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 ($)
Purchased
share Combin
4 ed
0
Stock Price
23 25 27 29 at Expiration
-4 Written call
19-8
Protective Put Buying
Profit ($)
Purchased
share
4 Combin
ed
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 Combine
d
2
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
Call Put E
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
2
ln ( S E ) (r .5 σ )t
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
