Chapter 15 Options: Puts, Calls, and Warrants

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Puts, Calls, and Warrants Learning Goals 1.Discuss the basic nature of options in general, and puts and calls in particular, and understand how these investment vehicles work. 2.Describe the options market, and note key options provisions, including strike prices and expiration dates. 3.Explain how put and call options are valued and the forces that drive options prices in the marketplace.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Puts, Calls, and Warrants Learning Goals (cont’d) 4.Describe the profit potential of puts and calls, and note some popular put and call investment strategies. 5.Describe market index options, puts and calls on foreign currencies, and LEAPS, and show how these securities can be used by investors. 6.Discuss the investment characteristics of stock warrants, and describe the trading strategies that can be used to gain maximum benefits from this investment vehicle.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Puts, Calls and Warrants Financial Asset: asset that represents a financial claim on an issuing organization –Stocks, bonds and convertible securities are examples Option: the right to buy or sell a certain amount of an underlying financial asset at a specified price for a given period of time

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Types of Options –Puts –Calls –Warrants All of the above are types of derivative securities, which derive their value from the price behavior of an underlying real or financial asset.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Puts and Calls Puts and calls may be traded on: –Common stocks –Stock indexes –Exchange traded funds –Foreign currencies –Debt instruments –Commodities and financial futures Owners of put and call options have no voting rights, no privileges of ownership, and no interest or dividend income.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Puts and Calls (cont’d) Puts and calls are created by individual investors, not by the organizations that issue the underlying financial asset.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Puts and Calls (cont’d) Option Buyer: –Has the right to buy or sell an underlying asset for a given period of time, at a price that was fixed at the time of the option contract in exchange for paying the seller a fee Buyer can walk away from a bad option

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Puts and Calls (cont’d) Option Seller/Maker/Writer: –Has the obligation to buy or sell the underlying asset according to the terms of the option contract, for which the seller has been paid a certain amount of money Seller cannot walk away from a bad option

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Puts and Calls (cont’d) Put and call options trade in the open market much like any other security and may be bought and sold through securities brokers and dealers. Values of puts and calls change with the values of the underlying assets. Values of puts and calls change with the time period before they expire: –Closer to expiration date, option values go down

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Advantages of Puts and Calls Allows use of leverage –Leverage: the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return Option buyer’s exposure to risk is limited to fee paid to purchase the put or call option Investor can make money when value of assets go up or down

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Disadvantages of Puts and Calls Investor does not receive any interest or dividend income Options expire; the investor has limited time to benefit from options before they become worthless Options are complex and tricky Option seller’s exposure to risk may be unlimited Options are risky because an investor has to be correct on two decisions to make money: –Which direction the price of the asset will move –When the price change will occur

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Calls Work Call: a negotiable instrument that gives the holder (buyer) the right to buy the underlying security at a specified price over a set period of time from the seller/maker/writer in exchange for a fee paid to the seller/maker/writer –The buyer of the call option wants the price of the underlying assets to go up –The seller/maker/writer of the call option wants the price of the underlying assets to go down

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Calls Work (cont’d) If the price of the underlying assets goes up: –The buyer will buy the asset at the lower strike price from the seller/maker/writer and sell it at the higher market price, making a profit –The seller will sell the assets at a price lower than the market price. If the seller does not already own the assets, then the seller will have to purchase them at the higher market price Covered call: seller owns the asset Naked call: seller does not own the asset

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. How Calls Work (cont’d) If the price of the underlying assets go down: –The buyer will let the call option expire worthless and lose the fee paid –The seller will keep the fee received and make a profit

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Calls Work (cont’d) Example: Assume the market price for a share of common stock is $50. A call option to purchase 100 shares of the stock at a strike price of $50 per share may be purchased for $500 If the market price of the stock goes up to $75 per share, the buyer will purchase 100 shares at the strike price from the seller/maker/writer and sell them at the higher market price. The buyer’s profit will be: The seller/maker/writer’s loss will be:

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Calls Work: The Value of Leverage Example: Assume the market price for a share of common stock is $50. A call option to purchase 100 shares of the stock at a strike price of $50 per share may be purchased for $500 If the market price of the stock goes up to $75 per share, the buyer will purchase 100 shares at the strike price from the seller/maker/writer and sell them at the higher market price. The buyer’s profit will be $2,000. The buyer’s total return using the call option will be: The buyer’s total return directly owning the stock would be:

