2. Derivative Securities (Options): Puts & Calls

3. Lockheed Martin (LMT) Transactions TransactionCost BasisSale PriceGain (Loss) Short 1,000 LMT @ 51.99 -$54,225+$51,965-$2,260 Net Gain or (Loss) -$2,260

4. Lockheed Martin (LMT) Transactions TransactionCost BasisSale PriceGain (Loss) Short 1,000 LMT @ 51.99 -$54,225+$51,965-$2,260 Buy 10 LMT- Mar-55 Calls -$925+$3,175+$2,250 Net Gain or (Loss) +$1,165

5. Lockheed Martin (LMT) Transactions TransactionCost BasisSale PriceGain (Loss) Short 1,000 LMT @ 51.99 -$54,225+$51,965-$2,260 Buy 10 LMT- Mar-55 Calls -$925+$3,175+$2,250 Sell 10 LMT- Jun-45 Puts -$425+$1,225+$800 Net Gain or (Loss) +$1,165

6. Lockheed Martin (LMT) Transactions TransactionCost BasisSale PriceGain (Loss) Short 1,000 LMT @ 51.99 -$54,225+$51,965-$2,260 Buy 10 LMT- Mar-55 Calls -$925+$3,175+$2,250 Sell 10 LMT- Jun-45 Puts -$425+$1,225+$800 Sell 10 LMT- Jun-50 Puts -$800+$1,175+$375 Net Gain or (Loss) +$1,165

7. Types of Options Rights Warrants Convertibles Puts Calls

8. A Growing Market – puts and calls can be traded on: Common Stock Stock Indexes Debt Instruments Foreign currencies Commodities Financial futures

9. Why so much interest in options? “…investors can buy a lot of price action with a limited amount of capital, while nearly always enjoying limited exposure to risk.”

10. Why Options? A basic question asked by investors is: “Why buy stock options instead of shares in the underlying stock?” To answer this question, we compare the possible outcomes from these two investment strategies: –Buy the underlying stock –Buy options on the underlying stock

11. Example: Buying the Underlying Stock versus Buying a Call Option Suppose IBM is selling for $90 per share and call options with a strike price of $90 are $5 per share. Investment for 100 shares: –IBM Shares: $9,000 –One listed call option contract: $500 Suppose further that the option expires in three months. Finally, let’s say that in three months, the price of IBM shares will either be: $100, $80, or $90.

12. Example: Buying the Underlying Stock versus Buying a Call Option, Cont. Let’s calculate the dollar and percentage return given each of the prices for IBM stock: Buy 100 IBM Shares ($9000 Investment): Buy One Call Option ($500 Investment): Dollar Profit: Percentage Return: Dollar Profit: Percentage Return: Case 1: $100$1,00011.11%$500100% Case 2: $80-$1,000-11.11%-$500-100% Case 3: $90$00%-$500-100%

13. Why Options? Conclusion Whether one strategy is preferred over another is a matter for each individual investor to decide. –That is, in some instances investing in the underlying stock will be better. In other instances, investing in the option will be better. –Each investor must weight the risk and return trade-off offered by the strategies. It is important to see that call options offer an alternative means of formulating investment strategies. –For 100 shares, the dollar loss potential with call options is lower. –For 100 shares, the dollar gain potential with call options is lower. –The positive percentage return with call options is higher. –The negative percentage return with call options is lower.

15. Characteristics of Options “Derivative” Securities - obtain their value from the underlying issue Contract to buy or sell other securities

16. Characteristics of Options No ownership interest in the underlying company (dividends; voting rights, etc.) Provide leverage through a fixed purchase price - exaggerates any gain or loss

17. Option Exchanges Chicago Board Options Exchange (CBOE) Established in 1973 cboe.org - professional traders cboe.com - private investors

18. Option Exchange Features Central marketplace vs. O-T-C Secondary market Option Clearing Corporation (OCC)

19. The Options Clearing Corporation The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised. The OCC issues and clears all option contracts trading on U.S. exchanges. Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC). Visit the OCC at: www.optionsclearing.com. www.optionsclearing.com

20. Buyer-Seller Relationship (pre-CBOE)

21. Buyer-Seller Relationship (Post-CBOE)

22. Option Exchange Features Standardized Terms: –contract size –expiration dates –exercise (striking) price

23. Basic Option Terms (listed equity options) Call Option: contract to buy stock 100 shares of stock exercise price set by exchange expires on fixed date – 3 rd Friday of the expiration month

24. Basic Option Terms (listed equity options) Put Option: contract to sell stock 100 shares of stock exercise price set by exchange expires on fixed date – 3 rd Friday of the expiration month

25. Basic Option Terms Call - contract to:Call - contract to: Buy 100 sharesBuy 100 shares Fixed priceFixed price Specified termSpecified term Put - contract to:Put - contract to: Sell 100 sharesSell 100 shares Fixed priceFixed price Specified termSpecified term

