Presentation on theme: "Options"— Presentation transcript
Slide1
Options
(Chapter 19)Slide2
Potential Benefits of Derivatives
Derivative instruments: Value is determined by, or derived from, the value of another instrument vehicle, called the underlying asset or security
Risk
shifting
Especially shifting the risk of asset price changes or interest rate changes to another party willing to bear that risk
Price formation
Speculation opportunities when some investors may feel assets are
mis
priced
Investment cost reduction
To hedge portfolio risks more efficiently and less costly than would otherwise be possibleSlide3
Option characteristics
Options are created by investors, sold to other investorsOption
to buy is a call option
Call options
gives the holder the right, but not the obligation, to
buy
a given quantity of some asset at some time in the future, at prices agreed upon today.
Option to sell is a put option
Put options
gives the holder the right, but not the obligation, to
sell
a given quantity of some asset at some time in the future, at prices agreed upon today
Option premium – price paid for the option
Exercise price or strike price – the price at which the asset can be bought or sold under the contract
Open interest: number of outstanding optionsSlide4
Option characteristicsExpiration date European: can be exercised only at expiration
American: exercised any time before expirationOption holder: long the option positionOption writer: short the option position Hedged position: option transaction to offset the risk inherent in some other investment (to limit risk)
Speculative position
: option transaction to profit from the inherent riskiness of some underlying asset.
Option contracts are a
zero sum game
before commissions and other transaction costs.Slide5
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
How Options WorkSlide6
Options TradingOption exchanges are continuous primary and secondary marketsChicago Board Options Exchange largest
Standardized exercise dates, exercise prices, and quantitiesFacilitates offsetting positions through Options Clearing CorporationOCC is guarantor, handles deliveriesSlide7
Options Contracts: Preliminaries
A call option is:
In

the

money
The exercise price is less than the spot price of the underlying asset.
Atthemoney
The exercise price is equal to the spot price of the underlying asset.
Outofthemoney
The exercise price is more than the spot price of the underlying asset.Slide8
Options Contracts: Preliminaries
A put option is:
In