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Calls Work (cont’d) Example: Assume the market price for a share of common stock is $50. A call option to purchase 100 shares of the stock at a strike price of $50 per share may be purchased for $500 If the market price of the stock goes down to $25 per share, the buyer will allow the call option to expire worthless. The buyer’s loss will be: The seller/maker/writer’s profit will be:

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Puts Work Put: a negotiable instrument that enables the holder (buyer) to sell the underlying security at a specified price over a set period of time to the seller/maker/writer in exchange for a fee paid to the seller/maker/writer –The buyer of the put option wants the price of the underlying assets to go down –The seller/maker/writer of the put option wants the price of the underlying assets to go up

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Puts Work (cont’d) If the price of the underlying assets goes down: –The buyer will buy the asset on the market at the lower price and force the seller/maker/writer to buy the asset at the higher option price, making a profit –The seller will pay a price higher than the market price and will own expensive assets or will have to sell them at a loss If the price of the underlying assets go up: –The buyer will let the put option expire worthless and lose the fee paid –The seller will keep the fee received and make a profit

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Puts Work (cont’d) Example: Assume the market price for a share of common stock is $50. A put option to sell 100 shares of the stock at a strike price of $50 per share may be purchased for $500. If the market price of the stock goes down to $25 per share, the buyer will purchase 100 shares at the market price and force the seller/maker/writer to buy them at the option strike price. The buyer’s profit will be: The seller/maker/writer’s loss will be:

Copyright © 2005 Pearson Addison-Wesley. All rights reserved How Puts Work (cont’d) Example: Assume the market price for a share of common stock is $50. A put option to sell 100 shares of the stock at a strike price of $50 per share may be purchased for $500. If the market price of the stock goes up to $75 per share, the buyer will allow the put option to expire worthless. The buyer’s loss will be: The seller/maker/writer’s profit will be:

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Put and Call Options Markets Conventional (OTC) Options –Sold over the counter –Primarily used by institutional investors Listed Options –Created in 1973 by the Chicago Board Option Exchange (CBOE) –Puts and calls traded through CBOE exchange, as well as AMEX, Philadelphia and Pacific stock exchanges –Provided convenient market that made options trading more popular and help create a secondary market –Helped standardize expiration dates and exercise/strike prices –Reduced trading costs

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Stock Options Common Stock Options –Over 700 million option contracts are traded each year. –Options on common stocks is the most popular form of option. –Over 90% of all option contracts are stock options.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Key Provisions of Stock Options Strike Price –Stated price at which you can buy a security with a call or sell a security with a put –Conventional (OTC) options may have any strike price –Listed options have standardized prices with price increments determined by the price of the stock Expiration Date –Stated date when the option expires and becomes worthless if not exercised –Conventional (OTC) options may have any working day as expiration date – Listed options have standardized expiration dates

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 15.1 Quotations for Listed Stock Options

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Expiration Date of Listed Stock Options Three Expiration Cycles –The January/April/July/October cycle –The February/May/August/November cycle –The March/June/September/December cycle The longest-term expiration dates are normally no longer than nine months The options that are longer than nine months are called LEAPS, and they are only available on some of the stocks Listed options always expire on the third Friday of the month of expiration

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Valuation of Stock Options Option Premium (Price): the quoted price the investor pays to buy a listed put or call option Option premiums (prices) are affected by: –Fundamental (intrinsic) value: based upon current market price of underlying assets –Time Premium: amount that option price exceeds the fundamental value

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Valuation of Stock Options: Fundamental Value of a Call

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Valuation of Stock Options: Fundamental Value of a Put

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 15.2 The Valuation Properties of Put and Call Options

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Valuation of Stock Options In-the-Money –Call option: when the strike price is less than the market price of the underlying security –Put option: when the strike price is greater than the market price of the underlying security Out-of-the-Money –Call option: when the strike price is greater than the market price of the underlying security –Put option: when the strike price is less than the market price of the underlying security

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Table 15.1 Option Price Components

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Option Trading Strategies Buying for Speculation Hedging Writing Options Spreading Options

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Speculating with Stock Options Similar to investing in common stocks –Goal is to “buy low, sell high” –Buyer does not need as much capital since can use leverage –Buyer cannot lose more than cost of the option

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Table 15.2 Speculating with Call Options

