Financial Markets and Institutions

Abridged 10th Edition

by Jeff Madura

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1
 14 Options Markets
Chapter Objectives

■ provide a background on options

■ explain why stock option premiums vary
■ explain how stock options are used to speculate
■ explain how stock options are used to hedge
■ explain the use of stock index options
■ explain the use of options on futures

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2
 Background on Options

Call Option: right to buy underlying financial instrument at

exercise price (or strike price) within a specified period of
time.
■ In the money when market price > exercise price
■ At the money when market price = exercise price
■ Out of the money when market price < exercise price
Put Option: right to sell underlying financial instrument at
exercise price (or strike price) within a specified period of
time.
■ In the money when market price < exercise price
■ At the money when market price = exercise price
■ Out of the money when market price > exercise price
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 Background on Options

Comparison of Options and Futures

■ To obtain an option, a premium must be paid in addition to the
price of the financial instrument.
■ The owner of an option can choose to let the option expire on
the expiration date without exercising it.
Institutional Use of Options
■ Although options positions are sometimes taken by financial
institutions for speculative purposes, they are more commonly
used for hedging.

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 Exhibit 14.1 Institutional Use of Options Markets

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 Background on Options

Markets Used to Trade Options

The Chicago Board Options Exchange (CBOE), created in
1973, is the most important exchange for trading options.
Options are also traded at the CME Group.
As the popularity of stock options increased, various stock
exchanges began to list options.
■ Listing Requirements - One key requirement is a minimum
trading volume of the underlying stock.
■ Role of the Options Clearing Corporation - serves as a
guarantor on option contracts traded in the United States.
■ Regulation of Options Trading – SEC and others.

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 Background on Options

How Option Trades Are Executed

■ Computer technology allows investors to have trades executed
electronically.
■ Market-makers can execute stock option transactions for
customers.
Types of Orders
■ An investor can use either a market order or a limit order for an
option transaction.
■ Online Trading - Option contracts can also be purchased or sold
online.
Stock Option Quotations (Exhibit 14.2)
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 Exhibit 14.2 Viperon Company Stock Option
Quotations

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 Determinants of Stock Option Premiums

Determinants of Call Option Premiums

1. Influence of the Market Price - The higher the existing market
price of the underlying financial instrument relative to the
exercise price, the higher the call option premium, other things
being equal.
2. Influence of the Stock’s Volatility - The greater the volatility
of the underlying stock, the higher the call option premium,
other things being equal.
3. Influence of the Call Option’s Time to Maturity - The longer
the call option’s time to maturity, the higher the call option
premium, other things being equal

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 Exhibit 14.3 Relationship between Exercise Price and
Call Option Premium on KSR Stock

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 Exhibit 14.4 Relationship between Time to Maturity
and Call Option Premium on KSR Stock

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 Determinants of Stock Option Premiums

Determinants of Put Option Premiums

1. Influence of the Market Price - The higher the existing market
price of the underlying stock relative to the exercise price, the
lower the put option premium, other things being equal.
2. Influence of the Stock’s Volatility - The greater the volatility
of the underlying stock, the higher the put option premium,
other things being equal.
3. Influence of the Put Option’s Time to Maturity - The longer
the time to maturity, the higher the put option premium, other
things being equal

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 Exhibit 14.5 Relationship between Exercise Price and
Put Option Premium on KSR Stock

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 Exhibit 14.6 Relationship between Time to Maturity
and Put Option Premium on KSR Stock

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 Determinants of Stock Option Premiums

How Option Pricing Can Be Used to Derive a Stock’s

Volatility

■ Some investors assess a specific stock’s risk by using the

option-pricing formula to estimate the stock’s anticipated
volatility.

■ By using the prevailing option premium and values for the other
factors in the option-pricing formula, the implied volatility or
implied standard deviation can be estimated.

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 Determinants of Stock Option Premiums

Explaining Changes in Option Premiums

Economic conditions and market conditions can cause abrupt

changes in the stock price or in the anticipated volatility of the
stock price over the time until option expirations, leading to
changes in the stock option’s premium.

