1. CHAPTER NINETEEN Options CHAPTER NINETEEN Options Cleary / Jones Investments: Analysis and Management

2. Learning Objectives n To define options and discuss why they are used n To describe how options work and give some basic strategies n To explain the valuation of options n To identify types of options other than puts and calls

3. OptionsOptions n Call (Put): Buyer has the right, but not the obligation, to purchase (sell) a fixed quantity from (to) the seller at a fixed price before a certain date –Exercise (strike) price: “fixed price” –Expiration (maturity) date: “certain date” n Option premium or price: paid by buyer to the seller to get the “right”

4. Why Options Markets? n Financial derivative securities: derive all or part of their value from another (underlying) security n Options are created by investors, sold to other investors n Why trade these indirect claims? –Expand investment opportunities, lower cost, increase leverage

5. How Options Work n Call buyer (seller) expects the price of the underlying security to increase (decrease or stay steady) n Put buyer (seller) expects the price of the underlying security to decrease (increase or stay steady) n Possible courses of action –Options may expire worthless, be exercised, or be sold prior to expiry

6. Options Trading n Options exchanges –Chicago Board Options Exchange (CBOE) –Chicago Mercantile Exchange (CME) –TSE-traded options n Standardized exercise dates, exercise prices, and quantities –Facilitate offsetting positions through a clearing corporation n Clearing corporation is guarantor, handles deliveries

7. Options Characteristics n In-the-money options have a positive cash flow if exercised immediately –Call options: S > E –Put options: S < E n Out-of-the-money options should not be exercised immediately –Call options: S < E –Put options: S > E

8. n Intrinsic value is the value realized from immediate exercise –Call options: maximum (S 0 -E or 0) –Put options: maximum (E-S 0 or 0) n Prior to option maturity, option premiums exceed intrinsic value Time value = Option price - Intrinsic value Options Characteristics

9. 25 27 29 4 0 -4 Stock Price at Expiration Profit per Option ($) How does buying a stock compare with buying a call option? Buyer Seller Payoff Diagram for a Call Option

10. 23 25 27 4 0 -4 Stock Price at Expiration Profit per Option ($) How does selling a stock compare with buying a put option? Buyer Seller Payoff Diagram for a Put Option

11. Covered Call Writing 23 25 27 29 4 0 -4 Stock Price at Expiration Profit ($) Purchased share Written call Combined

12. Protective Put Buying 23 25 27 29 4 0 -4 Stock Price at Expiration Profit ($) Combined Purchased put Purchased share

13. Portfolio Insurance n Hedging strategy that provides a minimum return on the portfolio while keeping upside potential n Buy protective put that provides the minimum return –Put exercise price greater or less than the current portfolio value? n Problems in matching risk with contracts

14. Portfolio Insurance 23 25 27 29 2 0 -2 Stock Price at Expiration Profit ($) Combined Purchased put Purchased share

15. Should Options be Exercised Early? n Exercise prior to maturity implies the option owner receives intrinsic value only, not time value –For call options, buy stock at below market price n Would more be earned by selling option? –For put options, receive cash from selling stock at above market price n Could cash be reinvested for a higher return?

16. Option Price Boundaries n At maturity, option prices are equal to their intrinsic values –Intrinsic value is minimum price prior to maturity n Maximum option prices prior to maturity –Call options: price of stock, S 0 –Put options: exercise price, E

17. Stock Prices Call Prices E Put Prices Option Price Boundaries Stock Prices E E C =S

18. Black-Scholes Model n Five variables needed to value a European call option on a non-dividend paying stock n The Black-Scholes pricing formula is:

19. Put-Call Parity n Black-Scholes valuation is for call options n Put-call parity shows relationship between call and put options so that riskless arbitrage is not possible Price of put = (EP/e rt ) - CMP +CP n Put replicated by riskless lending, short sale of stock, purchased call

20. Factors Affecting Prices

21. Riskless Hedging n Options can be used to control the riskiness of common stocks –If stock owned, sell calls or buy puts n Call or put option prices do not usually change the same dollar amount as the stock being hedged –Shares purchased per call written = N(d 1 ) –Shares purchased per put purchased = N(d 1 ) - 1

22. Stock-Index Options n Options available on S&P/TSE 60 Index, S&P 500 Index, NYSE Index, etc. n Bullish on capital markets implies buying calls or writing puts n Bearish on capital markets implies buying puts or writing calls n At maturity or upon exercise, cash settlement of position

23. Strategies with Stock-Index Options n Speculation opportunities similar to options on individual stocks n Hedging opportunities permit the management of market risk –Well-diversified portfolio of stocks hedged by writing calls or buying puts on stock index –What return can investor expect?