Mechanics of Options Markets Chapter 8 1. 2 Assets Underlying Exchange-Traded Options Page 183-184...
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Transcript of Mechanics of Options Markets Chapter 8 1. 2 Assets Underlying Exchange-Traded Options Page 183-184...
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Assets UnderlyingAssets UnderlyingExchange-Traded OptionsExchange-Traded Options
Page 18Page 1833-18-1844
Stocks Stock IndicesFutures Foreign CurrencyBond options VIX
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OptionsOptions
Options are generally different from forwards & futures contracts. An options gives the holder of the option the right to do something
Call optionsPut optionsBuyer or holderSeller or writerPremiumStrike priceMaturity date
Contract SpecificationsContract Specifications
Market type : NInstrument Type : OPTSTKUnderlying : Symbol of underlying securityExpiry date : Date of contract expiryOption Type : CE / PEStrike 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
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Call OptionCall 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)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
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A Long position in a Call A Long position in a Call optionoption
Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months
Max(S-X, 0)
30
20
10
0-5
70 80 90 100
110 120 130
Payoff ($)
Terminalstock price ($)
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A Short position in a A Short position in a Call Call (Figure 8.3, page 18(Figure 8.3, page 1822))
Profit from writing one European call option: option price = $5, strike price = $100.
Min(X-S, 0)
-30
-20
-10
05
70 80 90 100
110 120 130
Payoff ($)
Terminalstock price ($)
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Put optionPut 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- doesn’t 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)Payoffs (Put 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 10
Loss=premium p
Loss=premium p
Gain=X-S-p
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A Long A Long position in a position in a Put Put (Figure 8.2, page 18(Figure 8.2, page 1811))
Profit from buying a European put option: option price = $7, strike price = $70
Max(X-S, 0)
30
20
10
0
-770605040 80 90 100
Payoff ($)
Terminalstock price ($)
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A Short A Short position in a position in a Put Put (Figure 8.4, page 18(Figure 8.4, page 1822))
Profit from writing a European put option: option price = $7, strike price = $70
Min(S-X, 0)
-30
-20
-10
7
070
605040
80 90 100
Payoff ($)Terminal
stock price ($)
Zero- sum gameZero- sum game
Payoff of call option X=190
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Price of the assets
Payoff-call buyer Payoff-call writer
Buy from writer
Sell in the market
Profit/loss
Sell to holder
Buy from market
Profit/loss
125
Holders doesn’t exercise the call option, losses premium
paid
Obligation of writer doesn’t arise, gains premium received
150
175
200 190 200 10 190 200 -10
225 190 225 35 190 225 -35
Zero- sum gameZero- sum game
Payoff of put option X=160
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Price of the assets
Payoff-put buyer Payoff-put writer
Sell to writer
Buy from the market
Profit/loss
Pay to holder
Sell in the market
Profit/loss
125 160 125 35 160 125 -35
150 160 150 10 160 150 -10
175
Holders doesn’t exercise the put option, losses premium
paid
Obligation of writer doesn’t arise, gains premium received
200
225
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Payoffs from OptionsPayoffs from OptionsWhat is the Option Position in Each What is the Option Position in Each
Case? Case? K = Strike price, ST = Price of asset at maturity
Payoff Payoff
ST STK
K
Payoff Payoff
ST STK
K
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TerminologyTerminology
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
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Dividends & Stock Splits 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*m/n the no. of shares in options is increased by N*(1+n/m)
◦Stock dividends are handled in a manner similar to stock splits
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Dividends & Stock SplitsDividends & Stock Splits(continued)(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?
Margins (Page 190-19Margins (Page 190-1911))
Margins are required when options are soldWhen a naked option is written the margin is
the greater of:1 A total of 100% of the proceeds of the sale
plus 20% of the underlying share price less the amount (if any) by which the option is out of the money
2 A total of 100% of the proceeds of the sale plus 10% of the underlying share price
For other trading strategies there are special rules
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