14 14 C h a p t e r Stock OptionsStock Options second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 2 Stock Options In this chapter, we will discuss options generally, but with a focus on options on individual common stocks. We will see the tremendous flexibility that options offer investors in designing investment strategies. Goal © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 3 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, while put options are options to sell. Option contracts are standardized to facilitate trading and price reporting. Î A single standard option is an option to buy/sell 100 shares of stock. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 4 Option Basics In general, options on common stock must stipulate at least the following terms: c The identity of the underlying stock. d The strike price, or exercise price. e The option contract size. f The option expiration date, or option maturity. g The option exercise style (American or European). h The delivery or settlement procedure. There are organized options exchanges as well as over-the-counter (OTC) options markets where stock options may be traded. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 5 Work the Web Visit these options exchanges: http://www.cboe.com http://www.amex.com http://www.phlx.com http://www.nyse.com http://www.pacificex.com Option Price Quotes 14 - 6 © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 7 Option Price Quotes A list of available option contracts and their prices for a particular security arrayed by strike price and maturity is known as an option chain. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 8 Work the Web For information on options ticker symbols, see: http://www.cboe.com http://www.optionsites.com © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 9 Buy Shares Buy Option Profit Return Profit Return Case 1: $100 $1,000 11.11% $500 100% Why Options? Should you buy 100 IBM shares at $90 each ($9,000 investment), or should you buy a call option with a strike price of $90 expiring in three months at $500 ($5 per share)? Three months later, Case 2: $90 $0 0% -$500 -100% Case 3: $80 -$1,000 -11.11% -$500 -100% © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 10 Why Options? Whether one strategy is preferred over another is a matter for each individual investor to decide. What is important is the fact that options offer an alternative means of formulating investment strategies. [...]... by The McGraw-Hill Companies, Inc All rights reserved 14 - 14 Payoff Diagrams McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 15 Payoff Diagrams McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 16 Option Profits McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 17 Option Profits McGraw... http://www.optionsclearing.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 29 Chapter Review Options on Common Stocks Option Basics Option Price Quotes Why Options? Option Payoffs and Profits Option Writing Option Payoffs Payoff Diagrams Option Profits McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 30 Chapter Review Option Strategies The Protective... Profits McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 18 Work the Web To learn more on options, see: http://www.e-analytics.com http://www.tradingmarkets.com http://www.investorlinks.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 19 Option Strategies Protective put - Strategy of buying a put option on a stock already owned... McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 13 Option Payoffs It is useful to think about option investment strategies in terms of their initial and terminal cash flows The initial cash flow of an option is the price of the option, also called the option premium The terminal cash flow of an option is the option’s payoff that can be realized from the exercise... for stock index options McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 25 Stock Index Options 14 - 26 Work the Web Exchanges that trade index options include: http://www.cboe.com http://www.cbot.com http://www.cme.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 27 The Options Clearing Corporation The Options Clearing Corporation.. .14 - 11 Work the Web For more information on options education, see: http://www.optionscentral.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 12 Option Writing The seller of a call/put option is called the call/put “writer,” and the act of selling an option is referred to as option writing Option... against a decline in value 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 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 20 Work the Web For ideas on option... McGraw-Hill Companies, Inc All rights reserved 14 - 21 Option Prices, Intrinsic Values, and Arbitrage call option price < stock price Otherwise, arbitrage will be possible put option price < strike price Otherwise, arbitrage will be possible option price ≥ 0 By definition, an option can simply be discarded McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 22 Option... Arbitrage 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] Put option intrinsic value = max [0, K–S] where S = current stock price K = option’s strike price McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 23 Option Prices, Intrinsic... for a Put Option Price The Lower Bounds on Option Prices McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 14 - 31 Chapter Review Stock Index Options Features and Settlement Index Option Price Quotes The Options Clearing Corporation McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved . McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 14 Payoff Diagrams © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 15 Payoff Diagrams ©. strike price of $90 expiring in three months at $500 ($5 per share)? Three months later, Case 2: $90 $0 0% -$ 500 -1 00% Case 3: $80 -$ 1,000 -1 1.11% -$ 500 -1 00% © 2002 by The McGraw-Hill Companies,. McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 16 Option Profits © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 14 - 17 Option Profits ©