■ Indicators Monitored by Participants in the Options Market

Traders of options tend to monitor economic indicators because
economic conditions affect cash flows of firms and thus can
affect expected stock valuations and stock option premiums.

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 Exhibit 14.7 Framework for Explaining Why a Stock
Option’s Premium Changes over Time

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 Speculating with Stock Options

Speculating with Call Options

■ Call options can be used to speculate on the expectation of an
increase in the price of the underlying stock.
■ See Exhibits 14.8 – 14.11.

Speculating with Put Options

■ Put options can be used to speculate on the expectation of a
decrease in the price of the underlying stock.
■ See Exhibits 14.12.

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 Exhibit 14.8 Potential Gains or Losses on a Call
Option: Exercise Price = $115, Premium = $4

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 Exhibit 14.9 Potential Gains or Losses for Three Call
Options (Buyer’s Perspective)

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 Exhibit 14.10 Potential Returns on Three Different
Call Options

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 Exhibit 14.11 Potential Returns for Three Call Options
(Buyer’s Perspective)

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 Exhibit 14.12 Potential Gains or Losses on a Put
Option: Exercise Price = $110, Premium = $2

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 Speculating with Stock Options

Excessive Risk from Speculation

■ Firms should closely monitor the trading of derivative contracts
by their employees to ensure that derivatives are being used
within the firm’s guidelines.
■ Firms should separate the reporting function from the trading
function so that traders cannot conceal trading losses.
■ When firms receive margin calls on derivative positions, they
should recognize that there may be potential losses on their
derivative instruments and should closely evaluate those
positions.

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 Hedging with Stock Options

Hedging with Covered Call Options

■ Call options on a stock can be used to hedge a position in that
stock.
■ When the stock declines in value, the premium received from
selling the call partially offsets the losses incurred on the stock.
■ When the stock increases in value, the call will be exercised and
the stock will be sold to the purchaser of the call option.

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 Exhibit 14.13a Risk-Return Trade-off from Covered
Call Writing

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 Exhibit 14.13b Risk-Return Trade-off from Covered
Call Writing

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 Hedging with Stock Options

Hedging with Put Options

■ Put options are used to hedge when portfolio managers are
concerned about a temporary decline in a stock’s value.
■ Hedging with LEAPs
■ Long-term equity anticipations (LEAPs) are options that
have longer terms to expiration, usually between two and
three years from the initial listing date.
■ These options are available for some large capitalization
stocks, and they may be a more effective hedge over a longer
term period than using options with shorter terms to
expiration.

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 Options on ETFs and Stock Indexes

 Options are also traded on exchange-traded funds

(ETFs) and stock indexes.
 A stock index option provides the right to trade a
specified stock index at a specified price by a specified
expiration date.
 Call options on stock indexes allow the right to purchase
the index, and put options on stock indexes allow the
right to sell the index.
 Options on indexes have become popular for speculating
on general movements in the stock market.

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 Exhibit 14.14 Sampling of ETFs and Indexes on
Which Options Are Traded

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 Options on ETFs and Stock Indexes

Hedging with Stock Index Options

Financial institutions and other firms commonly take positions
in options on ETFs or indexes to hedge against market or sector
conditions that would adversely affect their asset portfolio or
cash flows.
■ Hedging with Long-Term Stock Index Options – LEAPs are
used by option market participants who want options with
longer terms until expiration.
Dynamic Asset Allocation with Stock Index Options
Dynamic asset allocation involves switching between risky and
low-risk investment positions in response to changing
expectations. Some portfolio managers use stock index options
as a tool for dynamic asset allocation.
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 Options on ETFs and Stock Indexes

Using Index Options to Measure the Market’s Risk

■ A stock index’s implied volatility can be derived from
information about options on that stock index.
■ The same factors that affect the option premium on a stock
affect the option premium on an index.

