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4504c17 - Option Market Chapter 17 Why Options Markets o...

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Option Market Chapter 17 Why Options Markets? o Financial derivative securities: derive all or part of their value from another (underlying) security o Options are created by investors, sold to other investors o Why trade these indirect claims? Expand investment opportunities, lower cost, increase leverage Options Terminology An option is a right to buy (or sell) a given number (if stock then 100 shares) of units of a particular security at a particular price before a particular expiration date. The buyer may: (1) exercise the option (2) sell the option (3) let the option expire. The buyer (holder) of the option pays the writer (seller) of the option for this right. This is known as the option premium (option price). o Option premium or price: price paid by buyer to the writer (seller) to get the “right” Buyers of option purchase rights to transact, whereas the seller has an obligation to transact. The Exercise or strike price is standardized. For most stocks with a market price greater than $25, the strike price is set by the exchange at 5 point intervals nearest to where the stock is currently trading ( ie. If the stock is trading at $43 then options at strikes of $40 and $45 may be issued by the exchange). For stocks with a market price under $25, the strike price is set at increments of $2.50. Exercise (strike) price: “fixed price”— the per share price at which the security may be purchased (call) or sold (put) to a writer Expiration (maturity) date: the last date at which an option can be exercised o Call: Buyer has the right but not the obligation to purchase (call away) a fixed quantity from the seller at a fixed price (exercise price) before a certain date (expiration date). Buyers of calls are protected from price increases Buyers expect prices to rise. Put: Buyer has the right but not the obligation to sell (put away) a fixed quantity to the seller at a fixed price (exercise price) before a certain date (expiration date). Buyers of puts are protected from price decreases . Buyers expect prices to fall .
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How Options Work o Buyers and sellers of options have opposite expectations about price movements o Call buyer (seller) expects the price of the underlying security to increase (decrease or stay steady) o Put buyer (seller) expects the price of the underlying security to decrease (increase or stay steady) o At option maturity Option may expire worthless, be exercised, or be sold Options Terminology Option Price is determined on the floor of the exchange Option Price has 2 components Intrinsic value (equate option price to market & strike) Speculative (Time) Premium Intrinsic Value o Intrinsic value is the value realized from immediate exercise Options premium rarely trade below its intrinsic value (If it did the investor would realize riskless returns).
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