FINS1612 Summaries - Week 11 - Options.docx

8/17/2019 FINS1612 Summaries - Week 11 - Options.docx

1/14

FINS1612 – SUMMARIES

Week 11Options

1/6 Nature of Options:

• An option gives the buyer the right, but not the o!i"ation, to buy or sell

a specifed commodity or instrument at a predetermined price (e#er$ise or

strike pri$e) on or beore a specifed date (e#piration %ate).

o Hence an option will on!& e e#er$ise% if it is in the u&er's est

interest

o Thereore there must be the payment o a pre(iu( & the u&er

to the seller (writer)

• These dier rom utures in that they provide as&((etri$ $o)er against

price movements.

• ptions limit the eects o adverse price movements without reducing

profts rom avourable price movements.

• *&pes:

o +a!! options give the option buyer the right to buy the commodity or

instrument at the e!ercise price

o ,ut options: "ive the buyer the right to sell the commodity or

instrument at the e!ercise price

• These can be e!ercised only on the e!piration date (#uropean) or any time

up to the e!piration date (American)


2/14

2/6 Option ,ro-t an% !oss ,a&o. ,ro-!es:

• +a!! option pro-t an% !oss pro-!es:

• The e!ample is where there is a call option or shares in a listed company at

a stri$e%e!ercise price (&) o ' and a premium (*) o '.+

o *he u&er/ho!%er is the !on" $a!! (-igure A)

o *he se!!er/riter is the short $a!! (-igure )

o

/e can see the critical points o the mar$et price o the share (0) atthe time o e!ecution are 1', ' to '2.+ and 3'2.+.

o 4 0 3 & (mar$et price is greater than e!ercise price), the option is 5in

the (one&6

• 7alue o the option to buyer%holder (long call)8

o V = max(S - X, 0) – P

• The value o the option to the writer (short call) is8

o V = P - max(S - X, 0)


3/14

• ,U* option pro-t an% !oss pro-!es:

• The e!ample is where there is a ,U* option or shares in a listed company

at a stri$e%e!ercise price (&) o ' and a premium (*) o '.+

o Fi"ure A is on$e a"ain the u&er/ho!%er 0!on" put

o Fi"ure is a!so the riter/se!!er 0short put

o The critical points here are dierent to the call e!ample, being where

0 at e!piration date are 1'.+, '.+ to ' and 3'

o *he u&er e#er$ises the option is S 3 4 03512

• 7alue o the option to buyer%holder (long call)8

o V = max(X - S, 0) – P

• The value o the option to the writer (short call) is8

o V = P - max(X - S, 0)


4/14

+o)ere% an% nake% options:

9nli$e the case with utures, the ris$ o loss or a buyer o an option

contract is limited to the premium.

However, sellers (writers) o options have potentially un!i(ite% risk and

may be sub:ect to margin re;uirements un!ess the& rite a $o)ere%

option

o The write o an option holds the underlying asset or provides a

fnancial guarantee.

A call option is considered to be written as a covered option i the writer

either8

o wns suT (>hicago board o trade)

and >hicago ?ercantile #!change (>?#) retain open@outcry

trading on the oor involving B, to +, people.


5/14

Cin$s between these internationally allow B@hour trading.

Austra!ian Options Markets 0*&pes *ra%e%

Options on Futures +ontra$ts 0 Traded on 0-# (0ydney utures

e!change))

o uyer o this options contract has the ri"ht to u& 0+a!! or se!!

0put a futures $ontra$t

D@day ban$@accepted bills

0-#%0*4 inde! utures contract

2 and @year >ommonwealth Treasury bonds

vernight options on the above Treasury bonds and share price

inde! utures contracts

Share Options 0 Traded on the A0&)

o 9sually three or more options contracts or each company, each wih

identical e!piration dates but dierent e!ercise prices

o The options clearing house maintains a system o deposits,maintenance margins and a share scrip depository.

• Warrants: Traded on >C4>E &T with settlement through A0& options

clearing house.

o E7uit& arrants attached to debt issues made by companies raising

unds through primary mar$et debt issues (Option to $on)ert %et

to or%inar& shares of the issuin" $o(pan&)

o

Finan$ia! pro%u$t arrants issued or investment and to manageris$ e!posure to price movements in the mar$et.

4ssued by fnancial institutions in American (up to expiration

date) or #uro@type (on expiration date) contracts

Fri$tiona! arrants cover only a part o a listed share so may

re;uire two or more rictional warrants to be e!ercised to buy a

share.

Fu!!& $o)ere% arrants has the underlying shares lodged in a

trust by issuer as a guarantee o issuers capacity to deliver

stoc$ on e!ercising o warrant.

8 *rice o this involves initial specifed instalment and

second instalment based on mar$et value o share.

