Chapter Fifteen

1
Chapter Fifteen

• Stock Options

2
Definitions

• A Call Option is the right, but not the
  obligation, to buy an underlying asset for a
  pre-specified price on (or before) a specific
  date.
• A Put Option is the right, but not the
  obligation, to sell an underlying asset for a
  pre-specified price on (or before) a specific
  date.
• American vs European Options

3
Option Characteristics

• Volume -- See Table on P. 412
• Each Contract represents 100 shares
• Expiration is on third Friday of Expiration Month
• Typically Short-term in Nature (1-3 months)
• LEAPS (Long-term Equity AnticiPation Securities)

4
Value Terminology

• Intrinsic Value
• Premium (Sometimes called Time Value or
  Speculative Premium).
• In-the-Money
• Out-of-the-Money

5
Valuation (Five Components)

• Stock Price (P0)
• Exercise (Strike) Price (X)
• Volatility (?)
• Risk-Free Rate (kRF)
• Time to Expiration (t)
• Black-Scholes Option Pricing Model
• See Handout
• Download Option Spreadsheet

6
Reading Option Quotations Online

• http//moneycentral.msn.com
• http//finance.yahoo.com
• Value Line

7
Options Trading Strategies

• Buying (long) vs Writing (short) Options
• Naked vs Covered Positions

8
Reasons For Buying a Call Option

• Leverage
• Substitute for Common
• Protecting a Short Position
• Lock in a Future Buying Price

9
Reasons For Buying a Put Option

• Bet on a Price Decline
• Protecting a Long Position
• Shares are Unborrowable for a Short Position

10
Reason for Writing an Option

• Collecting a Premium

11
Other Strategies

• Straddles Buy both a call and a put.
• Spreads Buy (or write) a call and take the
  opposite position with a put.
• See Handout

12
Meet the Greeks

• Delta (?) -- How sensitive is the option price to
  small changes in the stock price.
• Gamma(?) -- How sensitive is Delta to changes in
  the stock price
• Theta(?) -- The dollar change in the option price
  per unit change in time to expiration (divide by
  365 to get Theta per day)
• Vega(?) -- The dollar change in the value of the
  option when the underlying volatility changes by
  1
• Rho(?) -- The sensitivity of the option price
  with respect to changes in the risk-free rate of
  interest
• See Handout and Spreadsheet

13
Homework

• Text
• Q 4-5, 7 12, 14
• P 1-2, 4-5,7-13
• See Handout
• Explain the following option strategies. In
  answering these, you should explain how you would
  implement the strategy and what the payoff
  pattern would look like. Note that even though
  this is only a partial list of option trading
  strategies, you are responsible for all of the
  strategies covered in class.
• Covered Call
• Writing a Naked Call
• Straddle
• Vertical Bull Spread
• Vertical Bear Spread
• Strangle
• Butterfly Strike Spread
• Explain how an option trader may use the
  following tools
• Delta, Theta, Vega