7-0
Finance 457
The Mechanics of
Options Markets
7
Chapter Seven
7-1
Finance 457
Mechanics of Options Markets
7.1 Underlying Assets
7.2 Specifications of stock options
7.3 Newspaper Quotes
7.4 Trading
7.5 Commissions
7.6 Margins
7.7 The Options Clearing Corporation
7.8 Regulation
7.9 Taxation
7.10 Warrants, ESOs and Convertibles
7.11 Over-the-counter markets
Summary and Conclusions
7-2
Finance 457
Options Contracts: Preliminaries
• An option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset on (or perhaps
before) a given date, at prices agreed upon today.
• Calls versus Puts
– Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at
some time in the future, at prices agreed upon today.
When exercising a call option, you “call in” the asset.
– Put options gives the holder the right, but not the
obligation, to sell a given quantity of an asset at some
time in the future, at prices agreed upon today. When
exercising a put, you “put” the asset to someone.
7-3
Finance 457
Options Contracts: Preliminaries
• Exercising the Option
– The act of buying or selling the underlying asset through the
option contract.
• Strike Price or Exercise Price
– Refers to the fixed price in the option contract at which the
holder can buy or sell the underlying asset.
• Expiry
– The maturity date of the option is referred to as the
expiration date, or the expiry.
• European versus American options
– European options can be exercised only at expiry.
– American options can be exercised at any time up to expiry.
7-4
Finance 457
Options Contracts: Preliminaries
• In-the-Money
– The exercise price is less than the spot price of the
underlying asset.
• At-the-Money
– The exercise price is equal to the spot price of the
underlying asset.
• Out-of-the-Money
– The exercise price is more than the spot price of the
underlying asset.
7-5
Finance 457
Options Contracts: Preliminaries
• Intrinsic Value
– The difference between the exercise price of the option
and the spot price of the underlying asset.
• Speculative Value
– The difference between the option premium and the
intrinsic value of the option.
Option
Premium
=
Intrinsic
Value
+ Speculative
Value
7-6
Finance 457
7.1 Underlying Assets
• Stocks
– CBOE, PHLX, AMEX, and the Pacific Exchange
– Trade on more than 500 different stocks, on round lots
• Stock indices
– Settlement is always in cash.
• Foreign Currencies
– PHLX
– European and American options on a variety of currencies
• Futures Contracts
– The futures contract normally matures just after the expiry of the
option
7-7
Finance 457
7.2 Specifications of stock options
• Expiry
– 10:59 CST on the Saturday
immediately following the
third Friday of the month.
– The last trading day is the
third Friday.
– Holder of the option has
until 4:30 of that Friday to
exercise.
– His broker has until 10:59
the next day to notify the
exchange
• Expiry Cycles:
• January
– January, April, July, October
• February
– February, May, August, November
• March
– March, June, September,
December
• When one option expires, trading in
another begins.
7-8
Finance 457
7.2 Specifications of stock options
• Strike Price
– When a new expiration date
is introduced, the two or
three strike prices closest to
the current stock price are
usually selected by the
exchange.
– If the stock prices move
outside this range, new
options will be introduced.
• Terminology:
• An option class refers to all puts on
firm XYZ or all calls on ABC.
• An option series consists of all the
options of a given class with the same
expiry and strike (e.g. the IBM
October 50 calls)
7-9
Finance 457
7.2 Specifications of stock options
• Dividends and Splits
– Exchange traded options are
adjusted for stock splits and
stock dividends.
– Exchange traded options are
generally not adjusted for
cash dividends
• Position Limits
– A position limit is the maximum
number of option contracts that an
investor can hold on one side of
the market.
– Short calls and long puts are on
the same side.
• Exercise Limits
– Equals the position limit.
• Controversial issue.
7-10
Finance 457
Reading The Wall Street Journal
Option/Strike Exp.
130 Oct
IBM
130 Jan
138¼
135 Jul
138¼
135 Aug
138¼
140 Jul
138¼
140 Aug
138¼
--Put---Call-Vol. Last Vol. Last
5¼
107
364 15¼
9¼
420
112 19½
4¾ 2431 13/16
2365
5½
94
9¼
1231
2¾
427
1¾
1826
7½
58
6½
2193
7-11
Finance 457
Reading The Wall Street Journal
This option has a strike price of $135;
Option/Strike Exp.
