1 Chapter 14 Options Markets Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Background on options Speculating with stock options Determinants of stock option premiums Explaining changes in option premiums Hedging with stock options Using options to measure a stock’s risk 3 Chapter Outline (cont’d) Options on ETFs and stock indexes Options on futures contracts Hedging with options on futures Institutional use of options markets Globalization of options markets 4 Background on Options A call option grants the owner the right to purchase a specified financial instrument for a specified price (exercise or strike price) within a specified period of time Grants the right, but not the obligation, to purchase the specified investment The writer of a call option is obligated to provide the instrument at the price specified by the option contract if the owner exercises the option A call option is: In the money when the market price of the underlying security exceeds the strike price At the money when the market price is equal to the strike price Out of the money when the market price is below the strike price 5 Background on Options (cont’d) A put option grants the owner the right to sell a specified financial instrument for a specified price within a specified period of time Grants the right, but not the obligation, to sell the specified investment A put option is: In the money when the market price of the underlying security is below the strike price At the money when the market price is equal to the strike price Out of the money when the market price is above the strike price 6 Background on Options (cont’d) Call and put options specify 100 shares for stocks Premiums paid for call and put options are determined through open outcry on the exchange floor Participants can close out their option positions by taking an offsetting position The gain or loss is determined by the premium paid when purchasing the option and the premium received when selling the option American-style options can be exercised at any time prior to expiration European-style options can be exercise only just before expiration 7 Background on Options (cont’d) Markets used to trade options The CBOE: Is the most important exchange for trading options Serves as the market for options on more than 1,500 different stocks Lists standardized options Accounts for about 51 percent of all option trading Options are also traded on the AMEX, Philadelphia Stock Exchange, Pacific Stock Exchange, and the International Securities Exchange 8 Background on Options (cont’d) Markets used to trade options (cont’d) Listing requirements Each exchange has its own requirements One key requirement is a minimum trading volume of the underlying stocks Role of the Options Clearing Corporation (OCC) The OCC serves as a guarantor on option contracts traded in the U.S. Regulation of options trading The SEC and the various option exchanges regulate option trading Regulations: Are intended to ensure fair and orderly training Attempt to prevent insider trading Attempt to prevent price fixing among floor brokers 9 Background on Options (cont’d) How option trades are executed Floor brokers execute transactions desired by investors Some orders are executed electronically without a floor broker Market-makers: Can execute stock option transactions for customers Trade options on their own account May facilitate a buy order for one customer and a sell order for a different customer Earn the difference between the bid price and the ask price for the option 10 Background on Options (cont’d) Types of orders A market order results in the immediate purchase or sale of an option at the prevailing market price With a limit order, the transaction will occur only if the market price is no higher or lower than a specified price limit Online trading Many online brokerage firms, like E*Trade and Datek, facilitate options orders [...]... rises to $97 prior to the option’s expiration date If Pete exercises the option and immediately sells the shares in the market, what is his ?net gain from the transaction $97 − $92 − $4 = $1 per share 14 Speculating with Call Options (cont’d) Draw the contingency graph for the buyer of the call option and the writer of the call option Buyer’s Perspective Profit 0 -4 96 Writer’s Perspective 4 0 Stock . 1 Chapter 14 Options Markets Financial Markets and Institutions, 7e, Jeff Madura Copyright. ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Background on options Speculating with stock options Determinants