McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15 Put and Call Options

15-2 Objectives Understand the basic concept of an option Understand the basic concept of an option Distinguish between put and call options Distinguish between put and call options Define strike price, intrinsic value, and speculative premium Define strike price, intrinsic value, and speculative premium

15-3 Objectives cont. Describe speculative and hedging strategies with options Describe speculative and hedging strategies with options Explain how option contracts are closed out at expiration Explain how option contracts are closed out at expiration Be aware of the tax and commission factors associated with options Be aware of the tax and commission factors associated with options

15-4 Put and Call Options Options Markets Options Markets The Options Clearing Corporation The Options Clearing Corporation Basic Option Strategies Basic Option Strategies Using Options in Combinations Using Options in Combinations Other Option Considerations Other Option Considerations Appendix 15A: The Black-Scholes Option Pricing Model Appendix 15A: The Black-Scholes Option Pricing Model Appendix 15B: The Use of Options Spreads and Straddles Appendix 15B: The Use of Options Spreads and Straddles

15-5 Webster’s Definition of Option “the right, acquired for a consideration, to buy or sell something at a fixed price within a specified period of time”

15-6 Option Contract entered between two parties where choice of action or decision can be put off for limited time at a cost Contract entered between two parties where choice of action or decision can be put off for limited time at a cost Person acquiring option pays an agreed- upon sum to person providing the option Person acquiring option pays an agreed- upon sum to person providing the option

15-7 Most Widely Known Options Put (on common stock) Put (on common stock) Allows the option buyer (owner) the right to sell 100 shares of common stock at a specified price for a given period to the option seller (writer)Allows the option buyer (owner) the right to sell 100 shares of common stock at a specified price for a given period to the option seller (writer) Call (on common stock) Call (on common stock) Allows the option buyer (owner) the right to buy 100 shares of common stock at a specified price for a given period from the option sellerAllows the option buyer (owner) the right to buy 100 shares of common stock at a specified price for a given period from the option seller

15-8 Options Markets Contracts on listed puts and calls have been standardized and can be bought on several different exchanges Contracts on listed puts and calls have been standardized and can be bought on several different exchanges Options Clearing Corporation is equally owned by its major trading exchanges Options Clearing Corporation is equally owned by its major trading exchanges

15-9 Listed Options Exchanges Over 2,600 individual equity options trade on options exchanges Over 2,600 individual equity options trade on options exchanges Options on stock indexes Options on stock indexes

15-10 Options Data, Options Clearing Corporation Yearly Contract Volume Statistics

15-11 American Stock Exchange AMEX Philadelphia Exchange PHLX Chicago Board Options Exchange CBOE International Securities Exchange ISE Listed Options Exchanges

15-12 Listed Options Exchanges continued Long-term equity anticipation securities (LEAPS) Long-term equity anticipation securities (LEAPS) Long-term options (up to two years of expirationsLong-term options (up to two years of expirations

15-13 Listed Options Exchanges continued Standardized expiration dates Standardized expiration dates Cycle 1: January/April/OctoberCycle 1: January/April/October Cycle 2: February/May/August/NovemberCycle 2: February/May/August/November Cycle 3: March/June/September/DecemberCycle 3: March/June/September/December Standardized exercise price Standardized exercise price Price the option contract specifies for buy or sellPrice the option contract specifies for buy or sell Intervals of $5 for stocks over $25Intervals of $5 for stocks over $25 Intervals of $2.50 for stocks under $25Intervals of $2.50 for stocks under $25

15-14 The Options Clearing Corporation Function: the issuer of all options listed Function: the issuer of all options listed

15-15 Option Premiums Amount per share option buyer pays to seller Amount per share option buyer pays to seller Premium is primarily affected by Premium is primarily affected by Difference between stock price & strike priceDifference between stock price & strike price Time remaining for option to be exercisedTime remaining for option to be exercised Volatility of the underlying stockVolatility of the underlying stock Interest ratesInterest rates Market conditionsMarket conditions Dividend rate of the underlying stockDividend rate of the underlying stock

15-16 Common stock closed at $18.93 per share Calls & puts available at variety of strike prices from $15 to $25 Calls & puts available at variety of strike prices from $15 to $25 Calls allow option holder to buy stock at the strike price Calls allow option holder to buy stock at the strike price Puts allow option holder to sell stock at the strike price Puts allow option holder to sell stock at the strike price January calls closed at 2.80 $280 for 1 call on 100 shares January calls closed at 2.80 $280 for 1 call on 100 shares January 20 call closed at 1.50 January 20 call closed at & call options are said to be in-the-money 15 & call options are said to be in-the-money

