1、14,Options Markets,Chapter Objectives,Explain how stock options are used to speculate Explain why stock option premiums vary Explain how options are used by financial institutions to hedge their security portfolios,Stock Options,An option contract grants the buyer, who has paid a premium to the sell

2、er (writer), the right to buy or sell the underlying asset at a stated price within a specific period of time The premium paid to the writer is the cost of the option Buyer has the “option,” but not the obligation, to exercise the option,Background on Options,A call option buyer has right but not th

3、e obligation to buy the underlying asset at a set exercise or “strike” price for a specified period of time A put option buyer has the right but not the obligation to sell the underlying asset at a set “strike” price for a specified period of time Note components of an option: specific quantity of a

4、sset, price, and time period,Background on Options,Premium is the price the buyer of the put or call pays to buy an option contract Seller or writer of the option contract Receives the premium up front Has an ongoing obligation to sell (call) or buy (put) if the buyer decides to exercise the option

5、contract Current market price of the underlying asset or financial instrument is called the spot price,Background on Options,Call options “In-the-money” means the call options strike or exercise price is lower than the market price for the underlying financial instrument The holder of the call can b

6、uy the stock at a price below the current market price The call premium (price) of the option would also be higher by the “in-the-money” At-the-money means the strike price equals the market price of the underlying asset,Background on Options,Put option In-the-money means the put options strike or e

7、xercise price is higher than the market price for the underlying financial instrument Put options give the investor an opportunity to make money from falling prices Investor has locked in a sale price, making the price of the option (premium) higher as the stock price decreases At-the-money means th

8、e strike price equals the market price of the underlying asset,Background on Options,Expiration is the date when the contract matures American-style options contracts can be exercised any time up until they expire European-style options can only be exercised just before their expiration Option contr

9、acts guaranteed by a clearinghouse to make sure sellers or writers fulfill their obligations Stock options specify 100 shares of stock,Stock Option Quotations,Options quotations available in the financial press and on the Internet Typically more than one option contract for a companys stock Many con

10、tracts trade for the same stock but with different strike prices and expiration dates Quotes indicate the volume, premium, strike price and maturity,Exhibit 14.1 McDonalds Stock Option Quotations,S,t,r,i,k,e,E,x,p,.,V,o,l,.,C,a,l,l,V,o,l,.,P,u,t,M,c,D,o,n,a,l,d,s,4,5,J,u,n,1,8,0,4,6,0,2,4,5,O,c,t,7,

11、0,5,1,2,0,3,5,0,J,u,n,3,6,0,11/8,4,0,51/8,5,0,O,c,t,9,0,3,4,0,6,Speculating with Call Options,BUY A CALL: Speculator thinks a stock price will appreciate above a particular strike price Buyer of call pays premium for the right but not the obligation to buy stock at the strike price If the stock pric

12、e appreciates above the strike price the option contract is in-the-money and buyer of the call would exercise or sell the option at a price including the “in-the-money” and a premium If the stock price does not appreciate, buyer of the call does not exercise and losses are limited to the cost of the

13、 premiumbuyer able to share in appreciation without large investment,Speculating with Call Options,If stock price rises above calls strike price, buyer exercises and purchases shares at a price below their current market price Breakeven occurs once stock price is high enough above strike to cover pr

14、emiums cost Net gain or loss equals + Price received for selling stock (spot price) - Amount paid for the shares (calls strike) - Amount of the premium,+,0,-,Speculating with Call Options,Speculating with Put Options,BUY A PUT: Speculator thinks a stock price will depreciate below a particular strik

15、e price Buyer of put pays premium for the right but not the obligation to sell stock at the strike price If the stock price depreciates below the strike price the option contract is in-the-money and buyer of the put would exercise If the stock price does not depreciate, buyer of the put does not exe

16、rcise and losses are limited to the cost of the premium,Speculating with Put Options,If stock price falls below strike, buyer of a put exercises and sells shares at a price above their current market price Breakeven occurs once stock price is low enough below strike to cover premiums cost Net gain o

17、r loss equals +Price received for selling stock (strike price) - Amount paid for the shares (spot market) - Amount of the premium,+,0,-,Speculating with Put Options,Determinants of Call Option Premiums,Value of Call Option Premium,Determinants of Call Option Premiums,The greater the current market p

