Chapter 13
Introduction to Options
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Financial Modeling Spring 2008
Outline
What options are and where they come from
Why options are a good idea
Where and how options trade
Components of the option premium
Where profits and losses come from with options
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What Options Are and Where They
Come From
Call and put options
Categories of options
Standardized option characteristics
Where options come from
Opening and closing transactions
The role of the options clearing corporation
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Call and Put Options
Call Options
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A call option gives its owner the right to buy; it is not a promise
to buy
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For example, a store holding an item for you for a fee is a call
option
Put Options
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A put option gives its owner the right to sell; it is not a promise
to sell
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For example, a lifetime money back guarantee policy on items sold
by a company is an embedded put option
Categories of Options
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An American option gives its owner the right to
exercise the option anytime prior to option
expiration
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A European option may only be exercised at
expiration
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Categories of Options (cont’d)
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Options giving the right to buy or sell shares of
stock (stock options) are the best-known options
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The underlying asset of an index option is some
market measure like the S&P 500 index
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An option contract is for 100 shares of stock
Cash-settled
Standardized Option
Characteristics
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Expiration dates
 The Saturday following the third Friday of certain
designated months for most options
Striking price
 The predetermined transaction price, in multiples of
$2.50 or $5, depending on current stock price
Underlying Security
 The security the option gives you the right to buy or
sell
 Both puts and calls are based on 100 shares of the
underlying security
Standardized Option Characteristics (cont’d)
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The option premium is the amount you pay for the
option
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Exchange-traded options are fungible
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For a given company, all options of the same type with
the same expiration and striking price are identical
Identifying An Option
Expiration (3rd Friday in October)
Type of option
Microsoft OCT 80 Call
Underlying asset
(Microsoft common stock)
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Strike price
($80 per share)
Where Options Come From
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Unlike more familiar securities, there is no set
number of put or call options
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The number in existence changes every day
Opening and Closing Transactions
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The first trade someone makes in a particular
option is an opening transaction for that person
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When the individual subsequently closes that
position out with a second trade, this latter trade
is a closing transaction
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Opening and Closing Transactions
(cont’d)
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When someone buys an option as an opening
transaction, the owner of an option will ultimately
do one of three things with it:
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Sell it to someone else
Let it expire
Exercise it
For example, buying a ticket to an athletic event
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Opening and Closing
Transactions (cont’d)
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When someone sells an option as an opening
transaction, this is called writing the option
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No matter what the owner of an option does, the
writer of the option keeps the option premium that he
or she received when it was sold
The Role of the Options
Clearing Corporation (OCC)
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The Options Clearing Corporation (OCC)
contributes substantially to the smooth operation
of the options market
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It positions itself between every buyer and seller and
acts as a guarantor of all option trades
It sets minimum capital requirements and provides for
the efficient transfer of funds among members as gains
or losses occur
Why Options Are a Good Idea
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Increased risk
Instantaneous information
Portfolio risk management
Risk transfer
Financial leverage
Income generation
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Where and How Options Trade
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Exchanges
Over-the-counter options
Standardized option characteristics
Other listed options
Trading mechanics
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Exchanges
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Major options exchanges in the U.S.:
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Chicago Board Options Exchange (CBOE)
American Stock Exchange (AMEX)
Philadelphia Stock Exchange (Philly)
Pacific Stock Exchange (PSE)
International Securities Exchange (ISE)
Foreign options exchanges also exist
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Over-the-Counter Options
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With an over-the-counter option:
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Institutions enter into “private” option arrangements
with brokerage firms or other dealers
The striking price, life of the option, and premium are
negotiated between the parties involved
Over-the-counter options are subject to
counterparty risk and are generally not fungible
Some Exotic Options
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As-You-Like-It Option
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Barrier Option
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The owner can decide whether it is a put or a call by a
certain date
Created or cancelled if a prespecified price level is
touched
Forward Start Option
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Paid for now, with the option becoming effective at a
future date
Other Listed Options
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Long-Term Equity Anticipation Security (LEAP)
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Options similar to ordinary listed options, except they
are longer term
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May have a life up to 39 months
All LEAPs expire in January
Presently available on only the most active underlying
securities
Other Listed Options (cont’d)
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FLEX option
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Fundamentally different from an ordinary listed option
in that the terms of the option are flexible
Advantage of user flexibility while eliminating
counterparty risk
In general, a FLEX option trade must be for at least
