Intro to Project 2: Options

1. Intro to Project 2: Options

2. What is an Option? • An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset). • An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.

3. Similarities: Listed Options are securities, just like stocks. Options trade like stocks, with buyers making bids and sellers making offers. Options are actively traded in a listed market, just like stocks. They can be  bought and sold just like any other security. Differences Options are derivatives, unlike stocks (i.e, options derive their value from  something else, the underlying security). Options have expiration dates, while stocks do not. There is not a fixed number of options, as there are with stock shares available. Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights. Stocks vs. Options

4. Terms • Call Option – The right to buy a stock • Put Option – The right to sell a stock • American Option – may be exercised at any time prior to its expiration date, usually the 3rd Friday of the month • European Option – may only be exercised on its expiration date, usually the 3rd Friday of the month

5. American Call Options • An American Call Option is an option to buy a stock at a specific price on or before a certain date. • Call options are like security deposits. If you wanted to rent a certain property, and left a security deposit, the money would be used to insure that you could rent that property at the price agreed upon when you returned. • If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument increases.

6. American Call Options • When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price, called the strike price. • If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.

7. American Put Options • Put Options are options to sell a stock at a specific price on or before a certain date. • Put options are like insurance policies If you buy a new car, and then buy auto insurance on the car, you pay a premium to protect yourself if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. • If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.

8. American Put Options • With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. • If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. • This is the primary function of listed options, to allow investors ways to manage risk.

9. Strike Price • The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract. • For example, with the XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 per share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock at $30 per share.

10. Strike Price • The strike price also helps to identify whether an option is In-the-Money or Out-of-Money when compared to the price of the underlying security. • A call option is in-the-money if the strike price is below the current market price of the underlying security. • It is out-of-the-money if the strike price is above the current market price of the security. • The extent of a stock price’s variability is called its volatility.

11. An Example • Assume for a moment that it is April 5th, and you are following XYZ, which is presently at $29 a share. • You think that this stock will go up in price in the next month and a half or so, to well past $30 a share. • Knowing about options, you choose to buy an XYZ May 30 Call for 2, instead of buying the stock outright. • This option gives you the right to buy 100 shares of XYZ Stock at $30 a share any time before May expiration

12. Example Continued • On expiration Friday, assume XYZ is at $35 per share. You have a Call option, which can be exercised to purchase 100 shares of XYZ Stock at $30 per share. If you do that, you can then sell that stock back in the market and make a $5 return per share, or $500. Since your initial Call premium was $200, your net profit is $300. • You could also sell the option on the market get your profits from the increased value of your option • If XYZ’s stock traded to $25 per share, you would only be charged for the money you spent to purchase the option.

13. Project 2: European Call Options • For our project we will be limiting ourselves to European call options • Your are employed at the Chicago Board of Options Exchange, one of the largest traders of options in America. • Your goal is to find reasonable price, per share, on a European call option for a certain company • Market experience, financial theory and mathematics have helped to develop systematic processes for pricing options

14. Project 2: European Call Options • Options Pricing was revolutionized in 1973 with the publication of the Black-Scholes Model, the Nobel-prize winning equation which virtually created the options marketplace.

15. Project 2: European Call Options • Unfortunately, the mathematics behind this formula goes way beyond the scope of this course. • To simplify things, we will employ what is known as the boot-strapping method • Warning!: Because of this, you should not use this project to price options on your own. As the saying goes, “Don’t try this at home.”

16. Class Project • Our goal is to find the present value, per share, of a European call on Walt Disney Company stock. Currently the stock is trading at $21.87 on January 11, 2002. The call is to expire 20 weeks later, with a strike price of $23. Our work is to be based upon the stock’s price record of weekly closes for the past 8 years.

17. Project Assumptions • Past history cannot be used to predict the future price of a stock. If it did, then investors would move their money to the stock that would yield the best return, thereby driving up the price of that stock and destroying its value since no one would want to buy such a stock. • The past history of prices for a given stock can be used to predict the amount of future variation in the price of that stock. The greater the volatility the greater the stock will fluctuate in price. • All investments, whose values can be predicted probabilistically, are assumed to give the same rate of return. If this were not so, then investors would move their money to stocks that would give them the highest predicted rate of return, raising the cost of the investment and destroying its predicted rate of return

18. Project Assumptions • We will assume that the common growth rate for all investments whose future values can be predicted is the rate of return on a United States Treasury Bill. This rate is guaranteed by the federal government • All investments with the same expected rate of growth are considered to be of equal value to investors. We are choosing to ignore the fact that investors have different investing tastes and preferences. This is called the risk-neutral assumption.

19. What this project is NOT? • We only want to determine a fair price for our European Call option on a particular company. • We don’t want to know whether the option should be purchased • We don’t want to know whether stock the company should be purchased • We don’t want to know the closing value of company’s stock once the option expires. How can we? Assumption 1 says we can’t !

20. What’s on the horizon? • For this project, you will be assigned new teams • Each team will be given a certain company to price the value of a European call option. Each team will get: • Company ticker symbol • Start date of the option: Friday March 25th, 2005 • Strike Price • Length of the Option (Expiration Date) • N years of historical data • The current rate guaranteed by the federal government

21. Upcoming . . . • Begin reading your text and familiarize yourself with how options work • Visit the Chicago Board of Options Exchange at: www.cboe.com to read further information • Your team assignments will be determined by Wednesday’s class • Your team’s data will also be given by Wednesday’s class

22. Preliminary Report • Your team’s preliminary report will be delivered on Monday March 28th, 2005 • As before, you will want to meet with your team to examine the data that you’ll be downloading (more about this later) • Your team will again need to put together a presentation in powerpoint to deliver your report to determine a reasonable price for your particular call option

23. Citations • All slides seen here are courtesy of and inspired by the incredibly useful learning center offered by the CBOE website.