DERIVATIVES – OPTIONS MARKETS (CH 20)
THE OPTION CONTRACT
Call option Put option
Gives holder the right to purchase an asset Gives holder the right to sell an asset for a
for a specified price (exercise or strike specified exercise or strike price on or
price) on or before some specified. before some expiration date.
Sellers of call options are said to write calls Sellers of put options are said to write puts.
(holding a call).
Call only exercised if price of underlying Put only exercised if price of underlying
asset is more than exercise price asset is less than exercise price.
Call holders have decision-making power → choose to trade at a price most favourable to
them.
Worried about prices rising → take out a call option
Worried about prices falling → take out a put option
X = $105
So = $101.51
ST = ?
Co = $1.45
Po= $4.79
The purchase price of the option is called
the premium. It represents the
compensation the call holder pays to the
call writer that gives them the right to
exercise the option.
Note:
- underlying stock price = price currently trading at
- once your call/put option expires you have the option to take out a new one
- time to expiration affects value of option
▪ longer time to expiration = greater chance of something unexpected
occurring
,Market and exercise price relationships:
- in the money → exercise would result in a positive cashflow
▪ call option: asset price > exercise price (ST > X)
▪ put option: asset price < exercise price (ST < X)
- out of the money → exercise would result in a negative cashflow
▪ payoff at worst = 0
- at the money → exercise and asset prices equal
▪ would make a loss once the premium is accounted for
Note:
- C0 (call option premium) = $1.45; S0 = $101.51; ST = $106; X =. $105
, Note:
- P0 (put option premium) = $4.79; ST = $98; X = $105
- In the money because ST < X
- Losses are capped because you can choose not to exercise
Options trading
- options contracts traded on exchanges are standardized by allowable expiration
dates & exercise prices
- each stock option contract gives the option to buy/sell 100 shares of stock
- all market participants trade in a limited & uniform set of securities
▪ lower trading costs
▪ increased market liquidity
Exchanges:
- make markets efficient
- list in-the-money & out-the-money options
Call option → want to buy low
- value of call is lower when exercise price is higher
Put option → want to sell high
- value of a put is higher when the exercise price is higher
American & European options
American options:
- allows holder to exercise right to buy/sell underlying asset on/before expiration date
▪ buy if a call and sell is a put
- generally more valuable than European options
- most traded options in the. US
▪ except foreign currency & stock index options
European options:
- allows holder to exercise right to buy/sell underlying asset on expiration date (only)
- CE/PE = call European / put European
The options clearing corporation (OCC)
- the clearinghouse for options trading places itself btw the buyer and seller
- all individuals deal only with the OCC
▪ effectively guarantees contract performance
THE OPTION CONTRACT
Call option Put option
Gives holder the right to purchase an asset Gives holder the right to sell an asset for a
for a specified price (exercise or strike specified exercise or strike price on or
price) on or before some specified. before some expiration date.
Sellers of call options are said to write calls Sellers of put options are said to write puts.
(holding a call).
Call only exercised if price of underlying Put only exercised if price of underlying
asset is more than exercise price asset is less than exercise price.
Call holders have decision-making power → choose to trade at a price most favourable to
them.
Worried about prices rising → take out a call option
Worried about prices falling → take out a put option
X = $105
So = $101.51
ST = ?
Co = $1.45
Po= $4.79
The purchase price of the option is called
the premium. It represents the
compensation the call holder pays to the
call writer that gives them the right to
exercise the option.
Note:
- underlying stock price = price currently trading at
- once your call/put option expires you have the option to take out a new one
- time to expiration affects value of option
▪ longer time to expiration = greater chance of something unexpected
occurring
,Market and exercise price relationships:
- in the money → exercise would result in a positive cashflow
▪ call option: asset price > exercise price (ST > X)
▪ put option: asset price < exercise price (ST < X)
- out of the money → exercise would result in a negative cashflow
▪ payoff at worst = 0
- at the money → exercise and asset prices equal
▪ would make a loss once the premium is accounted for
Note:
- C0 (call option premium) = $1.45; S0 = $101.51; ST = $106; X =. $105
, Note:
- P0 (put option premium) = $4.79; ST = $98; X = $105
- In the money because ST < X
- Losses are capped because you can choose not to exercise
Options trading
- options contracts traded on exchanges are standardized by allowable expiration
dates & exercise prices
- each stock option contract gives the option to buy/sell 100 shares of stock
- all market participants trade in a limited & uniform set of securities
▪ lower trading costs
▪ increased market liquidity
Exchanges:
- make markets efficient
- list in-the-money & out-the-money options
Call option → want to buy low
- value of call is lower when exercise price is higher
Put option → want to sell high
- value of a put is higher when the exercise price is higher
American & European options
American options:
- allows holder to exercise right to buy/sell underlying asset on/before expiration date
▪ buy if a call and sell is a put
- generally more valuable than European options
- most traded options in the. US
▪ except foreign currency & stock index options
European options:
- allows holder to exercise right to buy/sell underlying asset on expiration date (only)
- CE/PE = call European / put European
The options clearing corporation (OCC)
- the clearinghouse for options trading places itself btw the buyer and seller
- all individuals deal only with the OCC
▪ effectively guarantees contract performance