Open out$r& is a method o communicating on an e!change involving verbal and

hand signal bids and oers to convey trading inormation in the trading pits. This

is ading with the introduction o electronic systems that improve e!ecution speed


6/14

In%e# arrants9 asket arrants9 $appe% arrants9

insta!(ent arrants9 +apita! p!us arrants9 en%o(ent

arrants

;o


7/14

o Hence the greater the spot price volatility, the greater the option

premium 0positi)e re!ationship

> Interest Rates

o O,,OSI*E i(pa$t on put an% $a!! options

-or a $a!! the beneft o present value o deerred payment i

e!ercised is greater than lower present value o proft i

e!ercised. 0,ositi)e re!ationship

-or a put there is an opportunity cost o holding the asset and a

lower present value o the proft i e!ercised. 0ne"ati)e

re!ationship


8/14

@/6 Option Risk Mana"e(ent Strate"ies:

A tra%er $an ha)e the fo!!oin" positions on the future pri$e of the

un%er!&in" se$urit&

u!!ish 0pri$e i!! rise:

0trongly bullish I Gormal call option

?oderately bullish I as stoc$ prices rarely rise by large leaps, setting target

price or bull run and then utiliJing bull spreads to reduce costs (not ris$ as

the option can still e!pire worthless)

o 9sed to proft rom moderate rise in price o underlying security

o *roft is capped but usually costs less to employ or a nominal amount

o e!posure.

u!! $a!! sprea%: >onstructed by buying a call option with low

e!ercise price and selling another with a higher e!ercise price

(same security and e!piration month)

The lower e!ercise price will oten be at the (one& whilst the

higher e!ercise price is out of the (one&

The combination o long calls and short calls yields a proft

graph li$e this8

u!! put sprea%:

>onstructed by selling higher stri$ing (in the money) put

options and buying the same number o lower stri$ing (in the

money) put options on the same underlying security with the

same e!piration date.

The trader hopes that the price o the underlying security goesup ar enough such that the written put options e!pire

worthless.


9/14

*roft is capped but ma!imum loss is much smaller than the

capped proft.

?ildly bullish I ma$e money in the long run i the underlying stoc$ price

does not go down by the option6s e!piration date. 0trategies may provide a

small downside protection as well

o /riting out@o@the@money covered calls is a good e!ample o such astrategy

earish 0pri$e i!! fa!!:

• 0trongly bearish I 0imple put options

• ?oderately bearish I pposite to bullish, stoc$ prices rarely all by large

leaps so set a target price or the e!pected decline and utiliJe bear spreads

to reduce cost.

o nce again, proft is capped but once again usually costs less to

employ

ear $a!! sprea%:

#ntered by buying call options o a certain stri$e price and

selling the same number o call options o lower stri$e price (in

the money) on the same underlying security with the same

e!piration month.

*roft occurs i price goes down to below call option (stri$eprice) value

Coss occurs i price does not go down or, indeed, rises

ear put sprea%:

uying higher stri$ing (in the money) put options and selling

the same number o lower stri$ing (out o the money) put

options on the same underlying security and the same

e!piration month.

*roft ma!imised when price goes below the stri$e price o the

written option (proft is dierence between stri$e prices, minus

the cost o entering into the position I the premium)


10/14

Neutra! / non


11/14

o 4 the options were sold, the holder has a short stra%%!e

0earish on )o!ati!it&

*roftable when there

is not such a

signifcant move

The profit is limited to thepremiums of the put and call,

but it is risky because if the

underlying security's price

goes very high up or very low

down, the potential losses are

virtually unlimited.

The deal breaks even if the intrinsic value of the put or the call equals the sum of the

premiums of the put and call.

The short straddle can also be classified as a credit spread because the sale of the

short straddle results in a credit of the premiums of the put and call.

o Stran"!e: The simultaneous buying and selling o out@o@the@money

put and out@o@the@money call, with the same e!pirations

0imilar to the straddle but with dierent stri$e prices

9nli$e a straddle, the options have dierent stri$e prices. A

strangle can be less e!pensive than a straddle i the stri$e

prices are out@o@the@money

!on" stran"!e', loss is decreased i price remains unchanged

compared with long@straddle. 0u!!ish on )o!ati!it&

http://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Strike_price


12/14

o Short stran"!e: 0ell call and put options, both out o the money.

A short strangle is similar to the 0hort 0traddle e!cept the stri$e

prices are urther apart, which lowers the premium received but

also increases the chance o a proftable trade.

earish on )o!ati!it&

Note: if u!!ish on )o!ati!it& – $an a!so use short $on%or an% short utter=&

Note: if earish on )o!ati!it& < $an a!so use ratio sprea%s9 !on" $on%or an%

!on" utter=&

http://www.optiontradingtips.com/strategies/short-straddle.htmlhttp://www.optiontradingtips.com/strategies/short-straddle.html


13/14

#"8 Cong asset (bought) and bearish (negative) about uture asset priceK

o Cimit downside ris$ by writing (selling) a call option, i.e Short Call

o

EB: Short asset 0so!% an% u!!ish 0positi)e aout future asset pri$eC


14/14

uy a call in the underlying asset (i.e long@call position)

E": E#pe$tation of in$rease% )o!ati!it& ith no tren%

Hold (buy) a put option

Hold (buy) a call option with common e!ercise price

E": E#pe$t in$rease% )o!ati!it&9 ithout tren%9 ith sta"nation

Hold (buy) call option with out@o@the@money e!ercise price

Hold (buy) put option with out@o@the@money e!ercise price

E": E#pe$t pri$e stai!it&

Ta$e opposite position to long straddle and long strangle8

6/6 Options )s Futures:

The potential gains and losses to buyers and sellers o utures contracts are

dierent rom those o options.

ptions provide one@sided price protection that is not available through

utures

The option buyer limits losses and allows profts to accumulate.

o However, the premium to pay may be ;uite high.

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FINS1612 Summaries - Week 11 - Options.docx

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