Project 2: Options

What is an Option? An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date The Strike (or Exercise) Price is the price at which the underlying security (shares of a certain stock) can be bought or sold as specified in the option contract.

What is an Option? Unlike stock shares, options can be exercised on or before a certain date. This date is called the expiration date. A buyer of a stock option has until the expiration date to buy or sell shares of a stock at the strike price on before the day the option expires. If an investor doesn’t exercise his/her option, the option no longer exists.

Types of Options There are basically two types of options a buyer can hold: Call option: gives the buyer the right, but not the obligation, to buy shares of a certain stock at a pre-specified price (i.e. the strike price) Put option: gives the buyer the right, but not the obligation, to sell shares of a certain stock at a pre-specified price (i.e. the strike price)

Which Option is the best? Call options do the best when the underlying asset (usually shares of a stock) increase in value. You decide to buy a call option on IBM stock for $2.00 per share with a strike price $30. Suppose that IBM’s stock is at $29 a share when you purchase the option. When the option expires, let’s say that IBM stock is trading at $35 a share.

Call Options Because you have a stock option for IBM, this gives you the right, but not the obligation, to buy IBM stock at $30 a share even though IBM is trading at $35 a share. In this case you exercise your option, buying IBM stock at $30 a share. You could then take the stock you’ve purchased and then sell it on the open market for profit of $5.00 - $2.00 = $3.00 per share.

Put Options Put options work in the reverse of call options. A put option give you the right, but not the obligation, to sell a stock at a pre-specified price (i.e. the strike price) Generally put options do better as the value of the stock decreases.

Put Options Suppose IBM stock is at $30 a share. You think that the stock will go down after 10 weeks. This is when you would buy a put option. Let’s say you buy a put option for $1.00 a share with a strike price of $30.

Put Options This put options give you the right, but not the obligation to sell stock in IBM at $30 a share no matter how low IBM’s stock goes in 10 weeks. After 10 weeks go buy, let’s say that IBM is trading at $20 a share. You decide to buy IBM stock at this price. You then exercise your put option and sell IBM stock for $30.00 a share. This would give you a profit of $10 - $1 or $9 per share.

Project 2: European Call Options For our project we will be limiting ourselves to European call options. This means the option can only be exercised on the expiration date. Your are employed at the Chicago Board of Options Exchange, one of the largest traders of options in America. Your goal is to find reasonable price, per share, on a European call option for a certain company

Class Project Our goal is to find the present value, per share, of a European call on Walt Disney Company stock. Currently the stock is trading at $21.87 on January 11, 2002. The call is to expire 20 weeks later, with a strike price of $23. Our work is to be based upon the stock’s price record of weekly closes for the past 8 years.

Project Assumptions Past history cannot be used to predict the future price of a stock. If it did, then investors would move their money to the stock that would yield the best return, thereby driving up the price of that stock and destroying its value since no one would want to buy such a stock. The past history of prices for a given stock can be used to predict the amount of future variation in the price of that stock. The greater the volatility the greater the stock will fluctuate in price. All investments, whose values can be predicted probabilistically, are assumed to give the same rate of return. If this were not so, then investors would move their money to stocks that would give them the highest predicted rate of return, raising the cost of the investment and destroying its predicted rate of return

Project Assumptions We will assume that the common growth rate for all investments whose future values can be predicted is the rate of return on a United States Treasury Bill. This rate is guaranteed by the federal government All investments with the same expected rate of growth are considered to be of equal value to investors. We are choosing to ignore the fact that investors have different investing tastes and preferences. This is called the risk-neutral assumption.

What this project is NOT? We only want to determine a fair price for our European Call option on a particular company the day we purchase our option (March 25th, 2005). We don’t want to know whether the option should be purchased We don’t want to know whether stock the company should be purchased We don’t want to know the closing value of company’s stock once the option expires. How can we? Assumption 1 says we can’t !

Team Data Each team will be given a certain company to price the value of a European call option. Each team will get: Company ticker symbol Start date of the option: Friday March 25th, 2005 Strike Price Length of the Option (Expiration Date) N years of historical data The current rate guaranteed by the federal government

Preliminary Report Your team’s preliminary report will be delivered on Monday March 28th, 2005 As before, you will want to meet with your team to examine the data that you’ll be downloading (more about this later) Your team will again need to put together a presentation in powerpoint to deliver your report to determine a reasonable price for a European call option that was purchased on March 25th, 2005

Downloading Historical Data Let’s look at the class project: Let’s imagine it is January 11th, 2002. We are working at the Chicago Board of Options Exchange and need to find a reasonable price that investor would be willing to pay for European call option on Walt Disney stock. Currently the stock is trading at $21.87 on January 11, 2002. The call is to expire 20 weeks later, with a strike price of $23. Our work is to be based upon the stock’s price record of weekly closes for the past 8 years.

Visiting a Web Site Yahoo Finance Page http://finance.yahoo.com/q/hp Type in DIS for the ticker symbol of Walt Disney Stock Click on “Historical Prices” link at the top left of the page. Type in end date of January 11th, 2002. Since we want to look at 8 years of historical data, type in January 11th, 1994 as your start data

Citations All slides seen here are courtesy of and inspired by the incredibly useful learning center offered by the CBOE website.