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7/29/2019 Ch 18 Slides
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Investments: Analysis
and Behavior
Chapter 18- Options Marketsand Strategies
2010 McGraw-Hill/Irwin
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Learning Objectives
Understand the characteristics of call and put options
Know the uses of index options
Be able to implement covered call and protective putstrategies
Utilize Black-Scholes option pricing
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Options Markets
Derivative securities: value is derived or stemsfrom 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 nearly 3 billion contracts in 2007
The most popular options - equity options
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Figure 18.1 Trading Activity in Equity Options Contracts Has Risen Sharply
0
500,000,000
1,000,000,000
1,500,000,000
2,000,000,000
2,500,000,000
3,000,000,000
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
OCCT
otalYearlyClearedC
ontractVolum
Total Contract Volume
Equity Options
Non-Equity Options
Source: O tions Clearin Cor oration
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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
Open interest: number of outstanding options
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Exercise price (orStrike price): Promised
or predetermined price for underlyingassets
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)
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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.
Long-term calls and puts.
Trading symbol for stock options combinationof the stock ticker symbol, plus a letter to indicate
the month of the year, plus a final letter toindicate strike price
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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
Table 18.2 Option Ticker Codes
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Options Clearing Corporation (OCC)
Sole issuer of all securities options listed onexchanges and NASD
All option transactions are ultimately clearedthrough OCC
OCC takes the opposite side of every optiontraded
Guarantees contract performance and reducesthe credit risk.
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Option concept
Option contracts are a zero sum game
before commissions and other transaction
costs.
Hedged position: option transaction to offsetthe risk inherent in some other investment (tolimit risk)
Speculative position: option transaction to profitfrom the inherent riskiness of some underlyingasset.
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Option style and settlement
Option holder: long the option position Option writer: short the option position
StyleAmerican 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 betweenexercise price and current determined price of the underlyingasset
Contract size: usually for 100 shares of stock
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Option types
Stock Options: generally cover 100 shares ofunderlying securities. Adjustment made for stockdividend, stock split, merger, etc.
Index options: Standard and Poors 100 Index(OEX) are the most actively traded.
Debt OptionsPhysical 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 securityYield based options: cash settled based on the
difference between the exercise price and value of anunderlying yield.
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Index
Index
Value CALL Last
Volum
e
Open
Interest PUT Last Volume
Open
Interest
S&P 100 581.85 Aug 580.0 8.90 1124 2994 Aug580.0 9.60 1917 3873
Dow Jones Industrial
Average 113.11 Aug 112.0 2.45 4034 3382 Aug112.0 1.02 50 4217
Nasdaq-100 1809.84 Aug 1825 26.00 471 2312 Aug 1825 43.00 185 4041
Russell 2000 708.6 Sep 710.0 26.70 372 11474 Sep710.0 28.15 257 10328
Source: www.cboe.com
Table 18.3 Sample of Index Options, August 4, 2008
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Call Option strategies
Long position: the right (but not obligation) tobuy the underlying asset at a strike price for alimited period of time.
The right to buy stock at a fixed price becomes morevaluable as price of stock increases (in the moneywhen current stock price > exercise price)
Risk for buyer is limited to the call premium andpotential is unlimited
Short position: payoff mirror image of longposition (zero sum game)
Covered call: sale of a call option on a stock thatis owned.
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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 themoney 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, butinvolves obligation to transact if buyer so
chooses.
Protective put: insurance against a sharp
correction. Purchase of a stock and put option
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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 sale of options on the sameunderlying 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 andpurchase or a low strike price put
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PayoffLong call
Short call
Bull call spread
PayoffLong 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
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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-moneyoptions strike price and current market price
Time value: speculative value.
Call price = Intrinsic value + time value
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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
)()( 21 dNe
XdNSC
rt
fundsinvestedof
costyOpportunit
potentialupside
ofValue
price
Call
t
trXSd
2
1
5.0ln tdd 12
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ExampleCurrent stock price: 50 exercise price : 55
Risk free rate: 6.25% time to expiration: 6 monthsVolatility: 40% What is the call price?
Solution
0851.02828.0
0713.00953.0
5.04.0
5.04.05.00625.05550lnd
2
1
3679.0
5.04.00851.0d2
N(d1) = 0.4661 N(d2) = 0.3564
30.4$]3564.0[55
]4661.0[50
)()(priceCall
)5.0)(0625.0(
21
e
dNe
XdNS
rt
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Put call parity
Relationship between the price of a putoption and the price of a call option on the
same underlying equity.
Using the same values before,
CSrteXpricePut
61.7$30.450e
55pricePut.5)(0.0625)(0
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Option risks
Delta: the sensitivity of option value to a unitchange in the underlying asset (hedge ratio)
Gamma: The responsiveness of delta to unitchanges in the value of the underlying asset
Theta: The sensitivity of option value tochange in time
Vega: The sensitivity of option value to changein volatility
Rho: The sensitivity of option value to changesin interest rate
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Such values are presented in CBOE Option
Calculator ( www.cboe.com )
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VIX
If you know the price of the option, youcan calculate the volatility that the priceimplies, called implied volatility.
The VIX is the scaled implied volatility ofthe S&P 500 Index option.
Say the VIX is at 22.06
Means the S&P500 index is expected tomove by 6.35% (= 22% 12) in the nextmonth.
The VIX is known as the fear index and is
a tradable product