Options

Ogtions on stocks were first traded on an organized exchange in 1973. Since then, there has been a dramatic growth in options markets. Options are now traded on many different exchanges throughout the world. Huge volumes of options are also traded over the counter by banks and other financial institutions. The /underlying assets include stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts. r w^j

There are two basic types of options. A call option gives the holder the right to buy the underlying asset by a certain date for a certain price. A put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The price in the contract is known as the exercise price or strike price; the date in the contract is known as the expiration date, exercise date, or maturity. American options can be exercised at any time up to the expiration date. European options can only be exercised on the expiration date itself.3 Most of the options that are traded on exchanges are American. However, European options are generally easier to analyze than American options, and some of the properties of an American option are frequently deduced from those of its European counterpart.

It should be emphasized that an option gives the holder the right to do something. The holder does not have to exercise this right. This fact distinguishes options from forwards and futures where the holder is obligated to buy or sell the underlying asset. Note that, whereas it costs nothing to enter into a forward or futures contract, an investor (must pay to purchase an'option contract.

2 As we will see in Chapter 3, a futures price can sometimes be related to the price of the underlying asset (gold, in this case).

'Note that the terms American and European do not refer to the location of the option or the exchange. Some options trading on North American exchanges are European.

Consider the situation of an investor who buys 100 European call options on IBM stock with a strike price of $140. Suppose that the cuiTent stock price js $138, the expiration date of the option is in 2 months, and the option price is $5? Since the options are European, the investor can exercise only on the expiration date. If the stock price on this date is less than $140, he or she will clearly choose not to exercise. (There is no point in buying for $140 a stock that has a market value of less than $140.) In these circumstances the investor loses the whole of the initial investment of $500. If the stock price is above $140 on the expiration date, the options will be exercised. Suppose, for example, that the stock price is $155. By exercising the options, the investor is able to buy 100 shares for $140 per share. If the shares are sold immediately, the investor makes a gain of $15 per share or $1,500, ignoring transactions costs. When the initial cost of the options is taken into account, the net profit to the investor is $10 per option, or $1,000. (This calculation ignores the time value of money.) Figure 1.2 shows the way in which the investor's net profit or loss per option varies with the terminal stock price. Note that in some cases the investor exercises the options but takes a loss overall. Consider the situation when the stock price is $142 on the expiration date. The investor exercises the options but takes a loss of $300 overall. This is better than the loss of $500 that would be incurred if the options were not exercised.

. _ - Whereas the purchaser of a call, option is hoping that the stock price will increase, the purchaser of a gut ogtion is hoping that it will decrease. Consider an investor who buys 100 European put options on Exxon with a strike price of $90. Suppose that the current stock price is $86, the expiration date of the option is in

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