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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or option maturity. and the seller of the option. The option contract size. or exercise price. The strike price. • Stock options trade at organized options exchanges.Option Basics. as well as over-the-counter (OTC) options markets. The option expiration date. • Option contracts are legal agreements between two parties—the buyer of the option. The delivery. or settlement. The option exercise style (American or European). Cont. • The minimum terms stipulated by stock option contracts are: – – – – – – The identity of the underlying stock. procedure. such as the CBOE. 14-4 .

Listed Option Quotations 14-5 .

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. $90. • Investment for 100 shares: – IBM Shares: $9. let’s say that in three months. the price of IBM shares will either be: $100. 14-6 . • Finally. or $80.000 – One listed call option contract: ($500) • Suppose further that the option expires in three months.

000 -11. Cont.000 Percentage Return: 11.11% -$500 -100% 14-7 .11% Buy One Call Option ($500 Investment): Dollar Profit: $500 Percentage Return: 100% Case II: $90 $0 0% -$500 -100% Case III: $80 -$1. • Let’s calculate the dollar and percentage return given each of the prices for IBM stock: Buy 100 IBM Shares ($9000 Investment): Dollar Profit: Case I: $100 $1.Example: Buying the Underlying Stock versus Buying a Call Option.

Call Option Payoffs 14-8 .

Put Option Payoffs 14-9 .

Call Option Profits 14-10 .

Put Option Profits 14-11 .

14-12 .Buying or selling a call and a put with the same exercise price..e. • Straddle .Strategy of selling a call option on stock already owned. This exchanges ―upside‖ potential for current income.Strategy of buying a put option on a stock already owned. it is "insurance") • Covered call . selling is a short straddle. This protects against a decline in value (i. Buying is a long straddle.Option Strategies • Protective put .

writecall.com 14-13 . see:  www.giscor. • For ideas on option trading strategies.com  www.More Option Trading Strategies • There are many option trading strategies available to option traders.com  www.commodityworld.

(Easy money for everybody) 14-14 . arbitrage is not allowed to persist.Arbitrage • Arbitrage: – No possibility of a loss – A potential for a gain – No cash outlay • In finance. • 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 figure out prices of derivative securities.

• How? – Suppose you see a call option selling for $65. there was no possibility of loss. • Best case? The stock sells for less than $65 at option expiration. arbitrage will be possible. 14-15 . and there was a potential for gain. • Worst case? The option is exercised and you pocket $5. and you keep all of the $65. and the underlying stock is selling for $60.The Upper Bound for a Call Option Price • Call option price must be less than the stock price. and buy the stock. – The arbitrage: sell the call. • Otherwise. – There was zero cash outlay today.

– Best case? Stock price is at least $50 at expiration. • You keep the entire $60. 14-16 . • The put expires with zero value (and you are off the hook). Otherwise. • But. • The Arbitrage: Sell the put. • You must pay $50 for the stock (because you were the put writer). and invest the $60 in the bank. plus interest. you have $60 from the sale of the put (plus interest).The Upper Bound for a Put Option Price • Put option price must be less than the strike price. – Worse case? Stock price goes to zero. • How? Suppose there is a put option with a strike price of $50 and this put is selling for $60. arbitrage will be possible. (Note you have zero cash outlay).

we need to introduce a new term: intrinsic value. • To derive a meaningful lower bound. – By definition. 14-17 .The Lower Bound on Option Prices • Option prices must be at least zero. an option can simply be discarded. • 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.

K – S ] – In words: The put option intrinsic value is the maximum of zero or the strike price minus the stock price. 14-18 . and K is the strike price of the option: • Call option intrinsic value = max [0. if S is the current stock price. 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.Option Intrinsic Values • That is.

• “At the Money” options is a term used for options when the stock price and the strike price are about the same. 14-19 . the strike price is greater than the stock price. • “Out of the Money” options have a zero intrinsic value. the strike price is less than the stock price. – For calls. – For calls. the strike price is less than the stock price. – For puts. – For puts. the strike price is greater than the stock price.Option ―Moneyness‖ • “In the Money” options have a positive intrinsic value.

