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McGraw-Hill/Irwin
Stock Options
Learning Objectives
Give yourself some in-the-money academic and professional options by understanding:
1. The basics of option contracts and how to obtain price quotes. 2. The difference between option payoffs and option profits. 3. The workings of some basic option trading strategies. 4. The logic behind the put-call parity condition.
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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.
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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 the 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.
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Stock options trade at organized options exchanges, such as the CBOE, as well as over-the-counter (OTC) options markets.
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Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC).
Visit the OCC at: www.optionsclearing.com.
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Why Options?
A basic question asked by investors is: Why buy stock options instead of shares in the underlying stock? To answer this question, we compare the possible outcomes from these two investment strategies:
Buy the underlying stock. Buy options on the underlying stock.
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Suppose further that the option expires in three months. Finally, lets say that in three months, the price of IBM shares will either be: $100, $80, or $90.
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Example: Buying the Underlying Stock versus Buying a Call Option, Cont.
Lets calculate the dollar and percentage returns given each of the prices for IBM stock:
Buy 100 IBM Shares ($9000 Investment): Dollar Profit: Case 1: $100 $1,000 Percentage Return: 11.11% Buy One Call Option ($500 Investment): Dollar Profit: $500 Percentage Return: 100%
Case 2: $80
-$1,000
-11.11%
-$500
-100%
Case 3: $90
$0
0%
-$500
-100%
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It is important to see that call options offer an alternative means of formulating investment strategies.
For 100 shares, the dollar loss potential with call options is lower. For 100 shares, the dollar gain potential with call options is lower. The positive percentage return with call options is higher. The negative percentage return with call options is lower.
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Because the actual delivery of all stocks comprising a stock index is impractical, stock index options have a cash settlement procedure.
That is, if the option expires in the money, the option writer simply pays the option holder the intrinsic value of the option. The cash settlement procedure is the same for calls and puts.
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Option Moneyness
In-the-money option: An option that would yield a positive payoff if exercised Out-of-the-money option: An option that would NOT yield a positive payoff if exercised Use the relationship between S (the stock price) and K (the strike price):
In-the-Money Call Option S>K Out-of-the-Money SK
Put Option
S<K
SK
Note for a given strike price, only the call or only the put can be in-the-money.
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Option Writing
The act of selling an option is referred to as option writing.
Because option writing obligates the option writer, the option writer receives the price of the option today from the option buyer.
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Option Exercise
Option holders have the right to exercise their option.
If this right is only available at the option expiration date, the option is said to have European-style exercise. If this right is available at any time up to and including the option expiration date, the option is said to have American-style exercise.
Exercise style is not linked to where the option trades. Europeanstyle and American-style options trade in the U.S., as well as on other option exchanges throughout the world. Very Important: Option holders also have the right to sell their option at any time. That is, they do not have to exercise the option if they no longer want it.
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The terminal cash flow can be realized by the option holder by exercising the option.
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Protective puts provide insurance for the value of an asset or a stream of cash inflows.
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Protective calls provide a way to lock-in the value of a liability or a stream of cash outflows.
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At the Money options is a term used for options when the stock price and the strike price are about the same.
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Think about what would happen if arbitrage were allowed to persist. (Easy money for everybody)
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Suppose a put option with a strike price of $50 is selling for $50.
The Arbitrage: Sell the put, and invest the $50 in the bank. (Note you have zero cash outlay).
Worse case? Stock price goes to zero.
You must pay $50 for the stock (because you were the put writer). But, you have $50 from the sale of the put (plus interest).
So, we see that if the put option price equals the strike price, there is an arbitrage.
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What is the maximum put value that does not result in an arbitrage?
Maximum put price 1.03 $50 Maximum put price $50/1.03 $48.54
Notice that the answer, $48.54, is the present value of the strike price computed at the risk-free rate. Therefore: The maximum price for a European put option is the present value of the strike price computed at the risk-free rate.
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American Calls. Can an American call sell for less than its intrinsic value? No.
Suppose S = $60, and a call option has a strike price of K = $50 and a price of $5. The $5 call price is less than the intrinsic value of S - K = $10.
Therefore, an American call option price is never less than its intrinsic value.
American call option price = MAX[S - K, 0]
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Therefore, an American put option price is never less than its intrinsic value.
American put option price = MAX[K - S, 0]
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The lower bound for a European call option is greater than its intrinsic value. European call option price MAX[S - K/(1 + r)T, 0]
European Puts. The lower bound for a European put option price is less than its intrinsic value.
In fact, in-the-money European puts will frequently sell for less than their intrinsic value. How much less? Using an arbitrage strategy that accounts for the fact that European put options cannot be exercised before expiration:
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Put-Call Parity
Put-Call Parity is perhaps the most fundamental relationship in option pricing. Put-Call Parity is generally used for options with European-style exercise. 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.
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K/(1 r)T S P C
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Useful Websites
For information on options ticker symbols, see:
www.schaeffersresearch.com www.optionsxpress.com
www.optionscentral.com
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Chapter Review, I.
Options on Common Stocks
Option Basics Option Price Quotes
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Put-Call Parity
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