chapter 19 options. define options and discuss why they are used. describe how options work and give...
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Chapter 19
Options
Define options and discuss why they are used.
Describe how options work and give some basic strategies.
Explain the valuation of options. Identify types of options other than puts and
calls.
Learning Objectives
Call (Put): Buyer has the right, but not the obligation, to purchase (sell) a fixed quantity from (to) the seller at a fixed price before a certain date Exercise (strike) price: “fixed price” Expiration (maturity) date: “certain date”
Option premium or price: paid by buyer to the seller to get the “right”
Options
Financial derivative securities: derive all or part of their value from another (underlying) security
Options are created by investors, sold to other investors
Why trade these indirect claims? Expand investment opportunities, lower cost,
increase leverage
Why Options Markets?
Exercise (Strike) price: the per-share price at which the common stock may be purchased or sold
Expiration date: last date at which an option can be exercised
Option premium: the price paid by the option buyer to the writer of the option, whether put or call
Option Terminology
Options exchanges Chicago Board Options Exchange (CBOE) Montreal Exchange (ME)
Standardized exercise dates, exercise prices, and quantities Facilitate offsetting positions through a clearing
corporationClearing corporation is guarantor, handles
deliveries
Options Trading
In-the-money options have a positive cash flow if exercised immediately Call options: S > E Put options: S < E
Out-of-the-money options should not be exercised immediately Call options: S < E Put options: S > E
If S = E, an option is at the money
Options Characteristics
Intrinsic value is the value realized from immediate exercise Call options: maximum (S0-E, 0)
Put options: maximum (E-S0, 0)
Prior to option maturity, option premiums exceed intrinsic value
Time Value = Option Price - Intrinsic Value
Options Characteristics
25 27 29
4
0
-4
Stock Priceat Expiration
Profit perOption ($)
How does buying a stock comparewith buying a call option?
Buyer
Seller
Payoff Diagram for a Call Option
23 25 27
4
0
-4
Stock Priceat Expiration
Profit perOption ($)
How does selling a stock comparewith buying a put option?
Buyer
Seller
Payoff Diagram for a Put Option
23 25 27 29
4
0
-4
Stock Priceat Expiration
Profit ($)Purchased share
Written call
Combined
Covered Call Writing
23 25 27 29
4
0
-4
Stock Priceat Expiration
Profit ($)
Combined
Purchased put
Purchased share
Protective Put Buying
Hedging strategy that provides a minimum return on the portfolio while keeping upside potential
Buy protective put that provides the minimum return Put exercise price greater or less than the
current portfolio value?
Problems in matching risk with contracts
Portfolio Insurance
23 25 27 29
2
0
-2
Stock Priceat Expiration
Profit ($)
Combined
Purchased put
Purchased share
Portfolio Insurance
Exercise prior to maturity implies the option owner receives intrinsic value only, not time value For call options, buy stock at below market
price Would more be earned by selling option?
For put options, receive cash from selling stock at above market price
Could cash be reinvested for a higher return?
Should Options be Exercised Early?
At maturity, option prices are equal to their intrinsic values Intrinsic value is minimum price prior to maturity
Maximum option prices prior to maturity Call options: price of stock, S0
Put options: exercise price, E
Option Price Boundaries
Stock Prices
CallPrices
E
PutPrices
Stock Prices
E
E
C =S
Option Price Boundaries
Five variables needed to value a European call option on a non-dividend paying stock
The Black-Scholes pricing formula is:
tdd t
t)5.r()EPCMPln(d
)d(Ne
EP)d(NCMPCP
12
2
1
2rt1
tdd t
t)5.r()EPCMPln(d
)d(Ne
EP)d(NCMPCP
12
2
1
2rt1
Black-Scholes Model
Black-Scholes valuation is for call options Put-call parity shows relationship between
call and put options so that riskless arbitrage is not possible
Price of put = E/(ert) - S +C Put replicated by riskless lending, short
sale of stock, purchased call
Put-Call Parity
Variable Call Put Stock Price + - Exercise Price - + Time to maturity + + Stock volatility + + Interest rates + - Cash dividends - +
Variable Call Put Stock Price + - Exercise Price - + Time to maturity + + Stock volatility + + Interest rates + - Cash dividends - +
Factors Affecting Prices
Options can be used to control the riskiness of common stocks If stock owned, sell calls or buy puts
Call or put option prices do not usually change the same dollar amount as the stock being hedged Shares purchased per call written = N(d1)
Shares purchased per put purchased = N(d1) - 1
Hedge Ratios
Stock-Index Options: option contracts on a stock market index
Interest Rate Options: option contracts on fixed income securities
Currency Options: Option contracts whose value is based on the value of an underlying currency
Other Types of Options
Options available on S&P/TSE 60 Index, S&P 500 Index, NYSE Index, etc.
Bullish on capital markets implies buying calls or writing puts
Bearish on capital markets implies buying puts or writing calls
At maturity or upon exercise, cash settlement of position
Basics of Stock-Index Options
Speculation opportunities similar to options on individual stocks
Hedging opportunities permit the management of market risk Well-diversified portfolio of stocks hedged by
writing calls or buying puts on stock index What return can investor expect?
Strategies with Stock-Index Options
Appendix 19-A Combinations of Options Straddle – A combination of a put and a call
on the same stock with the same exercise date and exercise price A purchaser believes that the underlying stock
price is highly volatile and may go either up or down
A seller believes that the underlying stock price will exhibit small volatility but could go up or down
Strip – A combination of two puts and a call on the same security, same exercise date and price
Strap – combines two calls with a put
The purchase and sale of an equivalent option varying in only one respect
Two basic spreads: Money spread involves the purchase of a call
option at one exercise price and the sale of the same maturity option, but with a different exercise price
Time spread involves the purchase and sale of options are identical except for expiration dates
Appendix 19-A Spreads of Options
Appendix 19-BRights and Warrants
Right – to purchase a stated number of common shares at a specified price with a specified time (often several months)
Warrant – to purchase a stated number or common shares at a specified price with a specified time (often several years)
Appendix 19-C Put-Call Parity
No-Arbitrage Argument Example:
Payoff at TPortfolio Action S(T) <E S(T) >EA Buy 1 call 0 S(T) – E
Invest PV(E) in T-bills
E E
Total Payoff E S(T)B Buy 1 share S(T) S(T)
Buy 1 put E – S(T) 0Total payoff E S(T)
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