FINS1612 W11 Lecture

OPTIONS MARKETS
Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips
20-1
LEARNING OBJECTIVES
Understand the structure and operation of option
contracts and the types available

Explain the profit and loss payoff profiles of call and
put option contracts
Describe the structure and organisation of
international and Australian options markets
Explain the factors affecting the price of options
Develop options strategies for hedging price risk
Discuss the advantages and disadvantages of option
contracts in managing risk

20-2
CHAPTER ORGANISATION
20.1
The nature of options
20.2
Option profit and loss payoff profiles
20.3
Organisation of the market
20.4
Factors affecting an option contract premium
20.5
Option risk management strategies
20.6
Conclusion
20.7
Summary

20-3
20.1
THE NATURE OF OPTIONS
Options differ from futures because they provide
asymmetric cover against price movements

Options limit the effects of adverse price
movements without reducing profits from

favourable price movements
Options involve the payment of a premium by
the buyer to the seller (writer)
(cont.)
20-4
20.1THE NATURE OF OPTIONS

(CONT.)
An option gives the buyer the right, but not the
obligation, to buy or sell a specified commodity

or financial instrument at a predetermined price
(exercise or strike price), on or before a
specified date (expiration date)
An option will be exercised only if it is in the
buyers best interests
(cont.)
20-5

(CONT.)
Types of options
Call options
Give the option buyer the right to buy the commodity or

instrument at the exercise price
Put options
Give the buyer the right to sell the commodity or instrument at

the exercise price
Options can be exercised either:
only on expiration date (European); or
any time up to expiration date (American)
(cont.)
20-6

(CONT.)
Premium
The price paid by an option buyer to the writer (seller) of the

option
Exercise price or strike price
The price specified in an options contract at which the option

buyer can buy or sell

20-7
20.1
20.2
20.3
20.4
20.5
20.6
Conclusion
20.7
Summary

20-8
20.2OPTION PROFIT AND LOSS

PAYOFF PROFILES
Call option profit and loss payoff profiles
Example: a call option for shares in a listed company at
a strike or exercise price (X) of $12, and a premium (P)

of $1.50
Figure 20.1 indicates the profit and loss profiles of a call

option for (a) the buyer or holder (long call) and (b) the
writer or seller (short call)
The critical break points of the market price of the share (S)
at expiration date are <$12, $12 to $13.50 and >$13.50
If S (market price of asset) > X (i.e. > $12) , option is in

the money
(cont.)
20-9

PAYOFF PROFILES (CONT.)
(cont.)
20-10

(cont.)
20-11

Call option profit and loss payoff profiles (cont.)
The value of the option to the buyer or holder (long call

party) is:
V = max(S - X, 0) - P
The value of the option to the writer (short call party) is:
V = P - max(S - X, 0)
(cont.)
20-12

Put option profit and loss payoff profiles
Example: a put option for shares in a listed company at a

strike or exercise price (X) of $12, and premium (P) of $1.50
Figure 20.2 indicates the profit and loss profiles of a put option
for (a) the buyer or holder (long put) and (b) the writer or seller
(short put)
The critical break points of the market price of the share (S) at
expiration date are <$10.50, $10.50 to $12 and >$12
Buyer exercises option if S < X (i.e. < $12)
(cont.)
20-13
20-13

(cont.)
20-14

(cont.)
20-15

Put option profit and loss payoff profiles
(cont.)
The value of the option to the buyer or holder (long
put party) is:
V = max(X - S, 0) - P
The value of the option to the writer (or short put
party) is:
V = P - max(X - S, 0)
(cont.)
20-16

Covered and naked options
Unlike the case with futures, the risk of loss for a
buyer of an option contract is limited to the premium

However, sellers (writers) of options have potentially
unlimited risk and may be subject to margin

requirements unless they write a covered option
I.e. the writer of an option holds the underlying asset or

provides a financial guarantee
(cont.)
20-17

Covered and naked options (cont.)
The writer of a call option has written a covered option
if the writer either:
owns sufficient of the underlying asset to satisfy the

option contract if exercised; or
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 put option on the

same asset, but with a higher exercise price

20-18
20.1
20.2
20.3
20.4
20.5
20.6
Conclusion
20.7
Summary

20-19
20.3
ORGANISATION OF THE
MARKET
Option markets are categorised as:
Over the counter
Exchange-traded
These are recorded through a 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

(i.e. reverse) their contracts
(cont.)
20-20
20-20
20.3ORGANISATION OF THE MARKET

