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Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

Pages 225-236 Options Derivatives are contracts between two parties (a buyer and a seller) that have a price and that trade in specific markets. REAL-WORLD RETURNS 19-1 DERIVATIVES  Derivatives are not dangerous but when in the hands of people who don’t understand them or have the wrong incentives, it is risky.  A derivative is a financial position based on an underling asset. They are fleeting with short life spans  A small change in the underlying asset’s price usually means a much bigger change in the derivative’s value, up or down  Most common derivatives that big U.S. banks are involved in are swaps whereby two investors agree to trade the return on different assets  Banks often use interest rate swaps to protect themselves Introduction to Options  Rather than trade directly in common stocks, investors can purchase securities representing a claim (an option) on a particular stock or group of stocks  This option gives the holder the right to receive or deliver shares of stock under specified conditions. The option does not need to be carried through.  Equity-derivative securities – securities that derive their value in whole or in part by having a claim on the underlying common stock  An investor can buy and sell these equity-derivative securities  Gains or losses depend on the difference between the purchase price and the sales price Options Basics  Options – claims that give the holder the right, but not the obligation, to buy or sell a stated number of shares within a specified period at a specified price  Options are created by investors and sold to other investors  A call option – an option that gives the holder the right, but not the obligation, to buy specified number of shares of stocks at a stated price within a specified period (before an expiration date) o Investors purchase calls if they expect the stock price to rise because the price of the call and the common stock will move together o Permit investors to speculate on a rise in the price of the stock without buying it  A put option – an option that gives the holder the right, but not the obligation, to sell a specified number of shares of stock at a stated price within a specified period o The shares are sold by the owner (buyer) of the put contract to a writer (seller) of the contract o Investors purchase puts if they expect the stock price to fall because the value of the put will rise as the stock price declines o Puts allow investors to speculate on a decline in the stock price without selling the common stock sort Why Options Markets?  Puts and calls expand the opportunity set available to investors, making available risk-return combinations that otherwise would be impossible or that improve the risk-return characteristics of a portfolio  For calls, an investor can control a claim on the underlying common stock for a much smaller investment than required to buy the stock itself. For puts, an investor can duplicate a short sale without a margin account and at a modest cost in relation to the value of the stock. The maximum loss is known in advance so if an option is worthless, the most the buyer can lose is the cost of the option  Options provide leverage by magnifying the percentage gains in relation to buying or short selling the underlying stock  Using options on a market index, an investor can participate in market movements with a single trading decision Understanding Options 1. The exercise (strike) price is the per-share price at which the common stock may be purchased or sold 2. The expiration date is the last date on which an option can be exercised. Equity options expire the Saturday following the third Friday of the month 3. The option premium is the price paid by the option buyer to the writer/seller of the option, whether put or call. Stated on a per-share basis for options on organized exchanges, REAL-WORLD RETURNS 19-2 EQUITY OPTION CYCLES  Expiry cycles are used to establish the length of time that an option will be listed and quoted by the equity option market makers o Cycle 1: four maturities – two near months and the next two months from the January, April, July, October cycle o Cycle 2: four maturities – two near months and the next two months from the February, May, August, November cycle o Cycle 3: four maturities – two near months and the next two months from the March, June, September, December cycle o Cycle 4: five maturities – three near months and the next two months from cycle 3  Long-term options or LEAPS are options with maturities greater than one year and ranging to two year and beyond How Options Work  The call writer expects the price of the stock to remain steady or move down  The call buyer expects the price of the stock to move upward and soon  The put writer expects the price of the stock to remain steady or go up  The put buyer expects the price of the stock to move down and soon The Mechanics of Trading The Options Exchanges  Most exchange listed equity options are American style – can be exercised at any time up to and including the expiration date  Index option and over-the-counter (OTC) options are typically European – they can only be exercised on the expiration date  All exchange-traded options in Canada trade on the Montreal Exchange (ME)  All-electronic markets are extremely efficient and the competition has led to lower costs and narrower spreads for customers and quicker access to the market  The options markets provide liquidity to investors – important for successful trading  Liquidity problems are overcome by: o Offering standardized option contracts o Having all transaction guaranteed by a clearing corporation – becomes the buyer and seller for each option contract  Market, limit, and stop orders are used in trading puts and calls  Transactions are handled as bookkeeping entries  Option trades settle on the next business day after the trade; equity option and a stock transaction settle in 3 business days; an investor must receive a risk disclosure statement issued by the clearing corporation before the initial order is executed The Clearing Corporation  Canadian Derivatives Clearing Corporation (CDCC) – the clearing corporation that issues and guarantees all equity, bond, and stock index positions on options exchanges in Canada o Owned by the ME  Clearing corporations function as intermediaries between the brokers representing the buyers and the writers – once the brokers negotiate the price, they no longer deal with each other but with the CDCC or (OCC –in U.S.)  CDCC becomes the buyer for every seller and the seller for every buyer  The number of contracts purchased must equal the number sold  net = 0  A call writer who receives an assignment must sell the underlying securities and a
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