1. Understanding options20
Understanding options
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 20-1 calls, puts, and shares Call Option Put Option
Right to buy an asset at specified price on or before exercise date
Put Option
Right to sell asset at specified price on or before exercise date
A call option is a right to buy an asset at a specified exercise price on or before the exercise date. A put option is a right to sell. Make sure to explain the difference between the two very clearly.

3. 20-1 calls, puts, and shares Option Obligations
Option buyers have the right, but not the obligation, to buy or sell the asset at the exercise price. The option sellers (writers) are obligated to sell (in the case of call option) or buy (in the case of put option) the asset at the exercise price.

4. 20-1 calls, puts, and shares Derivatives Option Premium
Financial instrument created from another instrument
Option Premium
Price paid for option, above price of underlying security
Intrinsic Value
Difference between strike price and stock price
Time Premium
Value of option above intrinsic value
Here various terminologies associated with options are described. These must be explained in detail.

5. 20-1 calls, puts, and shares Exercise Price (Strike Price)
Price at which security is bought or sold
Expiration Date
Last date on which option can be exercised
American Call
Can be exercised any time up to expiration date
European Call
Can only be exercised on expiration date
Make sure to explain the difference between closing your position vs. exercising the option. Make sure to explain the difference between European option and American option.

6. Table 20.1 options on apple stock, October 2011
Quotations for Apple stock options are provided.

7. 20-1 calls, puts, and shares Option Value
Value at expiration is a function of stock price and exercise price
Example
Option values given exercise price of $80
Value at expiration:
Stock price < exercise price: call value = 0
Stock price > exercise price: put value = 0
Stock price > exercise price: call value = stock price – exercise price Stock price < exercise price: put value = exercise price – stock price
These ideas are explained using numerical examples. Value at expiration: Stock price ($60) < exercise price ($80): call value = 0 [out-of-the-money]
Stock price ($90) > exercise price ($80): call value = stock price - exercise price = $20 [in-the-money]
Value at expiration: stock price ($100)> exercise price ($80): put value = 0 [out-of-the-money]
Stock price ($60) < exercise price ($80): put value = exercise price - stock price ($20) [in-the-money]

8. Figure 20.1a apple position diagram, call
The position diagram shows the payoff to owners of Apple call option.

9. Figure 20.1b apple position diagram, put
The position diagram shows the payoff to owners of Apple put option.

10. Figure 20.2a payoff to seller of apple call
Payoff to seller of a call option. This is a mirror image of the buyer of a call option. Profit to the buyer = loss to the seller. The seller of a call option has the unlimited potential for loss. (Ignores transaction costs.)

11. Figure 20.2b payoff to seller of apple put
Payoff to seller of a put option. This is a mirror image of the buyer of a put option. Limited potential for loss. (Ignores transaction costs.)

12. Figure 20.3a profit diagram for apple
The profit diagram is useful for analyzing profits. We can visualize the profits with the help of this diagram. Remember the usefulness of timeline in visualizing cash flows. This is for the buyer of a call option. The buyer of the call option will lose money if the stock price is below the exercise piece. As the stock price increases, profit potential is unlimited. (Ignores transaction costs.)

13. Figure 20.3b profit diagram for apple
This is the profit diagram for the seller of a put option. Seller of the put option will make a profit if the stock price is above the breakeven price. (Exercise price – price of the put option). Seller of the put option will lose if the stock price is below the breakeven price. Profit potential is limited. (Ignores transaction costs.)

14. 20-1 calls, puts, and shares Position Diagram
Long stock and short call
Share price
Position value
Poor strategy
Short call
Long stock
Position diagram for buying a stock and selling a call. (Long position in stock and short position in call.) This is not a good strategy. (Ignores transaction costs.)

15. 20-1 calls, puts, and shares Position Diagram
Protective put: long stock and long put
Share price
Position value
Protective put
Long put
Long stock
Combination of buying a stock and a put option (long position in stock and put) provides protection against falling stock prices. Loss due to a fall in the stock price is exactly offset by a gain in the put price. This strategy protects the investor from loss due to a fall in the stock price but preserves the gains if the stock price increases. This can also be thought of as insurance against falling stock price.

16. 20-1 calls, puts, and shares Position Diagram
Straddle: long call and long put
Share price
Position value
Straddle
Long put
Long call
A straddle is a combination of a put (buying a put) and a call (buying a call) in the same contract where the exercise price and maturity date are identical for both options. This provides profits when stock price volatility is high.

17. Figure 20.4 six-month payoff options, apple
Comparison of payoffs at the end of six months to three investment strategies for Apple stock. (a) You buy one share for $430. (b) No downside. If stock price falls, your payoff stays at $430. (c) A strategy for masochists? You lose if stock price falls, but you don’t gain if it rises.

18. Figure 20.5 options
Examples of options you can use to create a strategy where you lose if the stock price falls but do not gain if it rises (strategy [c] in Figure 20.4).

19. Figure 20.6 protection strategies
Each row in the figure shows a different way to create a strategy where you gain if the stock price rises but are protected on the downside (strategy [b] in Figure 20.4).

20. Figure 20.7 call to put
A strategy of buying a call, depositing the present value of the exercise price in the bank, and selling the stock is equivalent to buying a put.

21. Figure 20.8 ticket payoff
The payoff from one of Ms. Higden’s “tickets” depends on Flatiron’s stock price.

22. Figure 20.9 call purchase and sale
The solid black line shows the payoff from buying a call with an exercise price of $120. The dotted line shows the sale of a call with an exercise price of $160. The combined purchase and sale (shown by the colored line) is identical to one of Ms. Higden’s “tickets.”

23. 20-3 what determines option values?
Components of Option Price
Underlying stock price = Ps
Striking or exercise price = S
Volatility of stock returns (standard deviation of annual returns) = v
Time to option expiration = t = days/365
Time value of money (discount rate) = r
PV of dividends = D = (div)e−rt
Option price parts are:
Underlying stock price = PS
Exercise price = S
Volatility of stock return = v (or σ)
Time to expiration = t in years (days/365)
Discount rate = r
PV of dividends = D = (div)(e– rt)

24. Time decay chart
Option price
Stock price
90 days to expiration
60 days to expiration
30 days to expiration
Option price decreases, all other things equal, as time to expiration decreases
The graph shows how option price declines as time to expiration declines.

25. 20-3 what determines option values?
Upper limit
Stock price
Lower limit
(Stock price - exercise price) or 0, whichever is higher
Option price depends on these five variables.
Call Put
Underlying stock price + –
Exercise price – +
Volatility of stock return + +
Time to expiration + +
Discount rate + –

26. Figure 20.10 value of call before expiration date
The upper limit on the option value is the stock price. The lower limit is either the difference between the stock price and the exercise price or zero depending on which is higher.
The major determinants of option value are stock price and exercise price.

27. Figure 20.11 call options, firms x and y
In each case, current share price equals exercise price; each option has 50% chance of success or failure
Firm Y has greater chance of large payoff because it is more volatile
The idea that the options on volatile assets are worth more than options on safe assets is illustrated graphically. This an important characteristic of the option that distinguishes it from other types of securities.
20-27

28. Figure 20.12 apple call option value versus stock price
This is similar to time decay. As volatility increases; option value also increases.

29. Table 20.2 determinants of call price
This is a cause-effect table. What will happen to the option price given a specified variable change?

30. Table 20.3 executive stock options
This is merely a slide from the book for discussion purposes. Knowledge of the book example is required.