Ch08 :Mechanics of options Market of Financial derivatives @

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1. Mechanics of Options
Markets
Chapter 8
1
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008

2. Options are Different from
Forwards & Futures
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 2

3. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 3
Review of Option Types
A call gives the holder the right to buy an
asset by a certain date for a certain price.
A put gives the holder the right to sell an
asset by a certain date for a certain price.
An Europeanoption can be exercised only
at the end of its life (Maturity)
An American option can be exercised at
any time
A Bermudanoption can be exercised
during specified periods, but not for
the entire life of the option

4. The price in the contract is known as
strike price/exercise price.
The exercise of a call option is the act
of paying the strike price to receive the
asset.(exercise options in slide #3)
The date in the contract is known as
the maturity (or expiration) date.
The price the option buyer must pay to
the seller at Date 0(present time) to
acquire the contract itself is typically
referred to as the option premium.
both puts and calls require premium
payments.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 4

5. Option Positions
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 5

6. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 6
Option Positions
If you short/writea call option, you have
to sell the asset by a certain date for a
certain price.
If you short/write a put option, you have
to buy the asset by a certain date for a
certain price.
Result from option positions (payoff)
Long call –call holder max (St –K, 0)
Long put –put holder min (K –St, 0)
Short call -Call writer max (K –St, 0)
Short put –put writer min (St –K, 0)

7. Example-Call option
Style: long European call option
Strike price=$100
# of shares=100
Maturity=4 months
current stock price=$98
Option premium=$5/share = $500
Scenario 1:
Spot price at maturity=less than $100
Option will not be exercised. There is no point in
paying 100$ for a share worth less than 100.in this
case investor will loose $500,the option
premium/initial investment.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 7

8. Scenario 2:
Spot price at maturity= $102
Option will be exercised.
(marketprice-strikprice)*100shares
(102-100)*100=200gain
Overallloss/gain=200-500premium=lossof300
Incaseifinvestordidnotexercisetheoptionhewill
loose500.exercisingtheoptionhedecreasethe
hisloss.
Remember:alwaysexerciseacalloptionifthe
spotpriceisgreaterthanstrikeprice.
Investor can buy shares worth 102 for
100 and then can sale in open market
at 102 to gain profit.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 8

9. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 9
Long Call
(Figure 8.1, Page 180)
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months
30
20
10
0
-5
708090100
110120130
Profit ($)
Terminal
stock price ($)

10. Example-Put option
Style: long European call option
Strike price=$70
# of shares=100
Maturity=3 months
current stock price=$65
Option premium=$7/share = $700
Scenario 1:
Spot price at maturity=greater than $70
Option will not be exercised..in this case investor
will loose $700,the option premium/initial
investment.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 10

11. Scenario 2:
Spot price at maturity= $55
Option will be exercised.
(strikeprice-spotprice)*100shares
(70-55)*100=1500gain
Overallloss/gain=1500-700premium=profitof800
Remember:alwaysexerciseaputoptionifthe
spotpriceislessthanstrikeprice.
Investorcanbuy100sharesfromopenmarketat
55/shareandthensellthemat70/shareunderthe
putoptions.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 11

12. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 12
Long Put
(Figure 8.2, page 181)
Profit from buying a European put option: option
price = $7, strike price = $70
30
20
10
0
-7
70605040 8090100
Profit ($)
Terminal
stock price ($)

13. Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 13

14. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 14
Assets Underlying
Exchange-Traded Options
Page 183-184
Stocks-onecontract=100shares-tradeon
exchange
ForeignCurrency-mostlyotc-sizeofcontract
dependsoncurrency.
StockIndices-bothotc&exchange-mostly
european.onecontract=100timestheindex
value.
Futures-Afutureoptiontradingcontract(alsocalled
optiononfutures)awardsthebuyerorsellerofthe
optiontherighttobuyorselltheunderlyingfutures
contractatapre-determinedpriceonthedaythe
contractexpires.

15. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 15
Specification of
Exchange-Traded Options
Expiration date
Strike price
European or American
Call or Put (option class)
Dividends
Maximum position of investor
All are decided by the exchange.

16. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 16
Terminology
Moneyness :Call option
◦At-the-money option S=K
◦In-the-money option S>K
◦Out-of-the-money option S<K
Moneyness :Put option
◦At-the-money option S=K
◦In-the-money option S<K
◦Out-of-the-money option S>K
◦S=Spot price K= Strike price

17. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 17
Terminology
(continued)
Option class-option of same type. all
calls/all puts.
Option series-all options of same class on
an underlying asset having same expiry date
and strike price.
Intrinsic value-refers to how much 'in-
the-money' the contract is currently.
intrinsic value cannot be negative.(0)
Time value-the amount of time
remaining to expiry/maturity-how much
time an option has until it expires

18. Example
General Electric (GE) stock is selling
at $34.80
Strike price for call option is $30
Strike price for put option is $30
call option is trading at $5
Intrinsic call value=34.80-30=4.80$
Intrinsic put value=30-34.80=(4.80)=0
Time value=option price-intrinsic value
=5-4.80=0.20
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 18

19. Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 19

20. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 20
Dividends & Stock Splits
(Page 186-188)
Therearetwotypesofdividends:
Cashdividend&stockdividend.
◦Noadjustmentsaremadetotheoption
termsforcashdividendsinexchange
tradedoptions.
◦Ifthedividendisgreaterthan10%of
thestockprice,thenexchangemay
decidetoreducethestrikepricebythe
amountofthedividend
◦Stock dividends are handled similarly to
stock split

21. Stock Split
•A stock split is a corporate action in which a
company divides its existing shares into multiple
shares to boost the liquidity of the shares, decrease
share price, renew investor interest.
•number of shares outstanding increases by a specific
multiple, the total dollar value of the shares remains
the same compared to pre-split amounts.
•The most common split ratios are 2-for-1 or 3-for-1,
which means that the stockholder will have two or
three shares, respectively, for every 1 share held
earlier.The stock price will go down ½ or 1/3 of its
value.

22. Example-stock split
•assumethatXYZCorp.has20millionshares
outstandingandthesharesaretradingat$100.
•Itsmarketcapwillbe20millionsharesx$100=$2
billion.
•Let'ssaythecompany’sboardofdirectorsdecidesto
splitthestock2-for-1.
•Rightafterthesplittakeseffect,thenumberof
sharesoutstandingwoulddoubleto40million,
whilethesharepricewouldbehalvedto$50,
leavingthemarketcapunchangedat40million
sharesx $50 = $2 billion.

23. Stock Splits
Stockdividendsorsplitschangesthenumber
ofstocksoutstanding,butdoesnotchangethe
assetsortheearningabilityofthecompanyor
marketcaptilization.
Optionsareprotectedagainststockdividends
andstocksplits.
Ifastocksplitoccurs,thenumberofsharesare
multipliedbythesplitratioi.e.,numberof
sharesareincreasedton/mofitsprevious
value.
theexercisepriceisreducedtom/nofits
previousvaluei.e.,dividedbythesplitratioto
keeptheeconomicvalueoftheoption
unchanged.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 23

24. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 24
Dividends & Stock Splits
(Page 186-188)
Suppose you own Noptions with a strike
price of K:
◦When there is an n-for-mstock split,
the strike price is reduced to mK/n
the no. of options is increased to nN/m
◦Stock dividends are handled in a
manner similar to stock splits.
◦The stock price is expected rto go down
as a result of stock dividend

25. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 25
Dividends & Stock Splits
(continued)
Consider a call option to buy 100
shares for $20/share
How should terms be adjusted:
◦for a 2-for-1 stock split?
◦for a 5% stock dividend?

26. for a 2-for-1 stock split:
Strike becomes (½)*20=$10
no. of options (2/1)*100=200
for a 5% stock dividend (105-for-100
stocks):
Strike becomes (100/105)*20=$19.05
no. of options (105/100)*100=105
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 26

27. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 27
Market Makers

28. Each market maker displays buy and
sell quotations for a guaranteed
number of shares. Once the market
maker receives an order from a buyer,
they immediately sell off their position
of shares from their owninventory.
This allows them to complete the
order.
Operate under regulatory body.
Earn profit via bid-ask spread
Options, Futures, and Other
Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 28

29. Options, Futures, and Other Derivatives
7
th
Edition, Copyright © John C. Hull
2008 29
Margins (Page 190-191)
margin accounts are required when clients write
options but not when they buy options.
When an investor buys an option, cash(option
premium) must be paid up front. There is no
possibility of future liabilities and therefore no need
for a margin account.
When an investor sells an option, there are
potential future liabilities. To protect against the risk
of a default, margins are required.