Chapter 15

Stock Options

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 Stock Options

“I have no objection to the granting of options. Companies

should use whatever form of compensation best motivates
employees—whether this be cash bonuses, trips to Hawaii,
restricted stock grants or stock options.”
–Warren Buffett

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 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 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, I.

• 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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 Option Basics, II.

• Option contracts are legal agreements between two parties—

the buyer of the option and the seller of the option.

• The minimum terms stipulated by stock option contracts are:

― The identity of the underlying stock.
― The strike price, or exercise price.
― The option contract size.
― The option expiration date, or option maturity.
― The option exercise style (American or European).
― The delivery, or settlement, procedure.

• Stock options trade at organized options exchanges, such as

the CBOE, as well as over-the-counter (OTC) options markets.
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Listed Option Quotations for Intel (INTC)
www.wsj.com

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 Option Price Quotes

• A list of available option contracts and their prices for a particular security
is known as an option chain.

• Option chains are available online through many sources, including the
CBOE (http://quote.cboe.com) and Yahoo! Finance (
http://finance.yahoo.com).

• The format for option symbols had been the same for many years.

• In early 2010, however, the Options Clearing Corporation instituted a new,

expanded approach for option symbols.

• This change was driven by the increasing size of the option market.

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Listed Option Quotes for Starbucks (SBUX)
at Yahoo! Finance

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 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.

• The OCC issues and clears all option contracts trading on U.S.
exchanges.

• Note that the exchanges and the OCC are all subject to
regulation by the Securities and Exchange Commission (SEC).

Visit the OCC at: www.optionsclearing.com.

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 Why Options?

• A basic question asked by investors is: “Why buy

stock options instead of shares in the underlying
stock?”

• To answer this question, we compare the possible

outcomes from these two investment strategies:
― Buy the underlying stock.
― Buy options on the underlying stock.

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 Example: Buying the Underlying Stock
versus Buying a Call Option

• Suppose IBM is selling for $190 per share and call options
with a strike price of $190 are $5 per share.

• Investment for 100 shares:

―IBM Shares: $19,000
―One listed call option contract: $500

• Suppose further that the option expires in three months.

• Finally, let’s say that in three months, the price of IBM

shares will either be: $200, $180, or $190.
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 Example: Buying the Underlying Stock
versus Buying a Call Option, II.
• Let’s calculate the dollar and percentage returns
given each of the prices for IBM stock:
Buy 100 IBM Shares Buy One Call Option
($19,000 Investment): ($500 Investment):
Dollar Percentage Dollar Percentage
Profit: Return: Profit: Return:

Case 1: $200 $1,000 11.11% $500 100%

Case 2: $180 -$1,000 -11.11% -$500 -100%

Case 3: $190 $0 0% -$500 -100%

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 Why Options? Conclusion
• Whether one strategy is preferred over another is a matter for
each individual investor to decide.
― That is, in some instances, investing in the underlying stock will be better. In other
instances, investing in the option will be better.
― 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.

• Versus buying 100 shares:

― The dollar loss potential with call options is lower.
― The dollar gain potential with call options is lower.
― The positive percentage gains with call options is higher.
― The negative percentage return with call options is lower (i.e., as a percentage, you
can loss more of your investment using options).
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 Stock Index Options

• A stock index option is an option on a stock market index.

• The most popular stock index options are options on the

S&P 100, S&P 500, and Dow Jones Industrial Average.

• Because the actual delivery of all stocks comprising a

stock index is impractical, stock index options have a cash
settlement procedure.
―That is, if the option expires in the money, the option writer simply
pays the option holder the intrinsic value of the option.
―The cash settlement procedure is the same for calls and puts.
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Index Option Trading, Part One

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Index Option Trading, Part Two

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 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.
• Call option intrinsic value = MAX[0, 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.

S is the current stock price; K is the strike price of the option

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 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 Out-of-the-Money
Call Option S>K 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.”
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 More Option “Moneyness”

• “In the Money” options have a positive intrinsic value.

―For calls, the strike price is less than the stock price.
―For puts, the strike price is greater than the stock price.

• “Out of the Money” options have a zero intrinsic value.

