Option Markets Chapter 9

Topic 6

Important Concepts

Definitions and examples of call and put options Options available for trading Mechanics of trading options Payoff profiles Accessing option price quotations Time Value and Intrinsic Value Margins

Options
An option gives the holder the: right to buy or to sell a certain amount of an underlying asset

at a specified price at a particular time (or for a specified period of time) the right to buy or to sell a share the right to buy or to sell a commodity the right to convert a convertible preference share or a convertible bond

Examples:

Option Terminology

Option Premium/Price the amount paid by the option buyer to the option seller (referred to as the option writer) Strike (Exercise) price the price at which the holder of the option has the right to buy or to sell. Expiration date the right to buy or to sell exists up to a specified expiry date

Types of Options
CALL OPTION:

Gives the holder the right to buy the underlying asset at the exercise price Hedger: might buy a Call to hedge against a rise in the price of an underlying asset that it intends to buy in the future

Examples of who might buy a call option

Speculator: might buy a Call based on the view that the underlying asset price would increase

Types of Options (cont.)

PUT OPTION:

Gives the holder the right to sell the underlying asset at the exercise price Hedger: might buy a Put to hedge against a fall in the price of an asset held, or on asset it expects to have/produce in the future.
Speculator: might buy a Put based on the view that the underlying asset price would decrease;

Examples of who would buy a put option

Remember !!!
Buy Call Sell Put

Types of Options (cont)

European option:

an option that can only be exercised on a particular date (at expiry).

American option:
an option that can be exercised at any time up to its expiry date Most exchange traded options are American style but it is not common to exercise before expiry date (for reasons discussed later) OTC options are usually European options

Over-the-Counter Options Market

Worldwide Customized - terms such as exercise price, expiry date and amount are customised Private transactions Unregulated market Credit risk counterparties exposed to each others credit risk OTC options on bonds, interest rates & currencies are the most common

Organized Options Trading on Exchanges

Listing Requirements Contract Size specified Exercise Prices set by market makers Expiration Dates determined by exchange Margins who writes options Clearing House guarantees that the options writes will fulfill their obligations

Exchange Traded - Option Traders

Market Maker

Most options exchanges use market makers to facilitate trading A market maker quotes both bid (what they are prepared to buy at) and ask (what price they are prepared to sell at) prices when requested

Bid-ask spread

Bid price lower than the ask price Spreads widen if market liquidity is low

Types of options

Share Options and Share Price Index Options Currencies Interest Rates Commodities eg. oil Options on futures contracts * Other Types of Traded Options

options attached to bonds warrants, callable bonds, convertible bonds

Option Positions

There are two sides to every option contract. On one side is the investor who buys the call or the put option On the other side is the investor who sells or writes the call or the put option The buyer of a call or put must pay the option premium (effectively to the option writer) The writer of an option receives the option premium up front for accepting risk but has potential liabilities later.

Option Positions (cont)

The writers profit or loss on an option transaction is the reverse of that for the option buyer (ignoring transaction costs such a brokerage)

Notation for the following payoff diagrams

Ct = price (option premium) of call Pt = price (option premium) of put K = exercise (strike) price T = time to expiry of the option ST = price of the underlying asset (shares in the following illustrations) Option payoff at maturity (long position) CT = Max (0, ST K) PT = Max (0, K ST)

Payoff Profile: Long (Bought) Call

Assume: Ct = $1.50 So = $10; K = $11; T = 6m Profit ($) +$2.50

Break Even @ $12.50 Unlimited Upside

$0
$10 $11 $12.50

$15

Price (ST)

-$1.50
Maximum Loss = $1.50

Payoff Profile: Short (Written) Call

Assume: Ct = $1.50 So = $10; K = $11; T = 6m Profit ($) Maximum Gain = $1.50

+$1.50 $0
$10 $11 $12.50

$15

Price (ST)

Break even @ $12.50 Unlimited Downside

Payoff Profile: Long (Bought) Put

Assume: Pt = $0.90 So = $10; K = $9 ; T = 4m Profit ($) Break Even @ $8.10 Unlimited Upside

$0
$8.10 $9 $10

Price (ST)

-$0.90

Maximum Loss = $0.90

Payoff Profile: Short (Written) Put

Assume: Pt = $0.90 So = $10; K = $9; T = 4m Profit ($)

Maximum Gain = $0.90

+$.90

$0
$8.10 $9

$10

Price (ST)

Break Even @ $8.10 Unlimited Downside

Comparison of Bought Call with Long Futures

Assume: Ct = $1.50 So = $10; K = $10; T = 6m

Profit ($)

Long Futures Bought Call

+$5.00

+$3.50

$0
$10 $11.50

$15

Price (ST)

-$1.50
Bought Call: Unlimited Upside; Limited Risk Long Futures: Unlimited upside; unlimited risk

Option Price Quotations

For ASX share options refer www.asx.com.au and follow the prompts for options Options exchanges websites Newspapers For quotes on futures options go to http://www.futuresource.com and click on the option icon to the right of screen of futures quotes Problems Delayed information Non-synchronized prices

22

Example: BHP-Billiton Call & Put Prices 28/8/08; Share Price (S) = $40.90
Option C/P Expiry Exercise Margin Code Date Price Price* BHP11 C 30/10/08 40.00 3.16 BHP13 C 30/10/08 41.00 2.65 BHP18 C 30/10/08 42.00 2.16 BHP19 C 30/10/08 43.00 1.77 BHPV6 C 30/10/08 44.00 1.40 BHPWE C 30/10/08 45.00 1.10 Open Contract Interest Size 956 1000 294 1000 476 1000 866 1000 1486 1000 284 1000

BHP1E P 30/10/08 37.00 1.20 691 1000 BHP1R P 30/10/08 38.00 1.49 187 1000 BHP1W P 30/10/08 39.00 1.85 304 1000 BHP1Y P 30/10/08 40.00 2.34 339 1000 BHP14 P 30/10/08 41.00 2.73 96 1000 The theoretical fair value of the option calculated by the Australian Clearing * House (ACH) which is used to calculate the value of any margin obligations

Reading Option Quotes

Calls

Option premium (price) decreases as strike price increases. For example:

Oct $41 C = $2.65; Oct $43 C = $1.77

(margin prices used in this illustration are indicative only of bid-ask spread)

Option premium increases as time to expiration increases. For example:

Oct $41 C = $2.65 Dec $41 C = $3.70 (not shown in example)

Reading Option Quotes

Puts

Put option price decreases as strike price decreases; for example:

Oct $40 P = $2.34 Oct $38 P = $1.49

Put option price increases as time to expiration increases. For example:

Oct $40 P = $2.34 Dec $40 P = $3.01 (not shown)

More Terminology
At-the-money option share price (S0) = strike price (K) In-the-money option S0 > K for a long call S0 < K for a long put Out-of-the-money option S0 < K for a long call S0 > K for a long put

More Terminology (cont)

Intrinsic value

The amount by which an option is in the money

For example, the intrinsic value of a BHP Oct $40 Call = $40.90 - $40

= $0.90

Time value

Option premium (price) less intrinsic value For example, the time value of a BHP Oct $40 Call = $3.16 - $0.90

= $2.26