Chapter 14 Options: Puts and Calls

1. Chapter 14 Options: Puts and Calls

2. Options: Puts, Calls and Warrants • Financial Asset: asset that represents a financial claim on an issuing organization • Stocks, bonds and convertible securities are examples • Option: the right to buy or sell a certain amount of an underlying financial asset at a specified price for a given period of time

3. Types of Options • Types of Options • Puts • Calls • Rights • Warrants • All of the above are types of derivative securities, which derive their value from the price behavior of an underlying real or financial asset

4. Options: Puts and Calls • Puts and calls may be traded on: • Common stocks • Stock indexes • Exchange traded funds • Foreign currencies • Debt instruments • Commodities and financial futures • Owners of put and call options have no voting rights, no privileges of ownership, and no interest or dividend income

5. Options: Puts and Calls (cont’d) • Options allow buyers to use leverage; investors can benefit from stock-price movements without having to invest a lot of capital • A given percentage change in a stock’s price usually generates a larger percentage change in an option’s price • Puts and calls are created by individual investors, not by the organizations that issue the underlying financial asset

6. Options: Puts and Calls (cont’d) • Option Buyer • Has the right to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a fixed price (called the exercise price or strike price) for a given period of time • To acquire this right, the option buyer must pay the option seller a fee known as the option premium (or option price) • Buyers do not have to exercise their options; they can walk away if exercising the option isn’t profitable

7. Options: Puts and Calls (cont’d) • Option Seller (also called the option writer) • Receives the option premium from the buyer up front • Has the obligation to sell (in the case of a call option) or buy (in the case of a put option) the underlying asset according to the terms of the option contract • Whereas option buyer can walk away if exercising the option is unprofitable, option seller cannot walk away

8. Options: Puts and Calls (cont’d) • Put and call options trade in the open market much like any other security and may be bought and sold through securities brokers and dealers • Values of puts and calls change with the values of the underlying assets • Other factors influence option prices (e.g., an option’s value is usually higher if there is more time before the option expires)

9. Advantages of Puts and Calls • Allows use of leverage • Leverage: the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return • Option buyer’s potential loss is limited to fee paid to purchase the put or call option • Investors can make money when value of assets go up or down

10. Disadvantages of Puts and Calls • Investor does not receive any interest or dividend income • Options expire; the investor has limited time to benefit from options before they become worthless • Options are risky; a small change in the price of the underlying asset may make an option worthless • Option seller’s exposure to risk may be unlimited

11. How Calls Work • Call: an option that gives the holder (buyer) the right to buy the underlying security at a specified price over a set period of time • Thebuyer of the call option wants the price of the underlying asset to go up • The seller of the call option wants the price of the underlying asset to go down

12. How Calls Work (cont’d) • If the price of the underlying asset goes above the option’s strike price: • The option holder will purchase the asset at the strike price and then sell it at the higher market price, making a profit • The option writer must sell the asset at the strike price (which is lower than the asset’s market price). • If the seller does not already own the underlying asset, then the seller will have to purchase it at the higher market price • Covered call: seller owns the underlying asset • Naked call: seller does not own the underlying asset

13. How Calls Work (cont’d) • If the price of the underlying asset goesdown: • The buyer will let the call option expire worthless and lose the option premium • The seller will keep the option premium and make a profit

14. How Calls Work (cont’d) • Example: Assume the market price for a share of common stock is $50. An investor buys a call option which grants the right to purchase 100 shares of the stock at a strike price of $50. The call premium is $500 • If the market price of the stock goes up to $75 per share, the investor will exercise the right to purchase 100 shares for $50. The investor then sells the shares on the open market for $75. • The investor’s net profit will be: • The option seller’s loss will be: • Notice that the buyer’s profit equals the seller’s loss; options are a zero-sum game

15. How Calls Work:The Value of Leverage • In the previous example, the option buyer makes a profit of $2,000 after investing just $500 in capital • The buyer’s total return using the call option was: • Rather than buying the option, the investor might have simply purchased 100 shares of stock directly. At a price of $50 per share, the cost of 100 shares would have been $50,000. If the share price had risen to $75, the investor would have earned a $2,500 profit. The total rate of return on the investment would have been: • The same $25 increase in the stock price generates a much higher rate of return for the option investor than for an investor who buys stocks directly

16. How Calls Work (cont’d) • Example: Assume the market price for a share of common stock is $50. An investor buys a call option to purchase 100 shares of the stock at a strike price of $50 per share. The option premium is $500. • If the market price of the stock goes down to $25 per share, the investor will allow the call option to expire worthless. • The option buyer’s loss will be: • The option seller’s profit will be equal to the option premium:

17. How Puts Work • Put: an option that enables the holder (buyer) to sell the underlying security at a specified price over a set period of time • The buyer of the put option wants the price of the underlying asset to go down • The seller of the put option wants the price of the underlying asset to go up

18. How Puts Work (cont’d) • If the price of the underlying asset goesbelow the put option’s strike price: • The put owner will buy the underlying asset, paying the open-market price, and then force the put seller to buy the asset at the higher strike price, making a profit • The seller will pay a price higher than the market price • If the price of the underlying asset goes up: • The buyer will let the put option expire worthless and lose the option premium • The seller will keep the option premium and make a profit