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 Options on Futures Contracts

■ In recent years, the concept of options has been applied

to futures contracts to create options on futures contracts
(sometimes referred to as “futures options”).
■ An option on a particular futures contract gives its owner
the right (but not an obligation) to purchase or sell that
futures contract for a specified price within a specified
period of time.
■ Options are available on stock index futures.
■ Options on indexes have become popular for speculating
on general movements in the stock market.
■ Options are also available on interest rate futures, such
as Treasury note futures or Treasury bond futures.
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 Options on Futures Contracts

Speculating with Options on Futures

Speculators who anticipate a change in interest rates should also
expect a change in bond prices.
■ Speculation Based on an Expected Decline in Interest Rates
If speculators expect a decline in interest rates, they may
consider purchasing a call option on Treasury bond futures.
■ Speculation Based on an Expected Increase in Interest Rates
If speculators expect interest rates to increase, they can benefit
from purchasing a put option on Treasury bond futures.

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 Options on Futures Contracts

Hedging with Options on Interest Rate Futures

Financial institutions commonly hedge their bond or mortgage
portfolios with options on interest rate futures contracts
Hedging with Options on Stock Index Futures
■ Determining the Degree of the Hedge with Options on Stock
Index Futures - A higher premium must be paid to purchase
put options with a higher strike price.
■ Selling Call Options to Cover the Cost of Put Options – fees
can be generated by selling call options to help cover the cost of
purchasing put options.

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 Exhibit 14.15 Results from Hedging with Put Options
on Treasury Bond Futures

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 Options as Executive Compensation

Limitations of Option Compensation

■ Many option compensation programs do not account for general
market conditions.
■ Executives with substantial options may be tempted to
manipulate the stock’s price upward in the short term, even
though doing so adversely affects the stock price in the long
term.
■ Backdating Options - In the late 1990s and early 2000s, some
firms allowed their CEOs to backdate options they had already
been granted to an earlier period when the stock price was
lower. In 2006, firms that allowed backdating terminated the
practice.

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 Globalization of Option Markets

Currency Options Contracts

■ A currency call option provides the right to purchase a
specified currency for a specified price within a specified period
of time.
■ Speculators purchase call options on currencies that they
expect to strengthen against the dollar.
■ A currency put option provides the right to sell a specified
currency for a specified price within a specified period of time.
■ Speculators purchase put options on currencies they expect to
weaken against the dollar.
■ For every buyer of a currency call or put option, there must be a
seller (or writer).
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 SUMMARY

 Stock options are traded on exchanges, just as many stocks

are. Orders submitted by a brokerage firm are transmitted to
a trading floor, where floor brokers execute the trades. Many
trades are executed electronically.
 The premium of a call option is influenced by the
characteristics of the option and of the underlying stock that
can affect the potential gains. In particular, the premium is
higher when the market price of the stock is high relative to
the exercise price, when the stock’s volatility is greater, and
when the term until expiration is longer. For put options, the
higher the market price of the stock relative to the exercise
price, the lower the premium. The volatility of the underlying
stock and the term to expiration are related to the put option
premium in the same manner as they are to the call option
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 SUMMARY (Cont.)

 Speculators purchase call options on stocks whose

prices are expected to rise and purchase put options on
those expected to decrease.
 Financial institutions can hedge against adverse
movements in a stock by selling call options on that
stock. Alternatively, they can purchase put options on
that stock.
 Financial institutions commonly hedge their stock
portfolios by purchasing put options on stock indexes.
They may also use stock index options as a tool for
dynamic asset allocation, increasing their exposure when
they have optimistic views about the stock market and
reducing their exposure (buying put options on stock
indexes) when they have pessimistic views.
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 SUMMARY (Cont.)

 Speculators purchase call options on interest rate futures

contracts when they expect interest rates to decrease.
Financial institutions with large holdings of long-term
debt securities hedge against interest rate risk by
purchasing put options on interest rate futures. Index
options can be used to speculate on movements in stock
indexes and require only a small investment. Put options
on stock indexes can be purchased to hedge a stock
portfolio whose movements are similar to that of the
stock index. Options on stock index futures can be used
to speculate on movements in the value of the stock
index futures contract. Put options on stock index futures
can be purchased to hedge portfolios of stocks that move
in tandem with the stock index.
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