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14.1 EXAMPLE tions expire on the third Friday of the expiration month, which for this option is April 19. Until
the expiration day, the purchaser of the calls is entitled to buy shares of Microsoft for $70. On
Profit and Loss
January 4, Microsoft stock sells for $69.80, which is less than the exercise price. Because the
from a Call
stock price is currently less than $70 a share, it clearly would not make sense at the moment
Option on
to exercise the option to buy at $70. Indeed, if Microsoft stock remains below $70 by the ex-
Microsoft
piration date, the call will be left to expire worthless. If, on the other hand, Microsoft is selling
above $70 at expiration, the call holder will find it optimal to exercise. For example, if Mi-
crosoft sells for $73 on April 19, the option will be exercised since it will give its holder the right
to pay $70 for a stock worth $73. The value of the option on the expiration date will be
Value at expiration Stock price Exercise price $73 $70 $3
Despite the $3 payoff at maturity, the investor still realizes a loss of $1.60 on the investment
in the call because the initial purchase price was $4.60:
Profit Final value Original investment $3 $4.60 $1.60
Nevertheless, exercise of the call will be optimal at maturity if the stock price is above the exer-
cise price because the exercise proceeds will offset at least part of the investment in the option.
The investor in the call will clear a profit if Microsoft is selling above $74.60 at the maturity
date. At that price, the proceeds from exercise will just cover the original cost of the call.



A put option gives its holder the right to sell an asset for a specified exercise or strike price
on or before some expiration date. An April put on Microsoft with exercise price $70 entitles
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




493
14 Options Markets


its owner to sell Microsoft stock to the put writer at a price of $70 at any time before expira- put option
tion in April, even if the market price of Microsoft is less than $70. While profits on call op- The right to sell an
tions increase when the asset increases in value, profits on put options increase when the asset asset at a specified
value falls. A put will be exercised only if the exercise price is greater than the price of the un- exercise price on or
before a specified
derlying asset, that is, only if its holder can deliver for the exercise price an asset with market
expiration date.
value less than the exercise price. (One doesn™t need to own the shares of Microsoft to exer-
cise the Microsoft put option. Upon exercise, the investor™s broker purchases the necessary
shares of Microsoft at the market price and immediately delivers or “puts them” to an option
writer for the exercise price. The owner of the put profits by the difference between the exer-
cise price and market price.)


To illustrate, consider an April 2002 maturity put option on Microsoft with an exercise price of
$70 selling on January 4, 2002, for $5.40. It entitles its owner to sell a share of Microsoft for
EXAMPLE 14.2
$70 at any time until April 19. If the holder of the put option bought a share of Microsoft and
immediately exercised the right to sell at $70, net proceeds would be $70 $68.90 Profit and Loss
$1.10. Obviously, an investor who pays $5.40 for the put has no intention of exercising it im- from a Put
mediately. If, on the other hand, Microsoft is selling at $62 at expiration, the put will turn out Option on
to be a profitable investment. The value of the put on the expiration date would be
Microsoft
Value at expiration Exercise price Stock price $70 $62 $8
and profit would be $8.00 $5.40 $2.60. This is a holding-period return of $2.60/$5.40
.481 or 48.1%”over only 105 days! Obviously, put option sellers (who are on the other
side of the transaction) did not consider this outcome very likely.



An option is described as in the money when its exercise would produce a positive payoff in the money
for its holder. An option is out of the money when exercise would be unprofitable. Therefore, An option where
a call option is in the money when the exercise price is below the asset value. It is out of the exercise would be
money when the exercise price exceeds the asset value; no one would exercise the right to pur- profitable.
chase for the exercise price an asset worth less than that price. Conversely, put options are in
the money when the exercise price exceeds the asset™s value, because delivery of the lower out of the money
valued asset in exchange for the exercise price is profitable for the holder. Options are at the An option where
money when the exercise price and asset price are equal. exercise would not be
profitable.

