Option Terminology Option Terminology Assets Underlying - - PowerPoint PPT Presentation

Lecture 2.1: Structure of Options Markets and Basic Applications of Options

Nattawut Nattawut Jenwittayaroje Jenwittayaroje, Ph.D., CFA , Ph.D., CFA h l l k h l l k 01135531 01135531: Risk Management : Risk Management d Fi i l I t t d Fi i l I t t Chulalongkorn Chulalongkorn University University nattawut@cbs.chula.ac.th nattawut@cbs.chula.ac.th and Financial Instrument and Financial Instrument

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Important Concepts Important Concepts

 Assets underlying exchange-traded options  Options terminology  Options terminology  Specifications of exchange-traded options

h i f di

 Mechanics of trading  Open interest and volume  Types of traders  Basic use of options

Basic use of options

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Assets Underlying Exchange-Traded Options Assets Underlying Exchange-Traded Options

 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- style. y

 Index options: A call or put based on a stock market index such as S&P 500, Nasdaq

100, SET 50. The two most popular are options on the S&P100 and S&P500 on the CBOE CBOE

 Interest Rate Options: Options are traded on T-notes, T-bonds, T-bills, and other debt

instruments instruments.

 Foreign currency options The major exchange is PHLX. Offer both European and

American contracts on, e.g., Australian dollar, British pound, Canadian dollar, Euro, , g , , p , , , Yen, and Swiss franc.

 Futures options: in a futures option (or options on futures), the underlying asset is a

futures contract. The most actively traded futures options are the Treasury bond futures

• ption traded on CBOT and the Eurodollar futures option traded on CME.

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Option Terminology Option Terminology

 I

th d “ fit ” if it i d

 In-the-money: produce “profits” if it were exercised now.  At-the-money: give “nothing” if it were exercised now.  Out-of-the-money: produce “losses” if it were exercised now. In In-

• the

the-

• money:

money: S S > >X X In In-

• the

the-

• money:

money: S S < <X X Call option Call option At At-

• the

the-

• money:

money: S S = = X X Put option Put option At At-

• the

the-

• money:

money: S S = = X X Out Out-of

• f-the

the-money: money: S <X Out Out-of

• f-the

the-money: money: S >X Out Out of

• f the

the money: money: S S X Out Out of

• f the

the money: money: S S X where S = underlying price, X = exercise price

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Option Terminology

O i l IBM ll l h IBM

 Option class – e.g., IBM calls are one class whereas IBM puts

are another class.

 Option series – an option series consists of all the options of a  Option series

an option series consists of all the options of a given class with the same expiration date and strike price. In

• ther words an option series refers to a particular contract that
• ther 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 with strike of 300.

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SET50 Index Options Contract Contract Specifications

www.tfex.co.th www.tfex.co.th at at 1 Feb Feb 13 13

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at at 1 1 Feb Feb 13 13

Specification of Exchange-Traded Options p g p

 Underlying asset

 Individual stocks, stock indexes, currency, futures.

C ll P t ( ti l )

 Call or Put (option class)

 Call vs put

 European or American  European or American

 Can be exercised at any time (American), or at expiration only (European)

 Expiration date  Expiration date

 For example, the contract months for SET50 index options are the 3 nearest

consecutive months plus 1 quarterly month (previously March, June, S b d D b ) September, and December).

 Strike price

 For SET50 index option for each maturity at least 2 in the money strikes 2  For SET50 index option, for each maturity, at least 2 in-the-money strikes, 2

• ut-of-the-money strikes and 1 at-the-money strike.

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Specification of Exchange-Traded Options Specification of Exchange Traded Options

 Contract Size

 For individual stock, one contract is for 100 shares of the stock.  Contract sizes for index options are specified by a multiplier; e.g.,

SET50 index option has a multiplier of 200. An investor who buys one ll b 200 i h i d contract actually buys exposure to 200 times the index.  Position and Exercise Limits

 Position limits define the maximum number of option contracts that a

trader can hold on one side of the market. Long call and short put – bullish Short call and long bearish

• bullish. Short call and long – bearish.

 The position limit is designed to prevent the market from being unduly

influenced by the activities of an individual trader or group of traders influenced by the activities of an individual trader or group of traders.  Cash Settlement

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Call and Put Options on SET 50 Index p

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SET SET 50 50 index: last traded = index: last traded = 977 977 www.tfex.co.th www.tfex.co.th at at 3 3 July July 13 13

Options Listing Options Listing



Last: Last-traded price



Volume: A number

• f



Volume: A number

• f

contracts traded



Open interest: The



Open interest: The number

• f
• ption

contracts outstanding at any given in time any given in time.

