Man 308

Options
Part 1
 Options

• Derivatives are securities that derive value from

the price of other securities.

• Powerful tools:
• Hedging:

• Speculation:

• Options are traded both on organized exchanges

and OTC.

20-2
The Option Contract: Calls

• A call option gives its holder the right to buy an asset:

• At the exercise price
• On or before the expiration date

• Exercise the option if:

• market value > exercise price.

20-3
The Option Contract: Puts

• A put option gives its holder the right to sell an asset:

• At the exercise price
• On or before the expiration date

• Exercise the option if:

• market value < exercise price.

20-4
The Option Contract

• Sellers (writers) of options receive premium income.

• If holder exercises the option, the option writer must make (call) or
take (put) delivery of the underlying asset.

20-5
Example 20.1 Profit and Loss on a Call
(1 of 2)

• An August 2016 call on IBM

• Exercise price: $150
• Premium: $4.10 (on June 30, 2016)

• The option expires on the third Friday:

• Expiration date: August 19, 2016

• If IBM remains below $150, the call will expire worthless.

20-6
Example 20.1 Profit and Loss on a Call
(2 of 2)

• Suppose IBM sells for $152 on the expiration date

(Option will be exercised to offset loss of premium)

• Option value = stock price - exercise price

$152 - $150= $2.00

• Profit = Final value – Original investment

$2.00 - $4.10 = -$2.10

−$2.10
• Holding Period Return: = −51.22%
$4.10

20-7
Example 20.2 Profit and Loss on a Put
(1 of 2)

• An August 2016 call on IBM

• Exercise price: $150
• Premium: $5.91 (on June 30, 2016)

• The option expires on the third Friday:

• Expiration date: August 19, 2016

• If IBM remains above $150, the call will expire worthless.

20-8
Example 20.2 Profit and Loss on a Put
(2 of 2)

• Suppose IBM sells for $141 on the expiration date

• Option value = exercise price - stock price

$150 - $141 = $9.00

• Profit = Final value – Original investment

$9.00 - $5.91 = $3.09

• Holding Period Return: $3.09

= 52.28%
$5.91

20-9
Market and Exercise Price Relationships

In the Money - exercise of the option produces a positive

cash flow
Call: exercise price < asset price
Put: exercise price > asset price

Out of the Money - exercise of the option would not be

profitable
Call: asset price < exercise price.
Put: asset price > exercise price.

At the Money - exercise price = asset price

20-10
 American vs. European Options

American - the option can be exercised at any time before expiration

• In the U.S., most options are American style,
• Except for currency and stock index options.

European - the option can only be exercised on the expiration date

20-11
 Different Types of Options

• Stock Options
• Index Options
• Futures Options
• Foreign Currency Options
• Interest Rate Options

20-12
 Payoffs and Profits at
Expiration — Calls (1 of 2)

Notation
Stock Price = ST
Exercise Price = X
Payoff to Call Holder
(ST - X) if ST >X
0 if ST < X
Profit to Call Holder
Payoff - Purchase Price

20-13
 Payoffs and Profits at
Expiration — Calls (2 of 2)

Payoff to Call Writer

- (ST - X) if ST >X
0 if ST < X

Profit to Call Writer

Payoff + Premium

20-14
Figure 20.2 Payoff and Profit to Call Option at
Expiration

20-15
Figure 20.3 Payoff and Profit to Call Writers at
Expiration

20-16
 Payoffs and Profits at
Expiration — Puts (1 of 2)

Payoffs to Put Holder

0 if ST > X
(X - ST) if ST < X

Profit to Put Holder

Payoff - Premium

20-17
 Payoffs and Profits at
Expiration — Puts (2 of 2)

Payoffs to Put Writer

0 if ST > X
-(X - ST) if ST < X

Profits to Put Writer

Payoff + Premium

20-18
Figure 20.4 Payoff and Profit to Put Option at
Expiration

20-19
Option versus Stock Investments
(1 of 3)

• Could a call option strategy be preferable to a direct stock purchase?

• Suppose you think a stock, currently selling for $100, will appreciate.
• A 6-month call costs $10 (contract size is 100 shares).
• You have $10,000 to invest.

