Investments: Analysis

and Behavior

Chapter 18- Options Markets

and Strategies

©2008 McGraw-Hill/Irwin
Learning Objectives
 Understand the characteristics of call and put options
 Know the uses of index options
 Be able to implement covered call and protective put
strategies
 Utilize Black-Scholes option pricing

18-2
Options Markets

 Derivative securities: value is derived or stems from

changes in the value of some other assets.

 Call option: the right (but not obligation) to buy

 Put option: the right (but not obligation) to sell

 Total volume - 1.5 billion contracts (2005)

 The most popular options - equity options

18-3
 Figure 18.1 Trading Activity in Equity Options Contracts Has Risen Sharply

1,600,000,000
Total Contract Volume
OCC Total Yearly Cleared Contract Volume

1,400,000,000 Equity Options

1,200,000,000

1,000,000,000

800,000,000

600,000,000

400,000,000

200,000,000
Non-Equity Options
0
1975
1977
1979

1991
1993

1999
2001
1973

1981
1983
1985
1987
1989

1995
1997

2003
2005
Source: Options Clearing Corporation

18-4
Characteristics of Exchange Traded Options
 Four types of underlying assets
 Equity securities
 Stock indexes
 government debt securities
 foreign currencies

 Have standardized terms

 Trading activity is determined by supply and demand
 Option interest: number of outstanding options

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 Exercise price (or Strike price): Promised or
predetermined price for underlying assets

At-the-money: when option price equals current

market price of underlying assets
 In-the-money: when the strike price is less
(more) than the market price of the underlying
asset for a call (put)
 Out-of-money: when the strike price is more
(less) than the market price of the underlying
asset for call (put)

18-6
 Figure 18.2 Call and Put Options Quotes and Volume on Microsoft, CBOE

MSFT   26.93   -0.04

Mar 05, 2006 @ 18:27 ET (Data 15 Minutes Delayed) Bid 26.93   Ask 26.93   Size 14x146   Vol 45234151

Last Open Last Open

Calls Net Bid Ask Vol Puts Net Bid Ask Vol
Sale Int Sale Int

06 Mar 22.50 ( 4.60 pc 4.40 4.50 0 667 06 Mar 22.50 0.05 pc 0 0.05 0 110
MSQ CX-E) (MSQ OX-E
)
06 Mar 25.00 ( 2.15 +0.10 1.95 2.00 47 14613 06 Mar 25.00 0.05 pc 0 0.05 0 17347
MSQ CJ-E) (MSQ OJ-E)
+0.1
06 Mar 27.50 ( 0.10 -- 0.05 0.15 2578 79580 06 Mar 27.50 0.65 0.60 0.70 883 16534
MSQ CY-E) (MSQ OY-E 0
) -
06 Mar 30.00 ( 0.05 pc 0 0.05 0 23610 06 Mar 30.00 2.90 3.00 3.20 2 785
MSQ CK-E) (MSQ OK-E 0.20
)06 Apr 22.50
06 Apr 22.50 ( 4.60 pc 4.50 4.60 0 13679 0.05 pc 0 0.05 0 35081
MSQ DX-E) (MSQ PX-E)
06 Apr 25.00 06 Apr 25.00
2.15 -- 2.10 2.20 30 57696 0.10 pc 0.05 0.10 0 49933
(MSQ DJ-E) (MSQ PJ-E)
06 Apr 27.50 06 Apr 27.50 +0.0
0.35 -0.05 0.35 0.40 461 147305 0.80 0.75 0.85 128 34125
(MSQ DY-E) (MSQ PY-E) 5
06 Apr 30.00 06 Apr 30.00
0.05 pc 0 0.05 0 115365 3.08 pc 3.00 3.10 0 670
(MSQ DK-E) (MSQ PK-E)

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18-8
 Option premium: price at which the contract
trades (the amount paid for the option)

 Long-term Equity AnticiPation Securities

(LEAPS): expiration dates up to three years.

Trading symbol for stock options – combination of

the stock ticker symbol, plus a letter to indicate
the month of the year, plus a final letter to
indicate strike price

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 Expiration Months Code

JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
Calls A B C D E F G H I J K L
Puts M N O P Q R S T U V W X

Strike Price Codes

A B C D E F G H I J K L M
5 10 15 20 25 30 35 40 45 50 55 60 65
105 110 115 120 125 130 135 140 145 150 155 160 165
205 210 215 220 225 230 235 240 245 250 255 260 265
305 310 315 320 325 330 335 340 345 350 355 360 365
405 410 415 420 425 430 435 440 445 450 455 460 465
505 510 515 520 525 530 535 540 545 550 555 560 565
605 610 615 620 625 630 635 640 645 650 655 660 665
705 710 715 720 725 730 735 740 745 750 755 760 765
N O P Q R S T U V W X Y Z
70 75 80 85 90 95 100 7.50 12.50 17.50 22.50 27.50 32.50
170 175 180 185 190 195 200 37.50 42.50 47.50 52.50 57.50 62.50
270 275 280 285 290 295 300 67.50 72.50 77.50 82.50 87.50 92.50
370 375 380 385 390 395 400 97.50 102.50 107.50 112.50 117.50 122.50
470 475 480 485 490 495 500 127.50 132.50 137.50 142.50 147.50 152.50
570 575 580 585 590 595 600 157.50 162.50 167.50 172.50 177.50 182.50
670 675 680 685 690 695 700 187.50 192.50 197.50 202.50 207.50 212.50
770 775 780 785 790 795 800 217.50 222.50 227.50 232.50 237.50 242.50

18-10
Options Clearing Corporation (OCC)

 Sole issuer of all securities options listed on

exchanges and NASD
 All option transactions are ultimately cleared
through OCC
 OCC takes the opposite side of every option traded
 Guarantees contract performance and reduces the
credit risk.

