Stock Options


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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.


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.

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.