Basics of Financial Options Lecture No 42 Chapter 13 Contemporary Engineering Economics Copyright © 2016 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Chapter Opening Story Travel is adventure Prepare for the unexpected o o o Have you ever considered about buying a trip insurance? You want to minimize the downside risk in case of cancelation or change in your travel plan Can we think something like this in protecting your investment in business? th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Financial Option Theory • • • Call option: A right (not obligation) to purchase a stock at a predetermined price (exercise/strike price) before or on the date specified (maturity date) Put option: A right (not obligation) to sell a stock at a predetermined price before or on the date specified Main issues o o What is the value of this option? How you price this option? th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved The Language of Options Call Put Buy The right to buy the underlying item at the strike price The right to sell the underlying item at the strike price until until the expiration date the expiration date Sell Selling the right to buy the underlying item from you at Selling the right to sell the underlying item to you until the the strike price until the expiration date; known as expiration date; known as writing a put writing a call th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Process of Buying and Selling a Financial Option th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Option Notation The following notaton will be used throughout the remainder of this text: o o o o o o S = Underlying asset price today S = Underlying asset price at expiration T K = Exercise price T = Time to expiration r = Risk-free rate q = Continuous dividend yield th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Financial Options Terminologies • The Contracting Parties o Option seller o o • Option buyer o Taking a long position The Right or Obligation o Option buyer o o • Taking a short position Right to purchase Option seller o Obligation to sell Option Premium o o o o o o Underlying asset (S) Strike or exercise price (K) Maturity (T) Option premium (C) Intrinsic value Time value th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Financial Option Terminologies (continued) • Types of financial option o American option o An option that can be exercised earlier than its maturity date o European option • o An option that can be exercised only at the maturity date Payof (S = stock price, C = option premium) o At the money, if S−C = K o In the money, if S−C > K o Out of money, if S−C < K th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Option Positions th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 13.1: Profit from Call Option Given: o Buying 100 shares (one contract) o K = $625 o T = January 22,2016 o S = $579.11 (September 11, 2014) o C = $45.60 o The initial investment = 100 × ($45.60) = $4,560 Find: Profit from exercising the European call option when the stock price is $700 at maturity th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution Profit = ($700 - $625 - $45.60) × 100 = $2,940 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 13.2: Profit from Put Option Given: o Buying 100 shares (one contract) o K = $580 o T = January 22,2016 o S = $579.11 (September 11, 2014) o C = $58.30 o The initial investment = 100 × ($58.30) = $5,830 Find: Profit from exercising the European put option when the stock price is $500 at maturity th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution Profit = ($580 − $500 − $58.30) × 100 = $2,170 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Buy Option Strategies: Three Ways to Buy Call Options Investor buys for Call Options (a) Hold to Maturity and trade at (1,000 shares) on Stock Z strike price Price: $55 (b) Trade for profit before option Strike price: $60 expires Premium: $750 (c) Let the option expire th Contemporary Engineering Economics, edition Park If stock rises to 65 $5,000 − $750 = $4,250 If stock rises to 60 $0 − $750 = $750 loss If stock rises to 62 $2,000 − $750 =$1,250 If stock rises to 60 1/2 $500 − $750 = $250 loss If stock drops to 55 $750 loss Copyright © 2016 by Pearson Education, Inc All Rights Reserved Sell Option Strategies: Two Ways to Sell Call Options (Writing Call Options) Investor owns 1,000 shares of Stock Write 10 covered calls (a) If stock rises to $57 Keep the premium Z Strike price: $60 No takes; option expires ($750 profit) Price: (b) If stock rises to $60 $750 (premium collected) − $750 $55/share Buy 10 calls to cancel obligations and prevent (premium on ofsetting calls) = losing stocks Breakeven Write 10 naked calls (a) If stock rises to $57 Keep the premium ($750 profit) Strike price: $60 No takes; option expires Collect premium $750 Collect premium $750 Investor owns no share of Stock Z th Contemporary Engineering Economics, edition Park (b) If stock rises to $65 $750 premium − $65,000 to buy Option is exercised You must buy 1,000 + $60,000 = $4,250 net loss (You need to shares to sell to meet call line up $64,250.) Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 13.3: Limiting Downside Risk Given: o o o Option 1: Purchase 500 shares of GILD stock at $106 Option 2: Purchase GILD five-month $110 calls at $8 Three possible scenarios for stock price at expiration o $118 < ST o $100 < ST < $118 o $100 > ST Find: Profit or loss from three possible scenarios th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 13.4: How to Use a Protective Put as Insurance Given: o Option 1: Buy QCOM at $76, without o owning a put for protection Option 2: Buy QCOM at $76 and buy a QCOM six-month $75-put contract at $4.40 Find: Compare two options for risk exposure th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution o o Upside potential unlimited Downside risk only $5.40 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved How Option Premium Fluctuates o The greater the diference between the exercise price and the actual current price (exercise price > actual current price) of the item, the cheaper the premium, because there is less chance the option will be exercised o The closer the expiration date of an out-of-the money option (where the market price is higher than the strike price), the cheaper the price is th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Duration of Exercise Date o o The more time there is until expiration, the larger the premium, because the chance of reaching the strike price is greater and the carrying costs are more Call and put options move in opposition Call options rise in value as the underlying market prices go up Put options rise in value as market prices go down th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Option Premium = Option Price Option Premium = Intrinsic Value + Time Value What the position would be Market’s assessment worth if exercised now of future underlying value th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ... Call Options (Writing Call Options) Investor owns 1,000 shares of Stock Write 10 covered calls (a) If stock rises to $57 Keep the premium Z Strike price: $60 No takes; option expires ($750 profit)... Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Financial Option Terminologies (continued) • Types of financial option o American option o An option that can be exercised... Strategies: Three Ways to Buy Call Options Investor buys for Call Options (a) Hold to Maturity and trade at (1,000 shares) on Stock Z strike price Price: $55 (b) Trade for profit before option Strike