Chapter 14 Stock Options

1
Chapter 14 Stock Options

• Options on Common Stocks
• Why Options?
• Option Payoffs Profits
• Option Strategies
• Option Prices, Intrinsic Values, Arbitrage
• Stock Index Options
• Summary Conclusions

2
Option Basics

• Derivatives
• Puts and calls
• Option contract must stipulate
• Underlying asset
• Strike price / exercise price
• Expiration or maturity
• Contract size
• Exercise style American or European
• Delivery or settlement procedure

3
More Option Basics

• Exchanges
• CBOE, PHLX, NYSE, AMEX, PSE, CME
• Expire on Saturday following the 3rd Friday of
  expiration month
• Option price changes as stock price changes
• Standard contract size is 100 shares

4
Wall Street Journal Option Price Quotes
5
Why Buy Options?

• You can buy 100 shares of XYZ stock at 80 per
  share or buy the call option, with an exercise
  price of 80, for 5.
• If the stock price goes to 90, your return on
  each investment is
• Stock (9,000 - 8,000) / 8,000 12.50
• Call (9,000 - 8,000 - 500) / 500 100
• Of course if the price went down to 70
• Stock (7,000 - 8,000) / 8,000 -12.50
• Call you would let it expire worthless, so your
  return is -100

6
Option Payoffs Profits

• Option writing
• Call writing
• Put writing
• Option premium
• Zero-sum game

7
Stock vs. Option Payoffs

• Impact of leverage
• Stock price is 50. Buy 100 shares
• Call strike is 50, price is 10. Buy 1
  contract.
• Put strike is 50, price is 10. Buy 1 contract.
• C S - K
• P K - S

8
Call Option Payoffs
Buy a call
Write a call
9
Put Option Payoffs
10
Call Option Profits
Buy a call
Write a call
11
Put Option Profits
12
Option Pricing Bounds

• Arbitrage and option pricing
• Upper bounds
• Call Options
• Put Options
• Lower Bounds
• Call option intrinsic value
• max 0, S - K
• Put option intrinsic value
• max 0, K - S
• In-the-money / Out-of-the-money
• Time premium/time decay

13
Option Strategies

• Hedging versus Speculating
• Naked option writing
• Call writing
• Put writing
• Covered Call Writing
• Protective Put Buying
• Straddles
• Long straddle buy a call a put
• Short straddle sell a call a put

14
Straddle
Long straddle
Short straddle
15
Index Options

• Stock index options
• SPX, OEX, DJX
• European versus American
• Cash settlement
• Option Clearing Corporation (OCC)
• Market operations
• Role of the OCC
• Option exercise procedures

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Wall Street Journal Index Option Quotes
17
Problem 14-5

• Stock in Cheezy-Poofs Manufacturing is currently
  priced at 100 per share. A call option with a
  100 strike price and 90 days to maturity is
  quoted at 5. Compare the percentage gain
  losses from a 10,000 investment in the stock
  versus the option in 90 days for stock prices of
  80, 100, 120.
• Solution
• For 10,000 you get 100 shares and an option
  contract costs 500, so you get 20 contracts.
• continued on next slide

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Problem 14-5 Solution (contd)

• If stock is 120
• Return on stock is
• (12,000 - 10,000) / 10,000 20
• Return on option
• 20 x 20 contracts x 100 shares 40,000
• (40,000 - 10,000) / 10,000 300
• If stock is 100
• Return on stock is (10K - 10K) / 10,000 0
• Return on option option is worthless -100
• If stock is 80
• Return on stock -20
• Return on option option is worthless -100

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Problem 14-6

• Suppose you buy 60 contracts of February 80 call
  option. How much will you pay ignoring
  commissions?
• Solution
• 60 contracts x 700 per contract 42,000

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Problem 14-7

• In problem 6, suppose that Hendreeks stock is
  selling for 95 per share on the expiration date.
  How much is your option investment worth? What if
  the terminal stock price is 86?
• Solution
• Stock 95 Call 60(100)(95 - 80) 90,000
• Stock 86 Call 60(100)(86 - 80) 36,000

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Problem 14-8

• Suppose you buy 25 contracts of the August 80 put
  option. What is your maximum gain? On the
  expiration date, Hendreeks is selling for 55 per
  share. How much is your options investment worth?
  What is your net gain?
• Solution on next slide

22
Problem 14-8 Solution

• Solution
• Initial cost 25(100)(4.25) 10,625
• Maximum gain 25(100)(80) - 10,625 189,375
• Stock at 55
• Terminal value 25(100)(80 - 55) 62,500
• Net gain 62,500 - 10,625 51,875

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Problem 14-17

• You notice that shares of stock in the Patel
  Corporation are going for 50 per share. Call
  options with an exercise price of 35 per share
  are selling for 10. Whats wrong here? Describe
  how you would take advantage of this mispricing
  if the option expires today.
• Solution
• The call is selling for less than intrinsic
  value (50- 35 15). Buy the call for 10,
  exercise the call by paying 35 for the stock,
  and sell the stock for 50. Youve made a 5 per
  share riskless profit!