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Unformatted text preview: 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 . 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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This note was uploaded on 07/09/2011 for the course FIN 4504 taught by Professor Banko during the Summer '08 term at University of Florida.
- Summer '08