Options

Topics: Option, Call option, Options Pages: 31 (2474 words) Published: April 6, 2014
GSU, Department of Finance, AFM
Spring 2014

- Chapters 10-11 / page 1 -

Introduction to Derivative Markets
FI 4200/AFM

Characteristics of Options
r Definitions and Positions:
- A Call Option gives its owner for a specified time the right to purchase an underlying good at a specified price (= exercise price or strike price)

- A Put Option gives its owner for a specified time the right to sell an underlying good at a specified price (= exercise/strike price)

- An American Option permits the owner to exercise (=buy/sell the underlying) at any time before or at expiration.
A European Option can be exercised only at expiration

- There are always two positions in an option contract:
BUYER and SELLER.
The buyer of an option has to pay a “price”, the so-called option premium. The seller of an option receives the option premium. The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the owner (=buyer) ever exercises the option

- Four basic positions in options:
(1) Buying a Call à Long Call

(2) Selling a Call à Short Call

(3) Buying a Put à Long Put

(4) Selling a Put à Short Put

Buyer (Long)

Seller (Short)

Put

- Obligation to deliver the
underlying, if buyer
exercises the option

- Pays the premium

Call

- Right to buy the underlying
(i.e. to exercise the option)

- Receives the premium

- Right to sell the underlying
(i.e. to exercise the option)

- Obligation to buy the
underlying, if buyer
exercises the option

- Pays the premium

- Receives the premium

GSU, Department of Finance, AFM
Spring 2014

r

- Chapters 10-11 / page 2 -

Introduction to Derivative Markets
FI 4200/AFM

Trading Options
- Different types of options: Stock options, Index options, Options on Futures (like Commodity Futures, Stock Index Futures, Interest rate Futures, Currency Futures)

- Traded on Option Exchanges (EUREX, CBOE/CBOT, LIFFE, …)
- Options are traded in highly standardized contracts (standardized sizes, expiration dates, exercise prices)

- Different types of option traders:
à Market Makers (take positions)
à Brokers (act as intermediaries)

- Different types of orders:
à Limit orders (price limits, time limits)
à Market orders

r Motivation for engaging in options trading:
Hedging: Hedging of existing positions
Trading:
Speculating on higher/lower prices
Arbitrage: Exploiting price differences between different
markets (for example between derivatives and
spot markets )

r

Role of the Clearinghouse
- Matches all trades
- Guarantees both sides of the transaction
- Legal counterparty for buyers and sellers

r

Margin requirements
- No margin requirements for long positions
- Specific margin requirements for short positions and combinations (dependent on the risk involved in the transaction)

GSU, Department of Finance, AFM
Spring 2014

- Chapters 10-11 / page 3 -

Introduction to Derivative Markets
FI 4200/AFM

r Moneyness
- An option is in-the-money if
⇒ for a call option the price of the underlying exceeds the exercise price ⇒ for a put option the price of the underlying is below the exercise price

- An option is at-the-money if
⇒ the price of the underlying equals (or is very close to) the exercise price

- An option is out-of-the-money if
⇒ for a call option the price of the underlying is below the exercise price ⇒ for a put option the price of the underlying exceeds the exercise price Call

Put

In-the-money
(ITM)

Exercise price
<
price of underlying

Exercise price
>
price of underlying

At-the-money
(ATM)

Exercise price
=
price of underlying

Exercise price
=
price of underlying

Out-of-themoney (OTM)

Exercise price
>
price of underlying

Exercise price
<
price of underlying

Example: Optima Option Quotations (actual share price = 100): Which of the following options are ITM, ATM, OTM?
Exercise...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Currency Futures and Option Markets Essay

    ...CHAPTER 7: CURRENCY FUTURES AND OPTION MARKETS 7.1 FUTURE CONTRACTS 7.1.1 Definition of future contract–&gt; contracts written requiring a standard quantity of an available currency at a fixed exchange rate and at a set delivery date. A future contract is defined as a contractual agreement to buy or sell an asset at a pre-determined price in the future. The contracts detail the quality and quantity of the underlying asset. Background of currency futures in 1972: Chicago Mercantile Exchange (CME) opens International Monetary Market (IMM) CME began with grain and commodities future contracts more than a hundred years ago. 7.1.2 The International Monetary Market (IMM) provides: a) An outlet for hedging currency risk with future contracts (* explanation of hedging next page) b) Definition of future contracts (above) c) Main available futures currencies * EUR (Euro) - CHF (Swiss Franc) * GBP (Britain Pound) - BRL (Brazilian Real) * CAD (Canadian Dollar) - AUD (Australian Dollar) * JPY (Japanese Yen) - NZD (New Zealand Dollar) d) Standard contract sizes contract sizes differ for each of the available currencies. For example: EUR = 125.000 GBP = 62.500 e) Transaction costs : payment of commission to a trader f) Leverage is high the initial margin is required is relatively low, for example, less than 0, 2% of sterling contract value) g) Minimum price movements contracts set to a...

