# Options

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...

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