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

2. 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

3. 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

4. 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

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

6. Cash flow pattern IBM call with exercise price X=100

7. Cash flow pattern IBM put with exercise price X=100

8. Profit from buying an IBM call and holding until maturity

9. Profit from buying an IBM put and holding until maturity

10. 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

11. Cash flow of call writer

12. Profit from writing (selling) an IBM call

13. Profit from writing (selling) IBM put

14. 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 ( ) for this cute example!

15. Longer-term options are more valuable

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

17. 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

18. 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

19. Profit from buying or selling a stock

20. 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”)

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

22. Protective put
Buy a stock, buy a put

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

24. Covered call strategy
Buy stock, write a call

25. Covered call profit

26. Games to play

27. 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.

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

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

30. 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)

31. Butterfly strategy

32. Reverse butterfly strategy