250 contracts
Trading Mechanics
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Bid Price and Ask Price
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There are two option prices at any given time:
 Bid price: the highest price anyone is willing to pay
for a particular option
 Ask price: the lowest price at which anyone if
willing to sell a particular option
Trading Mechanics (cont’d)
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Types of orders
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A market order expresses a wish to buy or sell
immediately, at the current price
A limit order specifies a particular price (or better)
beyond which no trade is desired
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Typically require a time limit, such as “for the day” or “good
‘til canceled (GTC)”
Trading Mechanics (cont’d)
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Trading Floor Systems
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Under the specialist system, there is a single individual
through whom all orders to buy or sell a particular
security must pass
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Used at the AMEX and the Philly
The specialist keeps an order book with limit order from all
over the country
The specialist’s job is to maintain a fair and orderly market
Trading Mechanics (cont’d)
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Trading Floor Systems (cont’d)
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Under the marketmaker system, the specialist’s
activities are divided among three groups of people:
 Marketmakers
 Floor brokers
 Order Book Official
The Option Premium
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Intrinsic value and time value
Option price quotations
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Intrinsic Value and Time Value
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Intrinsic value is the amount that an option is
immediately worth given the relation between the
option striking price and the current stock price
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Call option
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stock price – striking price
Put option
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intrinsic value =
intrinsic value = striking price – stock price
Intrinsic value cannot be < zero
Intrinsic Value and Time Value
(cont’d)
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Intrinsic value (cont’d)
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An option with no intrinsic value is out-of-the-money
An option whose striking price is exactly equal to the
price of the underlying security is at-the-money
Options that are “almost” at-the-money are near-themoney
Intrinsic Value and Time Value
(cont’d)
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Time value is equal to the premium minus the
intrinsic value
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As an option moves closer to expiration, its time value
decreases (time value decay)
 An option is a wasting asset
Option Price Quotations
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Every service that reports option prices will show,
at a minimum, the
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Striking price
Expiration
Premium
Option Price Quotations (cont’d)
Intraday Prices from September 15, 2003
Microsoft Stock Price = $28.51
Call
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Strike
Expiration
20
SEP 03
20
OCT
22.50
22.50
Volume
Last
Put
Open Interest
Volume
Last
Open Interest
8.60
462
0
0
51
0
8.62
3079
0
0
13013
SEP
0
6.04
781
0
0
5920
OCT
0
6.06
7050
2
0.05
35024
0
Profits and Losses With Options
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Understanding the exercise of an option
Exercise procedures
Profit and loss diagrams
A note on margin requirements
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Understanding the Exercise of
an Option
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An American option can be exercised anytime
prior to the expiration of the option
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Exercising an American option early amounts to
abandoning any time value remaining in the option
A European option can only be exercised at
maturity
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Exercise Procedures
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Notify your broker
Broker notifies the Options Clearing Corporation
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Selects a contra party to receive the exercise notice
Neither the option exerciser nor the option writer
knows the identity of the opposite party
Exercise Procedures (cont’d)
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The option premium is not a down payment on
the purchase of the stock
The option holder, not the option writer, decides
when and if to exercise
In general, you should not buy an option with the
intent of exercising it
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Profit and Loss Diagrams
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Vertical axis reflects profits or losses on the expiration
day resulting from a particular strategy
Horizontal axis reflects the stock price on the
expiration day
Any bend in the diagram occurs at the striking price
By convention, diagrams ignore the effect of
commissions that must be paid
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Buying a Call Option (“Going
Long”)
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Example: buy a Microsoft October 25 call for $3.70
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Maximum loss is $3.70
Profit potential is unlimited
Breakeven is $28.70
Buying a Call Option (cont’d)
Breakeven = $28.70
0
Maximum
loss = $3.70
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20
40
60
80
100
Writing a Call Option (“Short
Option”)
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Ignoring commissions, the options market is a
zero sum game
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Aggregate gains and losses will always net to zero
The most an option writer can make is the option
premium
Writing a call without owning the underlying
shares is called writing a naked (uncovered) call
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Writing a Call Option (cont’d)
Breakeven = $28.70
Maximum
Profit = $3.70
0
40
20
40
60
80
100
Buying a Put Option (“Going
Long”)
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Example: buy a Microsoft April 25 put for $1.10
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Maximum loss is $1.10
Maximum profit is $23.90
Breakeven is $23.90
Buying a Put Option (cont’d)
$23.90
Breakeven = $23.90
0
$1.10
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20
40
60
80
100
Writing a Put Option (“Short
Option”)
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The put option writer has the obligation to buy if
the put is exercised by the holder
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Writing a Put Option (cont’d)
Breakeven = $23.90
$1.10
0
$23.90
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20
40
60
80
100
A Note on Margin Requirements
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A margin requirement is analogous to posting
collateral and can be satisfied by a deposit of cash
or other securities into your brokerage account
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The margin system is to reduce the likelihood
that option writers will be unable to fulfill their
obligations
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