1. Chapter 15
Options Markets

2. Option Terminology Buy - Long Sell - Short
Call Option: gives its holder the right to purchase an asset for a specified price before or on a specified expiration date.
Put Option: gives its holder the right to sell an asset at a specified price before or on a specified expiration date.
Key Elements
Exercise or Strike Price
Premium or Price
Maturity or Expiration

3. Market and Exercise Price Relationships
In the Money - exercise of the option would be profitable
Call: market price>exercise price
Put: exercise price>market price
Out of the Money - exercise of the option would not be profitable
Call: market price<exercise price
Put: exercise price<market price
At the Money - exercise price and asset price are equal

4. American vs European Options
American - the option can be exercised at any time before expiration or maturity
European - the option can only be exercised on the expiration or maturity date

5. Different Types of Options
Stock Options
Index Options
Futures Options
Foreign Currency Options
Interest Rate Options

6. Payoffs and Profits on Options at Expiration - Calls
Notation
Stock Price = ST Exercise Price = X
Payoff to Call Holder
(ST - X) if ST >X
0 if ST < X
or Max {ST – X, 0}
Profit to Call Holder
Payoff - Purchase Price

7. Payoffs and Profits on Options at Expiration - Calls
Payoff to Call Writer
- (ST - X) if ST >X
0 if ST < X
or Min {X – ST, 0}
Profit to Call Writer
Payoff + Premium

8. Profit Profiles for Calls
Call Holder
Call Writer
Stock Price

9. Payoffs and Profits at Expiration - Puts
Payoffs to Put Holder
0 if ST > X
(X - ST) if ST < X
or Max {X-ST, 0}
Profit to Put Holder
Payoff - Premium

10. Payoffs and Profits at Expiration - Puts
Payoffs to Put Writer
0 if ST > X
-(X - ST) if ST < X
or Min {ST - X, 0}
Profits to Put Writer
Payoff + Premium

11. Profit Profiles for Puts
Profits
Put Writer
Put Holder
Stock Price

12. Exercise in class
1. You purchase one IBM July 120 call contract for a premium of $5. You hold the option until the expiration date when IBM stock sells for $123 per share. You will realize a ______ on the investment.
A) $200 profit
B) $200 loss
C) $300 profit
D) $300 loss
2. You purchase one IBM July 120 put contract for a premium of $5. You hold the option until the expiration date when IBM stock sells for $123 per share. You will realize a ______ on the investment.
A) $300 profit
C) $500 loss
D) $200 profit
Answer: B Difficulty: Medium
Answer: C Difficulty: Medium

13. Exercise in class
A call option on Brocklehurst Corp. has an exercise price of $30. The current stock price of Brocklehurst Corp. is $32. The call option is __________.
A) at the money
B) in the money
C) out of the money
D) none of the above B D

14. Equity, Options & Leveraged Equity - Text Example
Investment Strategy Investment
Equity only Buy shares $8,000
Options only Buy options $8,000
Leveraged Buy options $1,000
equity Buy 2% $7,000
Yield

15. Equity, Options & Leveraged Equity - Payoffs
Microsoft Stock Price
$75 $80 $100
All Stock $7,500 $8,000 $10,000
All Options $0 $0 $16,000
Lev Equity $7,140 $7,140 $9,140

16. Equity, Options & Leveraged Equity - Rates of Return
Microsoft Stock Price
$75 $80 $100
All Stock % 0% 25%
All Options -100% % 100%
Lev Equity % % 14.25%

17. Put-Call Parity Relationship
ST < X ST > X
Payoff for
Call Owned ST - X
Put Written -( X -ST)
Total Payoff ST - X ST - X

18. Payoff of Long Call & Short Put
Combined =
Leveraged Equity
Stock Price
Short Put

19. Arbitrage & Put Call Parity
Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal.
C - P = S0 - X / (1 + rf)T
If the prices are not equal arbitrage will be possible

20. Put Call Parity - Disequilibrium Example
Stock Price = Call Price = 17
Put Price = Risk Free = 10.25%
Maturity = .5 yr X = 105
C - P > S0 - X / (1 + rf)T
17- 5 > (105/1.05)
12 > 10
Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative

21. Put-Call Parity Arbitrage
Immediate Cashflow in Six Months
Position Cashflow ST<105 ST> 105
Buy Stock ST ST
Borrow
X/(1+r)T =
Sell Call (ST-105)
Buy Put ST
Total

22. Option Strategies Protective Put Covered Call
Long Stock
Long Put
Covered Call
Short Call
Straddle (Same Exercise Price)
Long Call

23. Exercise in class
1 You buy one Chrysler August 50 call contract and one Chrysler August 50 put contract. The call premium is $4.25 and the put premium is $ Your highest potential loss from this position is __________.
A) $75
B) $925
C) $5,000
D) unlimited
2 An investor purchases a long call at a price of $2.50. The expiration price is $ If the current stock price is $35.10, what is the break even point for the investor?
A) $32.50
B) $35.00
C) $37.50
D) $37.60 B C

24. Option Strategies
Spreads - A combination of two or more call options or put options on the same asset with differing exercise prices or times to expiration
Vertical or money spread
Same maturity
Different exercise price
Horizontal or time spread
Different maturity dates

25. Exercise in class
You buy one Chrysler August 50 call contract and one Chrysler August 50 put contract. The call premium is $4.25 and the put premium is $ Your strategy is useful if you believe that the stock price __________.
A) will be lower than $41.25 in August
B) will be between $41.25 and $58.75 in August
C) will be higher than $58.75 in August
D) either a or c
Answer: D Difficulty: Hard