1. Options: Puts and Calls
Chapter 14
Options: Puts and Calls

2. Options: Puts, Calls and Warrants
Financial Asset: asset that represents a financial claim on an issuing organization
Stocks, bonds and convertible securities are examples
Option: the right to buy or sell a certain amount of an underlying financial asset at a specified price for a given period of time

3. Types of Options Types of Options
Puts
Calls
Rights
Warrants
All of the above are types of derivative securities, which derive their value from the price behavior of an underlying real or financial asset

4. Options: Puts and Calls
Puts and calls may be traded on:
Common stocks
Stock indexes
Exchange traded funds
Foreign currencies
Debt instruments
Commodities and financial futures
Owners of put and call options have no voting rights, no privileges of ownership, and no interest or dividend income

5. Options: Puts and Calls (cont’d)
Options allow buyers to use leverage; investors can benefit from stock-price movements without having to invest a lot of capital
A given percentage change in a stock’s price usually generates a larger percentage change in an option’s price
Puts and calls are created by individual investors, not by the organizations that issue the underlying financial asset

6. Options: Puts and Calls (cont’d)
Option Buyer
Has the right to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a fixed price (called the exercise price or strike price) for a given period of time
To acquire this right, the option buyer must pay the option seller a fee known as the option premium (or option price)
Buyers do not have to exercise their options; they can walk away if exercising the option isn’t profitable

7. Options: Puts and Calls (cont’d)
Option Seller (also called the option writer)
Receives the option premium from the buyer up front
Has the obligation to sell (in the case of a call option) or buy (in the case of a put option) the underlying asset according to the terms of the option contract
Whereas option buyer can walk away if exercising the option is unprofitable, option seller cannot walk away

8. Options: Puts and Calls (cont’d)
Put and call options trade in the open market much like any other security and may be bought and sold through securities brokers and dealers
Values of puts and calls change with the values of the underlying assets
Other factors influence option prices (e.g., an option’s value is usually higher if there is more time before the option expires)

9. Advantages of Puts and Calls
Allows use of leverage
Leverage: the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return
Option buyer’s potential loss is limited to fee paid to purchase the put or call option
Investors can make money when value of assets go up or down

10. Disadvantages of Puts and Calls
Investor does not receive any interest or dividend income
Options expire; the investor has limited time to benefit from options before they become worthless
Options are risky; a small change in the price of the underlying asset may make an option worthless
Option seller’s exposure to risk may be unlimited

11. How Calls Work
Call: an option that gives the holder (buyer) the right to buy the underlying security at a specified price over a set period of time
The buyer of the call option wants the price of the underlying asset to go up
The seller of the call option wants the price of the underlying asset to go down

12. How Calls Work (cont’d)
If the price of the underlying asset goes above the option’s strike price:
The option holder will purchase the asset at the strike price and then sell it at the higher market price, making a profit
The option writer must sell the asset at the strike price (which is lower than the asset’s market price).
If the seller does not already own the underlying asset, then the seller will have to purchase it at the higher market price
Covered call: seller owns the underlying asset
Naked call: seller does not own the underlying asset

13. How Calls Work (cont’d)
If the price of the underlying asset goes down:
The buyer will let the call option expire worthless and lose the option premium
The seller will keep the option premium and make a profit

14. How Calls Work (cont’d)
Example: Assume the market price for a share of common stock is $50. An investor buys a call option which grants the right to purchase 100 shares of the stock at a strike price of $50. The call premium is $500
If the market price of the stock goes up to $75 per share, the investor will exercise the right to purchase 100 shares for $50. The investor then sells the shares on the open market for $75.
The investor’s net profit will be:
The option seller’s loss will be:
Notice that the buyer’s profit equals the seller’s loss; options are a zero-sum game

15. How Calls Work: The Value of Leverage
In the previous example, the option buyer makes a profit of $2,000 after investing just $500 in capital
The buyer’s total return using the call option was:
Rather than buying the option, the investor might have simply purchased 100 shares of stock directly. At a price of $50 per share, the cost of 100 shares would have been $50,000. If the share price had risen to $75, the investor would have earned a $2,500 profit. The total rate of return on the investment would have been:
The same $25 increase in the stock price generates a much higher rate of return for the option investor than for an investor who buys stocks directly

16. How Calls Work (cont’d)
Example: Assume the market price for a share of common stock is $50. An investor buys a call option to purchase 100 shares of the stock at a strike price of $50 per share. The option premium is $500.
If the market price of the stock goes down to $25 per share, the investor will allow the call option to expire worthless.
The option buyer’s loss will be:
The option seller’s profit will be equal to the option premium:

17. How Puts Work
Put: an option that enables the holder (buyer) to sell the underlying security at a specified price over a set period of time
The buyer of the put option wants the price of the underlying asset to go down
The seller of the put option wants the price of the underlying asset to go up

18. How Puts Work (cont’d)
If the price of the underlying asset goes below the put option’s strike price:
The put owner will buy the underlying asset, paying the open-market price, and then force the put seller to buy the asset at the higher strike price, making a profit
The seller will pay a price higher than the market price
If the price of the underlying asset goes up:
The buyer will let the put option expire worthless and lose the option premium
The seller will keep the option premium and make a profit

