.

1. Investments: Analysis
and Behavior
Chapter 18- Options Markets
and Strategies
©2008 McGraw-Hill/Irwin

2. 18-2
Learning Objectives
 Understand the characteristics of call and put options
 Know the uses of index options
 Be able to implement covered call and protective put
strategies
 Utilize Black-Scholes option pricing

3. 18-3
Options Markets
 Derivative securities: value is derived or stems
from changes in the value of some other assets.
 Call option: the right (but not obligation) to buy
 Put option: the right (but not obligation) to sell
 Total volume - 1.5 billion contracts (2005)
 The most popular options - equity options

4. 18-4
Figure 18.1 Trading Activity in Equity Options Contracts Has Risen Sharply
0
200,000,000
400,000,000
600,000,000
800,000,000
1,000,000,000
1,200,000,000
1,400,000,000
1,600,000,000
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
OCC
Total
Yearly
Cleared
Contract
Volume
Total Contract Volume
Equity Options
Non-Equity Options
Source: Options Clearing Corporation

5. 18-5
Characteristics of Exchange Traded Options
 Four types of underlying assets
 Equity securities
 Stock indexes
 government debt securities
 foreign currencies
 Have standardized terms
 Trading activity is determined by supply and demand
 Option interest: number of outstanding options

6. 18-6
 Exercise price (or Strike price): Promised or
predetermined price for underlying assets
At-the-money: when option price equals current
market price of underlying assets
 In-the-money: when the strike price is less (more)
than the market price of the underlying asset for
a call (put)
 Out-of-money: when the strike price is more
(less) than the market price of the underlying
asset for call (put)

7. 18-7
Figure 18.2 Call and Put Options Quotes and Volume on Microsoft, CBOE
MSFT 26.93 -0.04
Mar 05, 2006 @ 18:27 ET (Data 15 Minutes Delayed) Bid 26.93 Ask 26.93 Size 14x146 Vol 45234151
Calls
Last
Sale
Net Bid Ask Vol
Open
Int
Puts
Last
Sale
Net Bid Ask Vol
Open
Int
06 Mar 22.50
(MSQ CX-E)
4.60 pc 4.40 4.50 0 667
06 Mar 22.50
(MSQ OX-E)
0.05 pc 0 0.05 0 110
06 Mar 25.00
(MSQ CJ-E)
2.15 +0.10 1.95 2.00 47 14613
06 Mar 25.00
(MSQ OJ-E)
0.05 pc 0 0.05 0 17347
06 Mar 27.50
(MSQ CY-E)
0.10 -- 0.05 0.15 2578 79580
06 Mar 27.50
(MSQ OY-E)
0.65
+0.
10
0.60 0.70 883 16534
06 Mar 30.00
(MSQ CK-E)
0.05 pc 0 0.05 0 23610
06 Mar 30.00
(MSQ OK-E)
2.90
-
0.20
3.00 3.20 2 785
06 Apr 22.50
(MSQ DX-E)
4.60 pc 4.50 4.60 0 13679
06 Apr 22.50
(MSQ PX-E)
0.05 pc 0 0.05 0 35081
06 Apr 25.00
(MSQ DJ-E)
2.15 -- 2.10 2.20 30 57696
06 Apr 25.00
(MSQ PJ-E)
0.10 pc 0.05 0.10 0 49933
06 Apr 27.50
(MSQ DY-E)
0.35 -0.05 0.35 0.40 461 147305
06 Apr 27.50
(MSQ PY-E)
0.80
+0.
05
0.75 0.85 128 34125
06 Apr 30.00
(MSQ DK-E)
0.05 pc 0 0.05 0 115365
06 Apr 30.00
(MSQ PK-E)
3.08 pc 3.00 3.10 0 670

8. 18-8

9. 18-9
 Option premium: price at which the contract
trades (the amount paid for the option)
 Long-term Equity AnticiPation Securities
(LEAPS): expiration dates up to three years.
Trading symbol for stock options – combination of
the stock ticker symbol, plus a letter to indicate
the month of the year, plus a final letter to
indicate strike price

10. 18-10
Expiration Months Code
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
Calls A B C D E F G H I J K L
Puts M N O P Q R S T U V W X
Strike Price Codes
A B C D E F G H I J K L M
5 10 15 20 25 30 35 40 45 50 55 60 65
105 110 115 120 125 130 135 140 145 150 155 160 165
205 210 215 220 225 230 235 240 245 250 255 260 265
305 310 315 320 325 330 335 340 345 350 355 360 365
405 410 415 420 425 430 435 440 445 450 455 460 465
505 510 515 520 525 530 535 540 545 550 555 560 565
605 610 615 620 625 630 635 640 645 650 655 660 665
705 710 715 720 725 730 735 740 745 750 755 760 765
N O P Q R S T U V W X Y Z
70 75 80 85 90 95 100 7.50 12.50 17.50 22.50 27.50 32.50
170 175 180 185 190 195 200 37.50 42.50 47.50 52.50 57.50 62.50
270 275 280 285 290 295 300 67.50 72.50 77.50 82.50 87.50 92.50
370 375 380 385 390 395 400 97.50 102.50 107.50 112.50 117.50 122.50
470 475 480 485 490 495 500 127.50 132.50 137.50 142.50 147.50 152.50
570 575 580 585 590 595 600 157.50 162.50 167.50 172.50 177.50 182.50
670 675 680 685 690 695 700 187.50 192.50 197.50 202.50 207.50 212.50
770 775 780 785 790 795 800 217.50 222.50 227.50 232.50 237.50 242.50

11. 18-11
Options Clearing Corporation (OCC)
 Sole issuer of all securities options listed on
exchanges and NASD
 All option transactions are ultimately cleared
through OCC
 OCC takes the opposite side of every option
traded
 Guarantees contract performance and reduces
the credit risk.

