Chapter 14

Options Markets

Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline
Background on options Speculating with stock options Determinants of stock option premiums Explaining changes in option premiums Hedging with stock options Using options to measure a stocks risk

Chapter Outline (contd)

Options on ETFs and stock indexes Options on futures contracts Hedging with options on futures Institutional use of options markets Globalization of options markets

Background on Options

A call option grants the owner the right to purchase a specified financial instrument for a specified price (exercise or strike price) within a specified period of time

Grants the right, but not the obligation, to purchase the specified investment The writer of a call option is obligated to provide the instrument at the price specified by the option contract if the owner exercises the option A call option is:

In the money when the market price of the underlying security exceeds the strike price At the money when the market price is equal to the strike price Out of the money when the market price is below the strike price
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Background on Options (contd)

A put option grants the owner the right to sell a specified financial instrument for a specified price within a specified period of time
Grants

the right, but not the obligation, to sell the specified investment A put option is:

In the money when the market price of the underlying security is below the strike price At the money when the market price is equal to the strike price Out of the money when the market price is above the strike price
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Background on Options (contd)

Call and put options specify 100 shares for stocks Premiums paid for call and put options are determined through open outcry on the exchange floor Participants can close out their option positions by taking an offsetting position

The gain or loss is determined by the premium paid when purchasing the option and the premium received when selling the option

American-style options can be exercised at any time prior to expiration European-style options can be exercise only just before expiration
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Background on Options (contd)

Markets used to trade options

The

CBOE:

Is the most important exchange for trading options Serves as the market for options on more than 1,500 different stocks Lists standardized options Accounts for about 51 percent of all option trading

Options

are also traded on the AMEX, Philadelphia Stock Exchange, Pacific Stock Exchange, and the International Securities Exchange
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Background on Options (contd)

Markets used to trade options (contd)

Listing requirements Each exchange has its own requirements One key requirement is a minimum trading volume of the underlying stocks Role of the Options Clearing Corporation (OCC) The OCC serves as a guarantor on option contracts traded in the U.S. Regulation of options trading The SEC and the various option exchanges regulate option trading Regulations:

Are intended to ensure fair and orderly training Attempt to prevent insider trading Attempt to prevent price fixing among floor brokers
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Background on Options (contd)

How option trades are executed

Floor

brokers execute transactions desired by investors

Some orders are executed electronically without a floor broker

Market-makers: Can execute stock option transactions for customers Trade options on their own account May facilitate a buy order for one customer and a sell order for a different customer Earn the difference between the bid price and the ask price for the option
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Background on Options (contd)

Types of orders
A

market order results in the immediate purchase or sale of an option at the prevailing market price With a limit order, the transaction will occur only if the market price is no higher or lower than a specified price limit Online trading

Many online brokerage firms, like E*Trade and Datek, facilitate options orders
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Background on Options (contd)

Stock option quotations

Financial

newspapers and some local newspapers publish quotations for stock options (see next slide) Options with higher exercise prices have lower call premiums and higher put premiums Options with a longer maturity have higher call option premiums and higher put option premiums
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Background on Options (contd)

Stock option quotations (contd)

Strike Exp. Jun Oct Vol. 180 70 Call 4 1/2 5 3/4 Vol. 60 120 Put 2 3/4 3 3/4

McDonalds

45 45

50 50

Jun Oct

360 90

1 1/8 3 1/2

40 40

5 1/8 6 1/2
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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 Assuming that the buyer of the option sells the stock when exercising the option and that the writer will obtain the stock only when the option is exercised, the writers net gain is the buyers net loss, assuming zero transaction costs

The maximum loss for the buyer of a call option is the premium, while the maximum gain is unlimited The maximum gain for the writer of a call option is the premium, while the maximum loss is unlimited

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Speculating with Call Options

