Chapter 9 Mechanics of Options Markets

Review of Option Types

A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time

Option Positions
Long call Long put Short call Short put

Long Call
30 Profit ($) 20

(Figure 9.1, Page 195)

Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months

10
70 0 -5 80 90 100

Terminal stock price ($)

110 120 130

Short Call
Profit ($)

(Figure 9.3, page 197)

Profit from writing one European call option: option price = $5, strike price = $100

5 0
-10

110 120 130

70 80 90 100 Terminal stock price ($)

-20 -30
5

Long Put (Figure 9.2, page 196)

Profit from buying a European put option: option price = $7, strike price = $70
30 Profit ($) 20

10 0
-7

Terminal stock price ($)

40

50

60

70

80

90 100

Short Put (Figure 9.4, page 197)

Profit from writing a European put option: option price = $7, strike price = $70
Profit ($) 7 0

40

50

60
70 80

Terminal stock price ($)

90 100

-10 -20 -30

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Payoffs from Options

What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff Payoff

K K
Payoff

ST
Payoff

ST

ST

ST Short call: -max(0,ST-K) Short call: - max(0,K-ST)

Long call: max(0,ST-K) Long put: max(0,K-ST)

Assets Underlying Exchange-Traded Options

Page 198-199

Stocks Foreign Currency Stock Indices Futures

Terminology
Moneyness :
At-the-money option In-the-money option Out-of-the-money option

10

Terminology
(continued)
Option class: all options of the same type (calls or puts) traded on a certain asset Option series: all the options of a given class with the same expiration date and strike price Intrinsic value: maximum of zero and the value of exercise if it were exercised immediately Time value: premium a rational investor would pay over its current exercise value (intrinsic value), based on the probability it will increase in value before expiry.
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Stock Splits
(Page 202-204)

Example: before the stock split the value of a firm is 100$ and is divided into 100 shares worth 1$ each After a 2 for 1 stock split the value of the firm is divided into 200 shares worth 0.5$ each Suppose you own N options with a strike price of K : When there is an n-for-m stock split, the strike price is reduced to mK/n the no. of options is increased to nN/m Stock dividends are handled similarly to stock splits

12

Dividends & Stock Splits: example

Consider a call option to buy 100 shares for $20/share How should terms be adjusted:
for a 2-for-1 stock split? Call option to buy 200 shares for $10/share for a 5% stock dividend? Equivalent to a 21 for 20 stock split (21/20=1.05): the holder of the option has the right to buy 100*21/20=105 share for 20/21*20$=19.05$ each

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Market Makers
Typically trading of options in an exchange market takes place through a market maker. A market maker quotes both bid and ask prices when requested The market maker does not know whether the individual requesting the quotes wants to buy or sell The offer price is higher than the bid and exchanges can set up upper bounds to the bidoffer spread Market makers make the market more liquid
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Margins (Page 205-206)

Margins are required when options are sold When a naked option is written the margin is the greater of: A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money A total of 100% of the proceeds of the sale plus 10% of the underlying share price (call) or exercise price (put) For other trading strategies there are special rules
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Employee Stock Options and Convertible Bonds

Employee stock options are a form of remuneration issued by a company to its executives They are usually at the money when issued When options are exercised the company issues more stock and sells it to the option holder for the strike price Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio

16

Chapter 10 Properties of Stock Options

17

Notation
c: p: S0: K: T: s: European call option price European put option price Stock price today Strike price Life of option Volatility of stock price
D: C: American call option price

P:
ST:

American put option price

Stock price at option maturity PV of dividends paid during life of option Risk-free rate for maturity T with cont. comp.

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Effect of Variables on Option Pricing (Table 10.1, page 215)

Variable
S0 K T s

c
+ ? +

p
+ ? +

C
+ + +

P
+ + +

r D

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American vs European Options

An American option is worth at least as much as the corresponding European option Cc Pp

20

Calls: An Arbitrage Opportunity?

Suppose that
c = 3; S0 = 20; K = 18; T = 1; r = 10%; D = 0

Is there an arbitrage opportunity? S0 Ke rT 20 18e 0.1 3.71 c 3.71 Short the stock and buy the call to get a cash flow of 20$ - 3$ = 17$. Invest for one year and get 17e0.1 = 18.79$ If ST > 18$, exercise the call and get a profit of 0.79$ If ST < 18$, for example, 17$, buy the stock back and make a profit of 18.79$ - 17$ = 1.79$
21

Lower Bound for European Call Option Prices; No Dividends

(Equation 10.4, page 220)

c S0 Ke -rT

22

Puts: An Arbitrage Opportunity?

