1. 20-1 FIN 200Investments CHAPTER 20 Options Markets An Introduction

2. 20-2 Review Work Week for the class.

3. 20-3 Call – to buy an asset Put - to sell an asset Buy - Long Sell - Short Key Elements –Exercise or Strike Price –Premium or Price –Maturity or Expiration Option Terminology that students are required to understand

4. 20-4 Purchasing versus Writing an Option When you purchase an option, it means,  you do not own the stock, but are purchasing the option (choice) to buy it for an agreed upon price. When you write an option, it means that,  you own the stock, and are selling somebody else the option (choice) to buy it for an agreed upon price.

5. 20-5 Options versus Stock investments  Purchasing call options is bullish because your plan is to earn money as the price of the stock increases.  Writing call options is bearish because you hope that the stock price does not increase. If the price increases, you will have to sell your stock to the purchaser at a lower price than you could sell it on the market and will lose your profit from the premium.

6. 20-6  Purchasing put options is bearish because you intend to earn as the price of the stock falls.  Writing put options is bullish because you hope that the market price increases, so you do not have to buy a stock from your customer at a higher price than the market is willing to pay today. Also, you will keep the premium and earn a profit.

7. 20-7 Exercise 1 : CALL OPTIONS. Read the text on page 672-673. You may use Example 20.1 to answer the questions, but your answers must be in your own words and must be written in such a way as to be useful in teaching someone that knows nothing about call options. Explain the following scenarios, from the perspective of n call option holder. 1a. Earning a profit from a call option 1b. Taking a loss from a call option 1c. Breaking even on a call option 2.Would a call option holder ever exercise the call option if she was going to take a loss? Yes or No. Explain your answer. 3.When does the writer of the call option earn a profit? 4.When does the writer of the call option suffer a loss? -

8. 20-8 Exercise 2 : PUT OPTIONS. Read the text on page 673-674. You may use Example 20.2 to answer the questions, but your answers must be in your own words and must be written in such a way as to be useful in teaching someone that knows nothing about call options. Explain the following scenarios, from the perspective of a put option holder. 1a. Earning a profit from a put option 1b. Taking a loss from a put option 1c. Breaking even on a put option 2.Would a put option holder ever exercise the put option if she was going to take a loss? Yes or No. Explain your answer. 3.When does the writer of the put option earn a profit? 4.When does the writer of the put option suffer a loss? -

9. 20-9 CALL OPTION The holder has purchased the right to purchase an asset for an agreed upon price, on or before a agreed upon date. EXAMPLE? EXERCISE PRICE OR STRIKE PRICE This is the price that was agreed to in the call option contract, which the asset can be purchased for. -

10. 20-10 PREMIUM The premium is the purchase price of the option. When will the holder of a call option purchase the asset? The call option holder will consider purchasing the asset if the market value of the asset exceeds the exercise price. Why will the call option holder consider it and not just go ahead and make the purchase?

11. 20-11 When the market value of the asset exceeds the exercise price + the premium, the holder of the call option will purchase the asset and realize a profit. If the expiry date is nearing, and the exercise price + the premium is greater than the market price, but not by more than the price of the premium, the purchase of the asset will still minimize (off set) the original premium paid. (this will be clear in the example coming up)

12. 20-12 Example 20.1 Call Option contract with a January expiration. Exercise Price = $105 Premium = $3.10 If the asset is selling for $107, the call option holder can exercise their right to purchase the asset for $105. Value at expiration = Stock price – Exercise price = $107 - $105 = $2 Profit = Final value – Original investment (premium) = $2.00 – $3.10 = -$1.10 Explain the variables that we have not yet discussed in this example.

13. 20-13 The call option holder lost $1.10. If the asset was selling for more than $108.10, the call option holder would have made a profit. However, if the call option holder did not purchase the asset, they would have lost $3.10. In this example, the call option holder purchased the asset for $107.00 to offset part of the cost of the premium. Instead of losing $3.10, the call option holder lost $1.10. If the asset was selling for more than $108.10, the call option holder would have a profit equal to the amount above $108.10. -

14. 20-14 Stock Price$90$100$110$120$130 Option Value Pay off to the Option Call Holder 00102030 When the stock price is below $100, the option is worthless. Above $100, the option is worth the excess of the stock price over $100. The option’s value increases by $1 for each dollar increase in the stock price.