Pete expects ABC stock to increase from its current price of $90 per share. He purchases a call option on ABC stock with an exercise price of $92 for a premium of $4 per share. ABC stock rises to $97 prior to the options expiration date. If Pete exercises the option and immediately sells the shares in the market, what is his net gain from the transaction?
$97 $92 $4 $1per share

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Speculating with Call Options (contd)

Draw the contingency graph for the buyer of the call option and the writer of the call option.
Profit

Buyers Perspective

Writers Perspective

96 0 -4 Stock Price At Expiration

4 0 96

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Speculating with Stock Options (contd)

Speculating with call options (contd)

Assume that ABC stock has three call options available:

Call option 1: Exercise price = $87; Premium = $7 Call option 1: Exercise price = $90; Premium = $5 Call option 1: Exercise price = $92; Premium = $4

The risk-return potential varies among the several options that are available The contingency graph for all three options is shown on the next slide

The graph can be revised to reflect returns for each possible price per share of the underlying stock

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Speculating with Stock Options (contd) Call option 1

Call option 2 Profit or Loss Per Share Call option 3

0 -4 -5 -7

94 95
96 Stock Price of ABC Stock

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Speculating with Stock Options (contd)

Speculating with put options

Put

options can be used to speculate on the expectation of a decrease in the price of the underlying stock The maximum gain for the buyer of a put option is the exercise price less the premium, while the maximum loss is the premium The maximum loss for the writer of a put option is the exercise price less the premium, while the maximum gain is the premium

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Speculating with Put Options

Mary expects XYZ stock to decrease from its current price of $54. Thus, she purchases a put option on XYZ stock with an exercise price of $53 and a premium of $2. If the stock price of XYZ stock is $47 when the option expires, what is Marys net gain?
$53 $47 $2 $4 per share

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Speculating with Put Options (contd)

Draw the contingency graph for the buyer of the put option and the writer of the put option.
Profit 51 51 Stock Price At Expiration 51
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Buyers Perspective

Writers Perspective

2 0

0 -2

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Speculating with Stock Options (contd)

Excessive risk from speculation

Firms should closely monitor the trading of derivative contracts by their employees to ensure that derivatives are being used within the firms guidelines Firms should separate the reporting function from the trading function so that traders cannot conceal trading losses When firms receive margin calls on derivative positions, they should recognize that there may be potential losses on their derivative instruments

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Determinants of Stock Option Premiums

The option premium must be sufficiently high to equalize the demand by buyers and the supply that sellers are willing to sell 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
The greater the volatility of the underlying stock, the higher the call option premium The longer the call options time to maturity, the higher the call option premium
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Influence of the stocks volatility

Influence of the call options time to maturity

Determinants of Stock Option Premiums (contd)

Determinants of put option premiums

Influence

of the market price

The higher the existing market price of the underlying financial instrument relative to the exercise price, the lower the put option premium

Influence

of the stocks volatility

The greater the volatility of the underlying stock, the higher the put option premium

Influence

of the put options time to maturity

The longer the call options time to maturity, the higher the put option premium
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Explaining Changes in Option Premiums

Economic conditions and market conditions can cause abrupt changes in the stock rice or in the anticipated volatility of the stock price

This would have a major impact on the stock option premium

Indicators monitored by participants in the option market

Option market participants closely monitor the indicators that are monitored for stocks:

Economic indicators, industry-specific conditions, firm-specific conditions

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Hedging with Stock Options

Mutual funds, insurance companies, and pension funds manage large stock portfolios and use options on stocks and stock indexes to hedge Hedging with call options
A

covered call involves the sale of a call option with a simultaneous long position in the stock

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Writing A Covered Call

Philly Mutual Fund owns 100 shares of ABC stock. Philly believes that the stock price will decline temporarily from its current price of $90, but does not want to liquidate its position because of transaction costs. Consequently, Philly writes one call option on ABC stock with an exercise price of $88 and a premium of $6. Construct a contingency graph showing Phillys position with covered call writing and without covered call writing.