―For calls, the strike price is greater than the stock price.
―For puts, the strike price is less 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.

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 Option Writing

• The act of selling an option is referred to as option writing.

• The seller of an option contract is called the writer.

―The writer of a call option contract is obligated to sell the underlying asset
to the call option holder.
―The call option holder has the right to exercise the call option (i.e., buy the
underlying asset at the strike price).
―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.e., sell the
underlying asset at the strike price).

• Because option writing obligates the option writer, the option writer
receives the price of the option today from the option buyer.
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 Option Exercise

• Option holders have the right to exercise their option.

― If this right is only available at the option expiration date, the option is said to have a
European-style exercise.
― If this right is available at any time up to and including the option expiration date, the
option is said to have an American-style exercise.

• Exercise style is not linked to where the option trades. European-

style and American-style options trade in the U.S., as well as on
other option exchanges throughout the world.

• Very Important: Option holders also have the right to sell their
option at any time. That is, they do not have to exercise the
option if they no longer want it.

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 Option Payoffs versus Option Profits

• Option investment strategies involve initial and terminal cash

flows.
―Initial cash flow: option price (often called the option premium).
―Terminal cash flow: the value of an option at expiration (often called the
option payoff).

• The terminal cash flow can be realized by the option holder

by exercising the option.

The profit from an option strategy is the difference from the

cash flows at expiration and the cash flow needed to
initiate the option strategy.
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Call Option Payoffs

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Put Option Payoffs

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Call Option Profits

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Put Option Profits

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 Using Options to Manage Risk, I.
• Protective put - Strategy of buying put options to protect against falling values.

• Protective puts provide “insurance” for the value of an asset or a stream of cash
inflows.

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 Using Options to Manage Risk, II.
• Protective call - 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.

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 The Three Types of
Option Trading Strategies
• Type I: Traders add an option position to their stock position.
―These strategies help traders modify their stock risk.
―Example: Covered Calls (Selling a call option on a stock already owned).

• Type II: Spreads.

―A position with two or more options of the same type (i.e., only calls or only puts).
―Example: Butterfly Spread.
o Three option positions using: equally-spaced strikes with the same expiration.
o Buy one call option with the lowest strike.
o Buy one call option with the highest strike.
There are many option trading
o Sell two call options with the middle strike.
strategies. Check out the
CBOE’s web site.

• Type III: Combinations.

―A position in a mixture of call and put options.
―Example: Straddle (buy one call and one put with the same strike and expiration).
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 Arbitrage and Option Pricing Bounds

• Arbitrage:
―No possibility of a loss
―A potential for a gain
―No cash outlay

• In finance, arbitrage is NOT allowed to persist.

―“Absence of Arbitrage” = “No Free Lunch”
―The “Absence of Arbitrage” assertion is often used in finance to calculate
option prices.

• Think about what would happen if arbitrage were allowed

to persist. (Easy money for everybody)
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 The Upper Bound for a Call Option Price

• Call option price must be less than the stock price.

• Otherwise, arbitrage will be possible.

• How?
―Suppose you see a call option selling for $65 with a strike of $65, and the
underlying stock is selling for $60.
―The Arbitrage: sell the call, and buy the stock.
o Worst case? The option is exercised and you pocket $5.
o Best case? The stock sells for less than $65 at option expiration, and you pocket $65
and still own the stock.
o “Worst” Best case? Stock price goes to zero—but you still pocket $5.
―Zero cash outlay today, no possibility of loss, and potential for gain.
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 The Upper Bound for
European Put Option Prices, I.

• European put option price must be less than the strike price .

• Suppose a put option with a strike price of $50 is selling for $50.

• The Arbitrage: Sell the put, and invest the $50 in the bank. (Note
you have zero cash outlay).
― Worse case? Stock price goes to zero.
o You must pay $50 for the stock (because you were the put writer).
o But, you have $50 from the sale of the put (plus interest).

― Best case? Stock price is at least $50 at expiration.

o The put expires with zero value (and you are off the hook).
o You keep the entire $50, plus interest.

• So, we see that if the put option price equals the strike price, there
is an arbitrage.
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 The Upper Bound for
European Put Option Prices, II.

