Lecture 11 Introduction of Options Agenda: I. Basics about options ~ Options underlying assets: ~ Expiration dates: ~ Strike prices: ~ Terminology: ~ Dividends: ~ Trading: ~ Taxation: ~ Warrants, Employee s stock options, and Convertibles: II. Properties of stock options: 1
I. Basics about options ~ Options underlying assets: Stock options: 100 shares strike price Currency options: i.e. BP 31,250, DM 62,500, JPY 6,250,000 Index: S&P500 index (SPX): 100 strike price S&P100 index (OEX): 100 strike price Nasdaq 100 (NDX): 100 strike price Dow Jones Industrial Index (DJX): 100 strike price settlement price = (spot strike) 100 Options on Futures: ~ Expiration dates: Expiration date: 10:59 p.m. Central time on the Saturday immediately following the third Friday of the expiration month. Last trading date: the third Friday of the expiration month. Exercise instruction time: 4:30 p.m. Central time. Expiration cycle: January February March April May June July August September October November December On March 2: March, April, June, and September On March 26: April, May, June, and September LEAPS (Long term equity anticipation securities): long-term options with maturity up to three years. The expiration month is in January. ~ Strike prices: Strike prices are spaced $2.5, $5, or $10 apart. A new option is introduced, two or three strike prices closet to the spot price are selected. If price moves outside the range, trading is introduced in an option with a new strike price. 2
~ Terminology: For any given time, many different option contracts are traded. Four expiration dates and five strike prices 40 different contracts: 2 option classes (call and put) 20 option series: the same class, expiration, and strike price. ATM, OTM, ITM, DITM, DOTM: By S/K By Delta: Option price = Intrinsic value: Max(S-K, 0) + Time value Time value=0 if at maturity date, or optimal to exercise the option immediately. Flex options: customized options ~ Dividends: Cash dividends ~ Exchange-traded options are not dividend protected. On ex-dividend day, stock price will drop by the amount of dividend. Stock splits ~ Does not affect earning ability or equity value. Exchange-traded options are adjusted to stock split. n-for-m split will cause stock price drops to m/n. Stock dividends ~ Does not affect earning ability or equity value. Exchange-traded options are adjusted to stock dividends: 20% stock dividend is similar to 6 to 5 stock split. Position limits (exercise limits): the maximum number of option contracts on one side. big stocks: 75,000 small stocks: 60,000 ~ Quotation: http://biz.yahoo.com/opt/ 3
~ Trading: Market makers: quote bid-ask Commission: One-way The spread should not be too wide: Spread < 0.25 if option price < 0.5 Spread < 0.5 if 0.5<option price < 10 Spread < 0.75 if 10<option price < 20 Spread < 1 if 20<option price Dollar amount of trade Commission <2500 20+0.02*Dollar amount 2500~10000 45+0.01*dollar amount >10000 120+0.0025*dollar amount Maximum: Minimum: $30/per contract for the first 5 contracts + $20/per contract for each addition contract. $30/per contract for the first contract plus $2 per contract of each additional contract. The commission cost is around 1% to 2% of the underlying asset value. Commission cost tends to push investors to offset instead to exercise the options: Exercise options: pay commission on stock trading. Trade options: pays no commission on stock trading. Hidden cost: bid-ask spread Margin: Investors are not allowed to buy options on margins. (Leverage effect) if buying options on margin Investors writing options must maintain funds in a margin account. Naked call options: the margin is the greater of: 1) 100% of the proceeds + 20% S (K-S) if OTM 2) 100% of the proceeds + 10% S 4
Call=10, S=100, K=105 Covered calls: (+ S, - C) no margin is required. Buy 100 S at $50 Margin=50% Call: $10 Initial investment = $50*100 - $50*100*50% - $10*100 The Options Clearing Corporation (OCC): Guarantee the payment of all investors Require all the members to maintain margins. Assign writers. ~ Taxation: For investors: the gains from stock options are capital gains. Gains (losses) are recognized when the options expire unexercised or the option position is closed out. If the option is exercised, the gain (loss) is rolled into the stock. Cost of stock is option premium plus exercise price. Wash sale rule: For investors, selling a stock at a loss and buying a call option with a 30-day period will lead to the loss being disallowed. This rule does not apply to market dealers. Constructive sales: Before 1997, if investors want to defer tax on trading profits, they can use derivatives to lock in their profits without paying tax. This constructive sales is not allowed after 1997. However, if investors using ITM put options to hedge a long position in stocks, the tax on the potential profit can be deferred. Tax planning using options: Multinational companies can take advantage of tax differential between two countries to minimize tax costs. US: higher Tax rate H.K.: low tax rate A capital gain in US can be locked in by buying options in H.K.. In this way, the profit is actually realized, but no capital tax paid in US. 5
~ Warrants, Employee s stock options, and Convertibles: When options are traded, the underlying asset prices are not affected. However, for some derivatives, the underlying asset prices will be affected. Warrants: call options issued by a firm. When warrants are exercised, the firm needs to issue new shares. Employee s stock options: Usually ATM options Convertible bond: convert the bond into stocks at a pre-specified price. When the right is exercised, number of shares will increase. 6
II. Properties of stock options: ~ Option premium f(s 0, K, T, σ, r, d) Relationship ~ European call: S 0 K T σ r d + -? + + - European put: S 0 K T σ r d - +? + - + American call: S 0 K T σ r d + - + + + - American put: S 0 K T σ r d - + + + - + ~ European call options may not be positively related to time to maturity: Wait to realized profits Dividend payment ~ European put options may not be positively related to time to maturity: Wait to realized profits ~ Options are always positively related to volatility: Downside risk is truncated. ~ Interest rate and option premiums: If interest rate, required rate of return of a stock will increase. If interest rate, the present value of a future cash flow will decrease. Argument: If interest rate, the stock price tends to drop. 7