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Chapter 10
Mechanics of OptionsMarkets
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Review of Option TypesA call is an option to buy
A put is an option to sell
A European option can be exercised only atthe end of its life
An American option can be exercised at any
time
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Option PositionsLong call
Long put
Short call
Short put
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Long Call (F igure 10.1, Page 214)Profit from buying one European call option: optionprice = $5, strike price = $100, option life = 2 months
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20
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0-5
70 80 90 100
110 120 130
Profit ($)
Terminalstock price ($)
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Short Call(F igure 10.3, page 216)
Profit from writing one European call option: optionprice = $5, strike price = $100
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70 80 90 100
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Terminalstock price ($)
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Long Put (F igure 10.2, page 215)
Profit from buying a European put option: optionprice = $7, strike price = $70
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0
-770605040 80 90 100
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Terminal
stock price ($)
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Short Put (F igure 10.4, page 216)Profit from writing a European put option: option price= $7, strike price = $70
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Terminalstock price ($)
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Payoffs from Options
What is the Option Position in Each Case?K= Strike price, S
T= Price of asset at maturity
Options, Futures, and Other Derivatives, 9th Edition,Copyright John C. Hull 2014 8
Payoff Payoff
ST
ST
K
K
PayoffPayoff
ST
ST
K
K
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Specif ication of
Exchange-Traded Options
Expiration date
Strike priceEuropean or American
Call or Put (option class)
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TerminologyMoneyness :
At-the-money option
In-the-money optionOut-of-the-money option
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Ways the CBOE I s Trying to Take
Market Share from the OTC Market
Flex options
Binary options
Credit event binary options (CEBOs)
Doom options
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Dividends & Stock Splits(Page 221-222)
Suppose you ownNoptions with a strikeprice ofK:
No adjustments are made to the option termsfor cash dividends
When there is an n-for-mstock split,
the strike price is reduced to mK/n
the no. of options is increased tonN/m
Stock dividends are handled similarly to stocksplits
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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 5% stock dividend?
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Market MakersMost exchanges use market makers tofacilitate options trading
A market maker quotes both bid and askprices when requested
The market maker does not know whether
the individual requesting the quotes wants tobuy or sell
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Margins (Page 224-226)Margins are required when options are sold
When a naked option is written the margin is thegreater of:
A total of 100% of the proceeds of the sale plus20% of the underlying share price less theamount (if any) by which the option is out of themoney
A total of 100% of the proceeds of the sale plus10% of the underlying share price (call) orexercise price (put)
For other trading strategies there are special rules
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WarrantsWarrants are options that are issued by acorporation or a financial institution
The number of warrants outstanding isdetermined by the size of the original issueand changes only when they are exercisedor when they expire
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Warrants(continued)
The issuer settles up with the holderwhen a warrant is exercised
When call warrants are issued by acorporation on its own stock, exercise willusually lead to new treasury stock being
issued
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Employee Stock Options(see also Chapter 16)
Employee stock options are a form ofremuneration issued by a company to its
executivesThey are usually at the money when issued
When options are exercised the company
issues more stock and sells it to the optionholder for the strike price
Expensed on the income statement
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Convertible BondsConvertible bonds are regular bonds that canbe exchanged for equity at certain times inthe future according to a predeterminedexchange ratio
Usually a convertible is callable
The call provision is a way in which the issuer
can force conversion at a time earlier than theholder might otherwise choose
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