Chapter 19

Options

Nature of options

Ø An options contract gives the option buyer the right, but not the obligation,
to buy or sell a specified commodity or financial instrument at a specified
price on or before a specified date
Ø The price established in the option contract is known as the exercise price
or the strike price
Ø A unique characteristic of an option is that it need not be exercised if it is
not in the option-buyer’s best interest
Ø Types of options
• Call options: give the option buyer the right to buy the commodity
or financial instrument specified in the options contract at the
exercise price
• Put options: give the option buyer the right to sell the commodity
or financial instrument specified in the options contract at the
exercise price
Ø Options can be exercised either
• Only on expiration date (European)
• Any time up to expiration date (American)
Ø The cost of an American type option will be higher relative to the price of
the equivalent European type option
Ø Premium is the price paid by an option buyer to the writer (seller) of the
option, whether or not the option buyer eventually exercises the option

Option profit and loss payoff profiles

Ø Consider an option with strike price $12.00 per share, and the premium
for both call and put contracts are $1.50 per share
Ø The profit and loss profile of a call option for the buyer and the seller
 • The critical break points of the market price of the share at
expiration date are <$12, $12 to $13.5 and >$13.5
• For the buyer
o If the actual price is less than $12, the buyer will allow the
option to lapse, as the shares can be bought at a lower price
in the stock market, total cost to the buyer will be the initial
premium of $1.5
o If the actual price is between $12 to $13.5, the buyer will be
able to use the profit made from exercising the option in
order to offset the premium that has already been paid
o If the actual price is above $13.5, the buyer of the option
makes an outright profit by exercising the contract, the profit
will continue dollar-for-dollar with the share price as it
moves above $13.5
o If the actual price is exactly $12, the buyer will be indifferent
to exercising the contract
• For the seller
o The total potential gain available to the seller is the $1.5
premium
o The gain from the premium will be eroded if the share price
begins to move above the $12 exercise price
o If the share price moves to $13.5 or above, losses are
potentially unlimited
• Value of option to the buyer = max (S-X,0) – P
• Value of option to the seller = P – max(S-X,0)
• It is expected that the option-writer would immediately close out a
negative position by implementing a new risk management strategy,
such as buying an opposite option contract
Ø The profit and loss profile of a put option for the buyer and the seller
 • The critical break points of the market price of the share at
expiration date are <$10.5, $10.5 to $12 and >$12
• For the buyer
o If the actual price is more than $12, the seller will allow the
option to lapse, as the shares can be sold at a higher price in
the market, the cost will be the premium
o If the actual price is between $10.5 to $12, profits are made
from exercising the option to offset the premium
o If the actual price is less than $10.5, profits can be made
• For the seller
o If the actual price is more than $12,the seller makes a profit
of the premium as the buyer will not exercise the option
o If the actual price is between $10.5 and $12, the seller’s
profit diminishes from the premium amount to zero
o If the actual price is less than $10.5, a loss is made and the
maximum extent of a loss potential is the amount of the
exercise price
• Value of option to the buyer = max (X-S,0) – P
• Value of option to the seller = P – max(X-S,0)
Ø Covered and uncovered options
• The potential loss that may be incurred by the writer of an option
contract could extend well beyond the amount of the premium
received
• Therefore the writer will typically need to meet margin
requirements unless a so called covered option is written
• A covered option is when an option writer holds the underlying
asset or provides a financial guarantee
• The writer of a call option has written a covered option if either
o The writer owns sufficient of the underlying asset to satisfy
the option contract if exercised, or
o The writer is also the holder of a call option on the same
asset, but with a lower exercise price
• The writer of a put option has written a covered option if the writer
is also the holder of a call option on the same asset, but with a
higher exercising price
• A writer of a call option who does not have the cover outlined is
said to have written an uncovered or naked call option
• In this case the writer is required to deliver an initial margin
payment to the brokage firm, additional maintenance deposits may
be required
Organisation of the market

