CHAPTER NINETEEN

Options

CHAPTER NINETEEN

Options

Cleary / Jones Investments: Analysis and

Management

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

To define options and discuss why To define options and discuss why they are usedthey are used

To describe how options work and To describe how options work and give some basic strategiesgive some basic strategies

To explain the valuation of optionsTo explain the valuation of options To identify types of options other To identify types of options other

than puts and callsthan puts and calls

OptionsOptionsOptionsOptions

Call Call (Put):(Put): Buyer has the right, but not Buyer has the right, but not the obligation, to purchase the obligation, to purchase (sell)(sell) a a fixed quantity from fixed quantity from (to)(to) the seller at a the seller at a fixed price before a certain datefixed price before a certain date– Exercise (strike) price: “fixed price”Exercise (strike) price: “fixed price”– Expiration (maturity) date: “certain date”Expiration (maturity) date: “certain date”

Option premium or price: paid by Option premium or price: paid by buyer to the seller to get the “right”buyer to the seller to get the “right”

Why Options Markets?Why Options Markets?Why Options Markets?Why Options Markets?

Financial derivative securities:Financial derivative securities: derive all or part of their value derive all or part of their value from another (underlying) securityfrom another (underlying) security

Options are created by investors, Options are created by investors, sold to other investorssold to other investors

Why trade these indirect claims?Why trade these indirect claims?– Expand investment opportunities, Expand investment opportunities,

lower cost, increase leveragelower cost, increase leverage

How Options WorkHow Options WorkHow Options WorkHow Options Work

Call buyer (seller) expects the price of Call buyer (seller) expects the price of the underlying security to increase the underlying security to increase (decrease or stay steady)(decrease or stay steady)

Put buyer (seller) expects the price of Put buyer (seller) expects the price of the underlying security to decrease the underlying security to decrease (increase or stay steady)(increase or stay steady)

Possible courses of actionPossible courses of action– Options may expire worthless, be Options may expire worthless, be

exercised, or be sold prior to expiryexercised, or be sold prior to expiry

Options TradingOptions TradingOptions TradingOptions Trading Options exchangesOptions exchanges

– Chicago Board Options Exchange (CBOE)Chicago Board Options Exchange (CBOE)– Chicago Mercantile Exchange (CME)Chicago Mercantile Exchange (CME)– TSE-traded optionsTSE-traded options

Standardized exercise dates, exercise Standardized exercise dates, exercise prices, and quantitiesprices, and quantities– Facilitate offsetting positions through a Facilitate offsetting positions through a

clearing corporationclearing corporation Clearing corporation is guarantor, handles Clearing corporation is guarantor, handles

deliveriesdeliveries

Options CharacteristicsOptions CharacteristicsOptions CharacteristicsOptions Characteristics

In-the-money options have a positive In-the-money options have a positive cash flow if exercised immediatelycash flow if exercised immediately– Call options: S > ECall options: S > E– Put options: S < EPut options: S < E

Out-of-the-money options should not Out-of-the-money options should not be exercised immediatelybe exercised immediately– Call options: S < ECall options: S < E– Put options: S > EPut options: S > E

Intrinsic value is the value realized Intrinsic value is the value realized from immediate exercisefrom immediate exercise– Call options: maximum (SCall options: maximum (S00-E or 0)-E or 0)

– Put options: maximum (E-SPut options: maximum (E-S00 or 0) or 0)

Prior to option maturity, option Prior to option maturity, option premiums exceed intrinsic valuepremiums exceed intrinsic value

Time value = Option price - Intrinsic Time value = Option price - Intrinsic valuevalue

Options CharacteristicsOptions CharacteristicsOptions CharacteristicsOptions Characteristics

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4

0

-4

Stock Priceat Expiration

Profit perOption ($)

How does buying a stock comparewith buying a call option?

Buyer

Seller

Payoff Diagram for a Call OptionPayoff Diagram for a Call OptionPayoff Diagram for a Call OptionPayoff Diagram for a Call Option

23 25 27

4

0

-4

Stock Priceat Expiration

Profit perOption ($)

How does selling a stock comparewith buying a put option?