    Read More
    1261 Words 6 Pages
  • Option and Value Essay

    ...related to the price of a European call option on a stock? c. The volatility 5. When we talked about Vega hedging, if a portfolio has 1000 shares of SPY and 10 contracts of at-the-money December 2013 put option on SPY (and nothing else in the portfolio), is the portfolio vega neutral? c. No, the portfolio can never be vega neutral. 6. Which of the following is not true? a. When a CBOE option on IBM is exercised, IBM issues more stock 7. Which of the following is not true? a. Futures contracts nearly always last longer than forward contracts 8. In the corn futures contract a number of different types of corn can be delivered (with price adjustments specified by the exchange) and there are a number of different delivery locations. Which of the following is true? b. This flexibility tends decrease the futures price. 9. Which of the following is true? b. The principal amounts usually flow in the opposite direction to interest payments at the beginning of a currency swap and in the same direction as interest payments at the end of the swap. 10. A trader sells 10 call option contracts on a certain stock. The option price is $10, the stock price is $50, and the option’s delta is 0.65. How can the trader hedge the short position so that the portfolio is delta-neutral? b. The trader needs to buy 650 shares. 0.65 * (-10)*100 = - 650. buy 650 shares to create a delta-neutral position....

    Read More
    1685 Words 7 Pages
  • Option Valuation Essay

    ...Option Valuation Chapter 21 Intrinsic and Time Value intrinsic value of in-the-money options = the payoff that could be obtained from the immediate exercise of the option for a call option: stock price – exercise price for a put option: exercise price – stock price the intrinsic value for out-the-money or at-themoney options is equal to 0 time value of an option = difference between actual call price and intrinsic value as time approaches expiration date, time value goes to zero 21-2 Determinants of Option Values Call + – + + + – Put – + + + – + Stock price Exercise price Volatility of stock price Time to expiration Interest rate Dividend rate of stock 21-3 Binomial Option Pricing consider a stock that currently sells at S0 the price an either increase by a factor u or fall by a factor d (probabilities are irrelevant) consider a call with exercise price X such that dS0 < X < uS0 hence, the evolution of the price and of the call option value is uS0 Cu = (uS0 – X) C S0 dS0 Cd = 0 21-4 Binomial Option Pricing (cont.) now, consider the payoff from writing one call option and buying H shares of the stock, where Cu − Cd uS0 − X H= = uS0 − dS0 uS 0 − dS0 the value of this investment at expiration is Up Down Payoff of stock HuS0 HdS0 Payoff of calls –(uS0 – X) 0 Total payoff HdS0...

    Read More
    960 Words 4 Pages
  • Essay about Call Option and Price

    ...is priced at $3.50. The maximum per-share loss to the writer of an uncovered put is __________, and the maximum per-share gain to the writer of an uncovered call is _________. A. $33; $3.50 B. $33; $31.50 C. $35; $3.50 D. $35; $35 You are cautiously bullish on the common stock of the Wildwood Corporation over the next several months. The current price of the stock is $50 per share. You want to establish a bullish money spread to help limit the cost of your option position. You find the following option quotes: 4. To establish a bull money spread with calls, you would _______________. A. buy the 55 call and sell the 45 call B. buy the 45 call and buy the 55 call C. buy the 45 call and sell the 55 call D. sell the 45 call and sell the 55 call 5. You are cautiously bullish on the common stock of the Wildwood Corporation over the next several months. The current price of the stock is $50 per share. You want to establish a bullish money spread to help limit the cost of your option position. You find the following option quotes: To establish a bull money spread with puts, you would _______________. A. sell the 55 put and buy the 45 put B. buy the 45 put and buy the 55 put C. buy the 55 put and sell the 45 put D. sell the 45 put and sell the 55 put 6. A covered call strategy benefits from what environment? A. Falling interest rates B. Price stability C. Price volatility D. Unexpected events You own $75,000...