Ø The option markets are categorised into exchange-traded markets and

over-the-counter markets
• Prior to 1973 options contracts were private contracts between two
parties
• Options exchanges now operate in the major financial centres
around the world
• All exchange traded options contract transactions are recorded by
an options clearing house
• Clearing house acts as counterparty to buyer and seller, thus
creating two options contracts through the process of novation
• The clearing house allows buyers and sellers to close out their
contracts without affecting the other party to the contract
Ø International options markets
• Typically, an exchange in a particular country will specialise in
options contracts that are directly related to physical market or
futures market products also traded in that country
• The largest exchanges, the Chicago Board of Trade and Chicago
Mercantile Exchange, retain the open outcry trading on the floor
involving 4000 to 5000 people
• International links between exchanges allow 24-hour trading
Ø The Australian options markets
• Options on futures contracts
o Buyer of the futures option has the right to call or put a
specified futures contract that is also traded on the exchange
o If the option is exercised, the writer of the option pays the
buyer the difference between the current price of the
futures contract and the exercise price of the option
o Options on futures contracts include:
§ 90-day bank-accepted bills future contract
§ SPI200 index futures contract
§ 10-year Commonwealth Treasury bonds future
contracts
• Equity options
o Share options contracts are based on the ordinary shares of
specified companies listed on the ASX
o Usually 3 or more options contracts for each company, each
with identical expiration dates but different exercise prices
 o The options clearing house maintains a system of deposits,
maintenance margins and a share scrap depository, to
ensure option writers meet their obligations under the
options contract
o The exercise price of a share option is generally set
reasonably close to the actual market price of the share at
the time of issue
o If the option is exercised, settlement occurs at the delivery of
the underlying shares by the option writer
• Low exercise price options
o A highly leveraged option on individual stocks, with an
exercise price between 1 and 10 cents, and a premium
similar to the price of the underlying stock
o Exercisable only at expiration date
o The cost is usually lower than the share price because the
holder of a LEPO is not entitled to receive dividend payments
associated with the shares
o Available over a range of high-liquidity stocks listed n the
ASX
• Warrants
o A financial instrument that conveys a right in the form of an
option
o It is necessary to distinguish between
§ Equity warrants attached to debt issue made by
companies raising funds through primary market debt
issues
§ Warrants that are issued as financial products
principally designed for investment and the
management of an exposure to price movements in
the markets
o Warrant contracts offered in the market include
§ Fractional warrants – cover only a part or a fraction of
a listed share
§ Fully covered warrants – underlying shares lodged in
trust by issuer as guarantee
§ Index warrants – issued over a specified S&P/ASX
share price index or an overseas stock index
§ Basket warrants – contain a group of shares from
different companies listed on the exchange
 § Capped warrants – low-exercise-price warrants, set at
one cent
§ Instalment warrants – give the warrant holder the
right to buy the underlying shares by payment of a
number of instalments during the term of the warrant
§ Capital plus warrants – based on a basket of shares,
typically long term warrants issued for approx. 5 years
§ Endowment warrants – do not have fixed exercise
price, but rather an outstanding amount
• Over-the-counter markets
o Manage risk exposures associated with instruments that do
not have options traded on formal exchanges
o Flexible risk management product in terms of amount, term,
interest rate and price
o Allow the setting of interest rate caps and floors, or the
implementation of cost-minimisation strategies using collars

Pricing an option

Ø Intrinsic value
• The market price of an underlying asset relative to the option
exercise price
• The greater the intrinsic value, the more the option is worth,
therefore the larger the premium
• Options with intrinsic value
o Positive are ‘in the money’ and the buyer is able to exercise
the contract at a profit
o Negative are ‘out of the money’ and the buyer will not
exercise
o Zero are ‘at the money’
Ø Time value
• The longer the time to expiry, the greater the possibility that the
option will be able to be exercised for a profit
• If the spot price moves adversely, the loss is limited to the premium
Ø Price volatility
• The higher the volatility if the price of the asset, the greater is the
chance that the holder of the option will be able to exercise the
option for a large profit
• The option will only be exercised if the price moves favourably
 • Thus, the value of an option is higher for an asset that
demonstrates higher price volatility than for one that displays low
volatility
Ø Interest rate
• Changes in interest rates are likely to have opposite effects on call
options and put options
• 1st avenue: the higher the rate of interest, the greater would be the
benefit from conserving capital, hence the value of the call option
increases with rises in interest rates
• 2nd avenue: the profit made by exercising the option is obtained in
the future, and the higher the interest rate, the lower will be the
present value of profit
• Of the two conflicting impacts of interest rates, it appears that the
first effect outweighs the second effect, hence the price of a call
option is positively related to interest rates
• In the case of put options, there is a negative relationship between
interest rates and the prices of the option

Option risk management strategies

Ø Long asset and bearish about the future asset price

• An option strategy that will allow the investor to limit the downside
exposure to a price fall is to hedge the long asset by writing a call
option (short call)
 • If the price falls below the exercise price, the holder of the call will
not exercise the option and the writer will make a profit
• This profit will be offset by the loss sustained by the fall in the price
of the asset
• If the price of the asset move above the exercise price, the writer
will make a net loss from the short call, reducing the profit gained
from the physical asset
Ø Short asset and bullish about the future asset price
• To manage this risk, the investor could buy a call option, to take a
long call on the underlying asset
• If the price rises above the exercise price in the call option, the
option holder will exercise the option and thus acquire the asset at
a price lower than the physical market price
• Should the spot price of the asset fall, the investor could acquire
the asset in the physical market at a lower price and not exercise
the option, with the loss limited to the premium paid
Ø Expectation of increased price volatility, with no trend
• To profit from a price rise, a call option would be bought
• To profit from a price fall, a put option would be bought
• This simultaneous purchase of a long call and a long put, with a
common exercise price, is referred to as a long straddle
• It provides positive pay-off for both large upward and downward
price movements
• If prices remain unchanged, individual makes loss equal to sum of
premiums
Ø Expectation of increased price volatility, with no trend and stagnation
• Buy call option with out of the money exercise price
• Buy put option with out of the money exercise price
• With long strangle loss is decreased if price remains unchanged,
compared to long straddle, this is due to the smaller premiums paid
Ø Expectation of asset price stability
• Short straddle – the simultaneous selling of a call option and a put
option with a single exercise price
• As long as the asset’s price remains at, or very near to the exercise
price, a profit will be made
• If the investor is concerned about the unlimited loss potential in the
short straddle, a short strangle may be the preferred strategy
• Short strangle – the simultaneous selling of a call option and a put
option with equally out-of—the-money exercise prices
• Profit potential is reduced due to less premium earned
 • However, if the asset price does not remain stable, the price can
move through a greater range before a loss is sustained

Conclusion

Ø The potential gains and losses to buyers and sellers of futures contracts
are different from that of options
o Options provide one-sided price protection that is not available
through futures
o The option buyers limit losses and allows profits to accumulate