12. 18-12
Option concept
 Option contracts are a
zero sum game before
commissions and other
transaction costs.
 Hedged position: option transaction to offset
the risk inherent in some other investment (to
limit risk)
 Speculative position: option transaction to profit
from the inherent riskiness of some underlying
asset.

13. 18-13
Option style and settlement
 Option holder: long the option position
 Option writer: short the option position
 Style
 American style option: exercised at any time (All stock options in
the US)
 European style option: only exercised on the expiration date.
 Delivery
 Physical delivery option: actual delivery of the underlying asset
takes place
 Cash-settle option: cash payment based on difference between
exercise price and current determined price of the underlying
asset
 Contract size: usually for 100 shares of stock

14. 18-14
Option types
 Stock Options: generally cover 100 shares of
underlying securities. Adjustment made for stock
dividend, stock split, merger, etc.
 Index options: Standard and Poor’s 100 Index
(OEX) are the most actively traded.
 Debt Options
 Physical delivery price-based options: right to
purchase (sell) a debt security
 Cash settled price-based options: right to receive
cash based on the value of debt security
 Yield based options: cash settled based on the
difference between the exercise price and value of an
underlying yield.

15. 18-15
Call Option strategies
 Long position: the right (but not obligation) to
buy the underlying asset at a strike price for a
limited period of time.
 The right to buy stock at a fixed price becomes more
valuable as price of stock increases (in the money
when current stock price > exercise price)
 Risk for buyer is limited to the call premium and
potential is unlimited
 Short position: payoff mirror image of long
position (zero sum game)
 Covered call: sale of a call option on a stock that
is owned.

16. 18-16

17. 18-17

18. 18-18
Put option strategies
 Long position: the right, but not obligation, to sell
an underlying asset at strike price.
 The right to sell stock at a fixed price becomes
valuable as price of the stock decreases (in the
money when current price < exercise price)
 Risk for buyer is limited to the premium and profit is
also limited (price cannot be below zero)
 Short position: mirror image of long position
 Protective put: insurance against a sharp
correction. Purchase of a stock and put option

19. 18-19

20. 18-20

21. 18-21
Combinations
 Spread: both buyer and writer of the same type
of option on the same underlying asset
 Price spread: purchase or sale of options on the
same underlying asset but different exercise price
 Time spread: purchase or sales of options on the
same underlying asset but different expiration dates
 Bull call spread: purchase of a low strike price
call and sale of a high strike price call.
 Bull put spread: sale of high strike price put and
purchase or a low strike price put

22. 18-22
Payoff
Long call
Short call
Bull call spread
Payoff
Long put
Short put
Bull put spread
Payoff
Long call Short put
Straddle
Straddle : purchasing a call and
Writing a put on the same asset,
exercise price, and expiration date

23. 18-23
Option pricing
 Factors contributing value of an option
 price of the underlying stock
 time until expiration
 volatility of underlying stock price
 cash dividend
 prevailing interest rate.
 Intrinsic value: difference between an in-the-money
option’s strike price and current market price
 Time value: speculative value.
Call price = Intrinsic value + time value

24. 18-24

25. 18-25
Black-Scholes Option Pricing Model
Where C: current price of a call option
S: current market price of the underlying stock
X: exercise price
r: risk free rate
t: time until expiration
N(d1) and N (d2) : cumulative density functions for d1 and d2
   
)
(
)
( 2
1 d
N
e
X
d
N
S
C rt


funds
invested
of
cost
y
Opportunit
potential
upside
of
Value
price
Call


   
t
t
r
X
S
d

 2
1
5
.
0
ln 

 t
d
d 1
2 



26. 18-26
Example
Current stock price: 50 exercise price : 55
Risk free rate: 6.25% time to expiration: 6 months
Volatility: 40% What is the call price?
Solution
   
0851
.
0
2828
.
0
0713
.
0
0953
.
0
5
.
0
4
.
0
5
.
0
4
.
0
5
.
0
0625
.
0
55
50
ln
d
2
1










3679
.
0
5
.
0
4
.
0
0851
.
0
d 2





N(d1) = 0.4661 N(d2) = 0.3564
   
30
.
4
$
]
3564
.
0
[
55
]
4661
.
0
[
50
)
(
)
(
price
Call
)
5
.
0
)(
0625
.
0
(
2
1





e
d
N
e
X
d
N
S rt

27. 18-27
Put call parity
 Relationship between the price of a put
option and the price of a call option on the
same underlying equity.
 Using the same values before,
C
S 

 rt
e
X
price
Put
61
.
7
$
30
.
4
50
e
55
price
Put .5)
(0.0625)(0





28. 18-28
Option risks
 Delta: the sensitivity of option value to a unit
change in the underlying asset (hedge ratio)
 Gamma: The responsiveness of delta to unit
changes in the value of the underlying asset
 Theta: The sensitivity of option value to
change in time
 Vega: The sensitivity of option value to change
in volatility
 Rho: The sensitivity of option value to changes
in interest rate

29. 18-29
Such values are presented in CBOE Option
Calculator ( www.cboe.com )