Options Trading at the money
Some options trade on over-the-counter (OTC) markets. The OTC market offers the advantage An option where the
that the terms of the option contract”the exercise price, maturity date, and number of shares exercise price and
asset price are equal.
committed”can be tailored to the needs of the traders. The costs of establishing an OTC op-
tion contract, however, are relatively high. Today, most option trading occurs on organized
exchanges.
Options contracts traded on exchanges are standardized by allowable maturity dates and
exercise prices for each listed option. Each stock option contract provides for the right to buy
or sell 100 shares of stock (except when stock splits occur after the contract is listed and the
contract is adjusted for the terms of the split).
Standardization of the terms of listed option contracts means all market participants trade
in a limited and uniform set of securities. This increases the depth of trading in any particular
option, which lowers trading costs and results in a more competitive market. Exchanges,
therefore, offer two important benefits: ease of trading, which flows from a central market-
place where buyers and sellers or their representatives congregate, and a liquid secondary mar-
ket where buyers and sellers of options can transact quickly and cheaply.
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




494 Part FIVE Derivative Markets




F I G U R E 14.1
Listing of stock option
quotations
Source: From The Wall Street
Journal, February 7, 2002.
Reprinted by permission of
Dow Jones & Company, Inc.
via Copyright Clearance
Center, Inc. © 2002 Dow
Jones & Company, Inc. All
Rights Reserved Worldwide.




Figure 14.1 is a reproduction of listed stock option quotations from The Wall Street Journal.
The highlighted options are for shares of Microsoft. The numbers in the column below the com-
pany name represent the last recorded price on the New York Stock Exchange for Microsoft
stock, $68.90 per share.1 The first column shows that options are traded on Microsoft at exer-
cise prices of $65 through $75, in $5 increments. These values also are called the strike prices.
The exercise or strike prices bracket the stock price. While exercise prices generally are set
at five-point intervals for stocks, larger intervals may be set for stocks selling above $100, and
intervals of $21„2 may be used for stocks selling below $30.2 If the stock price moves outside
the range of exercise prices of the existing set of options, new options with appropriate exer-
cise prices may be offered. Therefore, at any time, both in-the-money and out-of-the-money
options will be listed, as in the Microsoft example.
The next column in Figure 14.1 gives the maturity month of each contract, followed by two
pairs of columns showing the number of contracts traded on that day and the closing price for
the call and put, respectively.
When we compare the prices of call options with the same maturity date but different ex-
ercise prices in Figure 14.1, we see that the value of the call is lower when the exercise price
is higher. This makes sense, for the right to purchase a share at a given exercise price is not as
valuable when the purchase price is higher. Thus, the April maturity Microsoft call option with
strike price $70 sells for $4.60, while the $65 exercise price April call sells for $7.70. Con-
versely, put options are worth more when the exercise price is higher: You would rather have
the right to sell Microsoft shares for $70 than for $65, and this is reflected in the prices of the
puts. The April maturity put option with strike price $70 sells for $5.40, while the $65 exer-
cise price April put sells for only $3.50.
Throughout Figure 14.1, you will see that some options may go an entire day without trading.
A lack of trading is denoted by three dots in the volume and price columns. Because trading is


1
Occasionally, this price may not match the closing price listed for the stock on the stock market page. This is because
some NYSE stocks also trade on the Pacific Stock Exchange, which closes after the NYSE, and the stock pages may
reflect the more recent Pacific Exchange closing price. The options exchanges, however, close with the NYSE, so the
closing NYSE stock price is appropriate for comparison with the closing option price.
2
If a stock splits, the terms of the option”such as the exercise price”are adjusted to offset the impact of the split.
Therefore, stock splits will also result in exercise prices that are not multiples of $5.
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




495
14 Options Markets


infrequent, it is not unusual to find option prices that appear out of line with other prices. You
might see, for example, two calls with different exercise prices that seem to sell for the same
price. This discrepancy arises because the last trades for these options may have occurred at dif-
ferent times during the day. At any moment, the call with the lower exercise price must be worth
more, and the put less, than an otherwise-identical call or put with a higher exercise price.
Figure 14.1 illustrates that the maturities of most exchange-traded options tend to be fairly
short, ranging up to only several months. For larger firms and several stock indexes, however,
longer-term options are traded with maturities ranging up to three years. These options are
called LEAPS (for Long-term Equity AnticiPation Securities).


<
1. a. What will be the proceeds and net profits to an investor who purchases the April Concept
maturity Microsoft calls with exercise price $70 if the stock price at maturity is
CHECK
$60? What if the stock price at maturity is $80?
b. Now answer part (a) for an investor who purchases an April maturity Microsoft
put option with exercise price $70.


