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Chapter

15
McGraw-Hill/Irwin

Stock Options

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives
Give yourself some in-the-money academic and professional options by understanding:
1. The basics of option contracts and how to obtain price quotes. 2. The difference between option payoffs and option profits. 3. The workings of some basic option trading strategies. 4. The logic behind the put-call parity condition.
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Stock Options
• In this chapter, we will discuss general features of options, but will focus on options on individual common stocks. • We will see the tremendous flexibility that options offer investors in designing investment strategies.

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Option Basics
• A stock option is a derivative security, because the value of the option is ―derived‖ from the value of the underlying common stock. • There are two basic option types.
– Call options are options to buy the underlying asset. – Put options are options to sell the underlying asset.

• Listed option contracts are standardized to facilitate trading and price reporting.
– Listed stock options give the option holder the right to buy or sell 100 shares of stock.

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such as the CBOE. and the seller of the option. The option contract size. • The minimum terms stipulated by stock option contracts are: – – – – – – The identity of the underlying stock. The delivery. • Stock options trade at organized options exchanges. or settlement. Cont. or option maturity. 15-5 .Option Basics. procedure. or exercise price. The strike price. The option exercise style (American or European). The option expiration date. • Option contracts are legal agreements between two parties—the buyer of the option. as well as over-the-counter (OTC) options markets.

wsj.Listed Option Quotations www.com 15-6 .

M through X for puts). • Stock option ticker symbols include: – Letters to identify the underlying stock. • Option chains are available online through many sources. (A through L for calls.cboe.yahoo. – A letter to identify the strike price (a bit more complicated—see Yahoo or Stock-Trak for tables to explain this letter.) 15-7 .com). – A letter to identify the expiration month as well as whether the option is a call or a put.com) and Yahoo! Finance (http://finance. including the CBOE (http://quote.Option Price Quotes • A list of available option contracts and their prices for a particular security is known as an option chain.

Stock Option Ticker Symbol and Strike Price Codes 15-8 .

Listed Option Quotes at Yahoo! Finance 15-9 .

Visit the OCC at: www. • Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC).optionsclearing.com.S. 15-10 .The Options Clearing Corporation • The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised. exchanges. • The OCC issues and clears all option contracts trading on U.

15-11 . – Buy options on the underlying stock. we compare the possible outcomes from these two investment strategies: – Buy the underlying stock.Why Options? • A basic question asked by investors is: ―Why buy stock options instead of shares in the underlying stock?‖ • To answer this question.

• Investment for 100 shares: – IBM Shares: $9. 15-12 . $80. or $90. let’s say that in three months.000 – One listed call option contract: $500 • Suppose further that the option expires in three months. the price of IBM shares will either be: $100.Example: Buying the Underlying Stock versus Buying a Call Option • Suppose IBM is selling for $90 per share and call options with a strike price of $90 are $5 per share. • Finally.

• Let’s calculate the dollar and percentage returns given each of the prices for IBM stock: Buy 100 IBM Shares ($9000 Investment): Dollar Profit: Case 1: $100 $1.11% Buy One Call Option ($500 Investment): Dollar Profit: $500 Percentage Return: 100% Case 2: $80 -$1. Cont.000 Percentage Return: 11.Example: Buying the Underlying Stock versus Buying a Call Option.000 -11.11% -$500 -100% Case 3: $90 $0 0% -$500 -100% 15-13 .

In other instances. For 100 shares. – Each investor must weight the risk and return trade-off offered by the strategies. • It is important to see that call options offer an alternative means of formulating investment strategies. 15-14 . – – – – For 100 shares. – That is. The positive percentage return with call options is higher. investing in the option will be better. the dollar loss potential with call options is lower. in some instances investing in the underlying stock will be better. the dollar gain potential with call options is lower.Why Options? Conclusion • Whether one strategy is preferred over another is a matter for each individual investor to decide. The negative percentage return with call options is lower.

Stock Index Options • A stock index option is an option on a stock market index. 15-15 . S&P 500. • Because the actual delivery of all stocks comprising a stock index is impractical. if the option expires in the money. – The cash settlement procedure is the same for calls and puts. – That is. and Dow Jones Industrial Average. stock index options have a cash settlement procedure. the option writer simply pays the option holder the intrinsic value of the option. • The most popular stock index options are options on the S&P 100.

Part One 15-16 .Index Option Trading.

Index Option Trading. Part Two 15-17 .

Option ―Moneyness‖ • ―In-the-money‖ option: An option that would yield a positive payoff if exercised ―Out-of-the-money‖ option: An option that would NOT yield a positive payoff if exercised Use the relationship between S (the stock price) and K (the strike price): In-the-Money Call Option S>K Out-of-the-Money S≤K • • Put Option S<K S≥K Note for a given strike price. only the call or only the put can be “in-the-money.” 15-18 .

