  Index options

• Options on stock market indexes

• Cash settlement used instead of delivering Index

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(2) Futures options

• Right to buy or sell specified futures contracts

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(3) Foreign currency options

• Right to buy or sell a quantity of a foreign currency

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(4) Interest rate options

• Options on Treasury bills, notes, bonds, and government bonds of major countries

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2.  Value of options at expiration

a.  Call options

(1)  Value to buyer

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(2)  Value to writer

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b.  Put options

(1)  Value to buyer

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(2)  Value to writer

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c.  Options vs. stocks

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• Options provide leverage and potential insurance

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3.  Option strategies

a.  Protective puts

• Invest in stock and buy put

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b.  Covered calls

• Invest in stock and sell call

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c.  Straddles

• Long - buy both a call and a put on a stock with same strike price and expiration date

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• Short - sell both a call and a put

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• Strip - two puts and one call

• Strap - two calls and one put

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d.  Spreads

• Two or more calls or puts with different strike prices or different expiration dates

• Buy one, sell the other

• Money spread - different strike prices

• Time spread - different expiration dates

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e.  Collars

• Bracket value of portfolio between two bounds

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4.  Option-like securities

a.  Callable bonds

• Same as selling straight bond and buying a call option

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b.  Convertible securities

• Convertible bonds or preferred stock

• Option goes to holder of security

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c.  Warrants

• Call options issued by a firm

• New shares issued when exercised, funds go to firm

• Expiration date usually longer

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d.  Collateralized loans

• Collateral offered to get loan

• Same as a call option on the asset

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5.  Exotic options

a.  Asian options

• Payoff depends on the average price of an asset

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b.  Currency-translated options

• Prices denominated in a foreign currency

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c.  Digital options

• Fixed payoff depending on whether a condition is met