Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Chapter 19 An Introduction to Options

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. An Option A right to buy or sell stock –at a specified price (exercise price or "strike" price) –within a specified time period The price of an option is called the "premium.”

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Call Options Option to buy –created by investors Warrants option to buy –created by a corporation

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Puts Option to sell stock –at a specified price –within a specified time period

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Intrinsic Value of an Option Depends on the value of the underlying stock Is derived from the underlying stock –hence the name "derivatives”

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Intrinsic Value of an Option The intrinsic value of an option to buy stock: the difference between –the price of the stock and –the strike (exercise) price

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. In, Out, & At the Money Options An "in" the money call option: price of the stock exceeds the exercise price (positive intrinsic value) An "out" of the money call option: exercise price exceeds the price of the stock An "at" the money call option: exercise price equals the price of the stock

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Intrinsic Value of an Option

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Intrinsic Value of an Option An option cannot sell for less than its intrinsic value An option sells for its intrinsic value on the expiration date

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Time Premium of an Option The "time" premium paid for an option: price of the option minus its intrinsic value Prior to expiration, an option sells for a time premium At expiration there is no time premium

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Time Premium of an Option

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Chicago Board Options Exchange The first secondary market in options Option prices are reported in the financial press The "open interest:” number of contracts in existence

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Options & Leverage Options are purchased for their potential leverage Percentage return on option may exceed the return on the underlying stock

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profits & Losses to Buyers of Calls Maximum potential loss is the cost of the option Unlimited possible profits

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profits & Losses to Buyers of Calls

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profits, Buying Stock & Calls Calls –limited loss Stock –large possible loss Unlimited profit potential to either long position

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profits, Buying Stock & Calls

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Writing Options Options are created ("written") by investors who either –own the underlying stock: covered option writing –do not own the underlying stock: naked option writing

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Covered Call To write a covered call: buy the stock and sell the option Combines a long in the stock and a short in the option Covered call takes advantage of the disappearing time premium Profit is limited to the time premium

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profit / Loss Profit/loss profile for covered call writing

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Naked Call To write a naked call, sell the call The maximum possible profit is the sale price Since the writer does not own the stock, unlimited risk of loss if the price of the stock rises

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Naked Call

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profit / Loss Compared When the buyer profits, the naked writer sustains a loss When the naked writer profits, the buyer sustains a loss The profit/loss on buying a call or writing a naked call are mirror images

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profit / Loss Compared

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Puts An option to sell stock –at a specified price –within a specified time period Buy a put in anticipation of the stock's price declining Sell a put in anticipation of the stock's price remaining stable or rising

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Put’s Intrinsic Value A Put's intrinsic value rises as the price of the stock declines

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profit / Loss: Buying a Put Profit/loss profile for buying a put

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profit / Loss: Writing a Put Profit/loss profile for writing a put

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profit / Loss Once again the profit/loss profiles from buying a put and writing a put are mirror images

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Profit / Loss

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Protective Put The protective put combines –the purchase of a put –with the purchase of a stock If the price of the stock declines –the value of the put rises –offsets the loss on the stock

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Index Options Put and call options based on –an index of stock prices –instead of a specific stock Avoid the risk of selecting individual securities Capture movements in the market as a whole

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Index Call Buying a stock index call –a long position in the market –anticipates a market increase Selling a stock index call –a short position against the market –anticipates a market decline

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Index Put Buying a put is made in anticipation of a market decline Both buying a stock index put or selling an index call is made in anticipation of lower stock prices

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Index Calls & Puts The risk exposure, possible profit, and cash flows differ –for selling the stock index call –or buying the stock index put

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Warrants Options to buy stock –at a specified price –within a specified time period This definition is the same as the definition of a call Buy a warrant for the potential leverage

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Warrants & Calls Compared Warrants are issued by firms Calls are written by investors A warrant’s term to expiration is generally longer The firm issues new shares when the warrant is exercised

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Rights Offerings Gives existing stockholders the right to buy additional shares Maintains stockholders’ proportionate ownership Rights may be sold

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Rights Offerings The value of a right (trading rights- on): V = (P s - P e ) / n + 1 The +1 represents the new share

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Rights Offerings The value of a right (trading ex- rights): V = (P s - P e )/ n + 1