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Chapter 14
Options:
Puts and
Calls
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14-2
Options: Puts, Calls, and Warrants
• Learning Goals
1. Discuss the basic nature of options in general, and puts
and calls in particular, and understand how these
investment vehicles work.
2. Describe the options market, and note key options
provisions, including strike prices and expiration dates.
3. Explain how put and call options are valued and the
forces that drive options prices in the marketplace.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
14-3
Options: Puts, Calls, and Warrants
• Learning Goals (cont’d)
4. Describe the profit potential of puts and calls, and note
some popular put and call investment strategies.
5. Explain the profit potential and loss exposure from
writing covered call options, and discuss how writing
options can be used as a strategy for enhancing
investment returns.
6. Describe market index options, puts and calls on
foreign currencies, and LEAPS, and discuss how
investors can use these securities.
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14-4
Options: Puts, Calls and Warrants
• Financial Asset: asset that represents a
financial claim on an issuing organization
– Stocks, bonds and convertible securities
are examples
• Option: the right to buy or sell a certain
amount of an underlying financial asset at a
specified price for a given period of time
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14-5
Types of Options
• Types of Options
– Puts
– Calls
– Rights
– Warrants
• All of the above are types of derivative securities,
which derive their value from the price behavior of
an underlying real or financial asset

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14-6
Options: Puts and Calls
• Puts and calls may be traded on:
– Common stocks
– Stock indexes
– Exchange traded funds
– Foreign currencies
– Debt instruments
– Commodities and financial futures
• Owners of put and call options have no voting
rights, no privileges of ownership, and no interest
or dividend income
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14-7
Options: Puts and Calls
(cont’d)
• Options allow buyers to use leverage;
investors can buy a lot of price action with
limited capital
• Options allows investors to nearly always
enjoy limited exposure to risk
• Puts and calls are created by individual
investors, not by the organizations that
issue the underlying financial asset
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14-8
Options: Puts and Calls
(cont’d)
• Option Buyer:
– Has the right to buy or sell an underlying asset
for a given period of time, at a price that was
fixed at the time of the option contract in
exchange for paying the seller a fee
• Buyer can walk away from a bad option

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14-9
Options: Puts and Calls
(cont’d)
• Option Seller/Maker/Writer:
– Has the obligation to buy or sell the underlying
asset according to the terms of the option
contract, for which the seller has been paid a
certain amount of money
• Seller cannot walk away from a bad option
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14-10
Options: Puts and Calls
(cont’d)
• Put and call options trade in the open market
much like any other security and may be bought
and sold through securities brokers and dealers
• Values of puts and calls change with the values of
the underlying assets
• Values of puts and calls change with the time
period before they expire:
– Closer to expiration date, option values go down
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14-11
Advantages of Puts and Calls
• Allows use of leverage
– Leverage: the ability to obtain a given equity
position at a reduced capital investment,
thereby magnifying total return
• Option buyer’s exposure to risk is limited to
fee paid to purchase the put or call option
• Investor can make money when value of
assets go up or down
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14-12
Disadvantages of Puts and
Calls
• Investor does not receive any interest or
dividend income
• Options expire; the investor has limited time to
benefit from options before they become worthless
• Options are complex and tricky
• Option seller’s exposure to risk may be unlimited
• Options are risky because an investor has to be
correct on two decisions to make money:
– Which direction the price of the asset will move
– When the price change will occur