19. How Puts Work (cont’d) • Example: Assume the market price for a share of common stock is $50. An investor buys a put option that grants the right to sell 100 shares of the stock at a strike price of $50. The option premium is $500. • If the market price of the stock goes down to $25 per share, the investor will purchase 100 shares of stock in the open market for $25 each. Then the investor exercises his right to sell those shares to the put seller for $50 each • The buyer of the put option earns a profit of $2,000: • The seller’s loss will be:

20. How Puts Work (cont’d) • Example: Assume the market price for a share of common stock is $50. A put option to sell 100 shares of the stock at a strike price of $50 per share may be purchased for $500. • If the market price of the stock goes up to $75 per share, the buyer will allow the put option to expire worthless. • The buyer’s loss will be: • The seller/maker/writer’s profit will be:

21. Put and Call Options Markets • Conventional (OTC) Options • Sold over the counter • Primarily used by institutional investors • Listed Options • Created in 1973 by the Chicago Board Option Exchange (CBOE) • Puts and calls traded through CBOE exchange, as well as International Securities Exchange, AMEX, Philadelphia exchange, NYSE Arca and Boston Options Exchange. • Provided convenient market that made options trading more popular and help create a secondary market • Helped standardize expiration dates and exercise/strike prices • Reduced trading costs

22. Stock Options • Common Stock Options • Several billion option contracts are traded each year • Options on common stocks are the most popular form of option • Over 90% of all option contracts are stock options

23. Key Provisions of Stock Options • Strike Price • Stated price at which you can buy a security with a call or sell a security with a put • Conventional (OTC) options may have any strike price • Listed options have standardized prices with price increments determined by the price of the stock • Expiration Date • Stated date when the option expires and becomes worthless if not exercised • Conventional (OTC) options may have any working day as expiration date • Listed options have standardized expiration dates

24. Figure 14.1 Quotations for Listed Stock Options Source: quotemedia.com, accessed August 8, 2012.

25. Expiration Date of Listed Stock Options • Three Expiration Cycles • The January/April/July/October cycle • The February/May/August/November cycle • The March/June/September/December cycle • The longest-term expiration dates are normally no longer than nine months • The options that are longer than nine months are called LEAPS, and they are only available on some of the stocks • Listed options always expire on the third Friday of the month of expiration

26. Valuation of Stock Options • Option Premium (Price): the quoted price the investor pays to buy a listed put or call option • Option premiums (prices) are affected by: • Intrinsic value: based upon current market price of underlying assets • Time Premium: amount that option price exceeds the fundamental value

27. Intrinsic Value of a Call Option • The intrinsic value of a call option equals the difference between the market price of the stock and the strike price of the option, or zero, whichever is greater • Example: Suppose a call option has a strike price of $50 • If the underlying stock price is $75, the call’s intrinsic value is $25 (actually, $2,500 because the call grants the right to buy 100 shares) • If the underlying stock price is $25, the call’s intrinsic value is $0

28. Intrinsic Value of a Put Option • The intrinsic value of a put option equals the difference between the strike price of the option and the market price of the stock, or zero, whichever is greater • Example: Suppose a put option has a strike price of $50 • If the underlying stock price is $25, the put’s intrinsic value is $25 (actually $2,500 because the put grants the right to sell 100 shares) • If the underlying stock price is $75, the put’s intrinsic value is $0

29. Figure 14.2 The Valuation Properties of Put and Call Options

30. Valuation of Stock Options • In-the-Money • Call option: when the strike price is less than the market price of the underlying security • Put option: when the strike price is greater than the market price of the underlying security • When an option is in the money, its intrinsic value is greater than zero • Out-of-the-Money • Call option: when the strike price is greater than the market price of the underlying security • Put option: when the strike price is less than the market price of the underlying security

31. Option Pricing Models • The best known option pricing model is the Black and Scholes Model • The model states that an option’s price depends on five variables • The option’s strike price • The option’s expiration date • The price of the stock • The risk free rate of interest • The stock’s volatility

32. Option Trading Strategies • Buying for Speculation • Hedging to modify risks • Writing Options to enhance returns • Spreading Options to enhance returns

33. Stock-Index Options • Stock-Index Option: a put or call option written on a specific stock market index • Major stock indexes for options: • The S&P 500 Index • The S&P 100 Index • The Dow Jones Industrial Average • The Nasdaq 100 Index

34. Stock-Index Options (cont’d) • Market price is function of strike price of option and latest published stock market index value • Valuation techniques are similar to valuing options for individual securities • Price behavior and investment risk are similar to options for individual securities • May be used to hedge a whole portfolio of stocks rather than individual stocks • May be used to speculate on the stock market as a whole

35. Other Types of Options • Exchange traded funds: put and call options written on exchange traded funds (EFT’s) • Very similar to market index options • Interest rate options: put and call options written on fixed-income (debt) securities • Small market involving only U.S. Treasury securities • Option prices change with yield behavior of debt securities

36. Other Types of Options (cont’d) • Currency options: put and call options written on foreign currencies • Available on most major world currencies • Option prices change as exchange rates between currencies fluctuate • LEAPS: long-term options that may extend out to 3 years • Available on several hundred stocks and over two dozen stock indexes and ETF’s