®1999 South-Western College Publishing 1 Chapter 23 Options-Basic Concepts And Strategies

®1999 South-Western College Publishing 2 Limitations Of Option Trading Lack of Standard ContractsLack of Standard Contracts Lack of Transferability Between InvestorsLack of Transferability Between Investors Have to Take Physical DeliveryHave to Take Physical Delivery Risk Associated With Lack of CollateralRisk Associated With Lack of Collateral Lack of Market MakerLack of Market Maker

®1999 South-Western College Publishing 3 Chicago Board Options Exchange (CBOE) Began 1973Began 1973 Addresses LimitationsAddresses Limitations Explosive GrowthExplosive Growth

®1999 South-Western College Publishing 4 Option Terminology Exercising the Option ContractExercising the Option Contract Strike Price/Exercise PriceStrike Price/Exercise Price Long PositionLong Position Option WritersOption Writers Short PositionShort Position

®1999 South-Western College Publishing 5 Option Contract European-Style OptionEuropean-Style Option –Exercised only on specific date American-Style OptionAmerican-Style Option –Exercise anytime

®1999 South-Western College Publishing 6 Options Versus Stocks OptionsOptions –Low-cost for taking a position –Limit loss to purchase price OptimistOptimist –Buys call option PessimistPessimist –Buys put option

®1999 South-Western College Publishing 7 In-the-money option Out-of-the-money option At-the-money option Naked option Covered option Relationship Asset Option Between

®1999 South-Western College Publishing 8 Option Clearing Corporation (OCC) Maintains Records of TradesMaintains Records of Trades FacilitatesFacilitates –Validation –Delivery –Settlement Owned by ExchangesOwned by Exchanges CBOE AMEX NYSE PHLX CBOE AMEX NYSE PHLX Issues All Option ContractsIssues All Option Contracts Guarantees Both SidesGuarantees Both Sides

®1999 South-Western College Publishing 9 Option Values Intrinsic ValueIntrinsic Value –Immediately exercised Time ValueTime Value –Current value above intrinsic value

®1999 South-Western College Publishing 10 Payoff Diagrams IllustrateIllustrate –The value line –The P/L line –Both

®1999 South-Western College Publishing 11 $ Value and Profit or Loss Stock Price at Expiration P/L Line Value Line

®1999 South-Western College Publishing 12 Investment Strategies Using Options Protective Put BuyingProtective Put Buying –Put option and stock –Sets a floor for losses Covered Call WritingCovered Call Writing –Call option and stock –Sets a ceiling on the potential gain –Receives the call premium Bull SpreadBull Spread –Allow investors to profit if prices rise –Limits investors’ losses if prices fall –Price will rise by small amount