Suppose that
p= 1; S0 = 37; K = 40; T = 0.5; r =5%; D = 0

Is there an arbitrage opportunity?

Ke

rT

S0 40$e

0.050.5

37$ 2.01$ p 2.01$

Borrow 38$ to buy the put and the stock, and repay after 6 months 38e0.05*0.5=38.96$ If ST < 40 the arbitrageur exercises the put and sells for 40$. The profit is 40$ - 38.96$ = 1.04$ If ST > 40, for example 42$, the arbitrageur discards the option, sells the stock and makes a profit of 42$ - 38.96$ = 3.04$
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Lower Bound for European Put Prices; No Dividends

(Equation 10.5, page 221)

p Ke -rTS0

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Put-Call Parity: No Dividends

Consider the following 2 portfolios: Portfolio A: European call on a stock + zerocoupon bond that pays K at time T Portfolio C: European put on the stock + the stock

25

Values of Portfolios
ST > K Portfolio A Call option Zero-coupon bond ST K K ST < K 0 K

Total
Portfolio C Put Option Share

ST
0 ST

K
K ST ST

Total

ST

26

The Put-Call Parity Result (Equation

10.6, page 222)

Both are worth max(ST , K ) at the maturity of the options They must therefore be worth the same today. This means that

c + Ke -rT = p + S0 c p = S0 - Ke -rT
27

Arbitrage Opportunities
Suppose that

c= 3; S0= 31; K =30; r =10%; T = 0.25; D = 0

What are the arbitrage possibilities when p = 2.25? In this case the put-call parity condition does not hold: Portf. A: c + KerT =3+ 30e-0.1*0.25=32.26$ and Portf. C: p+S0=2.25+31=33.25$ Portfolio C is overpriced: short C and buy A. Buy the call and short both the put and the stock to generate the cash flow -3 + 2.25 + 31= 30.25$ Invest this cash flow at 10% to get 30.25e0.1*0.25=$31.02 in 3 months If ST>30, exercise the call and buy stock for 30.00$. If ST<30 the put is exercised and the counterparty sells at 30.00$. So independently of ST the net profit is: =31.02-30=1.02$
28

Arbitrage Opportunities
Suppose that

c= 3; S0= 31; K =30; r =10%; T = 0.25; D = 0

What are the arbitrage possibilities when p = 1? In this case the put-call parity condition does not hold: Portf.A: c + Ke rT =3+ 30e-0.1*0.25=32.26$ and Portf C: p+S0=1+31=32$ Portfolio A is overpriced: short A and buy C. Short the call to finance the purchase of the put and the stock which lead to a cash outflow 31+1-3=29$. Borrow 29$ at the 10%p.a. to repay 29e0.1*0.25=$29.73 in 3 months If ST<30, exercise the put and sell at 30.00$. If ST>30, the call will be exercised and the arbitrageur will sell at 30.00$. So independently of ST the net profit is: = 30.00 - 29.73 =0.27$
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Early Exercise
Usually there is some chance that an American option will be exercised early An exception is an American call on a nondividend paying stock This should never be exercised early

30

Reasons For Not Exercising a Call Early (No Dividends)

Consider an American call option: S0 = 100; T = 0.25; K = 60; D = 0 Suppose you think the stock is a good investment. Should you exercise immediately? No, for the following reasons:

No income is sacrificed (the stock bears no dividends) You would forgo interest payment (time value of money) You would be worse off in the case that the spot price falls below 60 at maturity (holding the call provides an insurance against stock price falling below strike)

31

Reasons For Not Exercising a Call Early (No Dividends)

Suppose you do not feel that the stock is a good investment (it is overpriced). Should you exercise the option and sell the stock? Doing so would generate a profit of S0 K =40$ (intrinsic value of the option) No, it is better to sell the call option because it has both intrinsic value and time value: C > S0 K Remember the lower bound for call prices: c S0 Ke-rT. Because C c, C S0 Ke-rT Because Ke-rT <K, it follows that C > S0 K
32

Bounds for European or American Call Options (No Dividends)

33

Should Puts Be Exercised Early ?

Are there any advantages to exercising an American put early? In contrast to call options it can be optimal to exercise put options early if deep in the money. Exercising the option earlier means getting money sooner than later (time value of money, i.e. interest rate) Because asset prices cannot be negative, if stock prices are sufficiently low the time value of holding the option is small
34

Bounds for European and American Put Options (No Dividends)

35