20-20
Option versus Stock Investments
(2 of 3)

• Strategy A: Invest entirely in stock.

• Buy 100 shares, each selling for $100.

• Strategy B: Invest entirely in at-the-money call options.

• Buy 1,000 calls, each selling for $10. (This would require 10
contracts, each for 100 shares.)

• Strategy C: Purchase 100 call options for $1,000. Invest

your remaining $9,000 in 6-month T-bills, to earn 3%
interest. The bills will be worth $9,270 at expiration.

©2018 McGraw-Hill Education 20-21

Option versus Stock Investments
(3 of 3)

Investment Strategy Investment

Equity only Buy stock @ 100 100 shares $10,000

Options only Buy calls @ 10 1000 options $10,000

Leveraged Buy calls @ 10 100 options $1,000

equity Buy T-bills @ 3% $9,000
Yield

©2018 McGraw-Hill Education 20-22

Strategy Payoffs

©2018 McGraw-Hill Education 20-23

Figure 20.5 Rate of Return to Three Strategies

©2018 McGraw-Hill Education 20-24

Strategy Conclusions

• Portfolio B responds more than proportionately to

changes in stock value; it is levered.

• Portfolio C, T-bills plus calls, shows the insurance

value of options.
• C ‘s T-bill position cannot be worth less than $9270.
• Some return potential is sacrificed to limit downside risk.

©2018 McGraw-Hill Education 20-25

Protective Put

• Puts can be used as insurance against stock price declines.

• Protective puts lock in a minimum portfolio value.
• The cost of the insurance is the put premium.
• Options can be used for risk management, not just for speculation.

©2018 McGraw-Hill Education 20-26

Value of a Protective Put
Position at Expiration (1 of 2)

©2018 McGraw-Hill Education 20-27

Value of a Protective Put
Position at Expiration (2 of 2)

©2018 McGraw-Hill Education 20-28

Protective Put vs. Stock

©2018 McGraw-Hill Education 20-29

Covered Calls

• Purchase stock and write calls against it.

• Call writer gives up any stock value above X in return for the initial
premium.
• If you planned to sell the stock when the price rises above X anyway,
the call imposes “sell discipline.”

20-30
Value of a Covered Call
Position at Expiration (1 of 2)

20-31
Value of a Covered Call
Position at Expiration (2 of 2)

20-32
Straddle

• Long straddle: Buy call and put with same exercise price and
maturity.
• The straddle is a bet on volatility.
• To make a profit, the change in stock price must exceed the cost of both
options.
• You need a strong change in stock price in either direction.
• The writer of a straddle is betting the stock price will not change
much.

20-33
Value of a Straddle Position
at Option Expiration

20-34
Figure 20.9 Value of a Straddle at Expiration

20-35
Spreads

• A spread is a combination of two or more calls (or puts) on the same

stock with
• Differing exercise prices or
• Times to maturity.
• Some options are bought, whereas others are sold, or written.
• A bullish spread is a way to profit from stock price increases.

20-36
Value of a Bullish Spread
Position at Expiration (1 of 2)

20-37
Value of a Bullish Spread
Position at Expiration (2 of 2)

20-38
Collars

• A collar is an options strategy that brackets the

value of a portfolio between two bounds.
• Limit downside risk by selling upside potential.
• Buy a protective put
• Fund put purchase by writing a covered call.
• Net outlay for options is approximately zero.

20-39
 Put-Call Parity

•The call-plus-bond portfolio (on left)

must cost the same as the stock-plus-
put portfolio (on right):

X
C+ = S0 + P
(1 + rf ) T

20-40
 Put Call Parity - Disequilibrium Example

Stock Price = 110 Call Price = 17

Put Price = 5 Risk Free = 5%
Maturity = 1 yr X = 105
X
C+ = S0 + P
(1 + rf ) T

117 > 115

Since the leveraged equity is less expensive, acquire
the low cost alternative and sell the high cost
alternative

20-41
Arbitrage Strategy

20-42
 Option-like Securities

• Callable Bonds
• Convertible Securities
• Warrants
• Collateralized Loans

20-43