Topic 6 Option Market

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Option Markets Chapter 9

Topic 6


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Important Concepts

Definitions and examples of call and putoptions

Options available for trading Mechanics of trading options

Payoff profiles

Accessing option price quotations Time Value and Intrinsic Value

Margins


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Options

An option gives the holder the:

rightto buy or to sell a certain amount of anunderlying asset

at a specified price

at a particular time (or for a specified period of time)

Examples:

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 aconvertible bond


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Option Terminology

Option Premium/Price

the amount paid by the option buyer to theoption seller (referred to as the option writer)

Strike (Exercise) price

the price at which the holder of the option hasthe right to buy or to sell.

Expiration date

the right to buy or to sell exists up to a specifiedexpiry date


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Types of Options

CALLOPTION:

Gives the holder the right to buythe

underlying asset at the exercise priceExamples of who might buy a call option

Hedger: might buy a Call to hedge against arise in the price of an underlying asset that it

intends to buy in the future Speculator: might buy a Call based on the

view that the underlying asset price wouldincrease


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Types of Options (cont.)

PUTOPTION:

Gives the holder the right to sellthe underlying

asset at the exercise priceExamples of who would buy a put option

Hedger: might buy a Put to hedge against a fallin the price of an asset held, or on asset itexpects to have/produce in the future.

Speculator: might buy a Put based on the viewthat the underlying asset price would decrease;


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Remember !!!

Buy Sell

Call Put


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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 tradedoptions are Americanstyle but it is not common to exercise beforeexpiry date (for reasons discussed later)

OTC options are usually European options


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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


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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


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Types of options

Share Options and Share Price IndexOptions

Currencies

Interest Rates

Commodities eg. oil

Options on futures contracts * Other Types of Traded Options

options attached to bonds

warrants, callable bonds, convertible bonds


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Option Positions

There are two sides to every option contract.

On one side is the investor who buysthe callor the put option

On the other side is the investor who sells orwritesthe call or the put option

The buyer of a call or put must pay the option

premium (effectively to the option writer) The writerof an option receives the option

premium up front for accepting risk but haspotential liabilities later.


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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)


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Notation for the followingpayoff diagrams

Ct = price (option premium) of callPt = price (option premium) of putK = exercise (strike) priceT = time to expiry of the optionST = 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)


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Payoff Profile: Long (Bought) CallAssume: Ct = $1.50 So = $10; K = $11; T = 6m

Price (ST)$0

Profit($)

-$1.50

$11 $12.50 $15

+$2.50

Maximum Loss = $1.50

Break Even @ $12.50Unlimited Upside

$10


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Payoff Profile: Short (Written) CallAssume: Ct = $1.50 So = $10; K = $11; T = 6m

Price (ST)$0

Profit ($)

+$1.50

$11 $12.50 $15

Maximum Gain = $1.50

Break even @ $12.50

Unlimited Downside

$10


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Payoff Profile: Long (Bought) PutAssume: Pt = $0.90 So = $10; K = $9 ; T = 4m

Price (ST)$0

Profit ($)

-$0.90$10$8.10

Break Even @ $8.10Unlimited Upside

Maximum Loss = $0.90

$9


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Payoff Profile: Short (Written) PutAssume: Pt = $0.90 So = $10; K = $9; T = 4m

Price (ST)$0

Profit ($)

$10$8.10

Break Even @ $8.10Unlimited Downside

Maximum Gain = $0.90

$9

+$.90


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Comparison of Bought Call with Long FuturesAssume: Ct = $1.50 So = $10; K = $10; T = 6m

Price (ST)$0

Profit ($)

-$1.50

$11.50 $15

+$3.50

$10

Bought Call

Long Futures

Bought Call: Unlimited Upside; Limited RiskLong Futures: Unlimited upside; unlimited risk

$5.00


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Option Price Quotations

For ASX share options refer www.asx.com.au andfollow the prompts for options

Options exchanges websites

Newspapers

For quotes on futures options go tohttp://www.futuresource.com and click on theoption icon to the right of screen of futures quotes

Problems

Delayed information

Non-synchronized prices
http://www.asx.com.au/http://www.futuresource.com/http://www.futuresource.com/http://www.asx.com.au/


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E l BHP Billit C ll & P t


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Example: BHP-Billiton Call & PutPrices 28/8/08; Share Price (S) =$40.90

Option C/P Expiry Exercise Margin Open Contract

Code Date Price Price* Interest SizeBHP11 C 30/10/08 40.00 3.16 956 1000BHP13 C 30/10/08 41.00 2.65 294 1000

BHP18 C 30/10/08 42.00 2.16 476 1000BHP19 C 30/10/08 43.00 1.77 866 1000BHPV6 C 30/10/08 44.00 1.40 1486 1000BHPWE C 30/10/08 45.00 1.10 284 1000

BHP1E P 30/10/08 37.00 1.20 691 1000

BHP1R P 30/10/08 38.00 1.49 187 1000BHP1W P 30/10/08 39.00 1.85 304 1000BHP1Y P 30/10/08 40.00 2.34 339 1000BHP14 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


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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 toexpiration increases. For example: Oct $41 C = $2.65

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


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More Terminology

At-the-money option

share price (S0) = strike price (K)

In-the-money optionS0 > 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


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More Terminology (cont)

Intrinsic value The amount by which an option is in the money

For example, theintrinsic valueof a BHP Oct

$40 Call = $40.90 - $40= $0.90

Time value

Option premium (price) less intrinsic value For example, the time valueof a BHP Oct $40

Call = $3.16 - $0.90

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Topic 6 Option Market

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