15. 20-15 Figure 20.2 Payoff and Profit to Call Option at Expiration

16. 20-16 Net profit = the profit that you keep after deducting all expenses and costs associated with doing the deal. Gross profit = the profit before deducting the transaction costs. Example: You buy an asset for $100 and sell it for $120. Gross profit is $20. Your net profit (what you keep) is the amount that remains after paying the commissions. $20gross profit Less$ 3commission to purchase the asset Less$ 3commission to sell the asset Net$14Net profit A

17. 20-17 Figure 20.2 The solid line in Figure 20.2 shows the value of the call option at expiration date. The net profit to the holder of the call equals the gross payoff less the initial investment (premium) in the call. Example: The option call is $100. The call (premium) cost $14. An asset value of $100 or less is worthless. An asset value of between $100 and $114 will offset the loss to something less than $14. An asset value above $114 will result in a positive / net profit.

18. 20-18 Figure 20.3 Page 679 in your textbook Payoff and Profit to Call Writers at Expiration The lower the price, the more profit earned by the call writer.

19. 20-19 Figure 20.4 Payoff and Profit to Put Option at Expiration

20. 20-20 The other party in this transaction is the call option writer. The writer of the call option will profit the most if the call option is not exercised. The gross profit will be equal to the premium. If the asset price is high and the option is called, the writer will have to provide the asset as promised, incurring a reduction in their profit equal to the amount which the asset is worth, above its value.

21. 20-21 In the Money - exercise of the option would be profitable Call: market price>exercise price Put: exercise price>market price Out of the Money - exercise of the option would not be profitable Call: market price<exercise price Put: exercise price<market price At the Money - exercise price and asset price are equal Market and Exercise Price Relationships

22. 20-22 American - the option can be exercised at any time before expiration or maturity European - the option can only be exercised on the expiration or maturity date American vs. European Options

23. 20-23 Option versus Stock Investments Question. Is the purchase of call options bullish or bearish? Answer. Bullish. You are expecting the price of the stock to increase so you can buy it for the lower agreed price and sell it for a profit or keep it.

24. 20-24 Question. Is the purchase of a put option bullish or bearish? Answer. Bearish. You are expecting the price of the stock to decrease so that you can sell it for the agreed upon higher price and keep the profit.

25. 20-25 Question. Why would you purchase a call option rather than buy shares of stock? Answer. You have expertise in that area and believe that the value of the stock is going to increase. And / Or… your money is busy working elsewhere and you don’t have the money to invest right now OR you want to minimize your potential loss to the premium of the option call. Can you think of any other reasons?

26. 20-26 Page 680 in your text book. Take two minutes and review Options vs. Stock Investments. See the three investment strategies. Let us compare them. Read the three strategies to yourself and follow the value of each portfolio based on the price fluctuations of the stock.

27. 20-27 Summary of investment options. A – 100 shares x $100 = $10,000 B – 1,000 calls (10 contracts) x $10 = $10,000 C – 6 month T-Bill $9,000 + 100 calls ($1,000) = $10,000 REMEMBER: The increases you see are gross profits, (before the expenses are factored in). $95$100$105$110$115$120 Portfolio After 6 months based on the stock prices above. A: All stock9,50010,00010,50011,00011,50012,000 B: All options005,00010,00015,00020,000 C: Call plus T- Bills 9,270 9,77010,27010,77011,270? 12,270

28. 20-28 Net Profits Portfolio A The transaction fee to buy and sell the stock might have been $100. The net is then $12,000 less the initial investment of $10,000 less transaction fee $100 for a net profit of $1,900. Portfolio B $20,000 less the premium price of $10,000 to purchase the call options leaves a net profit of $10,000

29. 20-29 Portfolio C Is there an error in the text book? $9,000 with 3% earned in 6 months = $270 100 call options at $10 each = $1000 Original investment of $10,000 At $120 per share, the 100 call options are now worth $2,000. Should the gross value of the portfolio after 6 months be $12,270? If yes, then the initial cost of the call options being $1,000 (100 x $10) leaves a net profit of $1,270.

