Topic 6

Topic 6
Options:
Puts and Calls
Options: Puts, Calls and Warrants

When investors buy shares of common or
preferred stocks, they are entitled to all the
rights and privileges of ownership such as
receiving dividends or to vote (in the case
of common stocks). Financial Asset: asset
that represents a financial claim on an
issuing organization
Stocks, bonds and convertible securities
are examples
Option: the right to buy or sell a certain

amount of an underlying financial asset at a
specified price for a given period of time
Copyright 2014 Pearson Education, Inc. All rights reserved.
14-2
Options are contractual instruments,

whereby two parties enter into a contract to
give something of value to the other.
The option buyer has the right to buy or
sell an underlying asset for a given period of
time, at a price that was fixed at the time of
the contract.
The option seller stands ready to buy or
sell the underlying asset according to the
terms of the contract, for which the buyer
has paid seller an upfront amount of money.
14-3
Types of Options
Types of Options
Puts
Calls
Rights
Warrants
All of the above are types of derivative

securities, which derive their value from the
price behavior of an underlying financial
asset.
14-4
The option to buy an asset is called Call

Option.
The option to sell an asset is called Put
Option.
The price at which an option can be
exercised is called Strike Price or
Exercise Price.
The asset on which the put or call option is
created is referred to as Underlying
Asset.
14-5
Options: Puts and Calls

Puts and calls may be traded on:
Common stocks
Stock indexes
Exchange traded funds
Foreign currencies
Debt instruments
Commodities and financial futures
Owners of put and call options have no

voting rights, no privileges of ownership,
and no interest or dividend income
14-6
Options: Puts and Calls (contd)

Options allow buyers to use leverage;
investors can benefit from stock-price
movements without having to invest a lot of
capital
A given percentage change in a stocks price
usually generates a larger percentage
change in an options price
Puts and calls are created by individual
investors, not by the organizations that
issue the underlying financial asset
14-7

Option Buyer
Has the right to buy (in the case of a call option)
or sell (in the case of a put option) an underlying
asset at a fixed price (called the exercise price or
strike price) for a given period of time
To acquire this right, the option buyer must pay
the option seller a fee known as the option
premium (or option price)
Buyers do not have to exercise their options;
they can walk away if exercising the option isnt
profitable
14-8

Option Seller (also called the option writer)
Receives the option premium from the buyer up
front
Has the obligation to sell (in the case of a call
option) or buy (in the case of a put option) the
underlying asset according to the terms of the
option contract
Whereas option buyer can walk away if
exercising the option is unprofitable, option
seller cannot walk away
14-9

Put and call options trade in the open market much
like any other security and may be bought and sold
through securities brokers and dealers
Values of puts and calls change with the values of
the underlying assets
Other factors influence option prices (e.g., an
options value is usually higher if there is more
time before the option expires)
14-10
Advantages of Puts and Calls

Allows use of leverage
Leverage: the ability to obtain a given equity
position at a reduced capital investment, thereby
magnifying total return
Option buyers potential loss is limited to

fee paid to purchase the put or call option
Investors can make money when value of
assets go up or down
14-11
Disadvantages of Puts and Calls

Investor does not receive any interest or dividend
income
Options expire; the investor has limited time to
benefit from options before they become worthless
Options are risky; a small change in the price of
the underlying asset may make an option worthless
Option sellers exposure to risk may be unlimited
14-12
How Calls Work

Call: an option that gives the holder (buyer) the
right to buy the underlying security at a specified
price over a set period of time
The buyer of the call option wants the price of the
underlying asset to go up
The seller of the call option wants the price of the
underlying asset to go down
14-13
How Calls Work (contd)

If the price of the underlying asset goes above the
options strike price:
The option holder will purchase the asset at the strike
price and then sell it at the higher market price, making a
profit
The option writer must sell the asset at the strike price
(which is lower than the assets market price).
If the seller does not already own the underlying asset,
then the seller will have to purchase it at the higher
market price
Covered call: seller owns the underlying asset
Naked call: seller does not own the underlying asset
14-14

If the price of the underlying asset goes
down:
The buyer will let the call option expire worthless
and lose the option premium
The seller will keep the option premium and
make a profit
14-15