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Options Listing



R f i i il bl

Options Listing



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 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



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 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



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

• ptions
• ptions



More applicable to American options

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Mechanics of Trading Mechanics of Trading

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Open Interest and Volume Open Interest and Volume 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 and

volume.

Time Trading Activity Open Volume Who are in the p Interest market? Jan 1 A buys 1 option and B sells 1 i

• ption contract

Jan 2 C buys 5 option and D sells 5

• ption contracts
• ption contracts

Jan 3 A sells his 1 option and D buys 1

• ption contract
• ption contract

Jan 4 E buys 5 option from C who sells 5 option contracts p Jan 5 B buys 1 option from D who sells 1 option contracts

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Open Interest and Volume Open Interest and Volume Open Interest and Volume Open Interest and Volume

 Consider the following example on how to compute open interest  Consider the following example on how to compute open interest

and volume.

O Volume Wh i th Time Trading Activity Open Interest Volume Who are in the market? Jan 1 A buys 1 option and B sells 1 1 1 A(+1) : y p

• ption contract

( ) B(-1) Jan 2 C buys 5 option and D sells 5 6 5 A(+1), C(+5) :

• ption contracts

6 5 B(-1), D(-5) Jan 3 A sells his 1 option and D buys 1

• ption contract

5 1 C(+5) : B( 1) D( 4)

• ption contract

B(-1), D(-4) Jan 4 E buys 5 option from C who sells 5 option contracts 5 5 E(+5) : B(-1) D(-4) p B(-1), D(-4) Jan 5 B buys 1 option from D who sells 1 option contracts 5 1 E(+5) : D(-5)

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( )

Types of Traders in Derivative Markets yp

 Hedgers

 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 currency will be received at a certain time in the future can hedge the foreign 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 b ht t t i f t ti h d b t ki l iti i bought at a certain future time can hedge by taking a long position in a forward contract.

 Speculators

Specu

• s

 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 iti i th i f th t t position in the price of that asset.

 Arbitrageurs

 Arbitrageurs involves locking in a profit by simultaneously entering into  Arbitrageurs involves locking in a profit by simultaneously entering into

transactions in two or more markets.

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Hedging Example Hedging Example

 An investor owns a share of PTT currently worth Bt300 per

h A t th t ith t ik i f Bt295 t

• share. A two- month put with a strike price of Bt295 costs
• Bt3. The investor decides to hedge by buying a put option.

g y y g p p

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Hedging Example Hedging Example

 Returns of a portfolio with a PTT share and one put option for various

scenarios of the PTT stock prices.

Stock Price 260 280 295 300 320 340 260 280 295 300 320 340 PTT fi /l profit/loss Put fi /l profit/loss Total profit/loss profit/loss Total Return

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Return

Hedging Example Hedging Example

 Returns of a portfolio with a PTT share and one put option for various

scenarios of the PTT stock prices.

Stock Price 260 280 295 300 320 340 260 280 295 300 320 340 PTT fi /l

• 40
• 20
• 5

20 40 profit/loss (-13.3%) (-6.7%) (-1.7%) (0%) (6.7%) (13.3%) Put fi /l +32 +12

• 3
• 3
• 3
• 3

profit/loss +32 +12 3 3 3 3 Total profit/loss

• 8
• 8
• 8
• 3

+17 +33 profit/loss Total Return

• 2.6%
• 2.6%
• 2.6%
• 1%

5.6% 10.9%

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Return

Speculation Example Speculation Example

 An investor with $7,800 to invest feels that Exxon’s stock

price will increase over the next 3 months. The current stock p price is $78 and the price of a 3-month call option with a strike

• f 80 is $3

 What are the alternative strategies?  What are the alternative strategies?

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Speculation Example Speculation Example

 Returns of investment for various scenarios of the Exxon stock price

Stock Price 60 70 78 80 90 100 60 70 78 80 90 100 Stock fi /l profit/loss Return Option profit/loss Return

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Speculation Example Speculation Example

 Returns of investment for various scenarios of the Exxon stock price

Stock Price 60 70 78 80 90 100 60 70 78 80 90 100 Stock fi /l

• 1 800
• 800

200 1 200 2 200 profit/loss

• 1,800
• 800

200 1,200 2,200 Return

• 23.1%
• 10.3%

0% 2.6% 15.4% 28.2% Option profit/loss

• 7,800
• 7,800
• 7,800
• 7,800

18,200 44,200 Return

• 100%
• 100%
• 100%
• 100%

233% 566%

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