Chapter 16, Section 3

 Understand what a futures contract is, and how and why people use them  Learn the meaning of “puts” and “calls,” and how investors can use them both aggressively and defensively

 A futures contract is an agreement to buy or sell a specific amount of something (often a commodity such as wheat or currency such as dollars) at a specific price on future date  A form of “insurance” … in this case, protecting against risk of future changes in price of something  Can also be used to speculate  The contract itself costs nothing (unlike options)  “Miller” example—p. 450  “Long” and “short” positions

 Similar to commodity futures contract, except the subject is a foreign currency  When a U.S. buyer is buying (importing) foreign goods at some time in the future, a futures contract can help protect against increases in the exchange rate of the foreign currency  “Toyota” example – p

 Two types: calls and puts  Call option—gives owner the right (but not the obligation) to buy shares of stock at a specified price up to a defined expiration date  Strike price—the price specified in the contract  Put option—gives owner the right (but not the obligation) to sell shares of stock at the strike price up to the defined expiration date  Traded on the CBOE (Chicago Board Options Exchange)  Each option contract covers 100 shares

 Speculation/leverage —a small price change in the underlying stock will cause a proportionately greater change in the underlying option.  Example: Ted thinks IBM stock will rise in price in the near future. He can buy 100 shares of IBM stock today at $90 per share, or he can buy a March 2012 $95 call option for $1.05 ($105 total: $1.05 x 100 shares = $105)  This option is “out of the money” … strike price is above current market price of the stock  Suppose IBM stock increases to $110 per share by the expiration date.  How much does Ted make if he buys the stock?  ($110-$90) x 100 shares = $2000; $2000/$9000 = 22.2%  How much does Ted make if he buys the option?  ($110-95) x 100 shares = $1500; $1500/$105 = 1430%

 In reality, Ted would just sell the option, not exercise it. The price of the option would “mirror” the difference between stock price and strike price on expiration day.  What happens if Ted is right about the direction of IBM stock, but wrong about the magnitude?  Suppose IBM stock is $94 on expiration day. The option has no value and expires worthless. Ted lost $105 (the cost of the option).  If he bought the stock itself, he would have a $40 paper gain ($94-90= $4 x 100 shares = $40)  Option pricing is very complicated … a function of (1) strike price relative to stock price, (2) volatility of the underlying stock, (3) dividends on the underlying stock and (4) time to expiration

 Options can also be used to generate income (selling options)  Most popular and “safest” way: writing covered calls  Example: Ted owns 100 shares of IBM stock, which is currently selling at $100 per share. He “writes” (sells) a March 2012 $105 call option for $0.85. What does this do for him?  Generates $85 in income ($0.85 x 100 = $85)  He can potentially make another $500 if the option is exercised ($105 – 100 = $5 x 100 = $500)  What does he give up?  Potential profits above $5 per share.  Ted’s risk is “limited” here because he owns 100 shares of IBM.  If he writes a “naked” call option, his risk is theoretically unlimited.  Example: Same facts except Ted doesn’t own IBM stock. He writes the call and makes $85. But now IBM stock explodes to $200 per share. When the call is exercised, Ted must buy 100 shares of IBM stock at $200 per share and then sell it to the call holder for only $105 per share. He loses $9500!  Other options strategies include “straddles” and “spreads”

 Options can also be used to “hedge” other investments.  A “hedge” is a form of protection in case your underlying assumption about the investment is wrong  Example: Ted owns 10,000 shares of IBM stock (current price: $150 per share). He relies on the $1.50 quarterly dividend to pay his living expenses. He is worried that the price of IBM stock may drop, but doesn’t want to sell the stock and lose the dividend payment. How can he protect himself?  He can buy a put option. Suppose he buys 100 December 2012 $145 put options for $1.10. What does this do for him?  Cost: $1.10 x 100 x 100 = $10,100  Benefit: He can lose no more than $5 per share on IBM stock through December, and he earns the quarterly dividend. If IBM stock drops below $145 by expiration date, he can sell the put options. If IBM stays above $145, the options expire worthless.