Example: Assume the market price for a share of common stock is
$50. An investor buys a call option which grants the right to purchase
100 shares of the stock at a strike price of $50. The call premium is
$500
If the market price of the stock goes up to $75 per share, the investor
will exercise the right to purchase 100 shares for $50. The investor
then sells the shares on the open market for $75.
The investors net profit will be:
Profit [(Market price Strike price) 100 Shares] Cost of call

$2,000 [($75 $50) 100 Shares] $500
The option sellers loss will be:
Loss [(Strikeprice Marketprice) 100Shares] Feeforcall

$(2,000) [($50 $75) 100Shares] $500
Notice that the buyers profit equals the sellers loss; options are a
zero-sum game
14-16
How Calls Work:

The Value of Leverage
In the previous example, the option buyer makes a profit of $2,000
after investing just $500 in capital
The buyers total return using the call option was:
TotalReturn
Profit
$2,000
400%
Amountinvested
$500
Rather than buying the option, the investor might have simply
purchased 100 shares of stock directly. At a price of $50 per share,
the cost of 100 shares would have been $50,000. If the share price
had risen to $75, the investor would have earned a $2,500 profit. The
total rate of return on the investment would have been:
Total Return
Profit
$2,500
5%
Amount invested
$50,000
The same $25 increase in the stock price generates a much higher rate
of return for the option investor than for an investor who buys stocks
directly
14-17

$50. An investor buys a call option to purchase 100 shares of the
stock at a strike price of $50 per share. The option premium is
$500.
If the market price of the stock goes down to $25 per share, the
investor will allow the call option to expire worthless.
The option buyers loss will be:
Loss Costofcall
Loss $(500)
The option sellers profit will be equal to the option premium:
Profit $(500)
14-18
How Puts Work

Put: an option that enables the holder
(buyer) to sell the underlying security at a
specified price over a set period of time
The buyer of the put option wants the price of
the underlying asset to go down
The seller of the put option wants the price of
the underlying asset to go up
14-19
How Puts Work (contd)

If the price of the underlying asset goes below
the put options strike price:
The put owner will buy the underlying asset, paying
the open-market price, and then force the put seller
to buy the asset at the higher strike price, making a
profit
The seller will pay a price higher than the market
price
If the price of the underlying asset goes up:

The buyer will let the put option expire worthless
and lose the option premium
The seller will keep the option premium and make a
profit
14-20

$50. An investor buys a put option that grants the right to sell 100
shares of the stock at a strike price of $50. The option premium is
$500.
If the market price of the stock goes down to $25 per share, the
investor will purchase 100 shares of stock in the open market for
$25 each. Then the investor exercises his right to sell those shares
to the put seller for $50 each
The buyer of the put option earns a profit of $2,000:
Profit [(Strikeprice Marketprice) 100shares] Costofput
$2,000 [($50 $25) 100Shares] $500
The sellers loss will be:

Loss [(Marketprice Strikeprice) 100shares] Feeforput
($2,000) [($25 $50) 100Shares] $500
14-21

Example: Assume the market price for a share of common
stock is $50. A put option to sell 100 shares of the stock at a
strike price of $50 per share may be purchased for $500.
If the market price of the stock goes up to $75 per share, the
buyer will allow the put option to expire worthless.
The buyers loss will be:
Loss Costofput
Loss $(500)
The seller/maker/writers profit will be:
Profit Feeforput
Profit $500
14-22
Put and Call Options Markets

Conventional (OTC) Options
Sold over the counter
Primarily used by institutional investors
Listed Options
Created in 1973 by the Chicago Board Option Exchange (CBOE)
Puts and calls traded through CBOE exchange, as well as
International Securities Exchange, AMEX, Philadelphia exchange,
NYSE Arca and Boston Options Exchange.
Provided convenient market that made options trading more
popular and help create a secondary market
Helped standardize expiration dates and exercise/strike prices
Reduced trading costs
14-23
Stock Options
Common Stock Options
Several billion option contracts are traded each
year
Options on common stocks are the most popular
form of option
Over 90% of all option contracts are
stock options
14-24
Key Provisions of Stock Options

