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Corp. at 60, and the market price was $75. We said there that you could exercise your
option, buy the shares for $6,000 and then sell them for $7,500, netting a $1,500 profit.
This could be settled more simply, though, if the writer of the option just directly paid
you $1,500 in cash. If you actually want the stock, you can buy it for $7,500 on the open
market, applying your $1,500 options profit toward the cost, leaving you a net cost of
$7,500 $1,500 $6,000.
While cash settlement makes matters simpler, it has some unusual side effects. In the
futures example we discussed, note that it really wasn’t necessary that either party either
own or want to buy any actual cotton. Likewise, in the options examples it wasn’t really
necessary that either the writer or the owner of the option actually ever own, or even want
to actually own, any stock. With cash settlement, options and futures essentially become
bets on the future price of a thing, no longer requiring that anyone actually have physical
possession of the thing in question.
Removing the need for any actual physical possession of the things in question allows
options and futures to be written even for abstract things that actually cannot actually be
owned! Index options are one common example of this sort of thing. Index futures also
exist. There are a number of indexes^7 that are calculated and reported as a way of measur-
ing the performance of some group of investments overall. Some well-known examples
include the Dow Jones Industrial Average (the Dow 30), calculated on the basis of prices of
the stocks of 30 large companies, and the Standard and Poor’s 500 (the S&P 500), based on
the stock prices of a larger number of companies. You have no doubt heard these indexes
mentioned on the news. There are also indices for foreign stocks (such as the Nikkei index
for Japanese markets and the FTSE, called the “footsie,” for British stocks), bonds of vari-
ous types, commodities, interest rates, and so on.
Obviously, you cannot own an index, and you can’t buy or sell it either. It is an abstract
thing, a number calculated by a mathematical formula. Nonetheless, you can “bet” on
whether the index will rise or fall over a period of time. With cash settlement, we can cal-
culate what one party must pay the other by calculating the settlement amount just as if the
index were a thing that could actually be owned.
Since the numerical value of an index may not be a number that would be a reasonable
price for a stock, index options are not always based on 100 “shares.” It is necessary to
know the number of shares (called the multiplier) in use for an index option.
The following example will illustrate:Example 6.3.10 Suppose that the GlobalInvestrex 375 index currently stands at
617.506 and you believe that it will rise in the near future. You buy fi ve call options at
620.000. The option price is 3.850. The index rises to 630.239 and you exercise your
option. The option multiplier is 10. What will you receive when you do this? How much
profi t will you make?Since the option multiplier is 10, each contract is equivalent to 10 “shares” of this index. So
you pay 5(10)3.850 $192.50.The difference between the strike price and the price when you exercise is 630.239
620.000 10.239. So you get 5(10)($10.239) $511.95.Yo ur profi t, therefore, is $511.95 $192.50 $319.45.Since the results of options and futures contracts are derived from the price performance of
other things they are often referred to as derivatives.Options on Futures and Other Exotica
Options contracts can be created at an even higher level of abstraction. Options on future
contracts can be written or bought. It is possible to construct options that do not simply
profit from a rise or fall in price but instead pay off if prices fall within a certain range. The(^7) Technically, the correct plural of index is indices. The term indexes is in common use, though, and so we will use
either term as the mood strikes.
6.3 Commodities, Options, and Futures Contracts 283