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14-13
How Calls Work
• Call: a negotiable instrument that gives the holder
(buyer) the right to buy the underlying security at a
specified price over a set period of time from the
seller/maker/writer in exchange for a fee paid to
the seller/maker/writer
– The buyer of the call option wants the price of the
underlying assets to go up
– The seller/maker/writer of the call option wants the price
of the underlying assets to go down
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14-14
How Calls Work (cont’d)
• If the price of the underlying assets goes up:
– The buyer will buy the asset at the lower strike price
from the seller/maker/writer and sell it at the higher
market price, making a profit
– The seller will sell the assets at a price lower than the
market price. If the seller does not already own the
assets, then the seller will have to purchase them at the
higher market price
• Covered call: seller owns the asset
• Naked call: seller does not own the asset
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How Calls Work (cont’d)
• If the price of the underlying assets
go down:
– The buyer will let the call option expire
worthless and lose the fee paid
– The seller will keep the fee received and make
a profit
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14-16
How Calls Work (cont’d)
• Example: Assume the market price for a share of common stock is
$50. A call option to purchase 100 shares of the stock at a strike price
of $50 per share may be purchased for $500
• If the market price of the stock goes up to $75 per share, the buyer will
purchase 100 shares at the strike price from the seller/maker/writer
and sell them at the higher market price.
• The buyer’s profit will be:
• The seller/maker/writer’s loss will be:
Profit = [(Market price – Strike price) × 100 Shares] ÷ Cost of call
$2,000 = [($75 ÷ $50) × 100 Shares] ÷ $500
Loss = [(Strike price ÷ Market price) × 100 Shares] + Fee for call
$(2,000) = [($50 ÷ $75) × 100 Shares] + $500
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14-17
How Calls Work:
The Value of Leverage
• Example: Assume the market price for a share of common stock is
$50. A call option to purchase 100 shares of the stock at a strike price
of $50 per share may be purchased for $500
• If the market price of the stock goes up to $75 per share, the buyer will
purchase 100 shares at the strike price from the seller/maker/writer
and sell them at the higher market price. The buyer’s profit will be
$2,000.
• The buyer’s total return using the call option will be:
• The buyer’s total return directly owning the stock would be:
Total Return =
Profit
Amount invested
=
$2,000
$500
= 400%
Total Return =
Profit
Amount invested
=
$2,000
$5,000
= 40%
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14-18
How Calls Work (cont’d)
• Example: Assume the market price for a share of common stock is
$50. A call option to purchase 100 shares of the stock at a strike price
of $50 per share may be purchased for $500
• If the market price of the stock goes down to $25 per share, the buyer
will allow the call option to expire worthless.
• The buyer’s loss will be:
• The seller/maker/writer’s profit will be:
Loss = Cost of call
Loss = $(500)
Profit = Fee of call
Profit = $(500)
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14-19
How Puts Work
• Put: a negotiable instrument that enables the
holder (buyer) to sell the underlying security at a
specified price over a set period of time to the
seller/maker/writer in exchange for a fee paid to
the seller/maker/writer
– The buyer of the put option wants the price of the
underlying assets to go down
– The seller/maker/writer of the put option wants the price
of the underlying assets to go up
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14-20
How Puts Work (cont’d)
• If the price of the underlying assets goes down:
– The buyer will buy the asset on the market at the lower
price and force the seller/maker/writer to buy the asset
at the higher option price, making a profit
– The seller will pay a price higher than the market price
and will own expensive assets or will have to sell them
at a loss
• If the price of the underlying assets go up:
– The buyer will let the put option expire worthless and
lose the fee paid
– The seller will keep the fee received and make a profit
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14-21
How Puts Work (cont’d)
• Example: Assume the market price for a share of common stock is
$50. A put option to sell 100 shares of the stock at a strike price of $50
per share may be purchased for $500.
• If the market price of the stock goes down to $25 per share, the buyer
will purchase 100 shares at the market price and force the
seller/maker/writer to buy them at the option strike price.
• The buyer’s profit will be:
• The seller/maker/writer’s loss will be:
Profit = [(Strike price ÷ Market price) × 100 shares] ÷ Cost of put
$2,000 = [($50 ÷ $25) × 100 Shares] ÷ $500
Loss = [(Market price ÷ Strike price) × 100 shares] + Fee for put
($2,000) = [($25 ÷ $50) × 100 Shares] + $500
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14-22
How Puts Work (cont’d)
• Example: Assume the market price for a share of common
stock is $50. A put option to sell 100 shares of the stock at
a strike price of $50 per share may be purchased for $500.
• If the market price of the stock goes up to $75 per share,
the buyer will allow the put option to expire worthless.
• The buyer’s loss will be:
• The seller/maker/writer’s profit will be:
Loss = Cost of put
Loss = $(500)
Profit = Fee for put
Profit = $500
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14-23
Put and Call Options Markets
• Conventional (OTC) Options
– Sold over the counter
– Primarily used by institutional investors
• Listed Options
– Created in 1973 by the Chicago Board Option Exchange (CBOE)
– Puts and calls traded through CBOE exchange, as well as
International Securities Exchange, AMEX, Philadelphia exchange,
NYSE Arca and Boston Options Exchange.
– Provided convenient market that made options trading more
popular and help create a secondary market
– Helped standardize expiration dates and exercise/strike prices
– Reduced trading costs
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14-24
Stock Options
• Common Stock Options
– Over 1.5 billion option contracts are traded
each year
– Options on common stocks is the most popular
form of option
– Over 90% of all option contracts are
stock options
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14-25
Key Provisions of Stock
Options
• Strike Price
– Stated price at which you can buy a security with a call
or sell a security with a put
– Conventional (OTC) options may have any strike price
– Listed options have standardized prices with price
increments determined by the price of the stock
• Expiration Date
– Stated date when the option expires and becomes
worthless if not exercised
– Conventional (OTC) options may have any working day
as expiration date
– Listed options have standardized expiration dates
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14-26
Figure 14.1 Quotations
for Listed Stock Options
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14-27
Expiration Date of Listed
Stock Options
• Three Expiration Cycles
– The January/April/July/October cycle
– The February/May/August/November cycle
– The March/June/September/December cycle
• The longest-term expiration dates are normally no longer
than nine months
• The options that are longer than nine months are called
LEAPS, and they are only available on some of the stocks
• Listed options always expire on the third Friday of the
month of expiration
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14-28
Valuation of Stock Options
• Option Premium (Price): the quoted price
the investor pays to buy a listed put or
call option
• Option premiums (prices) are affected by:
– Fundamental (intrinsic) value: based upon
current market price of underlying assets
– Time Premium: amount that option price
exceeds the fundamental value
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14-29
Valuation of Stock Options:
Fundamental Value of a Call
Fundamental value of a call =
Market price of
underlying
common stock,
or other
financial asset
÷
Strike price
on
the call
|
\

