INVESTMENTS: Analysis and Management Third Canadian Edition INVESTMENTS: Analysis and Management Third Canadian Edition W. Sean Cleary Charles P. Jones Prepared by Khalil Torabzadeh University of Lethbridge

Chapter 19 Options

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Define options and discuss why they are used. Describe how options work and give some basic strategies. Explain the valuation of options. Identify types of options other than puts and calls. Learning Objectives

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Call (Put): Buyer has the right, but not the obligation, to purchase (sell) a fixed quantity from (to) the seller at a fixed price up to 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” Options

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 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 Why Options Markets?

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Exercise (Strike) price: the per-share price at which the common stock may be purchased or sold Expiration date: last date at which an option can be exercised Option premium: the price paid by the option buyer to the writer of the option, whether put or call Option Terminology

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 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) Possible courses of action  Options may expire worthless, be exercised, or be sold prior to expiry How Options Work

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Options exchanges  Chicago Board Options Exchange (CBOE)  Montreal Exchange (ME) Standardized exercise dates, exercise prices, and quantities  Facilitate offsetting positions through a clearing corporation Clearing corporation is guarantor, handles deliveries Options Trading

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 In-the-money options have a positive cash flow if exercised immediately Call options: Stock price (S) > Exercise price (E)  Put options: S < E Out-of-the-money options should not be exercised immediately  Call options: S < E  Put options: S > E If S = E, an option is at the money Options Characteristics

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Intrinsic value is the value realized from immediate exercise  Call options: maximum (S 0 -E, 0)  Put options: maximum (E-S 0, 0) Prior to option maturity, option premiums exceed intrinsic value Time Value = Option Price - Intrinsic Value Options Characteristics

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter Stock Price at Expiration Profit per Option ($) How does buying a stock compare with buying a call option? Buyer Seller Payoff Diagram for a Call Option

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter Stock Price at Expiration Profit per Option ($) How does selling a stock compare with buying a put option? Buyer Seller Payoff Diagram for a Put Option

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter Stock Price at Expiration Profit ($) Purchased share Written call Combined Covered Call Writing

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter Stock Price at Expiration Profit ($) Combined Purchased put Purchased share Protective Put Buying

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 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 Portfolio Insurance

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter Stock Price at Expiration Profit ($) Combined Purchased put Purchased share Portfolio Insurance

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 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? Should Options Be Exercised Early?

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 At maturity, option prices are equal to their intrinsic values  Intrinsic value is minimum price prior to maturity Maximum option prices prior to maturity  Call options: price of stock, S 0  Put options: exercise price, E Option Price Boundaries

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Stock Prices Call Prices E Put Prices Stock Prices E E C =S Option Price Boundaries

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Five variables needed to value a European call option on a non-dividend paying stock The Black-Scholes pricing formula is: Black-Scholes Model

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Black-Scholes Model Where C = the price of call option S = current market price of underlying stock N(d 1 ) = Cumulative density function of d 1 E = Exercise price of the option ℮ = The base of natural logarithms r = riskless rate of interest on an annual basis t = Time remaining before the expiration date N(d 2 ) = Cumulative density function of d 2

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Black-Scholes Model Where In (S/E) = The natural logarithm of (S/E) σ = The standard deviation of the annual rate of return on the underlying common stock

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Black-Scholes valuation is for call options Put-call parity shows relationship between call and put options so that riskless arbitrage is not possible Price of put = E/(e rt ) - S +C Put replicated by riskless lending, short sale of stock, purchased call Put-Call Parity

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Factors Affecting Prices

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 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 call written = N(d 1 )  Shares purchased per put purchased = N(d 1 ) - 1 Hedge Ratios

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Stock-Index Options: option contracts on a stock market index Interest Rate Options: option contracts on fixed income securities Currency Options: Option contracts whose value is based on the value of an underlying currency Other Types of Options

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Options available on S&P/TSE 60 Index, S&P 500 Index, NYSE Index, etc. 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 Basics of Stock-Index Options

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 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? Strategies with Stock-Index Options

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Appendix 19A Spreads and Combinations Combinations of Options Straddle – A combination of a put and a call on the same stock with the same exercise date and exercise price  A purchaser believes that the underlying stock price is highly volatile and may go either up or down  A seller believes that the underlying stock price will exhibit small volatility but could go up or down Strip – A combination of two puts and a call on the same security, same exercise date and price Strap – combines two calls with a put

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Spreads The purchase and sale of an equivalent option varying in only one respect Two basic spreads:  Money spread involves the purchase of a call option at one exercise price and the sale of the same maturity option, but with a different exercise price  Time spread involves the purchase and sale of options are identical except for expiration dates Appendix 19A Spreads and Combinations

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Appendix 19B Rights and Warrants Right – to purchase a stated number of common shares at a specified price with a specified time (often several months) Warrant – to purchase a stated number or common shares at a specified price with a specified time (often several years)

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 19 Appendix 19C Put-Call Parity No-Arbitrage Argument Example: Payoff at T PortfolioAction S(T) <ES(T) >E ABuy 1 call 0S(T) – E Invest PV(E) in T- bills EE Total Payoff ES(T) BBuy 1 share S(T) Buy 1 put E – S(T)0 Total payoff ES(T)

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