Organized trading of standardized option contracts began in 1973 (prior to that had existed OTC)..immediately the CBOE was a big hit...OTC options still exist and are foing very well...more customizeable, higher transaction costs.

Call option -gives the buyer the right to buy at a prespecified price

purchase price is called the premium

call contract is for 100 shares

value at expiration is the starting point of any investigation

value at expiration=proceeds you could get = stock price-exercise price

Profit=proceeds - original investment

- asset that derives its value from the value of another asset

- an agreement between two parties for the delivery of some asset at some time for some price

- unique to each contract - nonnegotiable, nontransferable, and cannot be traded

- can be customized

- very illiquid, high transaction costs

- are rarely entered into except by companies that have good credit ratings because of the high risk of default

- payoff of a long position = underlying asset price - price agreed upon

Futures - Standardized

- much more liquid than forward contracts - very active market

- payoff looks the same as forward contracts

if long: spot-original futures price

if short: original futures-spot

- if the price of the product goes up then the payoff of the long position goes up

- every contract is made with a middleman called a clearinghouse

- marked-to-market daily

- the contracts used to be settled with delivery but now more people are settling with cash which allows easier speculation

- a call gives the purchaser of the option the right but not the obligation to buy the underlying asset at an agreed upon price at either any time before expiration ( American) or at expiration (European)

- can always walk away from a long option position

- put option gives the purchaser of the option the right but not the obligation to sell the underlying asset at an agreed upon price at any time as an American or an European

- you buy a call when you expect the price to go up and you buy a put when you expect the price to go down

- if you "long a call" you purchased the call option and if the stock price is above the strike price then you want to exercise the option

- if you "long a put option" you are betting the market price will go down and bought the option to sell - if the stock price is below the strike price then you exercise the option

long a call

call price = max ( 0, stock price - strike price)

short a call

call price = min ( 0, strike price - stock price)

long a put

call price = max ( 0, strike price - stock price)

short a put

call price = min ( 0, stock price - strike price)

In the money-if exercise would be profitable

at the money

out-of-the money-if exercise would NOT be profitable

OCC-options Clearing house: works much like the futures clearing houses

Naked- you do not own the underlying asset and are thus totally exposed to the price fluctuations

Covered- you own the underlying asset

Zero sum game-for every winner there is a loser.

hedge vs. speculate

hedging reduces volatility

Speculating increases volatility. It is betting on the same side as your core business risk.

Be aware that stale pricing effects the price/premium relationship.

Index options

Futures options-underlying asset is the futures contract

commodity options

Bounds on the price of a call.

upper=price of stock

lower=stock-PV(x)

Black-Scholes formula uses differential equations and solves for this price completely.

Black Scholes

Options in real world:

equity as a call position

callable bonds

convertibles

jr debt

product of financial engineering

Lyons etc that we spoke of earlier

1st issued by ML in 1985. They are zero-coupon bonds

callable, convertible, and puttable

Waste Management was underlying firm.

put option is a protective floor

simpler "new" product is a bull certificate. Issued by many banks....esp popular in Europe

ex 70% of mkt gain but no loss.

the 70% number is called a multiplier

an "at-the money option"

multiplier =[rf/(1+rf)]/[c/s]

price that the depositor pays is in forgone interest. This interest would be paid at the end of the period. Hence discounting by 1+rf.

Book example: rf=6%

6 month at the money call=$20

Index =400

$20/400=.05 per dollar of mkt value. (this is the denominator)

CD rate is 3% per 6 months.

So multiplier=[.03/1.03]/.05=.582.

many variations. Can have limited loss, or even set a min gain. (i.e. above zero)

generically this option is being purchased in forgone interest which is)