Mechanics of Options MarketsChapter 8*

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

*Assets UnderlyingExchange-Traded OptionsPage 183-184Stocks Stock IndicesFutures Foreign CurrencyBond options VIX

*OptionsOptions are generally different from forwards & futures contracts. An options gives the holder of the option the right to do somethingCall optionsPut optionsBuyer or holderSeller or writerPremiumStrike priceMaturity date

Contract SpecificationsMarket type : N Instrument Type : OPTSTK Underlying : Symbol of underlying security Expiry date : Date of contract expiry Option Type : CE / PE Strike Price: Strike price for the contractTrading cycle: Options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008*

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

*Call OptionA call option is a right, but not an obligation to buy an asset at a predetermined price within a specified time.Long call- expect price rise. Holder of the call has an option to exercise call or not. For this right he pays premium.

Short Call-The callwriterdoes not believe the price of the underlying security is likely to rise. The writer sells the call to collect the premium and does not receive any gain if the stock rises above the strike price.

Payoffs (Call option)When SX buyer exercise the call option

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008*Loss=premium c

Loss=premium c

Gain=S-X-c

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

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A Long position in a Call option

Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 monthsMax(S-X, 0)

*A Short position in a Call (Figure 8.3, page 182) Profit from writing one European call option: option price = $5, strike price = $100. Min(X-S, 0)

*Put optionA put option is a right, but not an obligation to sell an asset at a predetermined price within a specified time.Long put- expect price fall. Holder of the put has an option to exercise putor not. For this right he pays premium.

Short put- doesnt receive any gain if SP< Strike PriceThe option writer receives a premium and incurs an obligation to purchase (if a put is sold) the underlying asset at a stipulated price until a predetermined date.

Payoffs (Put option)When S>X buyer lets the call expireWhen S=X buyer is indifferentWhen S

*A Long position in a Put (Figure 8.2, page 181) Profit from buying a European put option: option price = $7, strike price = $70Max(X-S, 0)

*A Short position in a Put (Figure 8.4, page 182) Profit from writing a European put option: option price = $7, strike price = $70Min(S-X, 0)

Zero- sum gamePayoff of call option X=190*

Price of the assetsPayoff-call buyerPayoff-call writer

Buy from writerSell in the marketProfit/lossSell to holderBuy from marketProfit/loss125Holders doesnt exercise the call option, losses premium paidObligation of writer doesnt arise, gains premium received15017520019020010190200-1022519022535190225-35

Zero- sum gamePayoff of put option X=160*

Price of the assetsPayoff-put buyerPayoff-put writer

Sell to writerBuy from the marketProfit/lossPay to holderSell in the marketProfit/loss12516012535160125-3515016015010160150-10175Holders doesnt exercise the put option, losses premium paidObligation of writer doesnt arise, gains premium received200225

*Payoffs from OptionsWhat is the Option Position in Each Case? K = Strike price, ST = Price of asset at maturityPayoffPayoffSTSTKKPayoffPayoffSTSTKK

*Terminology Moneyness :At-the-money option would have no cash flowsIn-the-money option would have positive CFs to the buyerOut-of-the-money option would result in cash outflow if exercised Intrinsic value Time valueBased on the nature of exerciseBased on how they are traded & settledBased on the underlying asset on which option is created

*Dividends & Stock Splits

Suppose you own N options with a strike price of K :

No adjustments are made to the option terms for cash dividendsWhen there is an n-for-m stock split,the strike price is reduced to K*m/n the no. of shares in options is increased by N*(1+n/m)Stock dividends are handled in a manner similar to stock splits

*Dividends & Stock Splits(continued)Consider a call option to buy 100 shares for 20/shareHow should terms be adjusted:for a 2-for-1 stock split?for a 25% stock dividend?

Margins (Page 190-191)Margins are required when options are soldWhen 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 moneyA total of 100% of the proceeds of the sale plus 10% of the underlying share priceFor other trading strategies there are special rules*

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