(3) OPTION
A financial instrument that offers the
buyer the opportunity to buy or sell,
depending on the type of contract they
hold, the underlying asset.
- The holder is not required to buy
or sell the asset is they choose
not to.
- The buyer pays an options
premium (based on the strike
price and expiration date) for the
rights granted by the contract.
- Usually represents 100 shares of
the underlying security
- Puts and calls are created by
individual investors, not by
organizations.
Premium refers to its market price.
(a) Call – the right to buy stock
issued by individuals.
(b) Warrant – the right to buy stock
issued by firms.
(c) Put option – the right to sell
stock at a price and specified
time period.
(d) Strike/exercise price – the price
at which you may buy or sell the
stocks.
(e) Market price – actual value of
the stock.
(f) Expiration date – option expires.
Rights are issued to current
stockholders when the firm is issuing
new shares. By exercising it, current
stockholders maintain their
proportionate ownership in the
company.
Rights Warrant
Four (4) weeks Years
Intrinsic value of an option is the
value as its stock. It is the difference
between the market price and option’s
strike/selling price. [Formula: (Call) MP
– SP; (Put) SP – MP)
(1) In the money. – MP > SP
(2) At the money. – MP = SP
(3) Out of the money. – MP < SP
Rule: If the result of the intrinsic value is
negative, its value equates to 0.
*Hypothetical market value is given.
In the money call (ITM), the intrinsic
value used in time premium is the
difference between the call option’s
strike price and the stock’s current price.
(1) Intrinsic value for ITM: SP – CP
(2) Time premium for ITM: OP – IV
SP – strike/selling price; CP – current
price; OP – option’s price; IV – intrinsic
value.
Out of the money call (OTM), time
premium is only equal to the option’s
price.
(1) Time premium for ITM: OP
Decays refer to time premium that
depreciates as time passes, so the
option loses value.
Rule: Time premium decay accelerates
as expiration date gets nearer. On
expiration day, the time premium is
zero.
Illustrative problem.
Call Put
MP – SP SP – MP
A stock is selling for $48 (MP). The
three-month call with a strike price of
$50 (SP) is selling for $2 (OP). The put
option with a strike price of $50 (SP) is
selling for $5 (OP).
(a) Intrinsic value of each option:
(Formula: MP – SP; SP – MP)
(1) $48 - $50 = -2 = 0
(2) $50 - $48 = 2 = 2
(b) Time premium in each option:
(Formula: OP – IV)
(1) $2 - $0 = $2
(2) $5 - $2 = $3
(c) If the price of the stock is $55
(MP) at the options’ expiration
date, what is the percentage
change in the price of each
option?
(Formula: MP – SP; IV – OP;
D/OP)
(1) $55 - $50 = $5
$5 - $2 = $3
$3 / $2 = 1.5 or 150%
(2) $50 - $55 = -$5 = 0
No value, 100% loss.
(d) If the price of the stock is $44 at
the options’ expiration date, what
is the percentage change in the
price of each option?
(1) $44 - $50 = -$6 = 0,
therefore a 100% loss.
(2) $50 - $44 = $6
$6 - $5 = $1
$1 / $5 = 0.2 or 20%
Puts and calls may be traded on:
(1) Common stock – security that
represents ownership in a
corporation.
(2) Stock indexes – measurement
of a section of the stock market.
(3) Exchange trade funds – an
investment fund traded on stock
exchange such as stocks,
commodities, or bonds.
(4) Foreign currencies – options
written on foreign currencies.
(5) Debt instrument – utilized for the
purpose of obtaining capital;
provides capital to an entity.
(credit cards/lines, loans, bonds)
(6) Commodities and financial
futures
Rule: Owners of put and call options
have no voting rights, privileges of
ownership, and interest nor dividend
income.
- Options allows buyers to use
leverage; investors can benefit
from stock-price movements
without having to invest a lot of
capital.
- Percentage change in MP usually
generate larger percentage in
OP.
Option Buyer
- Has the right to buy (call/warrant
option) or sell (put option) an
 underlying asset at a fixed price
for a given period.
- To acquire this right, the option
buyer must pay the option
seller a fee known as the
option premium (or option
price).
- Not required to exercise
options, they can walk away if
it’s not profitable.
Option Seller/Writer
- Receives the option premium.
- Has the obligation to sell (with
respect on the part of the seller, a
call/warrant option) or buy (put
option).
- Option seller cannot walk away.
- Buyer of the call: wants the
price of the underlying asset to
increase.
- Seller of the call: wants the price
of the underlying asset to
decrease.
If the price of the underlying asset
goes above the SP:
- Option holder will purchase the
asset at the SP and sell it at a
high MP to earn profit.
- Option writer must sell the asset
at the SP.
Covered call: seller owns the asset.
Naked call: seller does not own the
underlying asset.