(CONT.)
International options markets
An exchange in a particular country will usually specialise
in option contracts that are directly related to physical or

futures market products also traded in that particular
country
Trading on international exchanges varies
The largest exchanges, the Chicago Board of Trade (CBOT)

and Chicago Mercantile Exchange (CME), retain open-outcry
trading on the floor involving 4000 to 5000 people
International links between exchanges allow 24-hour
trading
(cont.)
20-21

(CONT.)
The Australian options markets
Types of options traded
Options on futures contracts
Share options
Low-exercise-price options
Warrants
Over-the-counter options
(cont.)
20-22

(CONT.)
The Australian options market (cont.)
Options on futures contracts
Traded on the ASX
Buyer of options contract has the right to buy (call) or sell (put) a
futures contract
Options on futures available for:
90-day bank-accepted bills
SPI200 index futures contract
three-year and 10-year Commonwealth Treasury bonds
overnight options on the above Treasury bonds and share

price index futures contracts
(cont.)
20-23

(CONT.)
Share options
Traded on the ASX
Based on ordinary shares of specified listed companies
Usually three or more options contracts for each company, each with
identical expiration dates but different exercise prices
The options clearing house maintains a system of deposits, maintenance

margins and a share scrip depository
(cont.)
20-24

(CONT.)
Low exercise price options (LEPOs)
Traded on the ASX since 2005
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
Exercisable only at expiration date (i.e. European)
Available over a range of high-liquidity stocks listed on

the ASX
(cont.)
20-25

(CONT.)
Australian options market (cont.)
Warrants
An options contract (i.e. contractual right but not

obligation to buy or sell an underlying asset)
Two classes of warrants
Equity warrants attached to debt issues made by

companies raising funds through primary market
debt issues
Option to convert debt to ordinary shares of the

issuing company (discussed in Chapter 5)
(cont.)
20-26

(CONT.)
Warrants (cont.)
Two classes of warrants (cont.)
Warrants issued as financial products for investment and

to manage risk exposure to price movements in the
market
Issued by financial institutions
American- or European-type contracts
Traded on ASX Trade, the ASXs electronic trading

system
Settlement of contracts through ASX Trade
(cont.)
20-27

(CONT.)
Over-the-counter markets
Used to trade options not traded on the exchanges, e.g. semigovernment securities and other money-market instruments or
securities with unusual maturities
Allows flexibility in terms of:
amount
term
interest rate
price
Used to set interest rate caps, floors and collars

20-28
20.1
20.2
20.3
20.4
20.5
20.6
Conclusion
20.7
Summary

20-29
20.4FACTORS AFFECTING AN OPTION

CONTRACT PREMIUM
Option price (or premium) is influenced
by four key factors

1. Intrinsic value
2. Time value
3. Price volatility
4. Interest rates
(cont.)
20-30

CONTRACT PREMIUM (CONT.)
1.
Intrinsic value
The market price of the underlying asset relative to the
exercise price
The greater the intrinsic value, the greater the premium,
i.e. positive relationship

Options with an intrinsic value
Positive are in the money and the buyer is able to exercise

contract at a profit
Negative are out of the money and the buyer will not
exercise
Zero are at the money
(cont.)
20-31

(cont.)
20-32

2.
Time value
The longer the time to expiry, the greater the
possibility that the option will be able to be exercised

for a profit (in the money); i.e. positive relationship
If the spot price moves adversely, the loss is limited to
the premium
(cont.)
20-33

3.
Price volatility
The greater the volatility of the spot price, the greater
the chance of exercising the option for a profit, or a

loss
The option will be exercised only if the price moves
favourably
The greater the spot price volatility, the greater the
option premium; i.e. positive relationship
(cont.)
20-34

4.
Interest rates
Interest rates have opposite impacts on put and call
options
Positive relationship between interest rates and the price of

a call
Benefit of present value of deferred payment if

exercised > lower present value of profit if exercised
Negative relationship between interest rates and the price

of a put
Opportunity cost of holding asset
Lower present value of the profit if exercised

20-35
20.1
20.2
20.3
20.4
20.5
20.6
Conclusion
20.7
Summary

20-36
20.5OPTION RISK MANAGEMENT

STRATEGIES
Single-option strategies
Example: long asset (i.e. bought) and bearish
(negative) about future asset price
Strategy
Limit downside risk by writing (selling) a call option,

i.e. short call
Figure 20.5 and Table 20.4 in the textbook illustrate

the profit profile of this strategy
(cont.)
20-37

STRATEGIES (CONT.)
(cont
20-38

STRATEGIES (CONT.)
(cont.)
20-39

STRATEGIES (CONT.)
Single-option strategies (cont.)
Example: short asset (i.e. sold) and bullish (positive)
about future asset price
Strategy
Buy a call in the underlying asset (i.e. take a long-call

position)
Figure 20.6 and Table 20.5 in the textbook illustrate

the profit profile of this strategy
(cont.)
20-40

STRATEGIES (CONT.)
Combined-options strategies (cont.)
Example: expectation of increased price volatility, with no
trend
Strategy
Hold (buy) a put option
Hold (buy) a call option with common exercise price
Long straddle provides positive pay-off for both large

upward and downward price movements
If prices remain unchanged, individual makes loss equal

to sum of premiums
Figure 20.11 in the textbook illustrates the profit profile
(cont.)
20-41

