Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_2

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Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_2 O ptions fundamentals 30 P art 1  (a) $55 × 60/360 × 0.05 = $0.46 interest added to call price (b) $0.35 dividend subtracted from call price (c) $0.46 – 0.35 = $0.11, total added to call price Note that the price of the stock is not a factor in this calculation. In fact, DuPont was trading at 57 at the time of this example. There is a difference of opinion, however. Some traders think that the current price of the stock is a more accurate basis from which to calculate the interest rate compo- nent of the option. Practically speaking, the difference between these two methods is not significant unless the options are far out-of-the-money with many days until expiration. Again, an options model accounts for this. More important would be a change in the dividend or the interest rate until expiration. Also note that unless special circumstances occur with respect to dividends and interest rates, these pricing components are far less significant than the volatility component. Puts on stocks have the opposite pricing characteristics to calls with respect to cost of carry and dividends. Purchased calls and puts on stocks are paid for in cash up-front on most exchanges. Sold or short options, however, are margined because short calls incur potentially unlimited risk, and short puts incur extreme risk. Options on stock indexes A stock index is a proxy for all the stocks that comprise it. Calls and puts on a stock index are priced according to the cost of carry of the index, and the amount of dividends contained in the index. The costs of carry and dividends are added and discounted in the same manner as options on individual stocks. These options are also paid for in cash. Long and short options positions In practice, once a call or put is bought, it is considered to be a long options position. ‘I’m long 10, June 550 puts,’ you might say. Conversely, a call or put sold is considered to be a short options position. ‘I’m too short for my own good,’ means that you have sold too many calls or puts, or both, for your peace of mind. It may be helpful to think that when the terms ‘long’ and ‘short’ are applied to options, they designate ownership. The same terms applied to a position in the underlying designate exposure to market direction. To be short puts is to be long the market, i.e. you want the market to move upward. The following chapter on deltas clarifies this. P ricing and behaviour 3 31  Exercise and assignment In practice, most In practice, most options are not held through options are not held expiration. They are closed beforehand because through expiration the holders of options do not want to take deliv- ery of the underlyings. The exceptions are options on stock indexes and options on short-term interest rate contracts such as Eurodollars. In these contracts, no delivery of an underlying is involved. Long and short options positions that are in the money at expira- tion will be converted into underlying positions through exercise and assignment, respectively. The clearing firms manage this procedure. The resulting positions are similar to those stated at the end of Chapter 2 under a comparison of calls and puts (page 24). There are slight differences for each type of contract. Stocks Through exercise, the holder of a long call will buy, at the strike price, the number of shares in the underlying contract. Through assignment, the holder of a short call will sell the shares. If the short call holder does not own stock to sell, he will be assigned a short stock position. Through exercise, the holder of a long put will sell, at the strike price, the number of shares in the underlying contract. If the long put holder does not own shares to sell, he will be assigned a short stock position. Through assignment, the holder of a short put will buy the shares. Futures Through exercise, the holder of a long call will acquire, at the strike price, a long futures position in the underlying. Through assignment, the holder of a short call will acquire a short futures position at the strike price. On many futures exchanges, an options contract expires one month before its under ...