Principles of Finance with Excel, 2nd edition Instructor materials Chapter 20 Introduction to Options

Introduction to Options In this chapter: Description of call and put options Options terminology What affects option prices – first look Option pay-off diagrams Option strategies

Options The right to buy or sell at a specified price over a time period Call option The right (not a promise) to buy Put option The right to sell Options have no direct relationship to the underlying corporation

Options Purchaser of an option is betting against the writer (seller) Exercise price = strike price = price at which the underlying asset can be purchased Option premium = price of the option Option expiration date American option can be exercised any time before the expiration date European option can only be exercised on the expiration date

IBM options 8 May 2009: Current date 17 July 2009: Option expiration date T

Cash flow pattern IBM call with exercise price X=100

Cash flow pattern IBM put with exercise price X=100

Profit from buying an IBM call and holding until maturity

Profit from buying an IBM put and holding until maturity

Options can be sold and bought When you buy a call option: Get the right to buy a stock in the future for a predetermined price. Pay at time of purchase You have limited losses, potentially large upside gains When you write a call option: Sell the right to someone else to buy a stock in the future for a predetermined price You get $ today, have potentially large future losses

Cash flow of call writer

Profit from writing (selling) an IBM call

Profit from writing (selling) IBM put

Longer-term options worth more Which call option would you rather have? The more time to expiration, the more the option is worth True for both puts and calls My thanks to Timo Korkeamaki (http://www.hanken.fi/staff/korkeam/ ) for this cute example!

Longer-term options are more valuable

Call value ↓ as exercise price X  Put value  as exercise price X ↓

Why? Which call option would you rather have: Option to buy IBM for $100? Option to buy IBM for $150? Which put option would you rather have? Option to sell IBM for $100 Option to sell IBM for $150

Uses of Options Hedging: Speculation: Reduction of risk for companies, investors, and individuals (insurance) Speculation: Increase of risk Taking bets on the direction (or volatility) of price movements

Profit from buying or selling a stock

Option strategies “Option strategies” is a general name for combinations of options, stocks Examples: Buy a stock and a put on the stock (“protective put”) Buy a stock and write a call on the stock (“covered call”) Buy a call option with one X and sell a call with another X (“straddle”)

Next slides We’ll take a number of strategies and plot the profit patterns. Basic elements:

Protective put Buy a stock, buy a put

Protective put profit For next chapter: Is Put + stock like a call? Lots of similarity! Short answer: Almost …

Covered call strategy Buy stock, write a call

Covered call profit

Games to play

Homework exercise: Prove that all the lines cross at the same point. Stock + 1, 2, 3, 4 puts … Homework exercise: Prove that all the lines cross at the same point.

BULL SPREAD: Buy call with low X (expensive) Write call with high X (cheaper) Profit if stock price goes up

BEAR SPREAD: Write call with low X Buy call with high X Profit if stock price goes down

Butterfly strategy Buy a call with low Xlow Buy a call with high Xhigh Write 2 calls with Xlow < X < Xhigh Profit if stock price doesn’t change too much (see next slide)

Butterfly strategy

Reverse butterfly strategy