26. Option Jargon “Striking Price” - price at which the contract is exercised or carried out Example: –XYZ-AUG-30; “30” is the striking price, or exercise price of the option

27. Option Jargon “Expiration Date” - maturity date; the third Friday of the expiration month Example: –XYZ-AUG-30; option expires on the third Friday of August

28. Option Jargon “Option Writer (Maker)” - seller of an option contract

29. Option Jargon “Covered Writer” - already owns shares of the underlying stock; can deliver shares if exercised

30. Option Jargon “Naked Writer” - does not own shares of the underlying stock; must buy shares if exercised

31. Option Jargon [Call Options]  “In the Money” - stock price greater than exercise price

32. Option Jargon [Call Options]  “Out of the Money” - stock price less than exercise price

33. Option Jargon [Call Options]  “At the Money” - stock price = exercise price

34. Option Pricing [Three Prices to Consider] 1.Underlying stock price per share 2.Exercise (striking) price of the option contract 3.Price (Premium) of the option contract

35. Call Option Pricing Option premium reflects: Intrinsic value of the option, plus the option’s time value Premium = IV + TV Time Value = Premium - IV

36. Call Option Pricing [ABC-MAY-80] Intrinsic value (IV):  IV = Stock price - exercise price  IV = $81.75 - $80.00 = $1.75

37. Call Option Pricing [ABC-MAY-80] Time value (TV):  TV = premium - intrinsic value  TV = $3.75 - $1.75 = $2.00

39. Listed Option Quotes on the Web

41. Put Option Pricing [ABC-JUL-80] Intrinsic value (IV):  IV = Exercise price - stock price  IV = $80.00 - $79.00 = $1.00

42. Put Option Pricing [ABC-JUL-80] Time value (TV):  TV = premium - intrinsic value  TV = $3.00 – 1.00 = $2.00

43. Option Strategies

48. FIGURE 11.2 The Valuation Properties of Put and Call Options FIGURE 11.2 The Valuation Properties of Put and Call Options

50. Option Trading Strategies Buying options for speculation Hedging with puts and calls Option writing and spreading

51. Buying Options for Speculation Same motivation as buying stock “Buy low, sell high” Smaller investment - greater leverage Limited loss

52. Hedging with Puts and Calls Combination of two or more securitiesCombination of two or more securities :Objectives: –To earn or protect a profit –Limit losses

53. Hedging with Puts and Calls Examples:Examples: –buy stock; sell a put –sell short; buy a call Lockheed Martin transactions

54. Lockheed Martin (LMT) Transactions TransactionCost BasisSale PriceGain (Loss) Short 1,000 LMT @ 51.99 -$54,225+$51,965-$2,260 Buy 10 LMT- Mar-55 Calls -$925+$3,175+$2,250 Sell 10 LMT- Jun-45 Puts -$425+$1,225+$800 Sell 10 LMT- Jun-50 Puts -$800+$1,175+$375 Net Gain or (Loss) +$1,165

55. Option Writing and Spreading

56. Call Option Spread Strategies Spread: buying and selling different options at the same time

57. Call Option Spread Strategies Money, or vertical spreads Time, or calendar spreads “Butterfly” spreads

58. Call Option Spread Strategies “Money” or “vertical” spread: same month, different exercise prices

59. Call Option Spread Strategies Example: –buy Compq-May-40 –sell Compq-May-45 –objective: price between $40 - $45

60. Call Option Spread Strategies “Time” or “calendar” spread: different expiration dates

61. Call Option Spread Strategies Example: –buy Compq-Jun-40 –sell Compq-May-40 –objective: timed appreciation

62. Call Option Spread Strategies “Butterfly” spread: buy and sell different options at same time“Butterfly” spread: buy and sell different options at same time Example:Example: –buy 1 XYZ-Jul-80 ($7.375) –sell 2 XYZ-Jul-90 ($6.500) –buy 1 XYZ-Jul-100 ($1.250)

63. Index Options Put or call written on a market index –S & P 500 –S & P 100 –DJIA

64. Index Options Settled in cash 100 times index value Example (S & P 500): –1,418 (Value) – 1,400 (Strike) = 18 –18 x 100 = $1,800

65. Stock Index Options Because the actual delivery of all stocks comprising a stock index is impractical, stock index options have a cash settlement procedure. –if the option expires in the money, the option writer simply pays the option holder the intrinsic value of the option.

66. Using Index Options SpeculatingSpeculating Small investmentSmall investment LeverageLeverage Limited lossLimited loss HedgingHedging Portfolio approachPortfolio approach “have your cake; eat it too”“have your cake; eat it too” Limited lossLimited loss

67. “LEAPS” Options Long-term Equity AnticiPation Securities Maturities up to 3 years Similar to options in other respects: –100 shares –buy or sell at a specified price –stated maturity date

68. Black-Scholes Option Pricing Model Stock PriceStock Price Exercise PriceExercise Price Time RemainingTime Remaining Risk-free rateRisk-free rate Variability of stock (  )Variability of stock (  )

69. Black-Scholes Option Pricing Model