30. 20-30 Review When you purchase an option, it means,  you do not own the stock, but are purchasing the option (choice) to buy it for an agreed upon price. When you write an option, it means that,  you own the stock, and are selling somebody else the option (choice) to buy it for an agreed upon price.

31. 20-31 Options versus Stock investments Purchasing call options is bullish because, your plan is to earn money as the price of the stock increases. Writing call options is bearish because, you hope that the stock price does not increase. If the price increases, you will have to sell your stock to the purchaser at a lower price than you could sell it on the market and will lose your profit from the premium.

32. 20-32  Purchasing put options is bearish because you intend to earn as the price of the stock falls.  Writing put options is bearish because you hope that the market price increases, so you do not have to buy a stock from your customer at a higher price than the market is willing to pay today. Also, you will keep the premium and earn a profit.

33. 20-33 Interest Rates Compared on the 3 Portfolios See Figure 20.5 on page 681. The interest rates are accurate. Question. Even though the interest rates look good for all 3 portfolio options, realistically, can you earn a living and support yourself from option A or C.

34. 20-34 Answer 1. Yes. If you have a long term strategy and have other sources of income, like a good job. Answer 2. Yes. If you have much more money to invest than the small amount that we used in this example.

35. 20-35 Question. What is leverage? Answer. The ability to influence a system, or an environment, in a way that multiplies the outcome of one's efforts without a corresponding increase in the consumption of resources. In other words, leverage is the advantageous condition of having a relatively small amount of cost yield a relatively high level of returns.

36. 20-36 The advantages of choosing portfolio B are obvious (see figure 20.5). Questions. 1.What are the risks of choosing portfolio B? 2.Who is most likely to choose portfolio B? 3.Are you going to be the type of person that chooses a portfolio B? 4.Do you remember your score on the risk tolerance quiz we took last semester? What does that score tell you about your willingness to take financial risks? 5.How might your tolerance to risk increase?

37. 20-37 Insights Compare A and C to B. Look at the returns. 1.B returns disproportionate increases and decreases based on the same change in value of the underlying security. A 4.3% increase from $115 to $120 is equal to $5,000. 2.Figure 20.5. See the intersection of investments and how B increases much faster. All option portfolios have steeper slopes (greater risk – greater potential wins)

38. 20-38 Insights 3.The maximum loss of Portfolio C is -7.3%, reducing the original investment to $9,270. 4.The maximum risk of Portfolios A and B is - 100% if the options expire or the company goes bankrupt. 5.Portfolio C is the safest in terms of loss but also offers the least profit when the value of the stock increases. Question. What is your risk tolerance?

39. 20-39 Illegal Activity This leverage has led to some investors to be greedy. Corrupt investors with inside information often choose options to earn big returns quickly. Example. You work for a car manufacturer. Your big secret is that the new and improved electric car will made public knowledge in 2 months. You purchase call options and earn a quick profit.

40. 20-40 Question. What is wrong with doing this? Answer. 1.You had privileged information that the writer did not have and cost the writer to lose a lot of money, possibly putting them out of business. 2.If this unfair practice became common, putting call and put writers out of business, the markets could not function. 3.The investment markets are based on trust. 4.People go to jail for using inside information. 5.There are other ways to earn money and not damage the financial markets.

41. 20-41 Protective Put Strategies  You want to invest in a stock but are fearful of losing your hard earned money.  A Protective Put Strategy acts like insurance in case of a loss, but also reduces your profit when the stock increases in value.

42. 20-42 Example of a Protective Put  You own 500 shares of a Candy Company.  Each share has a value of $25 today for a total investment of $12,500.  You purchase Put Options with a strike price of $25 (right to sell) for 500 shares. Each put cost you $2, totaling a $1,000 premium. Question. What happens if the price falls? Question. What happens if the price rises?

