14

Stock Options

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
 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 an 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, Cont.

• 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

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 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.

• Investment for 100 shares:

– IBM Shares: $9,000
– 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: $100, $90, or $80.

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 Example: Buying the Underlying Stock
versus Buying a Call Option, Cont.

• Let’s calculate the dollar and percentage return given

each of the prices for IBM stock:
Buy 100 IBM Shares Buy One Call Option
($9000 Investment): ($500 Investment):
Dollar Percentage Dollar Percentage
Profit: Return: Profit: Return:

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

Case II: $90 $0 0% -$500 -100%

Case III: $80 -$1,000 -11.11% -$500 -100%

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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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 Option Strategies

• Protective put - Strategy of buying a put option on a

stock already owned. This protects against a decline in
value (i.e., it is "insurance")

• Covered call - Strategy of selling a call option on stock

already owned. This exchanges “upside” potential for
current income.

• Straddle - Buying or selling a call and a put with the

same exercise price. Buying is a long straddle; selling is
a short straddle.

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 More Option Trading Strategies

• There are many option trading strategies available to

option traders.

• For ideas on option trading strategies, see:

 www.commodityworld.com
 www.writecall.com
 www.giscor.com

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 Arbitrage

• 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” rule is often used in finance to figure
out prices of derivative securities.

• 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, and the
underlying stock is selling for $60.
– The arbitrage: sell the call, and buy the stock.
• Worst case? The option is exercised and you pocket $5.
• Best case? The stock sells for less than $65 at option expiration,
and you keep all of the $65.
– There was zero cash outlay today, there was no possibility of
loss, and there was a potential for gain.
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 The Upper Bound for a Put Option Price
• Put option price must be less than the strike price.
Otherwise, arbitrage will be possible.

• How? Suppose there is a put option with a strike price of

$50 and this put is selling for $60.

• The Arbitrage: Sell the put, and invest the $60 in the
bank. (Note you have zero cash outlay).
– Worse case? Stock price goes to zero.
• You must pay $50 for the stock (because you were the put writer).
• But, you have $60 from the sale of the put (plus interest).
– Best case? Stock price is at least $50 at expiration.
• The put expires with zero value (and you are off the hook).
• You keep the entire $60, plus interest.

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 The Lower Bound on Option Prices

• Option prices must be at least zero.

– By definition, an option can simply be discarded.

• To derive a meaningful lower bound, we need to

introduce a new term: intrinsic value.

• 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.

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 Option Intrinsic Values

• That is, if S is the current stock price, and K is the strike

price of the option:

• 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.

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 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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 Intrinsic Values and Arbitrage, Calls

• Call options with American-style exercise must sell for at

least their intrinsic value. (Otherwise, there is arbitrage)

• Suppose: S = $60; C = $5; K = $50.

• Instant Arbitrage. How?

– Buy the call for $5.
– Immediately exercise the call, and buy the stock for $50.
– In the next instant, sell the stock at the market price of $60.

• You made a profit with zero cash outlay.

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 Intrinsic Values and Arbitrage, Puts

• Put options with American-style exercise must sell for at

least their intrinsic value. (Otherwise, there is arbitrage)

• Suppose: S = $40; P = $5; K = $50.

• Instant Arbitrage. How?

– Buy the put for $5.
– Buy the stock for $40.
– Immediately exercise the put, and sell the stock for $50.

• You made a profit with zero cash outlay.

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 Back to Lower Bounds for Option Prices

• As we have seen, to prevent arbitrage, option prices

cannot be less than the option intrinsic value.
– Otherwise, arbitrage will be possible.
– Note that immediate exercise was needed.
– Therefore, options needed to have American-style exercise.

• Using equations: If S is the current stock price, and K is

the strike price:

Call option price  max [0, S – K ]

Put option price  max [0, K – S ]

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 Employee Stock Options, ESOs

• Essentially, an employee stock option is a call option

that a firm gives to employees.
– These call options allow the employees to buy shares of stock
in the company.
– Giving stock options to employees is a widespread practice.

• Because you might soon be an ESO holder, an

understanding of ESOs is important.

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 Features of ESOs

• ESOs have features that ordinary call options do not.

• Details vary by firm, but:

– The life of the ESO is generally 10 years.
– ESOs cannot be sold.
– ESOs have a “vesting” period of about 3 years.
• Employees cannot exercise their ESOs until they have worked for
the company for this vesting period.
• If an employee leaves the company before the ESOs are “vested,"
the employees lose the ESOs.
• If an employee stays for the vesting period, the ESOs can be
exercised any time over the remaining life of the ESO.

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 Why are ESOs Granted?

• Owners of a corporation (i.e., the stockholders) have a

basic problem. How do they get their employees to
make decisions that help the stock price increase?

• ESOs are a powerful motivator, because payoffs to

options can be large.
– High stock prices: ESO holders gain and shareholders gain.

• ESOs have no upfront costs to the company.

– ESOs can be viewed as a substitute for ordinary wages.
– Therefore, ESOs are helpful in recruiting employees.

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 ESO Repricing

• ESOs are generally issued exactly “at the money.”

– Intrinsic value is zero.
– There is no value from immediate exercise.
– But, the ESO is still valuable.

• If the stock price falls after the ESO is granted, the ESO
is said to be “underwater.”

• Occasionally, companies will lower the strike prices of

ESOs that are “underwater.”
– This practice is called “restriking” or “repricing.”
– This practice is controversial.
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 ESO Repricing Controversy

• PRO: Once an ESO is “underwater,” it loses its ability to

motivate employees.
– Employees realize that there is only a small chance for a payoff
from their ESOs.
– Employees may leave for other companies where they get
“fresh” options.

• CON: Lowering a strike price is a reward for failing.

– After all, decisions by employees made the stock price fall.
– If employees know that ESOs will be repriced, the ESOs loose
their ability to motivate employees.

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 ESOs Today

• Most companies award ESO on a regular basis.

– Quarterly
– Annually

• Therefore, employees will always have some “at the

money” options.

• Regular grants of ESOs means that employees always

have some “unvested” ESOs—giving them the added
incentive to remain with the company.

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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

C  P  S  Ke rT
• In the formula: e-rT is a discount factor,
so Ke-rT is simply the
– C is the call option price today discounted strike price.
– 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 rT

Ke  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:

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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 $Ke-rT.

• 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 rT > 0), then C > P.

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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

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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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 Useful Websites
• For information on options ticker symbols, see:
 www.cboe.com
 www.optionsites.com

• For more information on options education:

 www.optionscentral.com

• To learn more about options, see:

 www.e-analytics.com
 www.tradingmarkets.com
 www.investorlinks.com

• Exchanges that trade index options include:

 www.cboe.com
 www.cbot.com
 www.cme.com

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 Chapter Review, I.
• Options on Common Stocks
– Option Basics
– Option Price Quotes
• Why Options?
• Option Payoffs and Profits
– Option Writing
– Option Payoffs
– Payoff Diagrams
– Option Profits
• Option Strategies
– The Protective Put Strategy
– The Covered Call Strategy
– Straddles

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 Chapter Review, II.

• 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

• Employee Stock Options (ESOs)

– Features
– Repricing

• Put-Call Parity

• Stock Index Options

– Features and Settlement
– Index Option Price Quotes

• The Options Clearing Corporation

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