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Options Lecture 3

Options Lecture 3. Profit ($). 30. 20. 10. Terminal stock price ($). 70. 80. 90. 100. 0. 110. 120. 130. -5. Long Call on IBM. Profit from buying an IBM European call option: option price = $5, strike price = $100, option life = 2 months. Profit ($). 110. 120. 130. 5. 0.

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Options Lecture 3

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  1. OptionsLecture 3

  2. Profit ($) 30 20 10 Terminal stock price ($) 70 80 90 100 0 110 120 130 -5 Long Call on IBM Profit from buying an IBM European call option: option price = $5, strike price = $100, option life = 2 months

  3. Profit ($) 110 120 130 5 0 70 80 90 100 Terminal stock price ($) -10 -20 -30 Short Call on IBM Profit from writing an IBM European call option: option price = $5, strike price = $100, option life = 2 months

  4. Profit ($) 30 20 10 Terminal stock price ($) 0 40 50 60 70 80 90 100 -7 Long Put on Exxon Profit from buying an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths

  5. Profit ($) Terminal stock price ($) 7 40 50 60 0 70 80 90 100 -10 -20 -30 Short Put on Exxon Profit from writing an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths

  6. Payoff Payoff X X ST ST Payoff Payoff X X ST ST Payoffs from Options X = Strike price, ST = Price of asset at maturity

  7. Terminology Moneyness : • At-the-money option • In-the-money option • Out-of-the-money option • Expiration date • Strike price • European or American • Call or Put (option class)

  8. Types of Options • Exchange-traded options • Stocks • Foreign Currency • Stock Indices • Futures • Warrants • Convertible bonds • swapoptions • ....

  9. Warrants • Warrants are options that are issued (or written) by a corporation or a financial institution • The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire

  10. Warrants(continued) • Warrants are traded in the same way as stocks • When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued

  11. Executive Stock Options • Option issued by a company to executives • When the option is exercised the company issues more stock • Usually at-the-money when issued

  12. Executive Stock Options continued • They become vested after a period ot time • They cannot be sold • They often last for as long as 10 or 15 years

  13. Convertible Bonds • Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio

  14. Convertible Bonds(continued) • Very often a convertible is callable • The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose

  15. Exchangeable Bonds • An exchangeable bond is a sort of convertible bond that provides the conversion into the shares of a company different from the issuer • Usually, the underlying stock is the equity of a strategic partnership • There can be adverse signalling problem which are reduced with “best of” structures

  16. Trading Strategies Involving Options

  17. Three Alternative Strategies • Take a position in the option & the underlying • Take a position in 2 or more options of the same type (A spread) • Combination: Take a position in a mixture of calls & puts (A combination)

  18. Positions in an Option & the Underlying cap on long strategy floor on short strategy Profit Profit X ST ST X (a) (b) Profit Profit floor on long strategy cap on short strategy X X ST ST (c) (d)

  19. basket of options • spread type: basket of options of the same type (call or put) • bull spread • bearish spread • butterfly spread • combination type: basket of options of different types • straddles

  20. Bull Spread Using Calls Profit ST X1 • X2 initial cash outflow

  21. Profit X1 X2 ST Bull Spread Using Puts initial cash outflow

  22. Bear Spread Using Calls Profit X1 X2 ST initial cash inflow

  23. Profit X1 X2 ST Bear Spread Using Puts initial cash inflow

  24. Profit X1 X2 X3 ST Butterfly Spread Using Calls buy 2 calls and sell 2 calls

  25. Profit X1 X2 X3 ST Butterfly Spread Using Puts

  26. Profit X ST A Straddle Combination bottom straddle

  27. A 2nd Straddle Combination Profit ST X1 top straddle

  28. A Strangle Combination Profit X1 X2 ST

  29. A Top Vertical Combination Profit X1 X2 ST

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