FINS1612 SUMMARIES

Week 11
Options
1/6 Nature of Options:

An option gives the buyer the right, but not the obligation, to buy or sell
a specified commodity or instrument at a predetermined price (exercise or
strike price) on or before a specified date (expiration date).
o Hence an option will only be exercised if it is in the buyers best
interest
o Therefore there must be the payment of a premium by the buyer
to the seller (writer)

These differ from futures in that they provide asymmetric cover against
price movements.

Options limit the effects of adverse price movements without reducing

profits from favourable price movements.

Types:
o Call options give the option buyer the right to buy the commodity or
instrument at the exercise price
o Put options: Give the buyer the right to sell the commodity or
instrument at the exercise price

These can be exercised only on the expiration date (European) or any time
up to the expiration date (American)

2/6 Option Profit and loss Payoff Profiles:

Call option profit and loss profiles:

The example is where there is a call option for shares in a listed company at
a strike/exercise price (X) of $12 and a premium (P) of $1.50
o The buyer/holder is the long call (Figure A)
o The seller/writer is the short call (Figure B)

o We can see the critical points of the market price of the share (S) at
the time of execution are <$12, $12 to $13.50 and >$13.50.
o If S > X (market price is greater than exercise price), the option is in
the money

Value of the option to buyer/holder (long call):

o V = max(S - X, 0) P

The value of the option to the writer (short call) is:

o V = P - max(S - X, 0)

PUT option profit and loss profiles:

The example is where there is a PUT option for shares in a listed company
at a strike/exercise price (X) of $12 and a premium (P) of $1.50
o Figure A is once again the buyer/holder (long put)
o Figure B is also the writer/seller (short put)

o The critical points here are different to the call example, being where
S at expiration date are <$10.50, $10.50 to $12 and >$12
o The buyer exercises the option is S < X (<$12)

Value of the option to buyer/holder (long call):

o V = max(X - S, 0) P

The value of the option to the writer (short call) is:

o V = P - max(X - S, 0)

Covered and naked options:

Unlike the case with futures, the risk of loss for a buyer of an option
contract is limited to the premium.
However, sellers (writers) of options have potentially unlimited risk and
may be subject to margin requirements unless they write a covered
option
o The write of an option holds the underlying asset or provides a
financial guarantee.
A call option is considered to be written as a covered option if the writer
either:
o Owns sufficient of the underlying asset to satisfy the option contract if
excised
OR
o Is also the holder of a call option on the same asset, but with a lower
exercise price.
The write of a put option has written a covered option if:
o The writer is also the holder of a put option on the same asset, but
with a higher exercise price

3/6 Organisation of the market:

Options markets are broadly divided into OTC (over the counter) and
exchange traded.
o Exchange traded are recorded through a clearing house.

The clearing house acts as a counterparty to buyer and seller,

thus creating two options contracts through the process of
novation

The clearing house is the mechanism that allows buyers and

sellers to close out (reverse) their contracts.

International options markets

o An exchange in a particular country will usually specialise in option
contracts directly related to derivatives (physical or otherwise) that
are also traded in that particular country.

The largest exchanges are the CBOT (Chicago board of trade)

and Chicago Mercantile Exchange (CME) retain open-outcry
trading on the floor involving 4,000 to 5,000 people.

Links between these internationally allow 24-hour trading.

Open outcry is a method of communicating on an exchange involving verbal and

hand signal bids and offers to convey trading information in the trading pits. This
is fading with the introduction of electronic systems that improve execution speed

Australian Options Markets (Types Traded)

Options on Futures Contracts (Traded on SFE (Sydney futures
exchange))
o Buyer of this options contract has the right to buy (Call) or sell
(put) a futures contract

90-day bank-accepted bills

SFE/SPI200 index futures contract

3 and 10-year Commonwealth Treasury bonds

Overnight options on the above Treasury bonds and share price

index futures contracts

Share Options (Traded on the ASX)

o Usually three or more options contracts for each company, each wih
identical expiration dates but different exercise prices
o The options clearing house maintains a system of deposits,
maintenance margins and a share scrip depository.
Warrants: Traded on CLICK XT with settlement through ASX options
clearing house.
o Equity warrants attached to debt issues made by companies raising
funds through primary market debt issues (Option to convert debt
to ordinary shares of the issuing company)
o Financial product warrants issued for investment and to manage
risk exposure to price movements in the market.

Issued by financial institutions in American (up to expiration

date) or Euro-type (on expiration date) contracts

Frictional warrants cover only a part of a listed share so may

require two or more frictional warrants to be exercised to buy a
share.

Fully covered warrants has the underlying shares lodged in a

trust by issuer as a guarantee of issuers capacity to deliver
stock on exercising of warrant.
Price of this involves initial specified instalment and
second instalment based on market value of share.

Index warrants, basket warrants, capped warrants,

instalment warrants, Capital plus warrants, endowment
warrants.