– The call option holder has the right to exercise the call option (i. • Because option writing obligates the option writer. sell the underlying asset at the strike price).Option Writing • The act of selling an option is referred to as option writing. – The writer of a put option contract is obligated to buy the underlying asset from the put option holder. – The put option holder has the right to exercise the put option (i.. • The seller of an option contract is called the writer. buy the underlying asset at the strike price). – The writer of a call option contract is obligated to sell the underlying asset to the call option holder.e.. 15-19 .e. the option writer receives the price of the option today from the option buyer.

– If this right is available at any time up to and including the option expiration date. • Exercise style is not linked to where the option trades. – If this right is only available at the option expiration date. Europeanstyle and American-style options trade in the U.S. That is. they do not have to exercise the option if they no longer want it. the option is said to have American-style exercise. as well as on other option exchanges throughout the world. the option is said to have European-style exercise. 15-20 .Option Exercise • Option holders have the right to exercise their option. • Very Important: Option holders also have the right to sell their option at any time..

– Terminal cash flow: the value of an option at expiration (often called the option payoff.Option Payoffs versus Option Profits • Option investment strategies involve initial and terminal cash flows. • The terminal cash flow can be realized by the option holder by exercising the option. – Initial cash flow: option price (often called the option premium). Option Profits = Terminal cash flow − Initial cash flow 15-21 .

Call Option Payoffs 15-22 .

Put Option Payoffs 15-23 .

Call Option Profits 15-24 .

Put Option Profits 15-25 .

15-26 . • Protective put .Using Options to Manage Risk. • Protective puts provide ―insurance‖ for the value of an asset or a stream of cash inflows. I.Strategy of buying put options to protect against falling values.

Using Options to Manage Risk. II. 15-27 .Strategy of buying call options to protect against rising prices. • Protective calls provide a way to ―lock-in‖ the value of a liability or a stream of cash outflows. • Protective call .

– A position in a mixture of call and put options.  Buy one call option with the lowest strike. only calls or only puts).  Three option positions using: equally-spaced strikes with the same expiration. 15-28 • Type III: Combinations. – Example: Covered Calls (Selling a call option on a stock already owned).e.. – Example: Butterfly Spread. – Example: Straddle (buy one call and one put with the same strike and expiration). Check out the CBOE’s web site. There are many option trading strategies. • Type II: Spreads.  Buy one call option with the highest strike. – These strategies help traders modify their stock risk. – A position with two or more options of the same type (i.  Sell two call options with the middle strike. .The Three Types of Option Trading Strategies • Type I: Traders add an option position to their stock position.

and K is the strike price of the option: • Call option intrinsic value = MAX [0. • That is. S – K ] – In words: The call option intrinsic value is the maximum of zero or the stock price minus the strike price. • Put option intrinsic value = MAX [0. K – S ] – In words: The put option intrinsic value is the maximum of zero or the strike price minus the stock price.Option Intrinsic Values • The intrinsic value of an option is the payoff that an option holder receives if the underlying stock price does not change from its current value. if S is the current stock price. 15-29 .

– For calls. 15-30 . • “Out of the Money” options have a zero intrinsic value. – For puts. the strike price is less than the stock price. the strike price is greater than the stock price. • “At the Money” options is a term used for options when the stock price and the strike price are about the same.More Option ―Moneyness‖ • “In the Money” options have a positive intrinsic value. – For puts. – For calls. the strike price is greater than the stock price. the strike price is less than the stock price.

(Easy money for everybody) 15-31 . • Think about what would happen if arbitrage were allowed to persist. – ―Absence of Arbitrage‖ = ―No Free Lunch‖ – The ―Absence of Arbitrage‖ rule is often used in finance to calculate option prices. arbitrage is not allowed to persist.Arbitrage and Option Pricing Bounds • Arbitrage: – No possibility of a loss – A potential for a gain – No cash outlay • In finance.

and the underlying stock is selling for $60. • Worst case? The option is exercised and you pocket $5.The Upper Bound for a Call Option Price • Call option price must be less than the stock price. no possibility of loss. 15-32 . and buy the stock. • Otherwise. • Best case? The stock sells for less than $65 at option expiration. and potential for gain. • How? – Suppose you see a call option selling for $65. arbitrage will be possible. – The Arbitrage: sell the call. and you keep all of the $65. – Zero cash outlay today.

15-33 . and invest the $50 in the bank. (Note you have zero cash outlay).The Upper Bound for European Put Option Prices. • The put expires with zero value (and you are off the hook). • European put option price must be less than the strike price. – Best case? Stock price is at least $50 at expiration. plus interest. I. • So. • Suppose a put option with a strike price of $50 is selling for $50. we see that if the put option price equals the strike price. there is an arbitrage. • The Arbitrage: Sell the put. • You keep the entire $50. • But. you have $50 from the sale of the put (plus interest). – Worse case? Stock price goes to zero. • You must pay $50 for the stock (because you were the put writer).

is greater than the stock price. is the present value of the strike price computed at the risk-free rate. suppose the risk-free rate is 3 percent per quarter. Therefore: The maximum price for a European put option is the present value of the strike price computed at the risk-free rate.The Upper Bound for European Put Option Prices.03  $48. $48.03  $50 Maximum put price  $50/1.54. II. – We have a put option with an exercise price of $50 and 90 days to maturity. plus the interest you could earn over the life of the option. • There will be an arbitrage if price of the put. – For example. 15-34 • .54 • Notice that the answer. • What is the maximum put value that does not result in an arbitrage? Maximum put price  1.

