Slides_Fundamentals of Investments - Chapter 14 ppt

Option BasicsŠ A stock option is a derivative security, because the value of the option is “derived” from the value of the underlying common stock.. Option BasicsŠ In general, options o

Valuation & Management

Charles J Corrado Bradford D.Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

Stock Options

In this chapter, we will discuss options generally, but with a focus on options on individual common

stocks We will see the tremendous flexibility that options offer investors

in designing investment strategies

Goal

Option Basics

Š A stock option is a derivative security, because

the value of the option is “derived” from the value of the underlying common stock

Š There are two basic option types Call options

are options to buy, while put options are

options to sell

Š Option contracts are standardized to facilitate

trading and price reporting

Î A single standard option is an option to buy/sell

100 shares of stock.

Option Basics

Š In general, options on common stock must

stipulate at least the following terms:

c The identity of the underlying stock.

d The strike price, or exercise price.

e The option contract size.

f The option expiration date, or option maturity.

gThe option exercise style (American or European).

h The delivery or settlement procedure.

Work the Web

 Visit these options exchanges:

Price

Quotes

Option Price Quotes

Š A list of available option contracts and their

prices for a particular security arrayed by

strike price and maturity is known as an option chain.

Work the Web

 For information on options ticker

symbols, see:

Buy Shares Buy Option

Profit Return Profit Return Case 1: $100 $1,000 11.11% $500 100%

Why Options?

Š Should you buy 100 IBM shares at $90 each

($9,000 investment), or should you buy a call option with a strike price of $90 expiring in three months at $500 ($5 per share)?

Š Three months later,

Case 2: $90 $0 0% -$500 -100%

Case 3: $80 -$1,000 -11.11% -$500 -100%

Why Options?

Š Whether one strategy is preferred over another

is a matter for each individual investor to decide

Š What is important is the fact that options offer

an alternative means of formulating investment strategies

Work the Web

 For more information on options

education, see:

Option Writing

Š The seller of a call/put option is called the

call/put “writer,” and the act of selling an

option is referred to as option writing.

Š Option writing involves receiving the option

price and, in exchange, assuming the obligation to satisfy the buyer’s exercise rights

if the option is exercised

Option Payoffs

Š It is useful to think about option investment

strategies in terms of their initial and terminal cash flows

Š The initial cash flow of an option is the price

of the option, also called the option premium

Š The terminal cash flow of an option is the

option’s payoff that can be realized from the exercise privilege

Payoff Diagrams

Payoff Diagrams

Option Profits

Option Profits

Work the Web

 To learn more on options, see:

Option Strategies

Š Protective put - Strategy of buying a put option

on a stock already owned This protects against

a decline in value

Š Covered call - Strategy of selling a call option

on stock already owned This exchanges

“upside” potential for current income

Š Straddle - Buying or selling a call and a put

with the same exercise price Buying is a long straddle; selling is a short straddle.

Work the Web

 For ideas on option trading strategies,

see:

Option Prices, Intrinsic Values, and Arbitrage

Š call option price < stock price

Î Otherwise, arbitrage will be possible.

Š put option price < strike price

Î Otherwise, arbitrage will be possible.

Š option price ≥ 0

Î By definition, an option can simply be discarded.

Option Prices, Intrinsic Values, and Arbitrage

Š The intrinsic value of an option is the payoff

that an option holder receives if the underlying stock price does not change from its current

value

Š Call option intrinsic value = max [0, S–K]

Put option intrinsic value = max [0, K – S ]

Option Prices, Intrinsic Values, and Arbitrage

Š option price ≥ option’s intrinsic value

Î Otherwise, arbitrage will be possible.

Š So,

Call option price ≥ max [0, S – K ]

Put option price ≥ max [0, K – S ]

where S = current stock price

K = option’s strike price

Stock Index Options

Š A stock index option is an option on a stock

market index

Š The most popular stock index options are

options on the S&P 100, S&P 500, and Dow Jones Industrial Average

Š Since the actual delivery of all stocks

comprising a stock index is impractical, a cash

Stock Index Options

Work the Web

 Exchanges that trade index options

include:

The Options Clearing Corporation

Š The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of

an option contract will be fulfilled if the option

is exercised

Š The OCC issues and clears all option contracts trading on U.S exchanges

Š Note that the exchanges and the OCC are all

subject to regulation by the Securities and Exchange Commission (SEC)

Work the Web

 Visit the OCC at:

Chapter Review

Š Option Strategies

Î The Protective Put Strategy

Î The Covered Call Strategy

Î Straddles

Š Option Prices, Intrinsic Values, and Arbitrage

Î The Upper Bound for a Call Option Price

Chapter Review

Š Stock Index Options

Î Features and Settlement

Î Index Option Price Quotes

Š The Options Clearing Corporation