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Writing A Covered Call (contd)

Without Covered Call Writing

3 With Covered Call Writing 0 85 88 90

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Hedging with Stock Options (contd)

Hedging with put options

If

an institution with a long position in a stock is concerned about a decline in the stock price, it could hedge against a temporary decline by purchasing put options on that stock Put options are typically used to hedge when portfolio managers are concerned about a temporary decline in a stocks value

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Using Options to Measure a Stocks Risk

Stock options can be used to drive the markets anticipation of a stocks standard deviation over the life of the option
The

option-pricing model can be used to derive the implied standard deviation of a stock The implied standard deviation increases when a firm experiences an event that creates more uncertainty

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Options on ETFs and Stock Indexes

An ETF option provides the right to trade a specified ETF at a specified price by a specified expiration date
Since

ETFs are traded like stocks, options on ETFs are traded like options on stocks Investors who exercise a call option on an ETF would receive delivery of the ETF in their account

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Options on ETFs and Stock Indexes (contd)

A stock index option provides the right to trade a specified stock index at a specified price by a specified expiration date

Options are offered on the S&P 100 index, the S&P 500 index, S&P SmallCap 600 Index, Dow Jones Industrial Average, Nasdaq 100 Index, Goldman Sachs Internet Index, among others If an index option is exercised, the cash payment is equal to a specified dollar amount multiplied by the difference between the index level and the exercise price Speculators who anticipate a sharp increase in the stock market would purchase call options on an index Speculators who anticipate a decrease in the stock market would purchase put options on an index
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ETFs for Which Options Are Traded

iShares Nasdaq Biotechnology
iShares Goldman Sachs Technology Index iShares Goldman Sachs Software Index iShares Russell 1000 Index Fund iShares Russell 1000 Value Index Fund iShares Russell 1000 Growth Index Fund Energy Select Sector SPDR Financial Select Sector SPDR Utilities Select Sector SPDR Health Care Select Sector SPDR

Indexes for Which Options Are Traded

Asia 25 Index
Euro 25 Index Mexico Index Dow Jones Industrial Average Dow Jones Transportation Average S&P 100 Index S&P 500 Index S&P SmallCap 600 Index Nasdaq 100 Index Russell 1000 Index, etc.
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Options on ETFs and Indexes (contd)

Hedging with stock index options

Portfolio managers consider purchasing put options on a stock index to protect against stock market declines The put options should be purchased on the stock index that most closely mirrors the portfolio to be hedged The greater the market downturn, the greater the decline in the market value of the portfolio, but the greater the gain from holding put options on a stock index Hedging with long-term stock index options

Long-term equity anticipations (LEAPs) have expiration dates at least two years ahead with a lower premium

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Options on ETFs and Indexes (contd)

Dynamic asset allocation with stock index options

Dynamic asset allocation involves switching between risky and low-risk investment positions over time in response to changing expectations

e.g., portfolio managers purchase call options under favorable conditions and put option under unfavorable conditions e.g., write call options when the stock market is expected to be very stable

Portfolio managers can select the exercise price that provides the desired protection

e.g., buy put options with an exercise price of 380 if the current level of the index is 400 and a 5 percent loss is acceptable

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Options on ETFs and Indexes (contd)

Using index options to measure the markets risk

A

stock indexs implied volatility can be derived from information about options on that stock index Impact of the September 11 Crisis on the implied volatility of stock indexes

The attacks caused more uncertainty about the future value of stocks Implied volatility increased when the markets reopened on September 17
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Options on Futures Contracts

An option on a futures contract allows the right to purchase or sell that futures contract for a specified price within a specified period of time
Options

on futures grant the power to take the futures position if favorable conditions occur but the flexibility to avoid the future position if unfavorable conditions occur Options are available on stock index futures and on interest rate futures

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Options on Futures Contracts (contd)

Speculating with options on futures

Speculation

based on an expected decline in interest rates

Speculators may consider purchasing a call option on Treasury bond futures When interest rates decline, buyers of call options would sell the option just before expiration If interest rates rise, buyers of call options will let the options expire Speculators who expect interest rates to remain stable or decline could sell put options on Treasury bond futures
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Speculating on a Decrease in Rates with Options on Futures

