Using Puts and Calls

Chapter 19 Charles P. Jones, Investments: Analysis and Management, Tenth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University

17-1

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

19-2

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

19-3

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

19-4

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

19-5

Payoff Diagram for a Call Option

Profit per Option ($)

Buyer
4

25

27

29

Stock Price at Expiration

-4

Seller

How does buying stock compare with buying a call option?

19-6

Payoff Diagram for Put Option

Profit per Option ($)
4

Buyer Stock Price at Expiration

23
-4

25

27

Seller

How does selling stock compare with buying a put option?

19-7

Covered Call Writing

Profit ($) Purchased share
4

Combined

0
23 -4 25 27 29

Stock Price at Expiration

Written call

19-8

Protective Put Buying

Profit ($) Purchased share
4

Combined Stock Price at Expiration Purchased put

23
-4

25

27

29

19-9

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

19-10

Portfolio Insurance
Profit ($) Purchased share

Combined

2 0 23 -2 25 27 29

Stock Price at Expiration Purchased put

19-11

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

19-12

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

19-13

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?

19-14

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

19-15

Option Price Boundaries

C=S Call Prices Put Prices E

E
Stock Prices

E
Stock Prices
19-16

Black-Scholes Valuation

Five variables needed to value a European call option on a non-dividend paying stock

E C S N(d1 ) rt N(d 2 ) e 2 ln ( S E ) (r .5 )t d1 t d 2 d1 t
19-17

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
19-18

Factors Affecting Prices

Variable Stock Price Exercise Price Time to maturity Stock volatility Interest rates Cash dividends Call + + + + Put + + + +
19-19

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

19-20

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
19-21

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?

19-22

Copyright 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United states Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

19-23