– Therefore. – Suppose S = $60. – This means that no one would pay someone to take an option off their hands. and a call option has a strike price of K = $50 and a price of $5.K. • American Calls.The Lower Bound on Option Prices • Option prices must be at least zero. • Therefore. – An option holder can simply discard the option. • The Arbitrage Strategy: – Buy the call option at its price of C = $5. an American call option price is never less than its intrinsic value. – Then. American call option price = MAX[S . 0] 15-35 . the price of the option cannot be negative. Can an American call sell for less than its intrinsic value? No.K = $10. sell the stock at the current market price of S = $60. – The $5 call price is less than the intrinsic value of S . – Immediately exercise the call option and buy the stock at K = $50.

– Immediately exercise the put option and sell the stock at K = $50. • Therefore. an American put option price is never less than its intrinsic value. and a put option has a strike price of K = $50 and a price of $5. – The $5 put price is less than the intrinsic value of K .The Lower Bound on American Puts • Can an American put sell for less than its intrinsic value? No. – Suppose S = $40. • The Arbitrage Strategy: – Buy the put option at its price of P = $5.S. American put option price = MAX[K .S = $10. – Buy the stock at its price of S = $40. 0] 15-36 .

in-the-money European puts will frequently sell for less than their intrinsic value. How much less? – Using an arbitrage strategy that accounts for the fact that European put options cannot be exercised before expiration: European put option price ≥ MAX[K/(1 + r)T – S. European options cannot be exercised before expiration.K/(1 + r)T.The Lower Bounds for European Options • European Calls. The lower bound for a European put option price is less than its intrinsic value. – Therefore. 0] 15-37 . we cannot use the arbitrage strategies to set lower bounds for American options. European call option price ≥ MAX[S . – In fact. 0] • European Puts. – We must use a different approach (which can easily be found). • The lower bound for a European call option is greater than its intrinsic value.

• Put-Call Parity is generally used for options with European-style exercise.Put-Call Parity • Put-Call Parity is perhaps the most fundamental relationship in option pricing. 15-38 . • Put-Call Parity states: the difference between the call price and the put price equals the difference between the stock price and the discounted strike price.

The Put-Call Parity Formula C  P  S  K/(1  r) • In the formula: – – – – – – C is the call option price today S is the stock price today r is the risk-free interest rate P is the put option price today K is the strike price of the put and the call T is the time remaining until option expiration T • Note: this formula can be rearranged: K/(1  r)T  S  P  C 15-39 .

suppose an investor forms the following portfolio: – Buys 100 shares of Microsoft stock. they must sell for the same price today. – Writes one Microsoft call option contract. this portfolio will be worth: 15-40 . – Buys one Microsoft put option contract. • Today.Why Put-Call Parity Works • If two securities have the same risk-less pay-off in the future. • At option expiration.

That is. 15-41 . it is riskless. • Fun fact: If S = K (and if r > 0). and a maturity of T. • That is. the value of this portfolio today is $K/(1+r)T. then C > P.Put-Call Parity Notes • Notice that the portfolio is always worth $K at expiration. should equal the price of a risk-less security with a face value of $K. to prevent arbitrage: today’s cost of buying 100 shares and buying one put (net of the proceeds of writing one call). • Therefore.

Useful Websites • For information on options ticker symbols.numa.com • To learn more about options.cmegroup.optionsxpress.com • Exchanges that trade index options include: www.optionscentral. see: – – – www.com www.com www.tradingmarkets.com • For more information on options education:  www.investorlinks.cboe.com  www.com www.schaeffersresearch.com  15-42 . see: – – www.

Chapter Review. • Options on Common Stocks – Option Basics – Option Price Quotes • • • The Options Clearing Corporation Why Options? Stock Index Options – Features and Settlement – Index Option Price Quotes • • Option ―Moneyness‖ Option Payoffs and Profits – – – – Option Writing Option Payoffs Payoff Diagrams Option Profits 15-43 . I.

Chapter Review. II. Intrinsic Values. • • Using Options to Manage Risk The Three Types of Option Trading Strategies – Adding Options to a Stock Position – Combinations – Spreads • • Option Intrinsic Values Option Prices. and Arbitrage – The Upper Bound for a Call Option Price – The Upper Bound for a Put Option Price – The Lower Bounds on Option Prices • Put-Call Parity 15-44 .