Chapter 14: Options Markets - Financial Markets and Institutions

Background and Fundamentals of Options

• Definition of Options     * Call Option: Represents the right to purchase an underlying financial instrument at a specified exercise price (or strike price) within a defined period of time.         * In the money: When the current market price of the underlying instrument is greater than the exercise price ($Market Price > Exercise Price$).         * At the money: When the market price is exactly equal to the exercise price ($Market Price = Exercise Price$).         * Out of the money: When the market price is less than the exercise price ($Market Price < Exercise Price$).     * Put Option: Represents the right to sell an underlying financial instrument at a specified exercise price (or strike price) within a defined period of time.         * In the money: When the market price is less than the exercise price ($Market Price < Exercise Price$).         * At the money: When the market price equals the exercise price ($Market Price = Exercise Price$).         * Out of the money: When the market price is greater than the exercise price ($Market Price > Exercise Price$).

• Comparison of Options and Futures     * Premiums: To obtain an option, the buyer must pay a premium in addition to the price of the financial instrument itself. In contrast, futures contracts primarily involve obligations without an upfront premium of this nature.     * Expirations: The owner of an option maintains the choice to let the contract expire on the expiration date without exercising it if the transaction is not favorable. Futures contracts typically represent a binding obligation to fulfill the contract terms.

• Markets Used to Trade Options     * Chicago Board Options Exchange (CBOE): Established in 1973, it remains the most significant exchange for trading options.     * CME Group: Another major venue where options are traded.     * Stock Exchanges: As stock options gained popularity, various stock exchanges began listing them.     * Listing Requirements: A primary requirement for an option to be listed is a minimum trading volume of the underlying company's stock.     * Role of the Options Clearing Corporation (OCC): Serves as the essential guarantor for option contracts traded within the United States to ensure contract fulfillment.     * Regulation: Trading is regulated by the Securities and Exchange Commission (SEC) and other regulatory bodies.

• Executing Trades     * Types of Orders: Investors can utilize market orders (executed at the prevailing price) or limit orders (executed only at a specific price or better) for option transactions.     * Online Trading: Option contracts can be conveniently purchased or sold through online platforms.

Institutional Participation in Options Markets

• Commercial Banks: Sometimes offer options directly to business clients.

• Savings Institutions: Typically take positions in options on futures contracts to hedge against potential interest rate risk.

• Mutual Funds:     * Stock Mutual Funds: Take positions in stock index options to hedge against declines in the market value of their portfolios. They may also take speculative positions to boost returns.     * Bond Mutual Funds: Use options on futures to hedge against interest rate risk.

• Securities Firms: Function primarily as brokers, executing stock option transactions on behalf of individuals and businesses.

• Pension Funds:     * Utilize stock index options to protect their stock portfolios from price declines.     * Use options on futures contracts to hedge bond portfolios against adverse interest rate movements.

• Insurance Companies:     * Employ stock index options for hedging equity portfolios.     * Use options on futures to protect bond portfolios from interest rate volatility.

Determinants of Stock Option Premiums

• Determinants of Call Option Premiums     * Market Price: There is a positive relationship; the higher the existing market price relative to the exercise price, the higher the call option premium.     * Stock Volatility: Greater volatility in the underlying stock leads to a higher call option premium because of the increased potential for the price to exceed the strike.     * Time to Maturity: The longer the time until expiration, the higher the premium, as there is more time for price favorable movements.

• Determinants of Put Option Premiums     * Market Price: There is an inverse relationship; the higher the market price relative to the exercise price, the lower the put option premium.     * Stock Volatility: Similar to calls, greater volatility results in a higher put option premium.     * Time to Maturity: A longer duration until expiration increases the put option premium.

• Deriving Volatility through Pricing Formulas     * Investors use option-pricing formulas (like Black-Scholes) to estimate a stock's anticipated volatility.     * Implied Volatility: By inputting the prevailing market premium and other known factors into the formula, investors can calculate the implied standard deviation or implied volatility.

• Indicator Monitoring     * Option traders monitor economic indicators because conditions influence cash flows and firm valuations, which in turn impact premiums.     * Framework factors include economic conditions, market conditions, and anticipated volatility.

Data and Market Quotations (Exhibits 14.1 - 14.6)

• Exhibit 14.1 Company Quotations Sample:     * Option 1: Exercise Price $145$, Expiration June, Call Premium $2.34$, Put Premium $0.74$.     * Option 2: Exercise Price $145$, Expiration September, Call Premium $8.05$, Put Premium $4.80$.     * Option 3: Exercise Price $150$, Expiration June, Call Premium $0.17$, Put Premium $3.60$.     * Option 4: Exercise Price $150$, Expiration September, Call Premium $5.05$, Put Premium $6.85$.