15-17 Intrinsic Value Intrinsic Value In-the-money call options In-the-money call options Intrinsic value = market price - strike price Intrinsic value = market price - strike price January call option January call option Intrinsic value = $ $17.50 =$1.43 Options that are out-of-the-money have negative intrinsic value Options that are out-of-the-money have negative intrinsic value Options that are at-the-money have a strike price and stock price that are equal Options that are at-the-money have a strike price and stock price that are equal

15-18 Intrinsic Value Continued In-the-money put has a value in the opposite direction from the call Intrinsic value = Strike price - Market price Intrinsic value = Strike price - Market price January 20 put option January 20 put option Intrinsic value = $ $18.93 = $1.07 Intrinsic value = $ $18.93 = $1.07

15-19 Speculative Premium Components of Total Premium on a Call Option Intrinsic valueSpeculative premium Market price – Strike price Option price – Intrinsic value + +

15-20 Speculative Premium cont. The higher the volatility of the common stock & The lower the dividend yield The greater the speculative premium The longer the exercise period The higher the speculative premium The deeper the option is in the money The smaller the leverage potential and therefore The smaller the speculative premium

15-21 January 15 call option has lowest speculative premium January 25 call option has highest speculative premium 25 call option has a cash value of only 0.30 (the total premium) 6.07 required increase in stock price market price = strike price 33.65% = speculative premium January 25 call option represents percentage movement in stock price by expiration date for a break-even position

15-22 Speculative Premiums and the Time Factor Percent speculative premiums increase with time across all series of strike prices Percent speculative premiums increase with time across all series of strike prices

15-23  % speculative premiums increase with time across all series strike prices  Speculative premiums are lowest with in-the-money 15 & 7.50 calls  Commissions eat a good portion of cash inflow

15-24 Speculative Premiums, Betas, and Dividend Yields High-beta stocks have higher speculative premiums High-beta stocks have higher speculative premiums Stocks with low dividend yields more likely to have higher speculative premiums Stocks with low dividend yields more likely to have higher speculative premiums

15-25  High-beta stocks highest speculative premiums  Low dividend yield high speculative premium  High dividend yield low speculative premium

15-26 Option Premium - Other Factors Market conditions Market conditions Individual (current) company conditions Individual (current) company conditions Future expectations for a company Future expectations for a company Interest rates Interest rates

15-27 Speculative Premiums per Day Call writers should write short-lived calls on a continuous basis to get a maximum return Call writers should write short-lived calls on a continuous basis to get a maximum return Call buyers should buy long-lived calls to get more time for less premium per day Call buyers should buy long-lived calls to get more time for less premium per day

15-28 Basic Option strategies Very aggressive & risky risky Conservative Speculators Reduce risk

15-29 Buying Call Options The Leverage Strategy   Useful when market is expected to rise   Similar to buying warrants   Call options have shorter lives than warrants   Call options are priced much lower than common stock   Leverage derived from a small % change in the price of call option

15-30 November Call Option Quotes over Three Months

15-31 The Leverage Strategy November 15 call option increased by 13.1 times the percentage move in the common stock price

15-32 SINGLE Systems November 15 Call Option (excludes commissions) Assumes option is held until day of expiration (no speculative premium exists at expiration

15-33 Objectives - Buying Call Options Maximum leverage Maximum leverage Buy out-of-the-money or slightly in-the-moneyBuy out-of-the-money or slightly in-the-money Buy call options instead of stock Buy call options instead of stock Risk smaller amount of moneyRisk smaller amount of money Can reduce losses when stock prices are falling by significant amount Can reduce losses when stock prices are falling by significant amount Can increase losses when stock prices are falling by small amountCan increase losses when stock prices are falling by small amount

15-34 Objectives - Buying Call Options continued Protecting a short position Protecting a short position Reduces risk of rising stock pricesReduces risk of rising stock prices Reduces profit of short position by total premium paid for callReduces profit of short position by total premium paid for call

15-35 Objectives - Buying Call Options continued Guaranteed price Guaranteed price Allows investor to purchase the stock at the exercise price after the price of the stock has increasedAllows investor to purchase the stock at the exercise price after the price of the stock has increased If stock price declines, buy the stock at the lower price and consider option premium as insurance policyIf stock price declines, buy the stock at the lower price and consider option premium as insurance policy

15-36 Writing Call Options Writers of options take opposite side of the market from buyers Writers of options take opposite side of the market from buyers Writer is similar to short seller Writer is similar to short seller Expects stock to decline or stay the sameExpects stock to decline or stay the same Writers profit when prices decline or stay the same Writers profit when prices decline or stay the same Writers of call options receive speculative premiumWriters of call options receive speculative premium