130 Oct
IBM
130 Jan
138¼
135 Jul
138¼
135 Aug
138¼
140 Jul
138¼
140 Aug
138¼
--Put---Call-Vol. Last Vol. Last
5¼
107
364 15¼
9¼
420
112 19½
4¾ 2431 13/16
2365
5½
94
9¼
1231
2¾
427
1¾
1826
7½
58
6½
2193
a recent price for the stock is $138.25
July is the expiration month
7-12
Finance 457
Reading The Wall Street Journal
This makes a call option with this exercise price in-themoney by $3.25 = $138¼ – $135.
Option/Strike Exp.
130 Oct
IBM
130 Jan
138¼
135 Jul
138¼
135 Aug
138¼
140 Jul
138¼
140 Aug
138¼
--Put---Call-Vol. Last Vol. Last
5¼
107
364 15¼
9¼
420
112 19½
4¾ 2431 13/16
2365
5½
94
9¼
1231
2¾
427
1¾
1826
7½
58
6½
2193
Puts with this exercise price are out-of-the-money.
7-13
Finance 457
Reading The Wall Street Journal
Option/Strike Exp.
130 Oct
IBM
130 Jan
138¼
135 Jul
138¼
135 Aug
138¼
140 Jul
138¼
140 Aug
138¼
--Put---Call-Vol. Last Vol. Last
5¼
107
364 15¼
9¼
420
112 19½
4¾ 2431 13/16
2365
5½
94
9¼
1231
2¾
427
1¾
1826
7½
58
6½
2193
On this day, 2,365 call options with this exercise price were
traded.
7-14
Reading The Wall Street Journal
Finance 457
The CALL option with a strike price of $135 is trading for
$4.75.
Option/Strike Exp.
130 Oct
IBM
130 Jan
138¼
135 Jul
138¼
135 Aug
138¼
140 Jul
138¼
140 Aug
138¼
--Put---Call-Vol. Last Vol. Last
5¼
107
364 15¼
9¼
420
112 19½
4¾ 2431 13/16
2365
5½
94
9¼
1231
2¾
427
1¾
1826
7½
58
6½
2193
Since the option is on 100 shares of stock, buying this option
would cost $475 plus commissions.
7-15
Finance 457
Reading The Wall Street Journal
Option/Strike Exp.
130 Oct
IBM
130 Jan
138¼
135 Jul
138¼
135 Aug
138¼
140 Jul
138¼
140 Aug
138¼
--Put---Call-Vol. Last Vol. Last
5¼
107
364 15¼
9¼
420
112 19½
4¾ 2431 13/16
2365
5½
94
9¼
1231
2¾
427
1¾
1826
7½
58
6½
2193
On this day, 2,431 put options with this exercise price were
traded.
7-16
Finance 457
Reading The Wall Street Journal
The PUT option with a strike price of $135 is trading for
$.8125.
Option/Strike Exp.
130 Oct
IBM
130 Jan
138¼
135 Jul
138¼
135 Aug
138¼
140 Jul
138¼
140 Aug
138¼
--Put---Call-Vol. Last Vol. Last
5¼
107
364 15¼
9¼
420
112 19½
4¾ 2431 13/16
2365
5½
94
9¼
1231
2¾
427
1¾
1826
7½
58
6½
2193
Since the option is on 100 shares of stock, buying this
option would cost $81.25 plus commissions.
7-17
Finance 457
7.4 Trading
• Market Makers
– Offer bid and ask quotes on
the option.
– Market makers ensure that
buy and sell orders can
always be executed at some
price without delay.
– The bid-ask spread is their
compensation for this
liquidity intermediation
• Offsetting Orders
– An investor can close out a
long position by issuing an
offsetting order to sell the
same option.
– An investor can close out a
short position by issuing an
offsetting order to buy the
same option.
7-18
Finance 457
7.5 Commissions
• Commissions vary substantially
from one broker to another.
• A hidden cost is the bid-ask
spread
7-19
Finance 457
7.6 Margins
• Since options already have plenty of leverage, option premia must be
paid in full.
7-20
Finance 457
7.6 Margins
• Naked
– If you write a call on shares you don’t own.
– The initial margin is the greater of:
• 100% of the proceeds plus 20% of the underlying share price less
the amount if any by which the option is out of the money
• 100% of the option proceeds plus 10% of the underlying share
price
• Covered Call
– IF the option is out of the money, no margin is required
7-21
Finance 457
7.7 The Options Clearing Corporation
• Has the same function as the
• Exercising an option
clearinghouse in the futures
– The OCC randomly selects a
markets.
member with an outstanding
• Guarantees option writers fulfill
short position in the option.
their obligations and keeps a
– The member then selects a
record of all long and short
particular investor who has
positions.
written the option.