43. 20-43  If the price of the stock falls, you can exercise your right to sell the 500 shares for $25, thereby minimizing your loss. What is the cost to you?  The cost to you is equal to the premium you paid to purchase the Put Option.  If the price of the stock increases, and you sell the stock, you can earn a profit. What is your profit?  your profit will be reduced by the cost of the premium.

44. 20-44 The lesson about Protective Puts is that, derivative securities can be used as a risk management tool.

45. 20-45 Covered calls - Example A covered call is a method used by a portfolio managers when, 1.She owns stock and plans to sell it 2.She plans to increase the profit she will earn from the sale This two part transaction is referred to as a covered call, because the potential obligation to sell the stock is ‘covered’. It is already taken care of because the stock is owned. She does not have to go out and buy it if the Call Option is exercised.

46. 20-46 Example (acted out in front of the class) 1.I buy 100 shares of Coca Cola for $75 each. I pay $7,500. 2.I Write a Covered Call Option with a strike price of $82. The Covered Call Options sell for $3 per share. 3.You believe that the price of the Coca Cola shares are going to increase above $82, so you purchase the Call Option from me, for $300 (100 shares X $3). 4.Your break even price is $85 ($82 + $3).

47. 20-47 5.If the price goes above $82, you will Exercise your Call Option and purchase the shares for $82 each. 6.YOU MUST NOW THINK STRATEGICALLY ABOUT WHEN YOU ARE GOING TO SELL YOUR SHARES. Between $82.01 and $85.00, you do not make a profit BUT you do minimize your loss (the price you paid for the option). Above $85 you will make a profit if you sell.

48. 20-48 7.I already made a profit. I earned $700 ($7 X 100 shares) on the increase in price from $75 to $82 and another $300 ($3 X 100) when you paid me for the Call Option to Purchase the Coca Cola Shares. The example we just discussed is known as Covered Call. If we completed this transaction but the Coca Cola shares were not already owned, it would be known as Naked Option Writing. If I was the Option Writer, I would have to go out and buy 100 Coca Cola shares to give you, the person that purchased the Call Option from me.

49. 20-49

50. 20-50 Covered Calls: In class exercise See Word Document (Chapter 20 in class exercise covered calls) Covered Calls – In-class Exercise Source: Example 20.4, page 686 Summarized

51. 20-51 Start Here

52. 20-52 90419 90338 90306 90705 90426 90304 90330 90307 90320 90435 90311 90414 90444 90336 90308

53. 20-53 Take up Covered Calls Exercise. Distribute hard copies to students.

54. 20-54 Teach Straddle Options

55. 20-55 STRADDLE The non financial definition of straddle is: Straddle is an ACTION WORD (verb). 1.To straddle means to walk, stand, or sit with one leg on each side of; stand or sit astride of: to straddle a horse. 2.To spread (the legs) wide apart. 3.To favour or appear to favour both sides of (an issue, political division, etc.).

56. 20-56 A straddle is the purchase of both a call and a put, on a stock. Both the call and the put have the same  Exercise price  Expiry date A straddle is used to earn a profit when you believe that there is going to be a very big change in the price, but you do not know if the price of the stock will increase or decrease.

57. 20-57 Example A business is in court and the decision will be made public within 45 days. If the decision is favorable to the business, the value of the stock is expected to increase from $60 per share to $100 per share. If the decision is not favorable to the business, the value of the stock is expected to will decrease to $20 per share. e.

58. 20-58  The straddle position will do well in either extreme, whether the price goes UP OR DOWN.  The only time the straddle will not do well is if the price of the stock price does not change, up OR down.  If the price of the stock does not change, the options will expire worthless and you will lose the premium that you paid for the right to buy or sell the stock.

59. 20-59 How much does the stock have to move by in order to make a profit?  The stock must move by more than the premiums that you paid for the put and call.

60. 20-60 Use the Word Document to teach through the straddle exercise. Distribute paper copies to the students. Soft copies are available on the website.

61. 20-61 There will be an update to this chapter. Check for the update on April 3rd.

62. 20-62 Remember, There are ‘no free lunches’ in my classrooms. You will earn your marks here like you will earn your salary after graduation. Be sure to remain focused...