Reading,Hull Chapter 1: Perhaps re-read the section on options which is in sections 1.5 1,10. Hull Chapter 7: This starts with the basics of options and then goes on into the specific details of trading. Read up to 7.4 for the crucial details and the rest if youre still interested. Hull Chapter 8: This is quite interesting but perhaps a little technical at this point in time. The most important part as regards the lecture is 8.4 and perhaps 8.5. 8.1 is interesting to see the crucial factors in determining the price of an option and will be useful for future reference (i.e. the last two weeks). Hull Chapter 9: Quite a nice chapter explaining options strategies, Im going to work through a sample of these in class so it may be useful to famililiarise yourselves with the principal strategies.,Reading,HBR Article: Stock options have had a very negative press of late and here we have Nobel prize winner Robert Merton and other high-profile academics discussing some of the issues and argue for stock options to be put on the balance sheet. This will actually come into force at the start of 2005.,Futures contracts are contracts which cost nothing to enter. This is because if you are in the long position you gain when the spot price of the underlying asset, S, rises, you also lose when the price goes down (and vice versa with the short position). An option is similar in many ways to a futures contract in that you have the right to buy (or sell) at a certain price in the future (this time it is called the exercise price). However, the principal difference is that you dont have the obligation to buy at this price you have the option as whether or not you choose to buy (or sell) at this price. Clearly you will have to pay some premium for this privilege. How much?,Options: Introduction,Why options?,Options can again be used for three main purposes: hedging, speculating and arbitraging. An option enables you to hedge against adverse market movements (e.g. price of oil, price of corn, stock market value, interest rate changes) without, necessarily, limiting your potential gain should the market actually move in your favour. Just like with a futures contract an option enables you to leverage your position and hence make it easier to speculate on market movements. Again with options as the financial instruments become more complex then there are more arbitrage opportunities to exploit.,Options: definitions,An option gives the holder of the option the right, but not the obligation to buy an economic good (usually called the underlying asset), at a specific point in time (the expiry date), for a specific price (the exercise price). The party who bought the option is said to be in the long position, the party who sold (or wrote) the option is said to be in the short position. A Call Option gives the holder of the option the right, but not the obligation, to buy the underlying asset. A Put Option gives the holder of the option the right, but not the obligation, to sell the underlying asset.,Options: Types,There are two main types of options: European options: European options can only be exercised on the expiry date. American options: American options can be exercised at any time between the date of purchase and the expiry date. These names have no geographical significance, hence it is possible to buy American options on European options exchanges. Most traded options are American options, although we will start our discussion by assuming that all options are European.,Options: Example,Consider both call and put options on Microsoft shares, expiring on March 20, 2004. Both have exercise prices of $25 and each option enables the holder to buy or sell the Microsoft shares at this price. The current value of Microsoft shares is $27.03. Call options are currently priced at $2.20 and put options at $0.13. Microsoft current option prices Options Product Specifications The payoffs from these options for different values of the Microsoft shares are as follows:,Options: example,Options: example,Clearly is the value of a Microsoft share exceeds the exercise prices then the holder of the call option will exercise his right to exercise and make a profit of the share price less the exercise price. If it is less then he will not, in this case the option expires worthless. In the case of the put option the if the Microsoft share price drops below the exercise price then she will exercise and receive the difference between these prices. If it is more then the option expires worthless. From this we note that options must always have positive or zero value as the least they can ever be worth is zero.,Options: leverage,Options on individual shares are actually 100 shares. Notice that if the value of Microsoft shares at expiry at $30 then the holder of the call option makes a profit of $500 $220 = $280 or a return of 280/220 = 127%. If instead he would have spent this money on buying the shares then the return would have been only (30