Options 1

Introduction: Definitions and Market

Operations
 Definitions and Characteristics

• Call option gives buyer of contract (the holder) the

right, but not the obligation to buy specific asset at
specific price (exercise / strike price) on, or prior to,
specific expiry day.
• Put option gives holder right, but not obligation, to sell
asset.
• An option is a contract between two investors
(bilateral contract).

• Buyer of option pays seller (writer) option premium.

• Writer is subordinate to decision of holder. If option

called/exercised by holder, writer is obliged to sell
asset (if option is a call), or buy asset (if option is a
put).
 Selling a call versus buying a put

• Selling a call not the same as buying a put.

• Buying a put gives the right to sell the asset, while

selling a call gives someone else the choice of buying
asset from you.
Options versus Futures
risk structure
• Option holder has choice. Writer of option has not.
He/she is subservient to buyer.
• For buyer of option, asymmetric risk structure:
unlimited potential gain, limited potential loss. Vice
versa for writer.
• With futures, symmetric risk structure: potentially large
gains or losses to both buyer and seller.
Options versus Futures
payoff structure
• With both futures and options, gains (or losses) to
buyer = losses (or gains) to writer of contract.
• Buy call: Max loss Option premium
Max gain Unlimited
• Buy put: Max loss Option premium
Max gain Exercise price
• Write call: Max loss Unlimited
Max gain Option premium
• Write put: Max loss Exercise price
Max gain Option premium
• Futures contract to buy
Max loss Futures price
Max gain Unlimited
• Futures contract to sell
Max loss Unlimited
Max gain Futures price
 Exercising style of options
• Exercising call options does not increase share
capital of company.
• European option can be exercised only at expiry.
• American option can be exercised at any time until
the expiry date.
• Most options have “American” style of exercising.
Titles have nothing to do with Europe or America.
 Traded Options Market
• Negotiated options (customised) available in UK for
centuries.
• Traded options (standardised) since 1978.
• In 1992, London Traded Options Market merged
with London International Financial Futures
Exchange
• Created London International Financial Futures
and Options Exchange (LIFFE), now NYSE
Euronext LIFFE.
• American options traded with maturities of 3, 6, 9
and 12 months (March, June, Sep and Dec). Called
the maturity cycle.
• Traded options available on indices, such as the
FTSE100, and shares of approx. 126 large
companies.
• Each option contract is on 1,000 shares.
• But option price (premium) quoted per share.
(Quote is always per unit of underlying asset –
whatever the asset).
• A series of options are issued by the exchange for
each underlying asset.
• Series = options for specific company (asset) each
expiring on a specific date and has a specific
exercise price.
• For each maturity date a number of options are
issued with exercise price below current spot price
and a roughly equal number with exercise above
current spot price.
• Since option writing entails possibility of unlimited
losses. Option writer must deposit margin
(=collateral/security).
• No margin for buyer of option (limited risk).
• Clearing house/corporation (e.g., ICE Clear Europe
Ltd for Euronext LIFFE derivatives) splits contract
between buyer and seller. It then buys from the seller
and sells to the buyer.
• This leads to buyer (seller) has claim on (obligation
to) the clearing house.
• Few options result in exercise. Can ‘close’ or
‘square’ position by selling options held, or buying
options written.
• If option exercised, clearing house randomly selects
a writer to call from (or ‘match’ with – called
‘matching’).
• Writing call options against shares already held =
writing ‘covered’ call. If option called, deliver shares
at exercise price.
• Writer of ‘naked’ call does not hold the shares. If
called, must buy shares at spot to honour obligation.