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Chapter 17 Principles of Options and Option Pricing

Chapter 17 Principles of Options and Option Pricing. We sent the first draft of our paper to the Journal of Political Economy and promptly got back a rejection letter. We then sent it to the Review of Economics and Statistics, where it was also rejected.

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Chapter 17 Principles of Options and Option Pricing

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  1. Chapter 17Principles of Options and Option Pricing

  2. We sent the first draft of our paper to the Journal of Political Economy and promptly got back a rejection letter. We then sent it to the Review of Economics and Statistics, where it was also rejected. Merton Miller and Eugene Fama…then took an interest in the paper and gave us extensive comments on it. They suggested to the JPE that perhaps the paper was worth more serious consideration. The journal then accepted the paper. - Fischer Black

  3. Outline • Introduction • Option principles • Option pricing

  4. Introduction • Innovations in stock options have been among the most important developments in finance in the last 20 years • The cornerstone of option pricing is the Black-Scholes Option Pricing Model (OPM) • Delta is the most important OPM progeny to the portfolio manager

  5. Option Principles • Why options are a good idea • What options are • Standardized option characteristics • Where options come from • Where and how options trade • The option premium • Sources of profits and losses with options

  6. Why Options Are A Good Idea • Options: • Give the marketplace opportunities to adjust risk or alter income streams that would otherwise not be available • Provide financial leverage • Can be used to generate additional income from investment portfolios

  7. Why Options Are A Good Idea (cont’d) • The investment process is dynamic: • The portfolio managers needs to constantly reassess and adjust portfolios with the arrival of new information • Options are more convenient and less expensive than wholesale purchases or sales of stock

  8. What Options Are • Call options • Put options

  9. Call Options • A call option gives you the right to buy within a specified time period at a specified price • The owner of the option pays a cash premium to the option seller in exchange for the right to buy

  10. Practical Example of A Call Option

  11. Put Options • A put option gives you the right to sell within a specified time period at a specified price • It is not necessary to own the asset before acquiring the right to sell it

  12. Standardized Option Characteristics • All exchange-traded options have standardized expiration dates • The Saturday following the third Friday of designated months for most options • Investors typically view the third Friday of the month as the expiration date

  13. Standardized Option Characteristics (cont’d) • The striking price of an option is the predetermined transaction price • In multiples of $2.50 (for stocks priced $25.00 or below) or $5.00 (for stocks priced higher than $25.00) • There is usually at least one striking price above and one below the current stock price

  14. Standardized Option Characteristics (cont’d) • Puts and calls are based on 100 shares of the underlying security • The underlying security is the security that the option gives you the right to buy or sell • It is not possible to buy or sell odd lots of options

  15. Where Options Come From • Introduction • Opening and closing transactions • Role of the Options Clearing Corporation

  16. Introduction • If you buy an option, someone has to sell it to you • No set number of put or call options exists • The number of options in existence changes every day • Option can be created and destroyed

  17. Opening and Closing Transactions • The first trade someone makes in a particular option is an opening transaction • An opening transaction that is the sale of an option is called writing an option

  18. Opening and Closing Transactions (cont’d) • The trade that terminates a position by closing it out is a closing transaction • Options have fungibility • Market participants can reverse their positions by making offsetting trades • E.g., the writer of an option can close out the position by buying a similar one

  19. Opening and Closing Transactions (cont’d) • The owner of an option will ultimately: • Sell it to someone else • Let it expire or • Exercise it

  20. Role of the Options Clearing Corporation • The Options Clearing Corporation (OCC): • Positions itself between every buyer and seller • Acts as a guarantor of all option trades • Regulates the trading activity of members of the various options exchanges • Sets minimum capital requirements • Provides for the efficient transfer of funds among members as gains or losses occur

  21. OCC-Related Information on the Web

  22. Where and How Options Trade • Options trade on four principal exchanges: • Chicago Board Options Exchange (CBOE) • American Stock Exchange (AMEX) • Philadelphia Stock Exchange • Pacific Stock Exchange

  23. Where and How Options Trade (cont’d) • AMEX and Philadelphia Stock Exchange options trade via the specialist system • All orders to buy or sell a particular security pass through a single individual (the specialist) • The specialist: • Keeps an order book with standing orders from investors and maintains the market in a fair and orderly fashion • Executes trades close to the current market price if no buyer or seller is available

  24. Where and How Options Trade (cont’d) • CBOE and Pacific Stock Exchange options trade via the marketmaker system • Competing marketmakers trade in a specific location on the exchange floor near the order book official • Marketmakers compete against one another for the public’s business