18、rice of the underlying asset compared to the exercise price, the higher the premium for a call option As the market price of the underlying asset approaches or moves above the strike price, there is increased chance of continued price appreciation and increased gain from the option Purchaser is will

19、ing to pay more for the option “Under Water” option has less chance of being “in-the-money” and the premium is less,Determinants of Call Option Premiums,Greater volatility of the underlying financial asset means higher call option premiums Volatile price means a higher chance price will go well abov

20、e strike That chance makes buyers willing to pay more For a call, the longer the time to maturity, the higher the premium Owner will have increased chance for the option to be “in-the-money” with more time available,Determinants of Put Option Premiums,The lower the current market price of the underl

21、ying asset compared to the exercise price, the higher the premium for a put option Better chance of price depreciation well below strike price if the price of the underlying asset is already close to or below the exercise price Stock price appreciation reduces premium as chance of “in-the-money” dec

22、reases Volatility and maturity issues the same as for call options,Explaining Changes in Option Premiums,Indicators monitored by participants in the options market Premiums influenced by price movements of the underlying stocks Monitor economic indicators, industry-specific, and firm-specific condit

23、ions Speculative options positions limit the downside risk (the cost of the premium) so options owners may view some indicators differently,Exhibit 14.11 Stock Option Premium Changes Over Time,Hedging with Stock Options,Investor hedge against possible adverse stock price movements Downside price ins

24、urance for stock investor Investor can sell/write a call or buy a put if concerned about a temporary decline in a stock price Writer/seller gains premium income from “covered” option to offset possible stock losses in exchange for giving up possible upside profit Buying a put trades premium for down

25、side floor on stock portfolio,Using Options to Measure a Stocks Risk,Standard deviation is used to measure risk for a stock Stock option premiums commonly are used to derive the markets anticipation of a stocks standard deviation over the life of the option Anticipated volatility of a stock is not o

26、bservable but the stock option formula can be used to derive an estimate,Stock Index Options,Right to trade a specified stock index at a specified price by a specified expiration date Options on several indexes S&P 100 Major Market Index Value Line National OTC index NYSE composite,Stock Index Optio

27、ns,Hedging with stock index options Pension funds and financial institutions that own large portfolios of stocks Buy stock index puts to lock in gain or hedge downturns in the market Select index option that matches portfolio Hedging with long-term stock index futures LEAPs or long-term equity antic

28、ipations Expiration dates at least two years into the future, longer than normal options,Stock Index Options,Dynamic asset allocation with stock index options As expectations change, switch between risky and low-risk investment positions Anticipating stock price increases, portfolio managers purchas

29、e calls and increase their risk exposure Hedge if unfavorable conditions expected Sell calls to insure against market declines,Stock Index Options,Using index options to measure the markets risk Stock indexs implied volatility can be derived from options Over time standard deviation sometimes abrupt

30、ly changes Review of historical events explain changes Gulf War, stock market crashes, and global economic and financial crisis,Options on Futures Contracts,Options on futures allow the right but not the obligation to purchase or sell a particular futures contract for a specified price and for a spe

31、cified period of time Types of options on futures that are available Stock index futures Interest rate futures Used for speculation and one-way hedging,Options on Futures Contracts,Speculating with options on futures if an interest rate decline is anticipated Purchase a call option on Treasury bond

32、futures If expectations are correct, T-bond prices and futures contract increase as interest rate levels decrease Exercise the option to purchase futures at the strike price which is lower than the value of the futures contract Selling futures offsets futures position at a profit,Options on Futures

33、Contracts,Speculating with options on futures Advantages of using options on futures Expectations are not always correct If rates actually rise, speculator loses if in futures contracts, but just the premium if in options Loss is reduced using the options on futures strategy as compared to a futures

34、 only speculative position If rates rise, do not exercise option on futures,Options on Futures Contracts,Risks of speculating with options on futures Example in 1995 of Barings PLC U.K. investment bank $1 billion in losses from derivative positions Lessons Monitor derivative trading closely Separate reporting from trading so losses are not concealed Recognize margin calls may signal problems,Hedging with