the

money
The exercise price is greater than the spot price of the underlying asset.
Atthemoney
The exercise price is equal to the spot price of the underlying asset.
Outofthemoney
The exercise price is less than the spot price of the underlying asset.Slide9
Options
Example: Suppose you own a call option with an exercise (strike) price of $30.If the stock price is $40 (inthemoney):
Your option has an intrinsic value of $10
You have the right to buy at $30, and you can exercise and then sell for $40.
If the stock price is $20 (outofthemoney):
Your option has no intrinsic value
You would not exercise your right to buy something for $30 that you can buy for $20!Slide10
Options
Example: Suppose you own a put option with an exercise (strike) price of $30.If the stock price is $20 (inthemoney):
Your option has an intrinsic value of $10
You have the right to sell at $30, so you can buy the stock at $20 and then exercise and sell for $30
If the stock price is $40 (outofthemoney):
Your option has no intrinsic value
You would not exercise your right to sell something for $30 that you can sell for $40!Slide11
Options
Stock Option QuotationsOne contract is for 100 shares of stock
Quotations give:
Underlying stock and its current price
Strike price
Month of expiration
Premiums per share for puts and calls
Volume of contracts
Premiums are often small
A small investment can be “leveraged” into high profits (or losses)Slide12
Options
Example: Suppose that you buy a January $60 call option on Hansen at a price (premium) of $9.
Cost of your contract = $9 x 100 = $900
If the current stock price is $63.20, the intrinsic value is $3.20 per share.
What is your dollar profit (loss) if, at expiration, Hansen is selling for $50?
Outofthemoney, so Profit = ($900)
What is your percentage profit with options?
Return = (09)/9 = 100%
What if you had invested in the stock?
Return = (5063.20)/63.20 = (20.89%)Slide13
Options
What is your dollar profit (loss) if, at expiration, Hansen is selling for $85?Profit = 100(8560) – 900 = $1,600
Is your percentage profit with options?
Return = (85609)/9 = 77.78%
What if you had invested in the stock?
Return = (8563.20)/63.20 = 34.49%Slide14
Options
Payoff diagramsShow payoffs at expiration for different stock prices
(S)
for a particular option contract with a strike price of
E
For calls:
if the
S<E,
the payoff is zero
If S
>E,
the payoff is
SE
Payoff = Max [0, S
E]
For puts:
if the
S>E,
the payoff is zero
If
S<E,
the payoff is
ES
Payoff = Max [0,
ES]Slide15
Option Trading Strategies
There are a number of different option strategies:Buying call options
Selling call
options
Covered call
Buying put options
Selling put
options
Protective putSlide16
Buying Call Options
Position taken in the expectation that the price will increase (long position)
Profit for purchasing a Call Option:
Per Share Profit =Max [0,
SE]
– Call Premium
The following diagram shows different total dollar profits for buying a call option with a strike price of $70 and a premium of $6.13Slide17
Buying Call Options
40
50
60
70
80
90
100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise Price = $70
Option Price = $6.13
Profit from Strategy
Stock Price at ExpirationSlide18
Selling Call Options
Bet that the price will not increase greatly – collect premium income with no payoff
Can be a far riskier strategy than buying the same options
The payoff for the buyer is the amount owed by the writer (no upper bound on
ES)
Uncovered calls: writer does not own the stock (riskier position)
Covered calls: writer owns the stock
Moderately bullish investors sell calls against holding stock to generate incomeSlide19
Selling Call Options
40
50
60
70
80
90
100
(1,000)
(1,500)
(2,000)
(500)
0
500
1,000
(2,500)
(3,000)
Exercise Price = $70
Option Price = $6.13
Stock Price at Expiration
Profit from Uncovered Call StrategySlide20
Covered call S< E S>E Payoff of stock S S
Payoff call 0 (SE) Premium C C Total payoff C+S C+ESlide21
Covered Call Writing
0
Stock Price
at Expiration
Profit ($)
Purchased share
Written call
CombinedSlide22
Buying Put Options
Position taken in the expectation that the price will decrease (short position)
Profit for purchasing a Put Option:
Per Share Profit = Max [0,
ES]
– Put Premium
Protective put: Buying a put while owning the stock (if the price declines, option gains offset portfolio losses)Slide23
Buying Put Options
40
50
60
70
80
90
100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise Price = $70
Option Price = $2.25
Profit from Strategy
Stock Price at ExpirationSlide24
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
Portfolio InsuranceSlide25
Protective put
S< E S>E
Payoff of stock S S
Payoff put ES 0
Premium P P
Total
payoff
EP
SPSlide26
Selling Put Options
Bet that the price will not decline greatly – collect premium income with no payoffThe payoff for the buyer is the amount owed by the writer (payoff loss limited to the strike price since the stock’s value cannot fall below zero)Slide27
Selling Put Options
40
50
60
70
80
90
100
(1,000)
(1,500)
(2,000)
(500)
0
500
1,000
(2,500)
(3,000)
Exercise Price = $70
Option Price = $2.25
Stock Price at Expiration
Profit from StrategySlide28
Exam type question
An investor bought two Google June 425 (exercise price is $425) put contracts for a premium of $20 per share. At the maturity (expiration), the Google stock price is $370. (i) Draw the payoff diagram of the investment position.(ii) Calculate the total profit/loss of the position at the expiration.Slide29
Option pricing
Factors contributing value of an option
price of the underlying stock
time until expiration
volatility of underlying stock price
cash dividend
prevailing interest rate.
Intrinsic value: difference between an inthemoney option
’
s strike price and current market price
Time value: speculative value.
Call price = Intrinsic value + time
value
Exercise prior to maturity implies the option owner receives intrinsic value only, not time value
Slide30
Factors Affecting PricesSlide31
BlackScholes Option Pricing Model
Where C: current price of a call option
S: current market price of the underlying stock
X: exercise price
r: risk free rate
t: time until expiration
N(d
1
) and N (d
2
) : cumulative density functions for d
1
and d
2
Slide32
Learning outcomes
:discuss the benefits of using financial derivatives know the basic characteristics of options know the options’ payoffs know how to calculate the profits/losses of a long/short call and put options, covered call and protective put (numerical application) Know the factors affecting option pricing; no numerical problems with BlackScholesNOT on the exam: Boundaries on option prices p508509; Put option valuation, riskless hedging, Stock index options p 513519; Recommended
Endofchapter
questions:191 to 14
Recommended Endofchapter
problems:19.1, 2, 3