Low-exercise-price options
Over-the-counter options (For options not traded on exchanges such as
money-market instruments and those with unusual maturities)
o Used to set interest rate caps, floors and collars with flexible
amount, term, interest rate, price etc

4/6 Factors Affecting an Option Contract Premium:

1) Intrinsic Value
o Market price of the underlying asset relative to the exercise price
o The greater the intrinsic value, the greater the premium (positive
relationship)

POSITIVE intrinsic value = in the money and the buyer is able

to exercise contract at a profit

NEGATIVE intrinsic value = out of the money and the buyer

will not exercise

ZERO intrinsic value = at the money

2) Time Value
o The longer the time to expiry, the greater the possibility that the
option will be able to be exercised for a profit (positive
relationship)
o If the spot price moves adversely, the loss is limited to the premium
3) Price Volatility
o The greater the volatility, the greater the chance of exercising the
option for a profit or loss.
o The option will be exercised only if the price moves favourably.

o Hence the greater the spot price volatility, the greater the option
premium (positive relationship)
4) Interest Rates
o OPPOSITE impact on put and call options

For a call the benefit of present value of deferred payment if

exercised is greater than lower present value of profit if
exercised. (Positive relationship)

For a put there is an opportunity cost of holding the asset and a

lower present value of the profit if exercised. (negative
relationship)

5/6 Option Risk Management Strategies:

A trader can have the following positions on the future price of the
underlying security
Bullish (price will rise):
Strongly bullish Normal call option
Moderately bullish as stock prices rarely rise by large leaps, setting target
price for bull run and then utilizing bull spreads to reduce costs (not risk as
the option can still expire worthless)
o Used to profit from moderate rise in price of underlying security
o Profit is capped but usually costs less to employ for a nominal amount
of exposure.

Bull call spread: Constructed by buying a call option with low

exercise price and selling another with a higher exercise price
(same security and expiration month)

The lower exercise price will often be at the money whilst the
higher exercise price is out of the money

The combination of long calls and short calls yields a profit

graph like this:

Bull put spread:

Constructed by selling higher striking (in the money) put

options and buying the same number of lower striking (in the
money) put options on the same underlying security with the
same expiration date.

The trader hopes that the price of the underlying security goes
up far enough such that the written put options expire
worthless.

Profit is capped but maximum loss is much smaller than the

capped profit.

Mildly bullish make money in the long run if the underlying stock price
does not go down by the options expiration date. Strategies may provide a
small downside protection as well
o Writing out-of-the-money covered calls is a good example of such a
strategy
Bearish (price will fall):

Strongly bearish Simple put options

Moderately bearish Opposite to bullish, stock prices rarely fall by large

leaps so set a target price for the expected decline and utilize bear spreads
to reduce cost.
o Once again, profit is capped but once again usually costs less to
employ

Bear call spread:

Entered by buying call options of a certain strike price and

selling the same number of call options of lower strike price (in
the money) on the same underlying security with the same
expiration month.

Profit occurs if price goes down to below call option (strike

price) value

Loss occurs if price does not go down or, indeed, rises

Bear put spread:

Buying higher striking (in the money) put options and selling
the same number of lower striking (out of the money) put
options on the same underlying security and the same
expiration month.

Profit maximised when price goes below the strike price of the
written option (profit is difference between strike prices, minus
the cost of entering into the position the premium)

Neutral / non-directional strategies:

Options trader does not know whether the underlying stock price will rise or
fall.
Potential profit does not depend on whether the underlying stock price will
go upwards or downwards.
o Neutral strategies depend on expected volatility of the
underlying stock price
Examples:

Guts: Sell in the money put and call

Butterfly: Buy in the money and out of the money call, sell two at the
money calls (or vice versa)

Risk reversal

Straddle: holding a position in both a call and put with the same strike
price and expiration.
o If the options have been bought, the holder has a long straddle
(bullish on volatility)

Profitable if the underlying

stock changes value in a
significant way

The owner of a long

straddle makes a profit if
the underlying price
moves a long way from
the strike price, either
above or below.

This position is a limited risk, since the most a purchaser may

lose is the cost of both options. At the same time, there is
unlimited profit potential.

If the price goes up enough, he uses the call option and ignores
the put option. If the price goes down, he uses the put
option and ignores the call option. If the price does not change
enough, he loses money, up to the total amount paid for the
two options.

o If the options were sold, the holder has a short straddle

(Bearish on volatility)

Profitable when there

is not such a
significant move

The profit is limited to the

premiums of the put and call,
but it is risky because if the
underlying security's price
goes very high up or very low
down, the potential losses are
virtually unlimited.

The deal breaks even if the intrinsic value of the put or the call equals the sum of the
premiums of the put and call.

The short straddle can also be classified as a credit spread because the sale of the
short straddle results in a credit of the premiums of the put and call.

o Strangle: The simultaneous buying and selling of out-of-the-money

put and out-of-the-money call, with the same expirations

Similar to the straddle but with different strike prices

Unlike a straddle, the options have different strike prices. A

strangle can be less expensive than a straddle if the strike
prices are out-of-the-money

long strangle, loss is decreased if price remains unchanged

compared with long-straddle. (bullish on volatility)

o Short strangle: Sell call and put options, both out of the money.

A short strangle is similar to the Short Straddle except the strike

prices are further apart, which lowers the premium received but
also increases the chance of a profitable trade.

Bearish on volatility

Note: if bullish on volatility can also use short condor and short butterfly
Note: if bearish on volatility - can also use ratio spreads, long condor and
long butterfly

 EG: Long asset (bought) and bearish (negative) about future asset price;
o Limit downside risk by writing (selling) a call option, i.e Short Call
o

EG: Short asset (sold) and bullish (positive) about future asset price;

 Buy a call in the underlying asset (i.e long-call position)

Eg: Expectation of increased volatility with no trend
Hold (buy) a put option
Hold (buy) a call option with common exercise price

Eg: Expect increased volatility, without trend, with stagnation.

Hold (buy) call option with out-of-the-money exercise price
Hold (buy) put option with out-of-the-money exercise price

Eg: Expect price stability

Take opposite position to long straddle and long strangle:

6/6 Options vs. Futures:

The potential gains and losses to buyers and sellers of futures contracts are
different from those of options.
Options provide one-sided price protection that is not available through
futures
The option buyer limits losses and allows profits to accumulate.
o

However, the premium to pay may be quite high.