INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones

Chapter 19 Options

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

An option to purchase shares directly from the company at a specified price, usually below current market price Issued to current shareholders Trade on an exchange Have a very short life (1 to 3 months) Rights

Warrants are a negotiable security  Often issued as part of a “unit”  Trade on an exchange Holder has option to  Purchase a specific number of shares  At a specified price  For a specified period of time Warrants are issued as a “sweetener to new issue units, to compensate underwriters and to increase company’s equity base Warrants

Exercising a warrant  Exchange warrant for shares  Some extra cash may be needed Exercise Price  The price for each share of the underlying security Exercise Ratio  The number of shares for each warrant Expiry Date  Last day for exercise Warrant Terminology

Warrants  Life is 6 months to 10 years  Issued as part of new issue units  Exercise price above current market price Rights  Life is 1 to 3 months  Issued to existing shareholders  Exercise price below current market price Comparison of Warrants with Rights

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” Options

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?

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

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

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

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 If S = E, an option is at the money Options Characteristics

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

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

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

Stock Price at Expiration Profit ($) Purchased share Written call Combined Covered Call Writing

Stock Price at Expiration Profit ($) Combined Purchased put Purchased share Protective Put Buying

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

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

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

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

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

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

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