– At expiry, all in-the-money
options should be exercised
unless transactions costs are too
high.
7-22
Finance 457
7.8 Regulation
• Both the exchange and the OCC
have rules governing the
behavior of traders.
• Both federal and state regulatory
authorities exist.
• SEC CFTC
• There haven’t been any huge
scandals, so we leave them
alone.
• So far
7-23
Finance 457
7.9 Taxation
• Determining the tax implications
of options strategies can be
tricky.
7-24
Finance 457
7.10 Warrants, Executive Stock Options and
Convertibles
• The important questions are:
– How can warrants and convertibles be valued?
– What impact do warrants and convertibles have on firm
value?
– What are the differences between warrants, convertibles
and call options?
– Under what circumstances are warrants and convertibles
converted into common stock?
7-25
Finance 457
Warrants
• Warrants are call options that give the holder the right, but
not the obligation, to buy shares of common stock directly
from a company at a fixed price for a given period of time.
• Warrants tend to have longer maturity periods than exchange
traded options.
• Warrants are generally issued with privately placed bonds as
an “equity kicker”.
• Warrants are also combined with new issues of common
stock and preferred stock, given to investment bankers as
compensation for underwriting services.
– In this case, they are often referred to as a Green Shoe
Option.
7-26
Finance 457
The Difference Between Warrants and
Call Options
• When a warrant is exercised, a firm must issue new
shares of stock.
• This can have the effect of diluting the claims of
existing shareholders.
7-27
Finance 457
Dilution Example
• Imagine that Mr. Armstrong and Mr. LeMond are
shareholders in a firm whose only asset is 10 ounces of gold.
• When they incorporated, each man contributed 5 ounces of
gold, then valued at $300 per ounce. They printed up two
stock certificates, and named the firm LegStrong, Inc..
• Suppose that Mr. Armstrong decides to sell Mr. Mercx a call
option issued on Mr. Armstrong’s share. The call gives Mr.
Mercx the option to buy Mr. Armstong’s share for $1,500.
• If this call finishes in-the-money, Mr. Mercx will exercise,
Mr. Armstrong will tender his share.
• Nothing will change for the firm except the names of the
shareholders.
7-28
Finance 457
Dilution Example
• Suppose that Mr. Armstrong and Mr. LeMond meet as the
board of directors of LegStrong. The board decides to sell
Mr. Mercx a warrant. The warrant gives Mr. Mercx the
option to buy one share for $1,500.
• Suppose the warrant finishes in-the-money, (gold increased
to $350 per ounce). Mr. Mercx will exercise. The firm will
print up one new share.
7-29
Finance 457
Dilution Example
• The balance sheet of LegStrong Inc. would change in the
following way:
Balance Sheet Before
(Book Value)
Assets
Liabilities and
Equity
Gold:
$3,000 Debt
0
Equity
$3,000
(2 shares)
Total Assets $3,000
Total
$3,000
7-30
Finance 457
Dilution
• The balance sheet of LegStrong Inc. would change in the
following way:
Balance Sheet Before
(Market Value)
Assets
Liabilities and
Equity
Gold:
$3,500 Debt
0
Equity
$3,500
(2 shares)
Total Assets $3,500
Total
$3,500
7-31
Finance 457
Dilution
• The balance sheet of LegStrong Inc. would change in the
following way:
Balance Sheet After
(Market Value)
Assets
Liabilities and
Equity
Gold:
$3,500 Debt
0
Cash:
$1,500 Equity
$5,000
(3 shares)
Total Assets $5,000
Total
$5,000
Note that Mr. Armstrong’s claim falls in value from
$1,750 = $3,500 ÷ 2 to $1,666.67 = $5,000 ÷ 3
7-32
Finance 457
Convertible Bonds
• A convertible bond is similar to a bond with warrants.
• The most important difference is that a bond with warrants
can be separated into different securities and a convertible
bond cannot.
• Recall that the minimum (floor) value of convertible:
– Straight or “intrinsic” bond value
– Conversion value
• The conversion option has value.
7-33
Finance 457
The Value of Convertible Bonds
The value of a convertible bond has three components:
1. Straight bond value
2. Conversion value
3. Option value
7-34
Finance 457
Convertible Bond Problem
• Litespeed, Inc., just issued a zero coupon convertible bond
due in 10 years.
• The conversion ratio is 25 shares.
• The appropriate interest rate is 10%.
• The current stock price is $12 per share.
• Each convertible is trading at $400 in the market.
– What is the straight bond value?
– What is the conversion value?
– What is the option value of the bond?
