CALL AND PUT OPTIONS__Presented by Group 1__

Chang Hyun NahmAsenaca Wotta

Nga Diem Hang PhanDesi Kusumaningtyas

Group 1

1

Introduction• What is an Option?

Contract between a buyer & seller

gives the buyer the right, but not the obligation, to buy (or sell) a certain asset at a specific price at any time during the life of the contract

E.g. game ticket

Security (similar to stock & bond)2

Introduction• Option contract

gives the owners the option to purchase (call option) or sell (put option) an asset.

Two (2) types of option contract:

1. Call option; and

2. Put option3

General ConceptsAn option usually contains the following elements:1. Option holder/buyer - is given the right to buy or sell an asset2. Option writer/seller – issues option contract, has an obligation to

sell or buy the asset if the option is exercised by option’s holder.3. Strike/Exercise Price: price at which the asset can be traded under a

option contracts4. Limited time frame

Expiration date – the date at which an unexercised option becomes invalid

5. Price• Premium - purchase price of an option

4

Option Trading• Trading ActivityoCurrent options trading takes place at these

financial institutions:Chicago Board Options Exchange (CBOS);American Stock Exchange;Pacific Stock Exchange; and Philadelphia Stock Exchange (especially currency

options)

• 100shares/One option contract 5

• Call option - a negotiable instrument that gives the option

buyer (holder) the right to buy the underlying asset

• at a specific price (“exercise price”)

• within a given period of time (the option expiration date)

Call Option

6

Call Option• Example 1: Buying a Stock

Professor purchases a call option on shares of IBMStrike Price of $40Expiration date: 31 JulyOption contract: right to purchase 100 shares at price of $40 on 31 July

When will this right become valuable to exercise?Only valuable if IBM is trading above $40 per share on 31 July

7

Call Option• Example 2: Buying a House

8

Call Option• Example 2: Buying a House

9

• Example 2: Buying a House

Call Option

10

Call Option

• Example 2: Buying a House

11

Call Option• Example 2: Buying a House

12

Actual cost of this option (Premium)??(Note: each options contract represents an interest in 100 ounces of gold)

= 100 ounce X $2.00 = $200

If you want to buy gold (Currently trading at $1000 per ounce),

You purchase call option contract on gold with a $1000 strike price and at a

price of $2.00 per contract

Example 3: Buying Gold

Call Option

13

“The option is called in the money” (Market price > Strike price)

Gold is trading at $1050 per ounce(More valuable than

exercise price)

The option will be worth $50 per ounce (=$1050-$1000)And total sale price (payoff) will be $5000 (=$50X100)

The option buyer has the right to purchase gold at $1000 per ounce

Net profit to the buyer will be $4800

(= $5000-$200)

Example 3: Buying gold – Scenario 1

Call Option

14

Example 3: Buying gold – Scenario 2

Gold is trading at $1000 per ounce(Equally valuable to

exercise price)

The option buyer has the right to purchase gold at $1000 per ounce

The option will be worth zero per ounce (=$1000-$1000)And total sale price (payoff) will be zero (=$0.00X100)

Net profit to the buyer will be -$200

(= $-$200)“The option is called at the money” (Market price = Strike price)

Call Option

15

Example 3: Buying gold – Scenario 3

Gold is trading at $900 per ounce(Less valuable than

exercise price)

You have no reason to exercise your call option

You can let the option expire worthless

Net profit to the buyer will be -$200

(= $-$200)“The option is called out of the money” (Market price < Strike price)

Call Option

16

Put OptionWhat is Put Option?•An option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration)

17

Put OptionExample 1: Buying put option/ insurance policy

18

Put OptionExample 1: Buying put option/ insurance policy

19

Put Option• Example 1: Buying put option/ insurance policy

20

Put Option• Example 1: Buying put option/ insurance policy

21

Example 2: Selling stocks

Suppose that you believe yahoo stock is going to fall in the near future. And

you can buy put options on YAHOO.

If you want to sell YAHOO stock (Currently trading at $12 per shares),

You purchase put option contract on yahoo stock with a $10 strike price and

at a price of $0.01 per share for a 100 share contract

Actual cost of this option (Premium)??(Note: each options contract represents an interest in 100 shares of stock)

= 100 shares X $0.01 = $1

Put option

22

“The option is called in the money” (Market price < Strike price)

The stock is trading at $8 per share

(Less valuable than exercise price)

The option will be worth $2 per share (=$10-$8)And total sale price (payoff) will be $200 (=$2X100shares)

The option buyer has the right to sell the stock at $10 per share

Net profit to the buyer will be $199

(= $200-$1)

Example 2: Selling stocks – Scenario 1

Put Option

23

Example 2: Selling stocks - Scenario 2

The stock is trading at $10 per share

(Equally valuable to exercise price)

The option buyer has the right to sell the stock at $10 per share

The option will be worth zero per share (=$10-$10)And total sale price (payoff) will be zero (=$0.00X100)

Net profit to the buyer will be -$1

(= $-$1)“The option is called at the money” (Market price = Strike price)

Put Option

24

Example 2: Selling stocks - Scenario 3

The stock is trading at $15 per ounce

(More valuable than exercise price)

You have no reason to exercise your put option

You can let the option expire worthless

Net profit to the buyer will be -$1

(= $-$1)“The option is called out of the money” (Market price > Strike price)

Put Option

25

Why Investors Use Options?

1. Speculation•Speculators make bets/ guesses on where

they believe the market is headed

•Seek profit from fluctuating prices of

securities (buy low, sell high)

26

Why Investors Use Options?• Speculation: Example I am an investorI think that Desi’s Brewing Business (DBB) is

overvalued at $25I bet/guess that P in futureSo I borrow the stock & sell it for $25 per share (short

sell)Once P to $20, I will buy it back and return to

owner, making $5 profitIf P in future, say $30, then I lose $5 per share

27

Why Investors Use Options?

2. Hedging•Reducing risk, i.e like buying insurance, protection

against unforeseen events; reduce risks associated with uncertainty

28

• Hedging: Example 1 Buying Call Option

Asenaca’s Tequila Company depends on agave plants

Why Investors Use Options?

29

Suppose you bought 100 shares of Apple computer (AAPL) at $500 but wanted to make sure you don't lose more than 10% on this investment

You could buy an AAPL hedging option with a strike of $450

Hedging: Example 2: Selling stocks

Why Investors Use Options?

30

If the price drops below $450 a share

You will be able to exercise your hedging option and sell your stock for $450

If the price increases above $450 a share

Your hedging option would become worthless

(At least you had the protection)

Hedging - Example 2: Selling stocks – Scenario 1

Why Investors Use Options?

Hedging - Example 2: Selling stocks – Scenario 2

31

Value of an OptionOption value and the Volatility of the underlying asset Example 1: Buying cameras http://www.bestbuy.com/site/promo/select-dslr-2-lens-kits We want to buy camera, there are many alternativesExample 2: Flight ticket https://faq.orbitz.com/app/answers/detail/a_id/23662/~/how-much-does-it-cost-to-change-my-airline-ticket%3F Cancellable and Non-Cancellable ticket. