Chapter Six
Using Options as Investments
Options
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
Types of Options
Types of Options
Puts
Calls
All of the above are types of derivative
securities, which derive their value from the
price behavior of an underlying real or
financial asset
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
Options: Puts and Calls (cont’d)
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 stock’s price
usually generates a larger percentage change
in an option’s price
Puts and calls are created by individual
investors, not by the organizations that issue
the underlying financial asset
Options: Puts and Calls (cont’d)
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 isn’t profitable
Options: Puts and Calls (cont’d)
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
Options: Puts and Calls (cont’d)
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
option’s value is usually higher if there is
more time before the option expires)
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 buyer’s 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
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 seller’s exposure to risk may be
unlimited
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
How Calls Work (cont’d)
If the price of the underlying asset goes above
the option’s 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 asset’s 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
How Calls Work (cont’d)
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
How Calls Work (cont’d)
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 investor’s net profit will be:
The option seller’s loss will be:
Loss [(Strike price Market price) 100 Shares] Fee for call
$(2,000) [($50 $75) 100 Shares] $500
Notice that the buyer’s profit equals the seller’s loss;
options are a zero-sum game
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 buyer’s total return using the call option was:
Profit $2,000
Total Return 400%
Amount invested $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
Profit $2,500
been:Return
have Total 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
How Calls Work (cont’d)
Example: Assume the market price for a share of common
stock is $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 buyer’s loss will be:
Loss Cost of call
Loss $(500)
The option seller’s
Profit profit
$(500) will be equal to the option premium:
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
How Puts Work (cont’d)
If the price of the underlying asset goes
below the put option’s 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
How Puts Work (cont’d)
Example: Assume the market price for a share of common
stock is $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 [(Strike price Market price) 100 shares] Cost of put
$2,000 [($50 $25) 100 Shares] $500
The seller’s loss will be:
Loss [(Market price Strike price) 100 shares] Fee for put
($2,000) [($25 $50) 100 Shares] $500
How Puts Work (cont’d)
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.
Loss Cost of put
The buyer’s loss
Loss will be:
$(500)
Profit Fee for put
The seller/maker/writer’s
Profit $500 profit will be:
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
Stock Options
Common Stock Options
Severalbillion option contracts are
traded each year
Optionson common stocks are the
most popular form of option
Over90% of all option contracts are
stock options
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
Valuation of Stock Options
Option Premium (Price): the quoted
price the investor pays to buy a listed
put or call option
Option premiums (prices) are
affected by:
Intrinsic value: based upon current
market price of underlying assets
Time Premium: amount that option
price exceeds the fundamental value
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
Example: Suppose a call option has a strike
price of $50
If the underlying stock price is $75, the call’s
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 call’s
intrinsic value is $0
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
Example: Suppose a put option has a strike
price of $50
If the underlying stock price is $25, the put’s
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 put’s
intrinsic value is $0
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
Option Pricing Models
The best known option pricing model is the
Black and Scholes Model
The model states that an option’s price
depends on five variables
The option’s strike price
The option’s expiration date
The price of the stock
The risk free rate of interest
The stock’s volatility
Option Trading Strategies
Buying for Speculation
Hedging to modify risks
Writing Options to enhance returns
Spreading Options to enhance returns
Stock-Index Options
Stock-Index Option: a put or call option
written on a specific stock market index
Major stock indexes for options:
The S&P 500 Index
The S&P 100 Index
The Dow Jones Industrial Average
The Nasdaq 100 Index
Stock-Index Options (cont’d)
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
End of the Chapter
Thank you