  25. Where and How Options Trade (cont’d) • Any given option has two prices at any given time: • The bid price is the highest price anyone is willing to pay for a particular option • The asked price is the lowest price at which anyone is willing to sell a particular option

  26. The Option Premium • Intrinsic value and time value • The financial page listing

  27. Intrinsic Value and Time Value • The price of an option has two components: • Intrinsic value: • For a call option equals the stock price minus the striking price • For a put option equals the striking price minus the stock price • Time value equals the option premium minus the intrinsic value

  28. Intrinsic Value and Time Value (cont’d) • An option with no intrinsic value is out of the money • An option with intrinsic value is in the money • If an option’s striking price equals the stock price, the option is at the money

  29. The Financial Page Listing • The following slide shows an example from the online edition of the Wall Street Journal: • The current price for a share of Disney stock is $21.95 • Striking prices from $20 to $25 are available • The expiration month is in the second column • The option premiums are provided in the “Last” column

  30. The Financial Page Listing

  31. The Financial Page Listing (cont’d) • Investors identify an option by company, expiration, striking price, and type of option: Disney JUN 22.50 Call Company Expiration Striking Price Type

  32. The Financial Page Listing (cont’d) • The Disney JUN 22.50 Call is out of the money • The striking price is greater than the stock price • The time value is $0.25 • The Disney JUN 22.50 Put is in the money • The striking price is greater than the stock price • The intrinsic value is $22.50 - $21.95 = $0.55 • The time value is $1.05 - $0.55 = $0.50

  33. The Financial Page Listing (cont’d) • As an option moves closer to expiration, its time value decreases • Time value decay • An option is a wasting asset • Everything else being equal, the value of an option declines over time

  34. Sources of Profits and Losses With Options • Option exercise • Exercise procedures

  35. Option Exercise • An American option can be exercised at any time prior to option expiration • It is typically not advantageous to exercise prior to expiration since this amount to foregoing time value • European options can be exercised only at expiration

  36. Exercise Procedures • The owner of an option who decides to exercise the option: • Calls her broker • Must put up the full contract amount for the option • The premium is not a downpayment on the option terms

  37. Exercise Procedures (cont’d) • The option writer: • Must be prepared to sell the necessary shares to the call option owner • Must be prepared to buy shares of stock from the put option owner

  38. Exercise Procedures (cont’d) • In general, you should not buy an option with the intent of exercising it: • Requires two commissions • Selling the option captures the full value contained in an option

  39. Profit and Loss Diagrams • For the Disney JUN 22.50 Call buyer: Maximum profit is unlimited Breakeven Point = $22.75 $0 -$0.25 Maximum loss $22.50

  40. Profit and Loss Diagrams • For the Disney JUN 22.50 Call writer: Maximum profit Breakeven Point = $22.75 $0.25 $0 Maximum loss is unlimited $22.50

  41. Profit and Loss Diagrams • For the Disney JUN 22.50 Put buyer: Maximum profit = $21.45 Breakeven Point = $21.45 $0 -$1.05 Maximum loss $22.50

  42. Profit and Loss Diagrams • For the Disney JUN 22.50 Put writer: Maximum profit Breakeven Point = $21.45 $1.05 $0 Maximum loss = $21.45 $22.50

  43. Option Pricing • Determinants of the option premium • Black-Scholes Option Pricing Model • Development and Assumptions of the model • Insights into the Black-Scholes Model • Delta • Theory of put/call parity • Stock index options

  44. Determinants of the Option Premium • Market factors • Accounting factors

  45. Market Factors • Striking price • For a call option, the lower the striking price, the higher the option premium • Time to expiration • For both calls and puts, the longer the time to expiration, the higher the option premium

  46. Market Factors (cont’d) • Current stock price • The higher the stock price, the higher the call option premium and the lower the put option premium • Volatility of the underlying stock • The great the volatility, the higher the call and put option premium

  47. Market Factors (cont’d) • Dividend yield on the underlying stock • Companies with high dividend yields have a smaller call option premium than companies with low dividend yields • Risk-free interest rate • The higher the risk-free rate, the higher the call option premium

  48. Accounting Factors • Stock splits: • The OCC will make the following adjustments: • The striking price is reduced by the split ratio • The number of options is increased by the split ratio • For odd-lot generating splits: • The striking price is reduced by the split ratio • The number of shares covered by your options is increased by the split ratio

  49. Black-Scholes Option Pricing Model • The Black-Scholes OPM:

  50. Black-Scholes Option Pricing Model (cont’d) • Variable definitions: • C = theoretical call premium • S = current stock price • t = time in years until option expiration • K = option striking price • R = risk-free interest rate

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