Strike Price
Stated price at which you can buy a security with a call or
sell a security with a put
Conventional (OTC) options may have any strike price
Listed options have standardized prices with price
increments determined by the price of the stock
Expiration Date
Stated date when the option expires and becomes
worthless if not exercised
Conventional (OTC) options may have any working day as
expiration date
Listed options have standardized expiration dates
14-25
Intrinsic Value of a Call Option

The intrinsic value of a call option equals the
difference between the market price of the
stock and the strike price of the option, or
zero, whichever is greater.
Intrinsic Value of Call Option =
(Stock Price Strike Price) or Zero, Whichever
is Greater.
14-26
Example: Suppose a call option has a strike

price of $50
If the underlying stock price is $75, the calls
intrinsic value is $25 (actually, $2,500 because
the call grants the right to buy 100 shares)
If the underlying stock price is $25, the calls
intrinsic value is $0
14-27
Intrinsic Value of a Put Option

The intrinsic value of a put option equals the
difference between the strike price of the
option and the market price of the stock, or
zero, whichever is greater
The intrinsic value of a put option =
(Strike Price Stock Price) or Zero, Whichever
is greater
14-28
Example: Suppose a put option has a strike

price of $50
If the underlying stock price is $25, the puts
intrinsic value is $25 (actually $2,500 because
the put grants the right to sell 100 shares)
If the underlying stock price is $75, the puts
intrinsic value is $0
14-29
Figure 14.2 The Valuation Properties of

Put and Call Options
14-30
Valuation of Stock Options

In-the-Money
Call option: when the strike price is less than the market
price of the underlying security
Put option: when the strike price is greater than the
market price of the underlying security
When an option is in the money, its intrinsic value is
greater than zero
Out-of-the-Money
Call option: when the strike price is greater than the
market price of the underlying security
Put option: when the strike price is less than the market
price of the underlying security
14-31
Option Pricing Models

The best known option pricing model is the
Black and Scholes Model
The model states that an options price
depends on five variables
The
The
The
The
The
options strike price

options expiration date
price of the stock
risk free rate of interest
stocks volatility
14-32
Valuing Options
Accordingly
Call Price = (Stock Price X Probability 1)
(Present Value of Strike Price X Probability
2)
14-33
Option Trading Strategies

Buying for Speculation
Hedging to modify risks
Writing Options to enhance returns
Spreading Options to enhance returns
14-34
Speculating with Stock Options

Similar to investing in common stocks
Goal is to buy low, sell high
Buyer does not need as much capital since can
use leverage
If you feel that the market price of a particular
Stock is going up then you can make a call
option.
On the other hand, If you feel that the market
price of a particular Stock is going down then
you can make a put option.
Buyer cannot lose more than cost of the option
14-35
Hedging with Stock Options

Purpose is to reduce or eliminate risk.
You are trying to change not only the chance of
loss, but also the amount lost if the worst occurs.
Combines two or more securities into a single
investment position
For example: buying a stock and simultaneously
buying a put on that same stock.
Or it might consists of selling some stock short and
then buying a call.
An option hedge is appropriate if you have
generated a profit from earlier common stock
investment and you want to protect it.
14-36
Hedging a Long Position

Buying a put and holding appreciated stock in the same
company
Buying a put would provide insurance in case the stock
price went down before you sold the stock
Hedging a Short Position

Selling stock short and buying a call
Buying a call would allow you to buy stock to cover the
short sale if the stock price went up instead of down
14-37
Protective Puts: Limiting Capital