Kevin Phelps expects interest rates to decline and purchases a call option on Treasury bond futures with an exercise price of 9240. The option has a premium of 200. Shortly before the expiration date, the price of Treasury bond futures rises to 9500. Kevin exercises the option and closes out the position by selling an identical futures contract. What it is net gain from this strategy?
Net gain $95,000 $92,625 $2,000 $375 ROI $375 18.75% $2,000
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Options on Futures Contracts (contd)

Speculating with options on futures (contd)

Speculation

based on an expected increase in interest rates

Speculators who expect interest rates to increase could purchase a put option on Treasury bond futures If interest rates rise, the speculator can exercise the option to sell futures at the exercise price and purchase futures at a lower price than the price at which they sold futures If interest rates decline, the speculators will let the options expire Speculators who anticipate an increase in interest rates may consider selling call options on Treasury bond futures
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Speculating on an Increase in Rates with Options on Futures

Barnie Blythe expects interest rates to increase and purchases a put option on Treasury bond futures with an exercise price of 9800 and a premium of 200. Just prior to the expiration date, the price of Treasury bond futures is valued at 9412. What is Barnies net gain from this strategy if he exercises the option and closes out the position by purchasing an identical futures contract?
Net gain $98,000 $94,187.50 $2,000 $1 ,812.50 ROI $1 ,812.50 90.63% $2,000
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Hedging with Options on Futures

Hedging with options on interest rate futures

Financial institutions commonly hedge bond or mortgage portfolios using options on interest rate futures The position is designed to create a gain that can offset a loss on the bond or mortgage portfolio Put options on futures offer more flexibility than selling futures but require a premium Institutions wishing to hedge against interest rate risk should compare outcomes from selling futures contract versus buying put options on interest rate futures

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Hedging with Options on Futures (contd)

Hedging with options on stock index futures

The position taken on the options contract is designed to create a gain that can offset a loss on the stock portfolio Determining the degree of the hedge with options on stock index futures

The higher the strike price relative to the prevailing index value, the higher the price at which the investor can lock in the sale of the index, but the higher the premium

Selling call options to cover the cost of put options

Selling call options can generate some fees to help cover the cost of purchasing put options

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Institutional Use of Options Markets

Options positions are sometimes taken by financial institutions for speculative purposes, but more commonly for hedging Savings institutions and bond mutual funds use options on interest rate futures to hedge interest rate risk Stock mutual funds, insurance companies, and pension funds use stock index options and options on stock index futures to hedge stock portfolios

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Institutional Use of Options Markets (contd)

Options as compensation

Some institutions distribute call options on their own stock to their managers as compensation Managers may have an incentive to make decisions that increase the stocks value Distortion between performance and option compensation

Many option compensation programs do not account for general market conditions e.g., managers who received option during the 20012002 period may have earned low compensation even if their firm performed relatively well

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Institutional Use of Options Markets (contd)

Options as compensation (contd)

How stock option compensation can destroy shareholder value

Managers may be enticed to manipulate the stocks price upward in the near future even if it adversely affects the stock price in the future e.g., use accounting methods that defer expenses and accelerate revenue reporting The FASB has been unwilling to require firms to report this expense on the income statement Earnings will appear higher when a firm uses stock options to compensate its managers

Reporting option compensation as an expense

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Globalization of Options Markets

Options on stock indexes of various countries are available The existence of options on foreign stock indexes allows portfolio managers to hedge or speculate based on forecasts of foreign market conditions Currency options contracts

A currency call option provides the right to purchase a specified currency for a specified price within a specified period of time A currency put option provides the right to sell a specified currency for a specified price within a specified period of time Corporations use currency options to hedge foreign payables and receivables Speculators purchase put options on currencies they expect to weaken against the dollar

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