18-11
Option concept
 Hedged position: option transaction to offset
the risk inherent in some other investment (to
limit risk)
 Speculative position: option transaction to profit
from the inherent riskiness of some underlying
asset.
 Option contracts are a
zero sum game before
commissions and other
transaction costs.

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Option style and settlement

 Option holder: long the option position

 Option writer: short the option position
 Style
 American style option: exercised at any time (All stock options in the
US)
 European style option: only exercised on the expiration date.
 Delivery
 Physical delivery option: actual delivery of the underlying asset takes
place
 Cash-settle option: cash payment based on difference between
exercise price and current determined price of the underlying asset
 Contract size: usually for 100 shares of stock

18-13
Option types
 Stock Options: generally cover 100 shares of
underlying securities. Adjustment made for stock
dividend, stock split, merger, etc.
 Index options: Standard and Poor’s 100 Index
(OEX) are the most actively traded.
 Debt Options
 Physical delivery price-based options: right to
purchase (sell) a debt security
 Cash settled price-based options: right to receive
cash based on the value of debt security
 Yield based options: cash settled based on the
difference between the exercise price and value of an
underlying yield.

18-14
Call Option strategies
 Long position: the right (but not obligation) to buy the
underlying asset at a strike price for a limited period of
time.
 The right to buy stock at a fixed price becomes more
valuable as price of stock increases (in the money when
current stock price > exercise price)
 Risk for buyer is limited to the call premium and potential is
unlimited
 Short position: payoff mirror image of long position
(zero sum game)
 Covered call: sale of a call option on a stock that is
owned.

18-15
18-16
18-17
Put option strategies

 Long position: the right, but not obligation, to sell an

underlying asset at strike price.
 The right to sell stock at a fixed price becomes valuable as
price of the stock decreases (in the money when current price
< exercise price)
 Risk for buyer is limited to the premium and profit is also
limited (price cannot be below zero)
 Short position: mirror image of long position
 Protective put: insurance against a sharp correction.
Purchase of a stock and put option

18-18
18-19
18-20
Combinations
 Spread: both buyer and writer of the same type
of option on the same underlying asset
 Pricespread: purchase or sale of options on the same
underlying asset but different exercise price
 Time spread: purchase or sales of options on the
same underlying asset but different expiration dates
 Bull call spread: purchase of a low strike price
call and sale of a high strike price call.
 Bull put spread: sale of high strike price put and
purchase or a low strike price put

18-21
 Payoff Straddle
Payoff
Long call
Bull call spread

Long call Short put

Short call
Payoff
Long put
Straddle : purchasing a call and
Writing a put on the same asset,
Bull put spread exercise price, and expiration date

Short put
18-22
Option pricing
 Factors contributing value of an option
 price of the underlying stock
 time until expiration
 volatility of underlying stock price
 cash dividend
 prevailing interest rate.
 Intrinsic value: difference between an in-the-money
option’s strike price and current market price
 Time value: speculative value.

Call price = Intrinsic value + time value

18-23
18-24
Black-Scholes Option Pricing Model
Call Value of Opportunity cost
 
price upside potential of invested funds

X
C  S  N (d1 )  rt  N (d 2 )
e
Where C: current price of a call option
S: current market price of the underlying stock
X: exercise price
r: risk free rate
t: time until expiration
N(d1) and N (d2) : cumulative density functions for d1 and d2

d1 
 
ln  S X   r  0.5 2 t d 2  d1   t
 t 18-25
 Example
Current stock price: 50 exercise price : 55
Risk free rate: 6.25% time to expiration: 6 months
Volatility: 40% What is the call price?
Solution
d1 
 
ln  50 55  0.0625  0.5  0.4 2  0.5 d 2  0.0851  0.4 0.5
0.4 0.5  0.3679
 0.0953  0.0713
  0.0851
0.2828

N(d1) = 0.4661 N(d2) = 0.3564

X
Call price  S  N (d1 )   N (d 2 )
e rt
55
 50[0.4661]  ( 0.0625)(0.5) [0.3564]  $4.30
e
18-26
Put call parity
 Relationship between the price of a put
option and the price of a call option on the
same underlying equity.
X
Put price  rt  S  C
e
 Using the same values before,
55
Put price  (0.0625)(0.5)
 50  4.30  $7.61
e

18-27
Option risks

 Delta: the sensitivity of option value to a unit change

in the underlying asset (hedge ratio)
 Gamma: The responsiveness of delta to unit
changes in the value of the underlying asset
 Theta: The sensitivity of option value to change in
time
 Vega: The sensitivity of option value to change in
volatility
 Rho: The sensitivity of option value to changes in
interest rate

18-28
Such values are presented in CBOE Option
Calculator ( www.cboe.com )

18-29