(Otherwise. • Instant Arbitrage. How? – Buy the call for $5. there is arbitrage) • Suppose: S = $60. – In the next instant. C = $5. – Immediately exercise the call. K = $50. • You made a profit with zero cash outlay. and buy the stock for $50. Calls • Call options with American-style exercise must sell for at least their intrinsic value.Intrinsic Values and Arbitrage. 14-20 . sell the stock at the market price of $60.

and sell the stock for $50. P = $5. – Immediately exercise the put. 14-21 . K = $50. (Otherwise. How? – Buy the put for $5. – Buy the stock for $40. there is arbitrage) • Suppose: S = $40. • Instant Arbitrage. • You made a profit with zero cash outlay. Puts • Put options with American-style exercise must sell for at least their intrinsic value.Intrinsic Values and Arbitrage.

and K is the strike price: Call option price  max [0. S – K ] Put option price  max [0. to prevent arbitrage. K – S ] 14-22 . • Using equations: If S is the current stock price. option prices cannot be less than the option intrinsic value. – Therefore.Back to Lower Bounds for Option Prices • As we have seen. – Otherwise. options needed to have American-style exercise. – Note that immediate exercise was needed. arbitrage will be possible.

14-23 . • Because you might soon be an ESO holder. ESOs • Essentially. – Giving stock options to employees is a widespread practice. an employee stock option is a call option that a firm gives to employees.Employee Stock Options. – These call options allow the employees to buy shares of stock in the company. an understanding of ESOs is important.

Features of ESOs • ESOs have features that ordinary call options do not." the employees lose the ESOs. but: – The life of the ESO is generally 10 years. • If an employee leaves the company before the ESOs are ―vested. • Details vary by firm. 14-24 . • Employees cannot exercise their ESOs until they have worked for the company for this vesting period. the ESOs can be exercised any time over the remaining life of the ESO. • If an employee stays for the vesting period. – ESOs have a ―vesting‖ period of about 3 years. – ESOs cannot be sold.

• ESOs have no upfront costs to the company. 14-25 . – Therefore. – ESOs can be viewed as a substitute for ordinary wages.. How do they get their employees to make decisions that help the stock price increase? • ESOs are a powerful motivator. ESOs are helpful in recruiting employees. – High stock prices: ESO holders gain and shareholders gain. the stockholders) have a basic problem.e.Why are ESOs Granted? • Owners of a corporation (i. because payoffs to options can be large.

companies will lower the strike prices of ESOs that are ―underwater.‖ – This practice is called ―restriking‖ or ―repricing. – There is no value from immediate exercise. • If the stock price falls after the ESO is granted. 14-26 . the ESO is still valuable. the ESO is said to be ―underwater. – But.‖ – Intrinsic value is zero.‖ – This practice is controversial.‖ • Occasionally.ESO Repricing • ESOs are generally issued exactly ―at the money.

‖ it loses its ability to motivate employees. 14-27 . decisions by employees made the stock price fall. • CON: Lowering a strike price is a reward for failing.ESO Repricing Controversy • PRO: Once an ESO is ―underwater. – After all. – If employees know that ESOs will be repriced. the ESOs loose their 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.

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. – Quarterly – Annually • Therefore. 14-28 .ESOs Today • Most companies award ESO on a regular basis.

• 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.Put-Call Parity • Put-Call Parity is perhaps the most fundamental relationship in option pricing. 14-29 . • Put-Call Parity is generally used for options with European-style exercise.

The Put-Call Parity Formula C  P  S  Ke rT • 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 rT e-rT is a discount factor. • Note: this formula can be rearranged: Ke  SPC 14-30 . so Ke-rT is simply the discounted strike price.

this portfolio will be worth: 14-31 . 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.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. • At option expiration.

and a maturity of T. should equal the price of a risk-less security with a face value of $K. it is riskless. 14-32 . to prevent arbitrage: today’s cost of buying 100 shares and buying one put (net of the proceeds of writing one call). then C > P. • Therefore.Put-Call Parity Notes • Notice that the portfolio is always worth $K at expiration. That is. • That is. • Fun fact: If S = K (and if rT > 0). the value of this portfolio today is $Ke-rT.

if the option expires in the money. – That is. • The most popular stock index options are options on the S&P 100.Stock Index Options • A stock index option is an option on a stock market index. S&P 500. the option writer simply pays the option holder the intrinsic value of the option. 14-33 . stock index options have a cash settlement procedure. • Because the actual delivery of all stocks comprising a stock index is impractical. – The cash settlement procedure is the same for calls and puts. and Dow Jones Industrial Average.

Index Option Trading 14-34 .

14-35 . • Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC). • The OCC issues and clears all option contracts trading on U.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. Visit the OCC at: www.com.optionsclearing.S. exchanges.

com  www.cboe.com  www.com • To learn more about options.com  www.optionsites.cbot.optionscentral.Useful Websites • For information on options ticker symbols.investorlinks.e-analytics. see:  www.tradingmarkets.com • Exchanges that trade index options include:  www.com • For more information on options education:  www. see:  www.com  www.com  www.cboe.com 14-36 .cme.

• 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 14-37 . I.Chapter Review.

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 14-38 . • Option Prices. Intrinsic Values. II.Chapter Review.