• There will be an arbitrage if price of the put, plus the interest you could earn over
the life of the option, is greater than the stock price.
― For example, suppose the risk-free rate is 3 percent per quarter.
― We have a put option with an exercise price of $50 and 90 days to maturity.

• What is the maximum put value that does not result in an arbitrage?
Maximum put price  1.03  $50
Maximum put price  $50/1.03  $48.54

• Notice that the answer, $48.54, is the present value of the strike price computed at
the risk-free rate.

• Therefore: The maximum price for a European put option is the present value of
the strike price computed at the risk-free rate.
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 The Lower Bound on Option Prices
• Option prices must be at least zero.
― An option holder can simply discard the option.
― This means that no one would pay someone to take an option off their hands.
― Therefore, the price of the option cannot be negative.

• American Calls. An American call cannot sell for less than its intrinsic value?
― Suppose S = $60, and a call option has a strike price of K = $50 and a price of $5.
― The $5 call price is less than the intrinsic value of S - K = $10.

• The Arbitrage Strategy:

― Buy the call option at its price of C = $5.
― Immediately exercise the call option and buy the stock at K = $50.
― Then, sell the stock at the current market price of S = $60.
― Obtain $5 profit.

• Therefore, an American call option price is never less than its intrinsic value.

Minimum American call option price = MAX[S - K, 0]

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 The Lower Bound on American Puts

• Can an American put sell for less than its intrinsic value? No.
― Suppose S = $40, 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 - S = $10.

• The Arbitrage Strategy:

― Buy the put option at its price of P = $5.
― Buy the stock at its price of S = $40.
― Immediately exercise the put option and sell the stock at K = $50.
― Obtain $5 profit.

• Therefore, an American put option price is never less than its intrinsic value.

Minimum American put option price = MAX[K - S, 0]

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 The Lower Bounds for European Options
• European Calls. European options cannot be exercised before expiration.
― Therefore, we cannot use the arbitrage strategies to set lower bounds for American options.
― 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.

European call option price ≥ MAX[S - K/(1 + r)T, 0]

• European Puts. The lower bound for a European put option price is less than its
intrinsic value.
― In fact, 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, 0]

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 Put-Call Parity

• Put-Call Parity is perhaps the most fundamental relationship in

option pricing.

• Put-Call Parity is generally used for options with European-

style exercise.

• 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.
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 The Put-Call Parity Formula
T
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

• Note: this formula K/(1  r)T  S  P  C

can be rearranged:
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 Why Put-Call Parity Works
• If two securities have the same risk-less pay-off in the future, they must sell for
the same price today.

• Today, suppose an investor forms the following portfolio:

― Buys 100 shares of Microsoft stock.
― Writes one Microsoft call option contract.
― Buys one Microsoft put option contract.

• At option expiration, this portfolio will be worth, $K:

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 Put-Call Parity Notes

• Notice that the portfolio is always worth $K at expiration.

That is, it is riskless.

• Therefore, the value of this portfolio today is $K/(1+r) T.

• That is, to prevent arbitrage: today’s cost of buying 100

shares and buying one put (net of the proceeds of writing
one call), should equal the price of a risk-less security with a
face value of $K, and a maturity of T.

• Fun fact: If S = K (and if r > 0), then C > P.

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 Useful Websites
• For more information on options education:
― www.optionsclearing.com
― www.optinoseducation.org
― www.cboe.com/LearnCenter
― jmdinvestments.blogspot.com

• To learn more about options, see:

― www.numa.com
― www.optionscentral.com
― www.optionsxpress.com
― www.investorlinks.com
― www.commodityworld.com
― www.writecall.com
― www.optionetics.com
― www.ino.com

• Exchanges that trade index options include:

― www.cboe.com
― www.nyse.com

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 Chapter Review, I.
• 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 Intrinsic Value and Option “Moneyness”

• Option Payoffs and Profits

― Option Writing
― Option Payoffs
― Payoff Diagrams
― Option Profits
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 Chapter Review, II.

• Using Options to Manage Risk

• The Three Types of Option Trading Strategies

― Adding Options to a Stock Position
― Combinations
― Spreads

• Option Prices, Intrinsic Values, 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
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