Derivatives (ECONM3017)

Lecture Six: Options I

(Basic Details)

Nick Taylor
nick.taylor@bristol.ac.uk

University of Bristol

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Table of contents

1 Learning Outcomes

2 Review

3 Specifics

4 Trading Details

5 Option-Related Instruments

6 Summary

7 Reading

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Learning Outcomes

At the end of this lecture you will be able to:

1 Understand the basic features/terminology associated with options.
2 Adjust options prices in the presence of dividends and stock splits.
3 Appreciate some of the details associated with options trading.

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Review

Types
American Call Option (right, buy, prior to maturity).
American Put Option (right, sell, prior to maturity).
European Call Option (right, buy, at maturity).
European Put Option (right, sell, at maturity).

Plus many more...

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Review (cont.)

Notation
ST denotes the price of the underlying asset at expiration.
K denotes the (pre-specified) strike price.
Payoffs
Long call position payoff is max(ST − K , 0).
Short call position payoff is − max(ST − K , 0) = min(K − ST , 0).
Long put position payoff is max(K − ST , 0).
Short put position payoff is − max(K − ST , 0) = min(ST − K , 0).

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Review (cont.)

Payoffs (cont.)
Payoff 6 Payoff 6

- K -
K ST @ ST
@
@
@
@
@
Long Position in Call Option Short Position in Call Option

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Review (cont.)

Payoffs (cont.)
Payoff 6 Payoff 6
@
@
@
@
@
@ - K -
K ST ST

Long Position in Put Option Short Position in Put Option

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Specifics

Underlying Assets
Stocks (mainly American-style).
Foreign Currency.
Stock Indices (mainly European-style).
Futures.

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Specifics (cont.)

Contract Specifics (stock options)

Expiration Dates.
Strike Prices.
European or American.
Call or Put (option class).

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Specifics (cont.)

Moneyness
Calls Puts
In-the-money S>K S <K
At-the-money S≈K S ≈K
Out-of-the-money S<K S >K

Intrinsic Value and Time Value

Intrinsic Value of a Call = max(0, S − K ),
Intrinsic Value of a Put = max(0, K − S),

Note that the residual value of the

premium is the time value of the
option.

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Specifics (cont.)

Dividends and 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 mK /n.
The number of options is increased to nN/m.
Stock dividends are handled in a manner similar to stock splits.

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Specifics (cont.)

Dividends and Stock Splits (cont.)

Example (stock split)

Consider a call option to buy 100 shares of a company for $30 per share.
Suppose that the company makes a 2-for-1 stock split. In this instance, the
terms of the contract are changed so that the holder has the right to purchase
200 shares for $15 per share.

Example (share dividend)

Consider a put option to sell 100 shares of a company for $15 per share.
Suppose that the company declares a 25% stock dividend (note: not a cash
dividend). The stock dividend is equivalent to a 5-for-4 stock split. The terms
of the contract are changed so that the holder has the right to sell 125 shares
for $12 per share.

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Trading Details

Market Makers
Most exchanges use market makers to facilitate options trading.
A market maker quotes both bid and ask prices when requested.
The market maker does not know whether the individual requesting the
quotes wants to buy or sell.
Commissions
Fixed plus proportional commissions plus the market maker’s bid-ask spread.

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Trading Details (cont.)

Margins
Margins are required when options are sold.
When a naked option is written the margin is the greater of:
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.
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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Trading Details (cont.)

The Options Clearing Corporation (OCC)

The OCC guarantees that the options writer will fulfill their obligation.
The OCC provides sufficient capital to guarantee every trade.
When you want to exercise an option:
An OCC member is informed.
The OCC randomly assigns another member with an outstanding short
position.
This member assigns this exercise to a particular investor (referred to
as an ‘assigned investor’).

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Option-Related Instruments

Warrants
These are options issued by a financial institution or nonfinancial
corporation.
Employee Stock Options
These are call options issued to executives by their company.
Convertible Bonds
These are company issued bonds that can be converted into equity at
certain times using a predetermined exchange ratio.

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Summary

Review of Concepts
European v. American, call v. put, and payoffs.
Option Specifics
Underlying assets, contract specifics, moneyness, intrinsic and time value,
and dividends and stock split adjustments.
Trading Details
Market makers, commissions, margins, and the OCC.

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Reading

Essential Reading
Chapter 10, Hull (2015).
Further Reading
Chicago Board Options Ex-
change, Characteristics and Risks of Standardised Options. Available online at
www.optionsclearing.com/about/publications/character-risks.jsp.

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