Buyer

Seller

Payoff Diagram for a Put OptionPayoff Diagram for a Put OptionPayoff Diagram for a Put OptionPayoff Diagram for a Put Option

Covered Call WritingCovered Call WritingCovered Call WritingCovered Call Writing

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4

0

-4

Stock Priceat Expiration

Profit ($)Purchased share

Written call

Combined

Protective Put BuyingProtective Put BuyingProtective Put BuyingProtective Put Buying

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4

0

-4

Stock Priceat Expiration

Profit ($)

Combined

Purchased put

Purchased share

Portfolio InsurancePortfolio InsurancePortfolio InsurancePortfolio Insurance

Hedging strategy that provides a Hedging strategy that provides a minimum return on the portfolio while minimum return on the portfolio while keeping upside potentialkeeping upside potential

Buy protective put that provides the Buy protective put that provides the minimum return minimum return – Put exercise price greater or less than the Put exercise price greater or less than the

current portfolio value?current portfolio value? Problems in matching risk with Problems in matching risk with

contractscontracts

Portfolio InsurancePortfolio InsurancePortfolio InsurancePortfolio Insurance

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2

0

-2

Stock Priceat Expiration

Profit ($)

Combined

Purchased put

Purchased share

Should Options be Should Options be Exercised Early?Exercised Early?

Should Options be Should Options be Exercised Early?Exercised Early?

Exercise prior to maturity implies Exercise prior to maturity implies the option owner receives intrinsic the option owner receives intrinsic value only, not time valuevalue only, not time value– For call options, buy stock at below For call options, buy stock at below

market pricemarket price Would more be earned by selling option?Would more be earned by selling option?

– For put options, receive cash from For put options, receive cash from selling stock at above market priceselling stock at above market price

Could cash be reinvested for a higher Could cash be reinvested for a higher return?return?

Option Price BoundariesOption Price BoundariesOption Price BoundariesOption Price Boundaries

At maturity, option prices are At maturity, option prices are equal to their intrinsic valuesequal to their intrinsic values– Intrinsic value is minimum price prior Intrinsic value is minimum price prior

to maturityto maturity Maximum option prices prior to Maximum option prices prior to

maturitymaturity– Call options: price of stock, SCall options: price of stock, S00

– Put options: exercise price, EPut options: exercise price, E

Stock Prices

CallPrices

E

PutPrices

Option Price BoundariesOption Price BoundariesOption Price BoundariesOption Price Boundaries

Stock Prices

E

E

C =S

Black-Scholes ModelBlack-Scholes ModelBlack-Scholes ModelBlack-Scholes Model

Five variables needed to value a Five variables needed to value a European call option on a non-European call option on a non-dividend paying stockdividend paying stock

The Black-Scholes pricing formula The Black-Scholes pricing formula is:is:

tdd t

t)5.r()EPCMPln(d

)d(Ne

EP)d(NCMPCP

12

2

1

2rt1

Put-Call ParityPut-Call ParityPut-Call ParityPut-Call Parity

Black-Scholes valuation is for call Black-Scholes valuation is for call optionsoptions

Put-call parity shows relationship Put-call parity shows relationship between call and put options so that between call and put options so that riskless arbitrage is not possibleriskless arbitrage is not possible

Price of put = (EP/ePrice of put = (EP/ertrt) - CMP +CP) - CMP +CP Put replicated by riskless lending, Put replicated by riskless lending,

short sale of stock, purchased callshort sale of stock, purchased call

Variable Call PutStock Price + -Exercise Price - +Time to maturity + +Stock volatility + +Interest rates + -Cash dividends - +

Factors Affecting PricesFactors Affecting PricesFactors Affecting PricesFactors Affecting Prices

Riskless HedgingRiskless HedgingRiskless HedgingRiskless Hedging

Options can be used to control the Options can be used to control the riskiness of common stocksriskiness of common stocks– If stock owned, sell calls or buy puts If stock owned, sell calls or buy puts

Call or put option prices do not usually Call or put option prices do not usually change the same dollar amount as the change the same dollar amount as the stock being hedgedstock being hedged– Shares purchased per call written = N(dShares purchased per call written = N(d11))

– Shares purchased per put purchased = N(dShares purchased per put purchased = N(d11) ) - 1- 1

Stock-Index OptionsStock-Index OptionsStock-Index OptionsStock-Index Options

Options available on S&P/TSE 60 Index, Options available on S&P/TSE 60 Index, S&P 500 Index, NYSE Index, etc.S&P 500 Index, NYSE Index, etc.

Bullish on capital markets implies Bullish on capital markets implies buying calls or writing putsbuying calls or writing puts

Bearish on capital markets implies Bearish on capital markets implies buying puts or writing callsbuying puts or writing calls

At maturity or upon exercise, cash At maturity or upon exercise, cash settlement of positionsettlement of position

Strategies with Stock-Strategies with Stock-Index OptionsIndex Options

Strategies with Stock-Strategies with Stock-Index OptionsIndex Options

Speculation opportunities similar Speculation opportunities similar to options on individual stocksto options on individual stocks

Hedging opportunities permit the Hedging opportunities permit the management of market riskmanagement of market risk– Well-diversified portfolio of stocks Well-diversified portfolio of stocks

hedged by writing calls or buying puts hedged by writing calls or buying puts on stock indexon stock index

– What return can investor expect?What return can investor expect?