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University of Toronto Scarborough
Jason Wei

Chapter 9­ Mechanics of Options market Types of Options Call Option­ The right to buy Put Option­ The right to sell Expiration Date­ The date specified on the contract Exercise Price (strike price)­ The price specified on the contact American Option­ can be exercised at any time within the expiration date European Option: can be only exercised at the expiration date Most options traded are American, but European options is analyzed for its simplicity Call Options • Exercise when stock price is above strike price Put Options • Purchaser hopes that the stock price will decrease to earn a profit Options Positions • There are two positions in options: short and long  • Long is when the investor purchases the call option • Short is the position which the investor sells or writes the option o Writer of the option receives cash up front but has potential liabilities later • Writer’s profit/loss is the reverse of the purchaser Underlying Assets • Stock Options o The most traded on the exchange o One contract gives the holder the right to buy or sell 100 shares at a specified strike price • Foreign Currency Options o Mostly traded in the OTC market o One contract buys/sells 10 000 units of foreign currency • Index Options o Traded all over the world in OTC and exchange traded market o Most popular contracts: S&P 500 Index, S&P 100 index, Nasdaq, and Dow jones o One contract is to buy/ sell 100 times the index at the specified strike price • Future Options o Exchange trades that are traded in a future contract o Often matures just before the delivery period in the futures contract Specification of Stock Options • Expiration Dates o Precise expiration date is the Saturday immediately following the third Friday of the expiration  month o The last day of the trade is the third Friday of the expiration month o Stock options in US have January, February and March cylces o January cycle­ January, April, July, and October o February­February, May, August, November o March Cycle­ March, June, September, December • Strike Price o Strike are spaced by $2.5, 45, or $10 o When a new expiration date is introduced, two or three strike prices closest to the current stock  price is selected by the exchange o Ex. If current price is $84, they will offer $80.$85,$90 as strike prices • Terminology o Option class: All options of the same type (call or put) o Option Series: options of a given class with same expiration date and strike price o In­the money: gain o Out the money: lose o At the money: equal o Intrinsic Value: the maximum of zero and the value the option would have if it were exercised  immediately Flex Options o Options traded with non­standard terms o Different expiration or strike price compared to the exchange Dividends and Stock Splits o When a cash dividend occurs, there is no adjustments to the terms of the option contract o Exchange traded options are adjusted for stock splits o Stock split will cause stock price to go down Position Limits and Exercise Limits o Position Limit: the maximum number of options contract that an investor can hold on one side of the  market (long calls & short put are the same side) o Exercise Limit: it is the position limit and it is the maximum number of contracts that can be exercised  by any individual in any period of 5 consecutive business days Market Maker o A market maker is an individual who or when asked to, provides the bid or offer quote of an option o They ensure that buy and sell orders are executed at some prices without delays o They add liquidity to the market and make profits off bid­ask spreads Offsetting Orders o An investor who has purchased options can close their position by issuing an offsetting order to sell the  same number of options Commissions o Commission vary between different brokers, some charge at a discount (discount brokers) and offer  limited services o The commission is often calculated as a fixed cost plus a proportion of what was traded  o There are hidden costs within the Bid­Ask spread Margins o Buying on Margin: one borrows from the broker to purchase shares (up to 50%) o Margin Call: the broker requests money to be deposited  o Call and put options with maturities less than 9 months, the option price must be paid full o Investors cannot buy these options on margin because it will increase the leverage even more o Options with maturities greater than 9 months can be bought on margin up to 25% Writing Naked Options o Naked Option: an option that is not combined with an offsetting position in the underlying stock o The initial and maintenance margin required by the CBOE for a written naked call option is the greater  of the following 2 calculations: 1. A total of 100% of the proceeds of sales plus 20% of the underlying share price amount, if any, by  which the option is out of money 2. A total of 100% plus 10% of the underlying share price o For a written naked put option, it is the greater of: 1. 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 2. A total of 100% of the option proceeds plus 10% of the exercise price. The Option Clearing Corporation o The OCC guarantees that the option writers fulfill their obligations under the under the terms of options contracts and keeps all records of long and short positions o All option trades must be cleared through an OCC member, if a broker is not a member, they must arrange to clear the trade with one o The writer maintains a margin with the broker and the broker maintains a margin with the OCC member who clears the trades Exercising an Option o When investor notifies a broker to exercise an option, the broker in turn notifies the OCC member that clears its trades Taxation o Gains and losses from stock trade are taxed o Gain/loss is recognized when: o The option expires unexercised o The option position is closed out Wash Sale Rule o Investors who repurchase stocks within 30 days of the sale, any loss on the sale cannot be deductible Warrant, Employee Stock Option, and Convertibles o Warrants: options issued by financial institutions or non financial corporation o Employee Stock Options: call options issued to employees by their company to motivate them to act in the best interests of the company’s shareholders o Convertible Bonds: bonds issued by a company that can be converted into equity at certain times using a predetermined exchange ratio Chapter 10-Properties of Stock Options FactorsAffecting Option Prices o 6 factors that affect the price of stock options o The current stock price, So o The strike price, K o The time of expiration, T o The volatility of the stock price, O o The risk free interest rate, r o The dividends that are expected to be paid o Summary of the effect on the price of a stock option of increasing one variable while all others are fixed o Stock Price and Strike Price o Call options are valuable when the stock price exceeds the strike price, vice versa with put options Time of Expiration o The put and call options are more valuable in the American option with the time of expiration increases o This case is usually the same with European call and put option except when dividends are declared Volatility o Volatility of a stock price is a measure of how uncertain we are about future price movements o When volatility increases, stock can either do very well or very poor o Value of volatility for call and put increases as volatility increases as well Risk Free Interest Rate o Risk free interest affects the price of an option indirectly o When interest rates increase in an economy, this means that the expected return for investors increase as well o Present value (when interest increases) of all future cash flow will decrease o Combined impact results in increase value for call option and decrease value for put option o When interest rates rise (fall), stock prices fall (rise) Amount of Future Dividends o Dividends have the effect of reducing the stock price on the ex-dividend date o This is bad for call options and good for put options Upper and Lower bounds for Option Prices o Upper Bound o American/European call option gives holder the right to buy/sell the stock for a certain price o Option can NEVER be worth more than the stock o The Stock price is the upper bound to the option price  C
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