American and European Options
An American option allows its holder to exercise the right to purchase (if a call) or sell (if a American option
put) the underlying asset on or before the expiration date. European options allow for exer- Can be exercised on
cise of the option only on the expiration date. American options, because they allow more lee- or before its
way than their European counterparts, generally will be more valuable. Most traded options in expiration.
the U.S. are American-style. Foreign currency options and some stock index options are no-
table exceptions to this rule, however. European option
Can be exercised only
at expiration.
The Option Clearing Corporation
The Option Clearing Corporation (OCC), the clearinghouse for options trading, is jointly
owned by the exchanges on which stock options are traded. The OCC places itself between
options traders, becoming the effective buyer of the option from the writer and the effective
writer of the option to the buyer. All individuals, therefore, deal only with the OCC, which
effectively guarantees contract performance.
When an option holder exercises an option, the OCC arranges for a member firm with
clients who have written that option to make good on the option obligation. The member firm
selects from among its clients who have written that option to fulfill the contract. The selected
client must deliver 100 shares of stock at a price equal to the exercise price for each call op-
tion contract written or must purchase 100 shares at the exercise price for each put option con-
tract written.
Because the OCC guarantees contract performance, option writers are required to post mar-
gin to guarantee that they can fulfill their contract obligations. The margin required is deter-
mined in part by the amount by which the option is in the money, because that value is an
indicator of the potential obligation of the option writer upon exercise of the option. When the
required margin exceeds the posted margin, the writer will receive a margin call. The holder
of the option need not post margin because the holder will exercise the option only if it is prof-
itable to do so. After purchasing the option, no further money is at risk.
Margin requirements also depend on whether the underlying asset is held in portfolio. For
example, a call option writer owning the stock against which the option is written can satisfy
the margin requirement simply by allowing a broker to hold that stock in the brokerage
account. The stock is then guaranteed to be available for delivery should the call option be
exercised. If the underlying security is not owned, however, the margin requirement is
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




496 Part FIVE Derivative Markets


determined by the value of the underlying security as well as by the amount by which the op-
tion is in or out of the money. Out-of-the-money options require less margin from the writer,
for expected payouts are lower.


Other Listed Options
Options on assets other than stocks also are widely traded. These include options on market
indexes and industry indexes, on foreign currency, and even on the futures prices of agricul-
tural products, gold, silver, fixed-income securities, and stock indexes. We will discuss these
in turn.

Index options An index option is a call or put based on a stock market index such as the
S&P 500 or the New York Stock Exchange index. Index options are traded on several broad-
based indexes as well as on several industry-specific indexes. We discussed many of these in-
dexes in Chapter 2.
The construction of the indexes can vary across contracts or exchanges. For example, the
S&P 100 index is a value-weighted average of the 100 stocks in the Standard & Poor™s 100
stock group. The weights are proportional to the market value of outstanding equity for each
stock. The Dow Jones Industrial Average, by contrast, is a price-weighted average of 30 stocks.
Options contracts on many foreign stock indexes also trade. For example, options on the
Nikkei Stock Index of Japanese stocks trade on the Chicago Mercantile Exchange and options
on the Japan Index trade on the American Stock Exchange. Options on European indexes such
as the Financial Times Share Exchange (FTSE 100) and the Eurotrak index also trade. The
Chicago Board Options Exchange as well as the American exchange list options on industry
indexes such as the high-tech, pharmaceutical, or banking industries.
In contrast to stock options, index options do not require that the call writer actually “de-
liver the index” upon exercise or that the put writer “purchase the index.” Instead, a cash set-
tlement procedure is used. The payoff that would accrue upon exercise of the option is
calculated, and the option writer simply pays that amount to the option holder. The payoff is
equal to the difference between the exercise price of the option and the value of the index. For
example, if the S&P index is at 1,280 when a call option on the index with exercise price
1,270 is exercised, the holder of the call receives a cash payment equal to the difference,
1,280 1,270, times the contract multiplier of $100, or $1,000 per contract.
Figure 14.2 is a reproduction of listings for a few index options from The Wall Street Jour-
nal. The option listings are similar to those of stock options. However, instead of supplying
separate columns for put and calls, the index options are all listed in one column, and the
letters p or c are used to denote puts or calls. The index listings also report the “open interest”
for each contract, which is the number of contracts currently outstanding. Options on the
major indices, that is, the S&P 100 contract, often called the OEX after its ticker symbol, the
S&P 500 index (the SPX), and the Dow Jones Industrials (the DJX) are by far the most

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