Options Market Chapter Objectives •provide a background on options •explain why stock option premiums vary •explain how stock options are used to speculate •explain how stock options are used to hedge • Background on Options •Call Option: right to buy underlying financial instrument at exercise price (or strike price) within a specified period of time. •In the money when market price > exercise price •At the money when market price = exercise price •Out of the money when market price < exercise price •Put Option: right to sell underlying financial instrument at exercise price (or strike price) within a specified period of time. •In the money when market price < exercise price •At the money when market price = exercise price •Out of the money when market price > exercise price Background on Options •Comparison of Options and Futures •To obtain an option, a premium must be paid in addition to the price of the financial instrument. •The owner of an option can choose to let the option expire on the expiration date without exercising it. • Markets Used to Trade Options •The Chicago Board Options Exchange (CBOE), created in 1973, is the most important exchange for trading options. •As the popularity of stock options increased, various stock exchanges began to list options. •Listing Requirements - One key requirement is a minimum trading volume of the underlying stock. •Role of the Options Clearing Corporation - serves as a guarantor on option contracts traded in the United States. •Regulation of Options Trading – SEC and others. • Background on Options •How Option Trades Are Executed •Computer technology allows investors to have trades executed electronically. •Market-makers can execute stock option transactions for customers. •Types of Orders •An investor can use either a market order or a limit order for an option transaction. •Online Trading - Option contracts can also be purchased or sold online. • Background on Options •Stock Option Quotations (Exhibit 14.1) •Institutional Use of Options •Although options positions are sometimes taken by financial institutions for speculative purposes, they are more commonly used for hedging. (Exhibit 14.2) • Viperon Company Stock Option Quotations Determinants of Call Option Premiums •Influence of the Market Price - The higher the existing market price of the underlying financial instrument relative to the exercise price, the higher the call option premium, other things being equal. (Exhibit 14.3) •Influence of the Stock’s Volatility - The greater the volatility of the underlying stock, the higher the call option premium, other things being equal. •Influence of the Call Option’s Time to Maturity - The longer the call option’s time to maturity, the higher the call option premium, other things being equal (Exhibit 14.4) • 14.3 Relationship between Exercise Price and Call Option Premium on KSR Stock Viperon Company Stock Option Quotations Determinants of Put Option Premiums •Influence of the Market Price - The higher the existing market price of the underlying stock relative to the exercise price, the lower the put option premium, other things being equal. (Exhibit 14.5) •Influence of the Stock’s Volatility - The greater the volatility of the underlying stock, the higher the put option premium, other things being equal. •Influence of the Put Option’s Time to Maturity - The longer the time to maturity, the higher the put option premium, other things being equal (Exhibit 14.6) • Relationship between Exercise Price and Put Option Premium on KSR Stock Relationship between Time to Maturity and Put Option Premium on KSR Stock How Option Pricing Can Be Used to Derive a Stock’s Volatility §Some investors assess a specific stock’s risk by using the option-pricing formula to estimate the stock’s anticipated volatility. §By using the prevailing option premium and values for the other factors in the option-pricing formula, the implied volatility or implied standard deviation can be estimated. http://i.investopedia.com/black-scholes.png Black-Scholes Model for option pricing • http://img.youtube.com/vi/VIHldsSmASU/0.jpg Explaining Changes in Option Premiums §Economic conditions and market conditions can cause abrupt changes in the stock price or in the anticipated volatility of the stock price over the time until option expirations, leading to changes in the stock option’s premium. (Exhibit 14.7) §Indicators Monitored by Participants in the Options Market Traders of options tend to monitor economic indicators because economic conditions affect cash flows of firms and thus can affect expected stock valuations and stock option premiums Framework for Explaining Why a Stock Option’s Premium Changes over Time • Speculating with Stock Options •Speculating with Call Options •Call options can be used to speculate on the expectation of an increase in the price of the underlying stock. •See Exhibits 14.8 – 14.11. •Speculating with Put Options •Put options can be used to speculate on the expectation of a decrease in the price of the underlying stock. •See Exhibits 14.12. • Potential Gains or Losses on a Call Option: Exercise Price = $115, Premium = $4 Potential Gains or Losses on a Put Option: Exercise Price = $110, Premium = $2 • Option versus Stock Investments •Purchasing call option •Bullish strategy •Profit when stock prices are increase •Writing call option •Bearish strategy •Profit when stock prices are decrease •Purchasing put option •Bearish strategy •Writing put option •Bullish strategy •Because option values depend on the price of the underlying stock, purchase of options may be viewed as a substitute to direct purchase or sale of a stock • Option versus Stock Investments •Investment Strategy Investment • •Equity only Buy stock @ 100 100 shares $10,000 • •Options only Buy calls @ 10 1000 options $10,000 • •Call +T- bills Buy calls @ 10 100 options $1,000 • Buy T-bills @ 3% $9,000 • Yield Option versus Stock Investments • IBM Stock Price • $95 $105 $115 •All Stock $9,500 $10,500 $11,500 •All Options $0 $5,000 $15,000 •Call + T-bills $9,270 $9,770 $10,770 • •IBM Stock Price • $95 $105 $115 •All Stock -5.0% 5.0% 15% •All Options -100% -50% 50% •Call + T- bills -7.3% -2.3% 7.7% • Rate of Return to Three Strategies bod30611_2006 Hedging – Covered Call •The purchase of a share of stock with a simultaneous sale of a call on the stock •The call is covered because the potential obligation to deliver the stock is covered by the stock held in the portfolio bod30611_t2002 Hedging - Protective Put •Investing in a stock but with unwillingness to bear potential losses beyond some given level •Investing in stock with purchasing a put option on stock • bod30611_t2001 Hedging - Straddle •A long straddle buying both a call and a put on a stock with the same exercise price •For investors who expect move a lot in price but are not certain about direction of the move •The worst scenario for straddle is no movement in the stock price • bod30611_t2003