7-35
Finance 457
Convertible Bond Problem (continued)
– What is the straight bond value?
$1,000
SBV 
 $385.54
10
(1.10)
– What is the conversion value?
25 shares × $12/share = $300
– What is the option value of the bond?
$400 – 385.54 = $14.46
7-36
Finance 457
The Value of Convertible Bonds
Convertible
Bond Value
Convertible bond
values
Conversion
Value
floor value
Straight bond
value
floor
value
= conversion ratio
Option
value
Stock
Price
7-37
Finance 457
Reasons for Issuing Warrants and Convertibles
• A reasonable place to start is to compare a hybrid like
convertible debt to both straight debt and straight equity.
• Convertible debt carries a lower coupon rate than does
otherwise-identical straight debt.
• Since convertible debt is originally issued with an out-ofthe-money call option, one can argue that convertible debt
allows the firm to sell equity at a higher price than is
available at the time of issuance. However, the same
argument can be used to say that it forces the firm to sell
equity at a lower price than is available at the time of
exercise.
7-38
Convertible Debt vs. Straight Debt
Finance 457
• Convertible debt carries a lower coupon rate than does otherwiseidentical straight debt.
• If the company subsequently does poorly, it will turn out that the
conversion option finishes out-of-the-money.
• But if the stock price does well, the firm would have been better off
issuing straight debt.
• In an efficient financial market, convertible bonds will be neither
cheaper or more expensive than other financial instruments.
• At the time of issuance, investors pay the firm for the fair value of the
conversion option.
7-39
Convertible Debt vs. Straight Equity
Finance 457
• If the company subsequently does poorly, it will turn out
that the conversion option finishes out-of-the-money, but
the firm would have been even better off selling equity
when the price was high.
• But if the stock price does well, the firm is better off issuing
convertible debt rather than equity
• In an efficient financial market, convertible bonds will be
neither cheaper or more expensive than other financial
instruments.
• At the time of issuance, investors pay the firm for the fair
value of the conversion option
7-40
Why Warrants and Convertibles are Issued
Finance 457
• Convertible bonds reduce agency costs, by aligning the
incentives of stockholders and bondholders.
• Convertible bonds also allow young firms to delay
expensive interest costs until they can afford them.
• Support for these assertions is found in the fact that firms
that issue convertible bonds are different from other firms:
– The bond ratings of firms using convertibles are lower.
– Convertibles tend to be used by smaller firms with high
growth rates and more financial leverage.
– Convertibles are usually subordinated and unsecured.
7-41
Conversion Policy
Finance 457
•
•
•
Most convertible bonds are also callable.
When the bond is called, bondholders have about 30 days to choose
between:
1. Converting the bond to common stock at the conversion ratios.
2. Surrendering the bond and receiving the call price in cash.
From the shareholder’s perspective, the optimal call policy is to call
the bond when its value is equal to the call price.
– In the real world, most firms wait to call until the bond value is
substantially above the call price. Perhaps the firm is afraid of
the risk of a sharp drop in stock prices during the 30-day
window.
7-42
Executive Stock Options
Finance 457
• Executive Stock Options exist to align the interests of
shareholders and managers.
• Executive Stock Options are call options (technically
warrants) on the employer’s shares.
– Inalienable
– Typical maturity is 10 years.
– Typical vesting period is 3 years.
– Most include implicit reset provision to preserve
incentive compatibility.
• Executive Stock Options give executives an important tax
break: grants of at-the-money options are not considered
taxable income. (Taxes are due if the option is exercised.)
7-43
Valuing Executive Compensation
Finance 457
• FASB allows firms to record zero expense for grants of atthe-money executive stock options.
• However the economic value of a long-lived call option is
enormous, especially given the propensity of firms to reset
the exercise price after drops in the price of the stock.
• Due to the inalienability, the options are worth less to the
executive than they cost the company.
– The executive can only exercise, not sell his options.
Thus he can never capture the speculative value—only
the intrinsic value.
• This “dead weight loss” is overcome by the incentive
compatibility for the grantor.
7-44
Top Stock Option Grants
Finance 457
Company
CEO
Stock Option Award
Citigroup, Inc.
Sanford Weill
$351,319,000
American Express
Harvey Golub
$134,102,000
Cisco Systems, Inc.
John Chambers
$132,100,000
Bank of America
Hugh McColl Jr.
$104,300,000
Honeywell Inc.
Michael Bosignore
$121,496,000
ALCOA
Paul O’Neill
$96,353,000
7-45
Finance 457
7.11 Over-the-counter markets
7-46
Finance 457
Summary and Conclusions