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Chapter 19Charles P. Jones, Investments: Analysis and Management,Tenth Edition, John Wiley & Sons
Prepared byG.D. Koppenhaver, Iowa State University
Using Puts and Calls
17-17-11
19-2
Why Options Markets?
Financial derivative securities: derive all or part of their value from another (underlying) security
Options are created by investors, sold to other investors
Why trade these indirect claims? Expand investment opportunities, lower
cost, increase leverage
19-3
Options Terminology
Call (Put): Buyer has the right but not the obligation to purchase (sell) a fixed quantity from (to) the seller at a fixed price before a certain date Exercise (strike) price: “fixed price” Expiration (maturity) date: “certain date”
Option premium or price: paid by buyer to the seller to get the “right”
19-4
How Options Work
Call buyer (seller) expects the price of the underlying security to increase (decrease or stay steady)
Put buyer (seller) expects the price of the underlying security to decrease (increase or stay steady)
At option maturity Option may expire worthless, be exercised,
or be sold
19-5
Options Trading
Option exchanges are continuous primary and secondary markets Chicago Board Options Exchange largest
Standardized exercise dates, exercise prices, and quantities Facilitates offsetting positions through
Options Clearing Corporation OCC is guarantor, handles deliveries
19-6
25 27 29
4
0
-4
Stock Priceat Expiration
Profit perOption ($)
How does buying stock comparewith buying a call option?
Buyer
Seller
Payoff Diagram for a Call Option
19-7
23 25 27
4
0
-4
Stock Priceat Expiration
Profit perOption ($)
How does selling stock comparewith buying a put option?
Buyer
Seller
Payoff Diagram for Put Option
19-8
Covered Call Writing
23 25 27 29
4
0
-4
Stock Priceat Expiration
Profit ($)Purchased share
Written call
Combined
19-9
Protective Put Buying
23 25 27 29
4
0
-4
Stock Priceat Expiration
Profit ($)
Combined
Purchased put
Purchased share
19-10
Portfolio Insurance
Hedging strategy that provides a minimum return on the portfolio while keeping upside potential
Buy protective put that provides the minimum return Put exercise price greater or less than the
current portfolio value? Problems in matching risk with
contracts
19-11
Portfolio Insurance
23 25 27 29
2
0
-2
Stock Priceat Expiration
Profit ($)
Combined
Purchased put
Purchased share
19-12
Options Terminology
In-the-money options have a positive cash flow if exercised immediately Call options: S >E Put options: S <E
Out-of-the-money options should not be exercised immediately Call options: S <E Put options: S >E
19-13
Options Terminology
Intrinsic value is the value realized from immediate exercise Call options: maximum (S0-E or 0) Put options: maximum (E-S0 or 0)
Prior to option maturity, option premiums exceed intrinsic value Time value =Option price - Intrinsic value =seller compensation for risk
19-14
Should Options be Exercised Early?
Exercise prior to maturity implies the option owner receives intrinsic value only, not time value For call options, buy stock at below market
price Would more be earned by selling option?
For put options, receive cash from selling stock at above market price Could cash be reinvested for a higher return?
19-15
Option Price Boundaries
At maturity, option prices are intrinsic values Intrinsic value is minimum price prior to
maturity Maximum option prices prior to
maturity Call options: price of stock, S0
Put options: exercise price, E
19-16
Stock Prices
Option Price Boundaries
Stock Prices
CallPrices
E
PutPrices
E
E
C = S
19-17
Black-Scholes Valuation
Five variables needed to value a European call option on a non-dividend paying stock
tσd dtσ
)tσ5.(r)ES(ln d
)N(de
E)N(dS C
12
2
1
2rt1
19-18
Put-Call Parity
Black-Scholes valuation is for call options
Put-call parity shows relationship between call and put options if riskless arbitrage is not possible
Price of put =(E/ert) - S +C Put replicated by riskless lending, short
sale of stock, purchased call
19-19
Factors Affecting Prices
Variable Call Put Stock Price + - Exercise Price - + Time to maturity + + Stock volatility + + Interest rates + - Cash dividends - +
19-20
Riskless Hedging
Options can be used to control the riskiness of common stocks If stock owned, sell calls or buy puts
Call or put option prices do not usually change the same dollar amount as the stock being hedged Shares purchased per calls written =N(d1) Shares purchased per puts purchased
=N(d1) - 1
19-21
Stock Index Options
Options available on S&P 100 Index, S&P 500 Index, NYSE Index, others
Bullish on capital markets implies buying calls or writing puts
Bearish on capital markets implies buying puts or writing calls
At maturity or upon exercise, cash settlement of position
19-22
Strategies with Stock Index Options
Speculation opportunities similar to options on individual stocks
Hedging opportunities permit the management of market risk Well-diversified portfolio of stocks hedged
by writing calls or buying puts on stock index
What return can investor expect?
19-23
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