8/11/2019 Chapter 15 - FINA

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Chapter 15: Stock Options

Option Basics: Options on common stock

o Derivative SecuritySecurity whose value is derived from the value of another security. Options are a type of derivative security.

o Call Option: Grants the holder the right, but not the obligation, to buythe underlying asset at a given strike price.

o Put Option: Grants the holder the right, but not obligation, to sellthe underlying asset at a given strike price.

o Strike Price: Price specified in an option contract that the holder pays to buy the shares or receives to sell the shares if the option is

exercised. Also called the Exercise Price.

o American Option: An option that can be exercised any time before expiration.

o European Option: An option that can be exercised only at expiration.

o Option Chain: A list of available option contracts and their prices for a particular security arrayed by strike price and maturity.

The Options Clearing Corporation:

o

Options Clearing Corporation: Private agency that guarantees that the terms of an option contract will be fulfilled if the option isexercised; issues and clears all options contract trading on the U.S. Exchange.

Stock Index Options: An option on a stock market index. The most popular stock index options are options on the S&P 100 Index, S&P 500 and

Dow Jones Industries Index.

Cash Settled Option: An option contract settled by a cash payment from the option writer to the option holder when the option is exercise.

Option Intrinsic Value and Moneyness-

o Intrinsic Value: The Payoff that an option holder receives assuming the underlying stock price remains unchanged from its current val

o Call Option Intrinsic Value: The maximum of (a) the stock price minus the strike price or (b) zero.

Call Option intrinsic Value = MAX(SK, 0):

o Put Option Intrinsic Value:The max of (a) the strike price minus the stock price or (b) zero.

Put Option Intrinsic Value = MAX(K-S, 0):

o

Option Time Value: The difference b/t the price of an option and its intrinsic value.

American: can be exercised at any time. The time value is at least ZERO.

European: Deep in the money put option prices that are less than intrinsic value are possible.

o

Lessons about Intrinsic Value: first, investors can calculate intrinsic value whether the option is dead (at expiration) or alive (befexpiration). Second, at expiration, the value of an option equals its intrinsic value because no time value is left at expiration. Third, befo

expiration, the value of an option equals its intrinsic value plus its time value.

In the Money Option: Any option with a positive intrinsic value.

At the money option: Any option with a strike price exactly equal to the underlying price.

Out of the money option: An option that would not yield a positive payoff if the stock price remained unchanged until exp.

Option Payoffs and Profits: Options are appealing b/c they offer investors a wide variety of investment strategies. No Limit to number of

strategies, but really only a couple are used.

o Option Writing: Taking the sellers side of an option contract. Involves receiving the option price and, in exchange, assuming the

obligation to satisfy the buyers exercise right if the option is exercised.o

Call Writer: One who has the obligation to sell stock at the options strike price if the option is exercised.

o Put Writer: One who has the obligation to buy stock at the options strike price if the option is exercised.

o Think about this in terms of cash flow. The initial cash flow of an option is the price of the option, also called the Option Premium. To

Option Buyer, the option price (premium) is a cash outflow. To the option writer, the option price is a cash inflow. The terminal cash flo

an option is the optionspayoffthat could be realized from the exercise privilege. To the option buyer, apayoffentails a cash inflow. T

the writer, apayoffentails a cash outflow.

o Option Profit: The profit from an option strategy is the difference b/t the options terminal cash flow (the option payoff) &the options in

cash flow (the option price, or premium). The option premium is subtracted from the payoffs from buying options & added to writing.

Using Options to Manage Risk: So far we have only considered the payoffs and profits from buying and writing individual calls and puts. Now w

consider what happens when we start to combine puts, calls, and shares of stock.

o The Protective Put Strategy: Strategy of buyinga put option on a stock already owned. This strategy protects against a decline in

value.

Option Trading Strategies: 3 types of option trading Strategies.

o

The Covered Call Strategy: Strategy of sellinga call option on stock already owned.

o Spread: An option trading strategy involving 2 or more call options or two or more put options.

Bull Call Spreads: This spread is formed by buying a call and also selling a call with a higher strike price. Called Bull because

traders make a profit from this strategy if the underlying stock price increases in value.

Bear call Spreads: This spread is formed by buying a call and also selling a call with a lower strike price. Known as bear

because traders make a profit from this strategy if the underlying stock price decreases in value.

In the Money Out The Money At The Money

Call Option S>K S