    Read More
    2832 Words 12 Pages
  • Futures Contract and Option Essay

    ...speculation, the trader has no such exposure to offset. The trader is simply betting on the future movements of the asset. Arbitrage involves taking a position in two or more markets to lock in a profit. 3. Can you explain the difference between selling a call option and buying a put option? Ans: Selling a call option involves giving someone else the right to buy an asset from you. It gives you a payoff of -max(St-K-0)=min (K-St,0) On the other hand, buying a put option involves buying an option from someone else. It gives you a payoff of Max (K-St,0) It may be noted that in both cases the payoff is K-St. When you write a call option, the payoff is negative or zero since the counterparty chooses to exercise. When you buy a put option, the payoff is zero or positive since you choose whether to exercise or not. 4. What is the difference between entering into a long forward contract when the forward price is Taka 50 and taking a long position in a call option with a strike price of Taka? Ans: In the first case the trader is obligated to buy the asset at for Taka 50 and he/she has no choice. In the second case the trader has an option to buy the asset for Taka and the trader does not have to exercise the option. 5. An investor enters into a short forward contract to sell 200,000 British Pounds for U.S. dollars...

    Read More
    1544 Words 7 Pages
  • Option and Dividend Yield Essay

    ...currently standing at 800. Explain how a put option with a strike price of 700 can be used to provide portfolio insurance. Index goes down to 700 10*(800/700)= 8.75 million Buying put options= 10,000,000/800= 12,500 If you buy the options at 800, the value will be 12,500 times the index with a strike price of 700 therefore providing protection against a drop in the value of the portfolio below $8.75 million. Each contract is on 100 times the index, a total of 125 contracts would be required. 15.2) "Once we know how to value options on a stock paying a dividend yield, we know how to value options on stock indices and currencies." Explain this statement. A stock index is similar to a stock paying a dividend yield, only if the dividend yield is the dividend yield of the index. Currencies are similar to a stock paying a dividend yield, the dividend yield being the foreign risk-free interest rate. 15.3) A stock index is currently 300, the dividend yield on the index is 3% per annum, and the risk-free interest rate is 8% per annum. What is a lower bound for the price of a six month European call option on the index when the strike price is 290? (300e^-0.03*.5)- 290e^-.08*.5 = $16.90 15.4) A currency is currently worth $.80. Over each of the next two months it is expected to increase or decrease in value by 2%. The domestic and foreign risk-free interest rates are 6% and 8%,...

    Read More
    962 Words 4 Pages
  • Essay about Black-Scholes Option Pricing Model

    ...determinants of the option price in the Black-Scholes option pricing model for European options is likely to change the price of a call option. A derivative is a financial instrument that has a value determined by the price of something else, such as options. The crucial idea behind the derivation was to hedge perfectly the option by buying and selling the underlying asset in just the right way and consequently "eliminate risk" (Ray, 2012). The derivative asset we will be most interested in is a European call option. A call option gives the holder of the option the right to buy the underlying asset by a certain date for a certain price, but a put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The date in the contract is known as the expiration date or maturity date; the price in the contract is known as the exercise price or strike price. The market price of the underlying asset on the valuation date is spot price or stock price. Intrinsic value is the difference between the current stock market price and the exercise price or simply higher of zero. American options can be exercised at any time up to the expiration date. European options can be exercised only on the expiration date itself. (Hull, 2012). For example, consider a July...

    Read More
    1490 Words 6 Pages
  • Futures and Options Research Paper

    ...general market conditions. This phenomenon allows the investor to have higher profits and higher losses if the transaction is not developed as I thought. The value of the derivative changes in response to changes in the price of the underlying asset. Currently there are derivatives on all asset classes such as currencies, commodities, stocks, stock indices, precious metals, etc. Derivatives can be traded both organized stock exchanges or organized or not also called counter markets. Like any contract, the derivatives are settled at a future date. Role of Financial Derivatives. We can classify financial derivatives based on different parameters. The most common are: 1. Derivatives according to the type of contract involved: a. Options. b. Forwards. c. Contracts for difference. d. SWAPS. 2. Depending on where derivatives are traded and traded: Derivatives traded on organized markets: Here are standardized contracts on underlying assets that were previously authorized. Furthermore, both the exercise price and the maturity of the contracts are the same for all participants. The operations are performed on an exchange or regulated and organized center such as the Chicago Mercantile Exchange in the United States, where he traded derivatives and futures contracts. Derivatives contracted in unorganized or OTC markets: These are derivatives whose contracts and specifications are tailored to suit the parties to the derivative contract. In these...

    Read More
    1712 Words 7 Pages

Popular Essays

Become a StudyMode Member

Sign Up - It's Free