Options

Chapter 19
Charles P. Jones, Investments: Analysis and
Management,
Tenth Edition, John Wiley & Sons

Prepared by
G.D. Koppenhaver, Iowa State University

17-1
Why Options Markets?

 Financial derivative securities: derive all

or part of their value from another
(underlying) security
 Options are created by investors, sold
to other investors
 Why trade these indirect claims?
 Expand investment opportunities, lower
cost, increase leverage

19-2
Options Terminology

 Call (Put): Buyer has the right but not

the obligation to purchase (sell) a fixed
quantity from (to) the seller at a fixed
price before a certain date
 Exercise (strike) price: “fixed price”
 Expiration (maturity) date: “certain date”
 Option premium or price: paid by buyer
to the seller to get the “right”

19-3
How Options Work

 Call buyer (seller) expects the price of

the underlying security to increase
(decrease or stay steady)
 Put buyer (seller) expects the price of
the underlying security to decrease
(increase or stay steady)
 At option maturity
 Option may expire worthless, be exercised,
or be sold

19-4
Options Trading

 Option exchanges are continuous

primary and secondary markets
 Chicago Board Options Exchange largest
 Standardized exercise dates, exercise
prices, and quantities
 Facilitates offsetting positions through
Options Clearing Corporation
 OCC is guarantor, handles deliveries

19-5
Payoff Diagram for a Call Option

Profit per
Option ($)
Buyer
4

0
Stock Price
25 27 29 at Expiration

-4
Seller
How does buying stock compare
with buying a call option?
19-6
Payoff Diagram for Put Option
Profit per
Option ($)
Buyer
4

0
Stock Price
23 25 27 at Expiration

-4
Seller

How does selling stock compare

with buying a put option?
19-7
Covered Call Writing

Profit ($)
Purchased
share Combined
4

0
Stock Price
23 25 27 29 at Expiration

-4 Written call

19-8
Protective Put Buying
Profit ($)
Purchased
share
4 Combined

0
Stock Price
23 25 27 29 at Expiration

-4
Purchased
put

19-9
Portfolio Insurance

 Hedging strategy that provides a

minimum return on the portfolio while
keeping upside potential
 Buy protective put that provides the
minimum return
 Put exercise price greater or less than the
current portfolio value?
 Problems in matching risk with
contracts

19-10
Portfolio Insurance

Profit ($)
Purchased
share Combined

0
Stock Price
23 25 27 29 at Expiration
-2

Purchased
put

19-11
Options Terminology

 In-the-money options have a positive

cash flow if exercised immediately
 Call options: S >E
 Put options: S <E
 Out-of-the-money options should not
be exercised immediately
 Call options: S <E
 Put options: S >E

19-12
Options Terminology

 Intrinsic value is the value realized

from immediate exercise
 Call options: maximum (S0-E or 0)
 Put options: maximum (E-S0 or 0)
 Prior to option maturity, option
premiums exceed intrinsic value
 Time value =Option price - Intrinsic value
 =seller compensation for risk

19-13
Should Options be Exercised
Early?
 Exercise prior to maturity implies the
option owner receives intrinsic value
only, not time value
 For call options, buy stock at below market
price
 Would more be earned by selling option?
 For put options, receive cash from selling
stock at above market price
 Could cash be reinvested for a higher return?

19-14
Option Price Boundaries

 At maturity, option prices are intrinsic

values
 Intrinsic value is minimum price prior to
maturity
 Maximum option prices prior to
maturity
 Call options: price of stock, S0
 Put options: exercise price, E

19-15
Option Price Boundaries

C=S
E
Call Put
Prices Prices

E E

Stock Prices Stock Prices

19-16
Black-Scholes Valuation

 Five variables needed to value a

European call option on a non-dividend
paying stock
E
C  S  N(d1 )  rt  N(d 2 )
e
ln ( S E )  (r  .5 σ )t
2
d1 
σ t
d 2  d1  σ t
19-17
Put-Call Parity

 Black-Scholes valuation is for call

options
 Put-call parity shows relationship
between call and put options if riskless
arbitrage is not possible
 Price of put =(E/ert) - S +C
 Put replicated by riskless lending, short
sale of stock, purchased call

19-18
Factors Affecting Prices

Variable Call Put

Stock Price + -
Exercise Price - +
Time to maturity + +
Stock volatility + +
Interest rates + -
Cash dividends - +

19-19
Riskless Hedging

 Options can be used to control the

riskiness of common stocks
 If stock owned, sell calls or buy puts
 Call or put option prices do not usually
change the same dollar amount as the
stock being hedged
 Shares purchased per calls written =N(d1)
 Shares purchased per puts purchased
=N(d1) - 1

19-20
Stock Index Options

 Options available on S&P 100 Index,

S&P 500 Index, NYSE Index, others
 Bullish on capital markets implies
buying calls or writing puts
 Bearish on capital markets implies
buying puts or writing calls
 At maturity or upon exercise, cash
settlement of position

19-21
Strategies with Stock Index
Options
 Speculation opportunities similar to
options on individual stocks
 Hedging opportunities permit the
management of market risk
 Well-diversified portfolio of stocks hedged
by writing calls or buying puts on stock
index
 What return can investor expect?

19-22
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19-23