Option Terminology Assets Underlying Exchange-Traded Options - PowerPoint PPT Presentation

Important Concepts Lecture 2.1: Structure of Options Markets and  Assets underlying exchange-traded options  Options terminology Basic Applications of Options  Specifications of exchange-traded options  Mechanics of trading  Open interest and volume  Types of traders Nattawut Jenwittayaroje, PhD, CFA 01135534: Financial Modelling  Basic use of options NIDA Business School National Institute of Development Administration 2 1 Option Terminology Assets Underlying Exchange-Traded Options  In-the-money : produce “profits” if it were exercised now.  Stock options : A call or put on common stocks such as IBM, Microsoft and etc. They are traded on CBOE, PHLX, AMEX, and Pacific Stock Exchange. They are American-  At-the-money : give “nothing” if it were exercised now. style.  Index options : A call or put based on a stock market index such as S&P 500, Nasdaq  Out-of-the-money : produce “losses” if it were exercised now. 100, SET 50. The two most popular are options on the S&P100 and S&P500 on the CBOE  Interest Rate Options: Options are traded on T-notes, T-bonds, T-bills, and other debt In-the-money: S >X In-the-money: S <X instruments.  Foreign currency options The major exchange is PHLX. Offer both European and Call option At-the-money: S = X Put option At-the-money: S = X American contracts on, e.g., Australian dollar, British pound, Canadian dollar, Euro, Yen, and Swiss franc.  Futures options : in a futures option (or options on futures), the underlying asset is a Out-of-the-money: S <X Out-of-the-money: S >X futures contract. The most actively traded futures options are the Treasury bond futures option traded on CBOT and the Eurodollar futures option traded on CME. where S = underlying price, X = exercise price 3 4

Option Terminology  Option class – e.g., IBM calls are one class whereas IBM puts are another class. SET50 Index Options  Option series – an option series consists of all the options of a Contract given class with the same expiration date and strike price. In Specifications other words, an option series refers to a particular contract that is traded, e.g., IBM 110 January calls, SET 50 December call with strike of 300. www.tfex.co.th at 1 Feb 13 5 6 Specification of Exchange-Traded Options Specification of Exchange-Traded Options  Underlying asset  Contract Size  Individual stocks, stock indexes, currency, futures.  For individual stock, one contract is for 100 shares of the stock.  Call or Put (option class)  Contract sizes for index options are specified by a multiplier; e.g.,  Call vs put SET50 index option has a multiplier of 200. An investor who buys one  European or American contract actually buys exposure to 200 times the index.  Can be exercised at any time (American), or at expiration only (European)  Position and Exercise Limits  Expiration date  Position limits define the maximum number of option contracts that a  For example, the contract months for SET50 index options are the 3 nearest trader can hold on one side of the market. Long call and short put – consecutive months plus 1 quarterly month (previously March, June, bullish. Short call and long – bearish. September, and December).  Strike price  The position limit is designed to prevent the market from being unduly influenced by the activities of an individual trader or group of traders.  For SET50 index option, for each maturity, at least 2 in-the-money strikes, 2 out-of-the-money strikes and 1 at-the-money strike.  Cash Settlement 7 8

Call and Put Options on SET 50 Index Options Listing  Last: Last-traded price  Volume: A number of contracts traded  The Open interest: number of option contracts outstanding at any given in time. SET 50 index: last traded = 977 www.tfex.co.th at 3 July 13 9 10 Options Listing Mechanics of Trading  Ranges of exercise prices available. The exercise prices have to bracket the stock price, so that, at any time, both  in-the-money and out-of-the-money options will be listed.  Exercise prices for stock options generally are set at five-point intervals  For call options: the lower the exercise price (X), the higher the price of the calls The right to purchase is valuable when the purchase (i.e., exercise) price is  low.  For put options: the higher of the exercise price (X), the higher the price of the puts The right to sell is valuable when the selling (i.e., exercise) price is high.   For call/put options: the longer the time to expiration, the higher the price of the options More applicable to American options  11 12

Open Interest and Volume Open Interest and Volume  Consider the following example on how to compute open interest and  Consider the following example on how to compute open interest volume. and volume. Time Trading Activity Open Volume Who are in the Volume Open Who are in the Interest market? Time Trading Activity Interest market? Jan 1 A buys 1 option and B sells 1 Jan 1 1 1 A buys 1 option and B sells 1 A(+1) : option contract option contract B(-1) Jan 2 C buys 5 option and D sells 5 Jan 2 C buys 5 option and D sells 5 A(+1), C(+5) : 6 5 option contracts option contracts B(-1), D(-5) Jan 3 A sells his 1 option and D buys 1 Jan 3 A sells his 1 option and D buys 1 C(+5) : 5 1 option contract option contract B(-1), D(-4) Jan 4 E buys 5 option from C who Jan 4 E buys 5 option from C who E(+5) : 5 5 sells 5 option contracts sells 5 option contracts B(-1), D(-4) Jan 5 Jan 5 B buys 1 option from D who B buys 1 option from D who E(+5) : 5 1 sells 1 option contracts sells 1 option contracts D(-5) 13 14 Types of Traders in Derivative Markets Hedging Example  Hedgers  An investor owns a share of PTT currently worth Bt300 per  For example, an exporter who knows that a certain amount of foreign currency will be received at a certain time in the future can hedge the foreign share. A two- month put with a strike price of Bt295 costs exchange risk by taking a short position in a forward contract. Similarly, an importer who knows that a certain amount of foreign currency will have to be Bt3. The investor decides to hedge by buying a put option. bought at a certain future time can hedge by taking a long position in a forward contract.  Speculators  Whereas hedgers want to avoid an exposure to adverse movements in the price of an asset, speculators often are the counterparty who wish to take a position in the price of that asset.  Arbitrageurs  Arbitrageurs involves locking in a profit by simultaneously entering into transactions in two or more markets. 15 16

Hedging Example Hedging Example  Returns of a portfolio with a PTT share and one put option for various  Returns of a portfolio with a PTT share and one put option for various scenarios of the PTT stock prices. scenarios of the PTT stock prices. Stock Price Stock Price 260 280 295 300 320 340 260 280 295 300 320 340 PTT PTT -40 -20 -5 0 20 40 profit/loss profit/loss (-13.3%) (-6.7%) (-1.7%) (0%) (6.7%) (13.3%) Put Put +32 +12 -3 -3 -3 -3 profit/loss profit/loss Total Total -8 -8 -8 -3 +17 +37 profit/loss profit/loss Total Total -2.6% -2.6% -2.6% -1% 5.6% 12.3% Return Return 17 18 Speculation Example Speculation Example  Returns of investment for various scenarios of the Exxon stock price  An investor with $7,800 to invest feels that Exxon’s stock price will increase over the next 3 months. The current stock price is $78 and the price of a 3-month call option with a strike Stock Price of 80 is $3 60 70 78 80 90 100 Stock  What are the alternative strategies? profit/loss Return Option profit/loss Return 19 20

Speculation Example  Returns of investment for various scenarios of the Exxon stock price Stock Price 60 70 78 80 90 100 Stock -1,800 -800 0 200 1,200 2,200 profit/loss Return -23.1% -10.3% 0% 2.6% 15.4% 28.2% Option -7,800 -7,800 -7,800 -7,800 18,200 44,200 profit/loss Return -100% -100% -100% -100% 233% 566% 21