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Chapter 14
Options Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline

Background on options

Speculating with stock options

Determinants of stock option premiums

Explaining changes in option premiums

Hedging with stock options

Using options to measure a stock’s risk
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Chapter Outline (cont’d)

Options on ETFs and stock indexes

Options on futures contracts

Hedging with options on futures

Institutional use of options markets


Grants the right, but not the obligation, to sell the
specified investment

A put option is:

In the money when the market price of the underlying
security is below the strike price

At the money when the market price is equal to the strike
price

Out of the money when the market price is above the strike
price
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Background on Options (cont’d)

Call and put options specify 100 shares for stocks

Premiums paid for call and put options are determined
through open outcry on the exchange floor

Participants can close out their option positions by taking
an offsetting position

The gain or loss is determined by the premium paid when
purchasing the option and the premium received when selling
the option

American-style options can be exercised at any time
prior to expiration


One key requirement is a minimum trading volume of the
underlying stocks

Role of the Options Clearing Corporation (OCC)

The OCC serves as a guarantor on option contracts traded in
the U.S.

Regulation of options trading

The SEC and the various option exchanges regulate option
trading

Regulations:

Are intended to ensure fair and orderly training

Attempt to prevent insider trading

Attempt to prevent price fixing among floor brokers
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Background on Options (cont’d)

How option trades are executed

Floor brokers execute transactions desired by
investors

Some orders are executed electronically without a floor

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Background on Options (cont’d)

Stock option quotations

Financial newspapers and some local
newspapers publish quotations for stock
options (see next slide)

Options with higher exercise prices have
lower call premiums and higher put premiums

Options with a longer maturity have higher call
option premiums and higher put option
premiums
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Background on Options (cont’d)

Stock option quotations (cont’d)
Strike Exp. Vol. Call Vol. Put
McDonald’s 45 Jun 180 4 1/2 60 2 3/4
45 Oct 70 5 3/4 120 3 3/4
50 Jun 360 1 1/8 40 5 1/8
50 Oct 90 3 1/2 40 6 1/2
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Speculating with Stock Options

Speculating with call options

Call options can be used to speculate on the expectation of an

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96
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Buyer’s Perspective Writer’s Perspective
Profit
Stock Price
At Expiration
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Speculating with Stock Options
(cont’d)

Speculating with call options (cont’d)

Assume that ABC stock has three call options available:

Call option 1: Exercise price = $87; Premium = $7

Call option 1: Exercise price = $90; Premium = $5

Call option 1: Exercise price = $92; Premium = $4

The risk-return potential varies among the several options that
are available

The contingency graph for all three options is shown on the
next slide

The graph can be revised to reflect returns for each possible price
per share of the underlying stock
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exercise price less the premium, while the maximum
gain is the premium