ParT 2: ValuaTION, rISk aNd reTurNhe must sell Tony an asset for less than what it is worth. On the other hand, if BHP Billiton’s share
price does not rise above $20, then Tony will not attempt to buy the asset, and Oscar can keep the
$3 option premium.
Options trades do not usually occur in face-to-face transactions between two parties. Instead, options
trade either on an exchange such as the Australian Securities Exchange (ASX) or Chi-X Australia, or
on the over-the-counter (OTC) market. The exchanges list options on a limited number of shares,
with a limited set of exercise prices and expiration dates. By restricting the number and the variety
of listed options, the exchange expects greater liquidity in the option contracts that are available for
trading. Furthermore, an options exchange may serve as a guarantor, fulfilling the terms of an option
contract if one party defaults. In contrast, OTC options come in seemingly infinite varieties. They are
less liquid than exchange-traded options. A trader of OTC options faces counterparty risk, the risk that
their counterparty on a specific trade will default on their obligation. While there is a counterparty risk
for those trading with an exchange, the risk is greatly lowered because of the typically greater resources
held by the exchange, and the fact that it manages as its business a diversified portfolio of many different
options compared with a single individual.
Most investors who trade options never exercise them. An investor who holds an option and
wants to convert that holding into cash can do so in several ways. First, one investor can simply sell
the option to another investor, as long as there is some time remaining before expiration. Second,
an investor can receive a cash settlement for the option. To understand how cash settlement works,
go back to Tony’s call option to buy BHP Billiton shares for $20 each. Suppose that the price of
BHP Billiton is $30 per share when the option expires. Rather than have Tony pay Oscar $20
in exchange for one share of BHP Billiton, Oscar might agree to pay Tony $10, the difference
between the market price of BHP Billiton and the option’s strike price. Settling in cash avoids the
potential need for Oscar to buy one share of BHP Billiton to give to Tony and the need for Tony
to sell that share if he wants to convert his profit into cash. Avoiding these unnecessary trades
saves transactions costs.8 -1b OPTION PrICeS
Table 8.1 shows a set of option-price quotations for St Kilda Optics. The first column indicates that
the quoted options are on St Kilda Optics ordinary shares. On the day that these option prices were
obtained, the closing price of St Kilda Optics was $30.00. The second column illustrates the range of
expiration dates available for St Kilda Optics options. The prices we’ve chosen to illustrate in the table
are for options expiring either in April, May or July. The third column shows the range of option strike
prices available, from $27.50 to $35. The fourth and fifth columns give the most recent trading prices
for calls and puts.^4 For instance, an investor who wanted to buy a call option on St Kilda Optics shares,
with a strike price of $27.50 and an expiration date in May, would pay $3.91. For a May put with the
same strike price, an investor would pay just $1.23. Remember, we also refer to the price of an option as
the option’s premium.4 A minor institutional detail is worth mentioning here. An option contract grants the right to buy or to sell a specified number of shares of the
underlying stock, even though the price quotes in the table are on a ‘per-share’ or ‘per-option’ basis. That is, the call price of $3.91 for the May
option, with a $27.50 strike, means that for $391, an investor can purchase the right to buy 100 shares of St Kilda Optics at $27.50 per share.
All the examples in this chapter are constructed as if an investor can trade one option to buy or to sell one share. We make that assumption to
keep the numbers simple, but it does not affect any of the main lessons of the chapter.counterparty risk
The risk that the counterparty
in an options transaction will
default on its obligation
cash settlement
An agreement between two
parties, in which one party
pays the other party the cash
value of its option position,
rather than forcing it to
exercise the option by buying
or selling the underlying asset