STRATEGIES (CONT.)
Example: expectation of increased volatility, without
trend, with stagnation

Strategy
Hold (buy) call option with out-of-the-money exercise
price
Hold (buy) put option with out-of-the-money exercise
price
With long strangle loss is decreased if price remains
unchanged, compared with long straddle

Figure 20.12 in the textbook illustrates the profit profile
(cont.)
20-42

STRATEGIES (CONT.)
Example: expectation of asset price stability
Strategy
Take opposite position to long straddle and long strangle
Strategy I: Short straddle
Strategy II: Short strangle
Sell call and put options with same exercise price

Sell call and put options, both out of the money
Figure 20.13 in the textbook illustrates the profit profiles
(cont.)
20-43
20.1
20.2
20.3
20.4
20.5
20.6
Conclusion
20.7
Summary

20-44
20.6
CONCLUSION
The potential gains and losses to buyers
and sellers of futures contracts are

different from those of options
Options provide one-sided price protection that is not
available through futures

The option buyer limits losses and allows profits to
accumulate
However, the premium may be quite high

20-45
20.1
20.2
20.3
20.4
20.5
20.6
Conclusion
20.7
Summary

20-46
20.7
SUMMARY
The holder of an option (long party) has the right to buy
(call) or sell (put) the commodity at a specified exercise

price
The writer (seller) is the short party
ASX trades standardised options, unlike over-the-counter
market
The premium paid to buy an option is affected by its
intrinsic value, time value, price volatility, and interest
rates
A broad array of option strategies may be adopted by
hedgers and speculators

20-47

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OPTIONS MARKETS

Copyright 2012 McGraw-Hill Australia Pty Ltd

contracts and the types available

Copyright 2012 McGraw-Hill Australia Pty Ltd

The nature of options

Option profit and loss payoff profiles

Organisation of the market

Factors affecting an option contract premium

Option risk management strategies

Copyright 2012 McGraw-Hill Australia Pty Ltd

THE NATURE OF OPTIONS

Options differ from futures because they provide

asymmetric cover against price movements

movements without reducing profits from

the buyer to the seller (writer)

20.1THE NATURE OF OPTIONS

obligation, to buy or sell a specified commodity

buyers best interests

20.1THE NATURE OF OPTIONS

Give the option buyer the right to buy the commodity or

Give the buyer the right to sell the commodity or instrument at

Options can be exercised either:

only on expiration date (European); or

any time up to expiration date (American)

20.1THE NATURE OF OPTIONS

The price paid by an option buyer to the writer (seller) of the

Exercise price or strike price

The price specified in an options contract at which the option

Copyright 2012 McGraw-Hill Australia Pty Ltd

The nature of options

Option profit and loss payoff profiles

Organisation of the market

Factors affecting an option contract premium

Option risk management strategies

Copyright 2012 McGraw-Hill Australia Pty Ltd

20.2OPTION PROFIT AND LOSS

a strike or exercise price (X) of $12, and a premium (P)

Figure 20.1 indicates the profit and loss profiles of a call

If S (market price of asset) > X (i.e. > $12) , option is in

20.2OPTION PROFIT AND LOSS

20.2OPTION PROFIT AND LOSS

20.2OPTION PROFIT AND LOSS

The value of the option to the buyer or holder (long call

20.2OPTION PROFIT AND LOSS

Example: a put option for shares in a listed company at a

Buyer exercises option if S < X (i.e. < $12)

20.2OPTION PROFIT AND LOSS

20.2OPTION PROFIT AND LOSS

20.2OPTION PROFIT AND LOSS

put party) is:

The value of the option to the writer (or short put

20.2OPTION PROFIT AND LOSS

buyer of an option contract is limited to the premium

unlimited risk and may be subject to margin

I.e. the writer of an option holds the underlying asset or

20.2OPTION PROFIT AND LOSS

if the writer either:

owns sufficient of the underlying asset to satisfy the

is also the holder of a call option on the same asset, but

The writer of a put option has written a covered option

if the writer is also the holder of a put option on the

Copyright 2012 McGraw-Hill Australia Pty Ltd

The nature of options

Option profit and loss payoff profiles