Options

Professor Brooks

BA 444

01/09/08

The First Known Option Trader

Philosopher Thales of Milesian. Used the stars to determine the olive crop

would be large that year. Paid a deposit on all the olive presses in the

area for use in the harvest season Olive crop harvest large Presses in high demand Rented presses out a rate higher than he had

secured with his deposit…made $$$$$

Types of Options

Only Two Call – Right but not the obligation to buy

the underlying asset on or before a set date at a pre-set price (strike or exercise price)

Put – Right but not the obligation to sell the underlying asset on or before a certain date at a pre-set price (strike or exercise price)

Categories of Options

American vs. European Underlying Asset

Equity Option – Stock Index Option – Financial Index Futures Option – Futures Contract FX Option – Foreign Exchange Interest Rate Option – Treasury Bond

Standardized Option Contract

Traded on an Exchange ISE, CBOE, AMEX, Philly, PSE

Set Size of Underlying Asset Equities are 100 shares of stock Futures are the size of futures contract

Specific Expiration Date (Third Friday) Specific Strike Price (Exercise Price) Price of Option is current selling/buying

price of the financial asset.

Options Basics

A basketball ticket… Owner of the ticket has the right to

Attend the game Sell the ticket to someone else “Eat” the ticket, not use or sell the ticket

Original seller must provide the “seats” for the game if exercised by either original buyer or subsequent buyer of the ticket

Price of the ticket will vary through time based on the performance of the teams and the time left before tip-off

Four Positions in Options & Risk

Buy a Call – Risk is cost of option Sell a Call – Risk is rising prices Buy a Put – Risk is cost of option Sell a Put – Risk is falling prices Diagrams of four positions

Hockey Sticks of Options Reveals potential gains and losses

Trading Options

Option Ticker Symbols Page 23… Example at ISE, http://www.ise.com/

Bid Prices and Ask Prices Bid, price at which one is willing to buy Ask, price at which one is willing to sell

Market vs. Limit Order Book Official (Limit order book) Preference to price and time

Trading Options -- Continued

Exercise a Call (holder of option) Notify OCC Put up the strike price Receive the underlying asset

Exercise a Put (holder of option) Notify OCC Put up the underlying asset Receive the strike price

Or Sell the Call or Put

Option Values

Price of the option intrinsic value

Call Max (0, S-K) Put Max (0, K-S) Plus time value

Illustrate Intrinsic value…profit from exercising

Illustrate time value of option with binomial tree

Never exercise Call option (lose time value)