Ch 15

Arbitrage:

-No possibility of a loss -A potential for a gain -No cash outlay

The minimum terms stipulated by stock option contracts are:

-The identity of the underlying stock. -The strike price, or exercise price. -The option contract size. -The option expiration date, or option maturity. -The option exercise style (American or European). -The delivery, or settlement, procedure.

"Out-of-the-money" option

An option that would NOT yield a positive payoff if exercised

"In-the-money" option

An option that would yield a positive payoff if exercised

The Options Clearing Corporation (OCC)

is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised.

The writer of a put option contract is

obligated to buy the underlying asset from the put option holder.

The writer of a call option contract is

obligated to sell the underlying asset to the call option holder.

"At the Money" options

options is a term used for options when the stock price and the strike price are about the same.

Call options

options to buy the underlying asset

Put options

options to sell the underlying asset.

Because option writing obligates the option writer

the option writer receives the price of the option today from the option buyer

The call option holder has the right

to exercise the call option (i.e., buy the underlying asset at the strike price).

The put option holder has the right

to exercise the put option (i.e., sell the underlying asset at the strike price).

Think about what would happen if arbitrage were allowed to persist

Easy money for everybody

American-style exercise

If this right is available at any time up to and including the option expiration date, the option is said to have American-style exercise.

European-style exercise

If this right is only available at the option expiration date, the option is said to have European-style exercise.

Absence of Arbitrage

In finance, arbitrage is not allowed to persist. -"Absence of Arbitrage" = "No Free Lunch" -The "Absence of Arbitrage" rule is often used in finance to calculate option prices.

Option "Moneyness"

In the Money: Call option= S > K Put Option= S < K Out of the money Call option= S <_ K Put Option= S >_ K

"Out of the Money" options have a zero intrinsic value

-For calls, the strike price is greater than the stock price. -For puts, the strike price is less than the stock price.

"In the Money" options have a positive intrinsic value

-For calls, the strike price is less than the stock price. -For puts, the strike price is greater than the stock price.

Put-Call Parity

Put-Call Parity is perhaps the most fundamental relationship in option pricing. Put-Call Parity is generally used for options with European-style exercise. Put-Call Parity states: the difference between the call price and the put price equals the difference between the stock price and the discounted strike price.

What does OCC do?

The OCC issues and clears all option contracts trading on U.S. exchanges.

option writing

The act of selling an option

the writer

The seller of an option contract

"Why buy stock options instead of shares in the underlying stock?"

To answer this question, we compare the possible outcomes from these two investment strategies: -Buy the underlying stock. -Buy options on the underlying stock.