• Exhibit 14.3 Tesla, Inc. Call Premium vs. Exercise Price (April Expiration):     * Exercise $180$: Premium $22.00$     * Exercise $190$: Premium $14.64$     * Exercise $200$: Premium $8.40$     * Exercise $205$: Premium $6.15$     * Exercise $210$: Premium $4.45$

• Exhibit 14.4 Tesla, Inc. Call Premium vs. Maturity ($195$ Strike):     * June 23: Premium $14.25$     * July 21: Premium $20.80$     * August 18: Premium $24.77$

• Exhibit 14.5 Tesla, Inc. Put Premium vs. Exercise Price (June Expiration):     * Exercise $190$: Premium $3.15$     * Exercise $200$: Premium $6.90$     * Exercise $210$: Premium $12.90$     * Exercise $215$: Premium $16.67$     * Exercise $220$: Premium $21.00$

• Exhibit 14.6 KSR Stock Put Premium vs. Maturity ($195$ Strike):     * June 23: Premium $7.90$     * July 21: Premium $13.34$     * August 18: Premium $16.47$

Speculating with Stock Options

• Speculating with Call Options: Used when an investor expects the price of the underlying stock to increase. If the stock price rises above the strike price plus premium, the investor realizes a profit.

• Speculating with Put Options: Used when an investor expects the price of the underlying stock to decrease.

• Case Study: Steelco Potential Returns (Exhibit 14.10):     * Option 1 ($105$ strike, $10$ premium): Profit per unit ranges from $-10$ (at stock price $104$) to $11$ (at stock price $126$). Percentage return from $-100\%$ to $110\%$.     * Option 2 ($110$ strike, $7$ premium): Profit ranges from $-7$ to $9$. Percentage return from $-100\%$ to $129\%$.     * Option 3 ($115$ strike, $4$ premium): Profit ranges from $-4$ to $7$. Percentage return from $-100\%$ to $175\%$.

• Managing Speculative Risk:     * Firms must monitor employees to ensure trading stays within internal guidelines.     * Separation of reporting and trading functions is critical so traders cannot hide losses.     * Firms should evaluate positions closely when receiving margin calls.

Hedging Strategies using Options

• Covered Call Strategy:     * Involves selling a call option on a stock already owned by the investor.     * Downside Protection: The premium received from the call sale partially offsets losses if the stock price declines.     * Upside Limitation: If the stock price increases significantly, the call will be exercised, and the investor must sell the stock at the strike price, capping gains.

• Hedging with Put Options: Portfolio managers use put options to protect against temporary declines in a stock's value. The put sets a floor on the potential loss.

• Long-term Equity Anticipations (LEAPs):     * Options with expiration dates ranging from two to three years from their listing date.     * Available for large-capitalization stocks and are more effective for long-term hedging than short-term options.

Options on ETFs and Stock Indexes

• Overview: Options are available on various exchange-traded funds (ETFs) and major stock indexes, allowing for speculation on broader market movements.

• Settlement: These provide the right to trade the index at a specified price by the expiration date.

• Examples of Available Instruments (Exhibit 14.13):     * ETFs: iShares Nasdaq Biotechnology, iShares Russell 1000 Value, Financial Select Sector SPDR, Health Care Select Sector SPDR.     * Indexes: S&P 500, S&P 100, Nasdaq 100, Dow Jones Industrial Average, Russell 2000, Emerging Markets Asia Index.

• Dynamic Asset Allocation: Managers switch between risky and low-risk positions based on market expectations. Index options are used to adjust market exposure efficiently.

• Measuring Market Risk: A stock index's implied volatility can be derived from its index options, providing insight into market-wide risk sentiment.

Options on Futures Contracts

• Definition: Gives the owner the right (but not the obligation) to purchase or sell a specific futures contract at a set price within a set period.

• Speculation on Interest Rates:     * Decline in Rates: Speculators purchase call options on Treasury bond (T-bond) futures.     * Increase in Rates: Speculators purchase put options on Treasury bond futures.

• Hedging Interest Rate and Stock Risk:     * Banks hedge mortgage/bond portfolios with interest rate futures options.     * Investors hedge stock portfolios with index futures options to offset potential losses while retaining some upside potential.

• Exhibit 14.14 Hedging Results (T-Bond Put Options):     * Scenario 1 (Rates Rise): T-bond futures price declines to $91-00$. Decision: Exercise put option. Result: Sale at $98,000$ minus Purchase at $91,000$ minus Premium $2,000$ equals Net Gain of $5,000$.     * Scenario 2 (Rates Fall): T-bond futures price increases to $104-00$. Decision: Do not exercise. Result: Net loss of $2,000$ (the premium paid).

Executive Compensation and Globalization

• Options as Executive Compensation:     * Purpose: To align executive incentives with the firm's stock performance.     * Drawbacks: Programs often ignore general market conditions. Executives may be tempted to manipulate stock prices for short-term gain at the expense of long-term stability.

• Globalization of Options:     * Currency Options: Provide the right to buy (call) or sell (put) a specific currency at a set price.     * Speculation: Buyers pick calls for strengthening currencies and puts for weakening currencies.     * International Business: Firms use currency options to hedge future payables and receivables in foreign markets. Every buyer requires a seller (writer) to form a contract.