|
.
|
|
|
|
× 100
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14-30
Valuation of Stock Options:
Fundamental Value of a Put
Fundamental value of a put =
Strike price
on
the put
÷
Market price of
underlying
common stock,
or other
financial asset
|
\

|
.
|
|
|
|
× 100
V = SPP ÷ MP ( ) × 100
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14-31
Figure 14.2 The Valuation
Properties of Put and Call Options
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14-32
Valuation of Stock Options
• In-the-Money
– Call option: when the strike price is less than the market
price of the underlying security
– Put option: when the strike price is greater than the
market price of the underlying security
• Out-of-the-Money
– Call option: when the strike price is greater than the
market price of the underlying security
– Put option: when the strike price is less than the market
price of the underlying security
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14-33
Table 14.1 Option Price Components
for an Actively Traded Call Option
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14-34
Option Trading Strategies
• Buying for Speculation
• Hedging to modify risks
• Writing Options to enhance returns
• Spreading Options to enhance returns
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14-35
Speculating with Stock Options
• Similar to investing in common stocks
– Goal is to “buy low, sell high”
– Buyer does not need as much capital since can
use leverage
– Buyer cannot lose more than cost of the option
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14-36
Table 14.2 Speculating with Call
Options
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14-37
Hedging with Stock Options
• Purpose is to reduce or eliminate risk
• Combines two or more securities into a single investment
position
• Hedging a “Long” Position
– Buying a put and holding appreciated stock in the same company
– Buying a put would provide “insurance” in case the stock price went
down before you sold the stock
• Hedging a “Short” Position
– Selling stock short and buying a call
– Buying a call would allow you to buy stock to cover the short sale if
the stock price went up instead of down
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14-38
Table 14.3 Limiting Capital Loss
with a Put Hedge
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14-39
Table 14.4 Protecting Profits
with a Put Hedge
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14-40
Writing Stock Options
• The seller/maker/writer is betting that the option buyer will
be wrong about the direction of the stock price or the time
period the price change will occur
– Statistically, the odds favor the writer over the buyer
– Easy money if the option expires worthless. The writer cannot
make more than the fee received
– High risk if the option is “in-the-money”
• Naked options: writer does not own the optioned securities and has to
buy them. No limit on loss exposure
• Covered options: writer owns the optioned securities. Loss exposure is
limited to the price originally paid for the securities
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14-41
Table 14.5 Covered Call
Writing
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14-42
Spreading Options
• Purpose is to take advantage of differences in prevailing
option prices and premiums
• Combines two or more options into a single transaction
• “Vertical” Spread
– Buying a call at one strike price and writing a call (on same stock
for same expiration date) at a higher strike price
• “Option” Straddle
– Simultaneous purchase (or sale) of both a put and a call on the
same underlying common stock
• Spreading options is extremely tricky and should be used
only by knowledgeable investors
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14-43
Stock-Index Options
• Stock-Index Option: a put or call option
written on a specific stock market index
• Major stock indexes for options:
– The S&P 500 Index
– The S&P 100 Index
– The Dow Jones Industrial Average
– The Nasdaq 100 Index
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14-44
Stock-Index Options (cont’d)
• Market price is function of strike price of option and latest
published stock market index value
• Valuation techniques are similar to valuing options for
individual securities
• Price behavior and investment risk are similar to options
for individual securities
• May be used to hedge a whole portfolio of stocks rather
than individual stocks
• May be used to speculate on the stock market as a whole
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14-45
Other Types of Options
• Exchange traded funds: put and call options
written on exchange traded funds (EFT’s)
– Very similar to market index options
• Interest rate options: put and call options written
on fixed-income (debt) securities
– Small market involving only U.S. Treasury securities
– Option prices change with yield behavior of
debt securities
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14-46
Other Types of Options (cont’d)
• Currency options: put and call options written on
foreign currencies
– Available on most major world currencies
– Option prices change as exchange rates between
currencies fluctuate
• LEAPS: long-term options that may extend out
to 3 years
– Available on several hundred stocks and over two
dozen stock indexes and ETF’s
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14-47
Chapter 14 Review
• Learning Goals
1. Discuss the basic nature of options in general, and puts
and calls in particular, and understand how these
investment vehicles work.
2. Describe the options market, and note key options
provisions, including strike prices and expiration dates.
3. Explain how put and call options are valued and the
forces that drive options prices in the marketplace.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
14-48
Chapter 14 Review (cont’d)
• Learning Goals (cont’d)
4. Describe the profit potential of puts and calls, and note
some popular put and call investment strategies.
5. Explain the profit potential and loss exposure from
writing covered call options, and discuss how writing
options can be used as a strategy for enhancing
investment returns.
6. Describe market index options, puts and calls on
foreign currencies, and LEAPS, and discuss how
investors can use these securities.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
Chapter 14
Additional
Chapter Art
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14-50
Figure 14.3 Quotations on Index
Options
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14-51
Table 14.6 Foreign Currency Option
Contracts on the Philadelphia Exchange