Leverage is the ability to obtain a given If the price of the underlying asset
equity position at a reduced capital goes down:
investment, thereby magnifying total - The buyer will let the call option
return. expire and lose the option
Puts and Calls premium/price.
- The seller will keep the option
Advantages Disadvantages premium in order to make profit.
Allows use of Investor does not
leverage receive any FORMULA:
interest or dividend Investor
income [(MP – SP) x No. of Shares] – TP
Option buyer’s Options expire; Option Seller
potential loss is limited time of [(SP – MP) x No. of Shares] + TP
limited to option benefit
premium Illustrative problem.
Investors can Exposure to risk
make money when that can make an Assume the market price for a share of
value of assets go option worthless, common stock is $50. An investor buys
up or down unlimited a call option which grants the right to
purchase 100 shares of the stock at a
Call strike price of $50 (SP). The call
premium is $500. If the market price
increases to $75, the investor will
exercise the right to purchase 100
shares for $50. The investor then sells
the shares on the open market for $75.
(a) Investor’s net profit:
= [(MP – SP) x Shares] – CP
= [($75 - $50) x 100 shares] – 500
= $2,000
(b) Option seller’s loss:
= [(SP – MP) x Shares] + CP
= [($50 - $75) x 100] + 500
= -$2,000
FORMULA (Return):
= Profit / Amount invested
Put
- Buyer of the put: wants the price
of the underlying asset to
decrease.
- Seller of the put: wants the price
of the underlying asset to
increase.
If the price of the asset goes below the
put option’s strike price.
- Put owner will buy the asset,
pay the open-market price, and
force the put seller to buy the
asset at the higher strike price to
gain profit.
- The seller will pay a price higher
than the market price.
If the price of the asset goes up.
- The buyer will let the put option
expire and lose the option
premium.
- Seller will keep the option
premium and make profit.
Put and Call Option Markets.
(1) Conventional (OTC) Options
- Unlisted
- Not standardized as to SP and/or
expiration date
- Sold over the counter
- Primarily used by institutional
investors
(2) Listed Options
- Created in 1973 by the Chicago
Board Option Exchange
- Standardized expiration dates
and SP
- Reduced trading costs
- Gives the holder the right but not
the obligation to buy or sell an
asset
Common stock options.
- Most popular form of option
- Over 90% of all option contracts
are stock option
Key Provisions.
(1) Strike Price
- Stated price at which you can buy a
security (call) or sell a security (put).
- OTC may have any strike price.
- Listed options have standardized
prices with price increments
determined by the price of the stock.
(2) Expiration Date
- When the option expires and
becomes worthless
- OTC may have any working days as
expiration date
- Listed options have standardized (d) Spreading options to enhance
expiration dates returns
- Longest term: normally no more than
nine (9) months. Options longer than
that are called LEAPS (Long-term
equity anticipation securities), and
they are available on some of the
stocks.
- They always expire on the third
Friday of the month of expiration.

Valuation of Stock Options.

Option Premium/Price is the quoted

price the investor pays to buy a listed
put or call option. They are affected by:

(a) Intrinsic Value – based upon

current market price of an
underlying asset
(b) Time Premium – amount that
option price exceeds the
fundamental value.

Option Pricing Models.

Black and Scholes Model.

Depends on five (5) variables.

(1) SP
(2) Expiration date
(3) MP
(4) Risk free rate of interest
(5) Stock’s volatility (the higher, the
riskier)

Option Trading Strategies.

(a) Buying for speculation

(b) Hedging to modify risks
(c) Writing options to enhance
returns