Losses
Assume that you want to buy 100 shares of
stock at $25 each. Being a bit apprehensive
about the stock outlook you decided to use
hedge option to protect your capital from any
losses. So you simultaneously (1) Buy the
Stocks and (2) buy a put option on the stocks
(That covers all the 100 shares) at a strike
price of 25 and a put premium of $150.
This type of Hedge is called protective hedge.
14-38
No matter what will happen next, you will

not loose more than the option premium.
If a favorable event occur where the stock
price will rise, let us say $50,you will not
exercise the put option. Your capital gain will
be the difference between the selling price
(50*100) and the original purchase price
(25*100) which is $2500 less $150 the
option premium.
14-39
On the other hand, if the stock market price

dropped to less $25, let us say $15, then
you will exercise the put option and will stop
any capital losses. However you will incur a
loss which is equal to the option premium.
In other words instead of losing $1000 you
will lose only $150.
14-40
Protective puts: protecting

profits.
You can make an option hedge after making
profits on an existing underlying asset. In
this case let us say that you have 100 stocks
which you purchased at $10 each 6 months
ago now worth $65 each. If you want to
protect this profit from any decline in the
stock market price you can make a put
option (hedging option) at $65. if stock
prices keep going up you dont exercise the
option. On the other hand if stock price goes
down you exercise the option and protect
your profits.
14-41
Writing Stock Options

The seller (or writer) is betting that the option buyer will be
wrong about the direction of the stock price
Easy money if the option expires worthless. The writer cannot
make more than the fee received
High risk if the option is in-the-money
Naked options: writer does not own the optioned securities and has
to buy them. No limit on loss exposure
Covered options: writer owns the optioned securities. Loss exposure
is limited to the price originally paid for the securities
14-42
Spreading Options
Purpose is to take advantage of differences in
prevailing option prices and premiums
Combines two or more options into a single
transaction
Option Straddle
Simultaneous purchase (or sale) of both a put and a call

on the same underlying common stock
Spreading options is extremely tricky and should be

used only by knowledgeable investors
14-43
Stock-Index Options
Stock-Index Option: a put or call option
written on a specific stock market index
Major stock indexes for options:
The
The
The
The
S&P 500 Index

S&P 100 Index
Dow Jones Industrial Average
Nasdaq 100 Index
14-44
Stock-Index Options (contd)

Market price is function of strike price of option and
latest published stock market index value
Valuation techniques are similar to valuing options
for individual securities
Price behavior and investment risk are similar to
options for individual securities
May be used to hedge a whole portfolio of stocks
rather than individual stocks
May be used to speculate on the stock market as a
whole
14-45
Other Types of Options

Exchange traded funds: put and call options
written on exchange traded funds (EFTs)
Very similar to market index options
Interest rate options: put and call options

written on fixed-income (debt) securities
Small market involving only U.S. Treasury securities
Option prices change with yield behavior of debt securities
14-46
Other Types of Options (contd)

Currency options: put and call options
written on foreign currencies
Available on most major world currencies
Option prices change as exchange rates between
currencies fluctuate
LEAPS: long-term options that may extend

out to 3 years
Available on several hundred stocks and over
two dozen stock indexes and ETFs
14-47

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Topic 6

Options: Puts, Calls and Warrants

Option: the right to buy or sell a certain

Options are contractual instruments,

All of the above are types of derivative

Copyright 2014 Pearson Education, Inc. All rights reserved.

The option to buy an asset is called Call

Options: Puts and Calls

Owners of put and call options have no

Options: Puts and Calls (contd)

Options: Puts and Calls (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Options: Puts and Calls (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Options: Puts and Calls (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Advantages of Puts and Calls

Option buyers potential loss is limited to

Copyright 2014 Pearson Education, Inc. All rights reserved.

Disadvantages of Puts and Calls

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How Calls Work

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How Calls Work (contd)

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How Calls Work (contd)

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How Calls Work (contd)

Profit [(Market price Strike price) 100 Shares] Cost of call

The option sellers loss will be:

Loss [(Strikeprice Marketprice) 100Shares] Feeforcall

How Calls Work:

How Calls Work (contd)

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How Puts Work

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How Puts Work (contd)

If the price of the underlying asset goes up:

How Puts Work (contd)

The sellers loss will be:

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How Puts Work (contd)

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Put and Call Options Markets

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Key Provisions of Stock Options

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Intrinsic Value of a Call Option

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Example: Suppose a call option has a strike

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Intrinsic Value of a Put Option

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Example: Suppose a put option has a strike

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Figure 14.2 The Valuation Properties of

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Valuation of Stock Options

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Option Pricing Models

options strike price

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Copyright 2014 Pearson Education, Inc. All rights reserved.