15-37 Writing Call Options Write Covered Options Write Covered Options Writer owns the underlying common stockWriter owns the underlying common stock Considered a hedged positionConsidered a hedged position if the stock price declines, writer’s loss on stock is partially offset by option premium if the stock price declines, writer’s loss on stock is partially offset by option premium Write Naked options Write Naked options Writer does not own the underlying common stockWriter does not own the underlying common stock

15-38 Bow Wing 35 November Call, Payoff Graph for Writing One Naked Call

15-39 Bow Wing 35 November Call, Payoff Graph for Writing One Naked Call

15-40 Buying Put Options  Owner (buyer) of a put may Sell 100 shares of stock to the put writer at the strike priceSell 100 shares of stock to the put writer at the strike price  Put strategy is similar to Selling short orSelling short or Writing a call, except:Writing a call, except:  Loss limited to total investment (premium)  No risk exposure if stock rises  Buy a put in anticipation of price decline

15-41 Using Options in Combinations: Spreads Combinations of options are called spreads Combinations of options are called spreads Spreads consist of: Spreads consist of: Buying one option (going long) Writing an option (going short) Same underlying stock Same underlying stock AND On

15-42 Using Options in Combinations: Straddle Buy a call Buy a put Same stock Same stock Same strike price Same strike price Same expiration date Same expiration date AND On

15-43 Straddles Used to play wide fluctuations in stock prices Used to play wide fluctuations in stock prices Usually applied to stocks with Usually applied to stocks with High betasHigh betas History of large, short-term fluctuations in priceHistory of large, short-term fluctuations in price Speculator unsure of direction of price Speculator unsure of direction of price Enough profit on one side to cover cost of both options even if one expires worthlessEnough profit on one side to cover cost of both options even if one expires worthless

15-44 Other Option Considerations Tax laws relating to options constantly changing Tax laws relating to options constantly changing Significant impact onSignificant impact on Spread positions Spread positions Put options Put options Recognition of the year gain or loss is declared can affect option strategiesRecognition of the year gain or loss is declared can affect option strategies

15-45 Other Option Considerations continued Commissions vary for option transactions Commissions vary for option transactions Can significantly alter returns or even create lossesCan significantly alter returns or even create losses Commissions on acquiring stock through options are higher than transaction costs of options Commissions on acquiring stock through options are higher than transaction costs of options Better to close out option transactions before expirationBetter to close out option transactions before expiration Commissions on options higher than commodities or other highly leveraged investments Commissions on options higher than commodities or other highly leveraged investments

15-46 WebsitesComments Chicago Board Options Exchange website. A good source of education and data American Stock Exchange trades options and has a website section on options

15-47 Appendix 15A The Black-Scholes Option Pricing Model

15-48 Theory Started with three securities: Riskless bonds Shares of common stock Call options Shares of common stock and call options were combined to form a riskless hedge that Had to duplicate the return of a discount bond with the same maturity length as the option Using riskless-hedge concept as basis, Black and Scholes created their model Using riskless-hedge concept as basis, Black and Scholes created their model

15-49 Theory Black and Scholes assumptions: 1. Markets are frictionless i.e. there are no taxes or transactions costsno taxes or transactions costs all securities are infinitely divisibleall securities are infinitely divisible all market participants may borrow & lend at the known & constant riskless rate of interestall market participants may borrow & lend at the known & constant riskless rate of interest there are no penalties for short sellingthere are no penalties for short selling

15-50 Theory Black and Scholes assumptions: 2. 2.Stock prices are lognormally distributed, with a constant variance for the underlying returns 3. The stock neither pays dividends nor makes any other distributions 4. The option may be exercised only at maturity

15-51 Appendix 15B The Use of Option Spreads and Straddles

15-52 The Use of Option Spreads and Straddles Vertical spreads - Buying and writing two contracts at different Buying and writing two contracts at different striking prices with same month of expiration striking prices with same month of expiration Horizontal spreads – Buying and writing two options with the same strike price but different months Buying and writing two options with the same strike price but different months Diagonal spreads – Combination of the vertical and horizontal spreads Combination of the vertical and horizontal spreads

15-53 Anticipate increase in common stock price Anticipate increase in common stock price Limit both maximum gain and maximum loss Limit both maximum gain and maximum loss Buy expensive in-the-money and sell inexpensive out-of-the-money call option Buy expensive in-the-money and sell inexpensive out-of-the-money call option Vertical Bull Spread

15-54 Profit on Vertical Bull Spread XYZ Vertical Bull Spread

15-55 Profit and Loss Relationships on Spreads and Calls

15-56 Vertical Bear Spread Anticipate decline in common stock price Anticipate decline in common stock price Sell short the call with the lower strike price (highest premium) and purchase call with higher strike price (lowest premium) Sell short the call with the lower strike price (highest premium) and purchase call with higher strike price (lowest premium)

15-57 XYZ Vertical Bear Spread