19. How Puts Work (cont’d)
Example: Assume the market price for a share of common stock is $50. An investor buys a put option that grants the right to sell 100 shares of the stock at a strike price of $50. The option premium is $500.
If the market price of the stock goes down to $25 per share, the investor will purchase 100 shares of stock in the open market for $25 each. Then the investor exercises his right to sell those shares to the put seller for $50 each
The buyer of the put option earns a profit of $2,000:
The seller’s loss will be:

20. How Puts Work (cont’d)
Example: Assume the market price for a share of common stock is $50. A put option to sell 100 shares of the stock at a strike price of $50 per share may be purchased for $500.
If the market price of the stock goes up to $75 per share, the buyer will allow the put option to expire worthless.
The buyer’s loss will be:
The seller/maker/writer’s profit will be:

21. Put and Call Options Markets
Conventional (OTC) Options
Sold over the counter
Primarily used by institutional investors
Listed Options
Created in 1973 by the Chicago Board Option Exchange (CBOE)
Puts and calls traded through CBOE exchange, as well as International Securities Exchange, AMEX, Philadelphia exchange, NYSE Arca and Boston Options Exchange.
Provided convenient market that made options trading more popular and help create a secondary market
Helped standardize expiration dates and exercise/strike prices
Reduced trading costs

22. Stock Options Common Stock Options
Several billion option contracts are traded each year
Options on common stocks are the most popular form of option
Over 90% of all option contracts are stock options

23. Key Provisions of Stock Options
Strike Price
Stated price at which you can buy a security with a call or sell a security with a put
Conventional (OTC) options may have any strike price
Listed options have standardized prices with price increments determined by the price of the stock
Expiration Date
Stated date when the option expires and becomes worthless if not exercised
Conventional (OTC) options may have any working day as expiration date
Listed options have standardized expiration dates

24. Figure 14.1 Quotations for Listed Stock Options
Source: quotemedia.com, accessed August 8, 2012.

25. Expiration Date of Listed Stock Options
Three Expiration Cycles
The January/April/July/October cycle
The February/May/August/November cycle
The March/June/September/December cycle
The longest-term expiration dates are normally no longer than nine months
The options that are longer than nine months are called LEAPS, and they are only available on some of the stocks
Listed options always expire on the third Friday of the month of expiration

26. Valuation of Stock Options
Option Premium (Price): the quoted price the investor pays to buy a listed put or call option
Option premiums (prices) are affected by:
Intrinsic value: based upon current market price of underlying assets
Time Premium: amount that option price exceeds the fundamental value

27. Intrinsic Value of a Call Option
The intrinsic value of a call option equals the difference between the market price of the stock and the strike price of the option, or zero, whichever is greater
Example: Suppose a call option has a strike price of $50
If the underlying stock price is $75, the call’s intrinsic value is $25 (actually, $2,500 because the call grants the right to buy 100 shares)
If the underlying stock price is $25, the call’s intrinsic value is $0

28. Intrinsic Value of a Put Option
The intrinsic value of a put option equals the difference between the strike price of the option and the market price of the stock, or zero, whichever is greater
Example: Suppose a put option has a strike price of $50
If the underlying stock price is $25, the put’s intrinsic value is $25 (actually $2,500 because the put grants the right to sell 100 shares)
If the underlying stock price is $75, the put’s intrinsic value is $0

29. Figure 14.2 The Valuation Properties of Put and Call Options

30. Valuation of Stock Options
In-the-Money
Call option: when the strike price is less than the market price of the underlying security
Put option: when the strike price is greater than the market price of the underlying security
When an option is in the money, its intrinsic value is greater than zero
Out-of-the-Money
Call option: when the strike price is greater than the market price of the underlying security
Put option: when the strike price is less than the market price of the underlying security

31. Option Pricing Models
The best known option pricing model is the Black and Scholes Model
The model states that an option’s price depends on five variables
The option’s strike price
The option’s expiration date
The price of the stock
The risk free rate of interest
The stock’s volatility

32. Option Trading Strategies
Buying for Speculation
Hedging to modify risks
Writing Options to enhance returns
Spreading Options to enhance returns

33. Stock-Index Options
Stock-Index Option: a put or call option written on a specific stock market index
Major stock indexes for options:
The S&P 500 Index
The S&P 100 Index
The Dow Jones Industrial Average
The Nasdaq 100 Index

34. Stock-Index Options (cont’d)
Market price is function of strike price of option and latest published stock market index value
Valuation techniques are similar to valuing options for individual securities
Price behavior and investment risk are similar to options for individual securities
May be used to hedge a whole portfolio of stocks rather than individual stocks
May be used to speculate on the stock market as a whole

35. Other Types of Options
Exchange traded funds: put and call options written on exchange traded funds (EFT’s)
Very similar to market index options
Interest rate options: put and call options written on fixed-income (debt) securities
Small market involving only U.S. Treasury securities
Option prices change with yield behavior of debt securities

36. Other Types of Options (cont’d)
Currency options: put and call options written on foreign currencies
Available on most major world currencies
Option prices change as exchange rates between currencies fluctuate
LEAPS: long-term options that may extend out to 3 years
Available on several hundred stocks and over two dozen stock indexes and ETF’s