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Hedging with Stock Options Purpose is to reduce or eliminate risk Combines two or more securities into a single investment position Hedging a “Long” Position –Buying a put and holding appreciated stock in the same company –Buying a put would provide “insurance” in case the stock price went down before you sold the stock Hedging a “Short” Position –Selling stock short and buying a call –Buying a call would allow you to buy stock to cover the short sale if the stock price went up instead of down

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Table 15.3 Limiting Capital Loss with a Put Hedge

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Table 15.4 Protecting Profits with a Put Hedge

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Writing Stock Options The seller/maker/writer is betting that the option buyer will be wrong about the direction of the stock price or the time period the price change will occur –Statistically, the odds favor the writer over the buyer –Easy money if the option expires worthless. The writer cannot make more than the fee received –High risk if the option is “in-the-money” Naked options: writer does not own the optioned securities and has to buy them. No limit on loss exposure Covered options: writer owns the optioned securities. Loss exposure is limited to the price originally paid for the securities

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Table 15.5 Covered Call Writing

Spreading Options Purpose is to take advantage of differences in prevailing option prices and premiums Combines two or more options into a single transaction “Vertical” Spread –Buying a call at one strike price and writing a call (on same stock for same expiration date) at a higher strike price “Option” Straddle –Simultaneous purchase (or sale) of both a put and a call on the same underlying common stock Spreading options is extremely tricky and should be used only by knowledgeable investors

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Stock-Index Options Stock-Index Option: a put or call option written on a specific stock market index Major stock indexes for options: –The S&P 500 Index –The S&P 100 Index –The Dow Jones Industrial Average –The Nasdaq 100 Index

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Stock-Index Options (cont’d) Market price is function of strike price of option and latest published stock market index value Valuation techniques are similar to valuing options for individual securities Price behavior and investment risk are similar to options for individual securities May be used to hedge a whole portfolio of stocks rather than individual stocks May be used to speculate on the stock market as a whole

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Other Types of Options Exchange traded funds: put and call options written on exchange traded funds (EFT’s) –Very similar to market index options Interest rate options: put and call options written on fixed-income (debt) securities –Small market involving only U.S. Treasury securities –Option prices change with yield behavior of debt securities

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Other Types of Options (cont’d) Currency options: put and call options written on foreign currencies –Available on most major world currencies –Option prices change as exchange rates between currencies fluctuate LEAPS: long-term options that may extend out to 3 years –Available on several hundred stocks and over two dozen stock indexes and ETF’s

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Options: Warrants Warrant: a long-lived option that gives the holder the right to buy stock in a company at a price specified on the warrant –Warrants have the longest lives of all types of options, with maturities that extend out 5, 10, or even 20 years or more –Warrants are created by the organizations that issue the underlying financial asset –Usually added as “sweeteners” to bond issues –May be traded through brokers

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Advantages of Warrants Offer a chance to benefit indirectly if the common stock price goes up without buying the stock Price tends to move same direction as the common stock price Low unit cost Loss exposure is limited to price of warrant Opportunity to use leverage to increase total return

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Disadvantages of Warrants Have no voting rights Pay no dividends Have no claims on assets of the issuing company Eventually expire

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Valuing Warrants Fundamental value of warrant is derived from price behavior of the underlying common stock Warrant premium: the difference between the true value of a warrant and its market price where M=prevailing market price of the common stock E=exercise price stipulated on the warrant N=number of shares of stock that can be acquired with one warrant (If one warrant entitles the holder to buy one share of stock, N = 1. If two warrants are necessary to buy one share of stock, N = 0.5, etc.)

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 15.4 Normal Price Behavior of Warrant Premiums

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Price Behavior of Warrants Low unit costs allows use of leverage to potentially earn high rates of return Extreme price volatility can result in significant profits or significant losses

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Chapter 15 Review Learning Goals 1.Discuss the basic nature of options in general, and puts and calls in particular, and understand how these investment vehicles work. 2.Describe the options market, and note key options provisions, including strike prices and expiration dates. 3.Explain how put and call options are valued and the forces that drive options prices in the marketplace.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Chapter 15 Review (cont’d) Learning Goals (cont’d) 4.Describe the profit potential of puts and calls, and note some popular put and call investment strategies. 5.Describe market index options, puts and calls on foreign currencies, and LEAPS, and show how these securities can be used by investors. 6.Discuss the investment characteristics of stock warrants, and describe the trading strategies that can be used to gain maximum benefits from this investment vehicle.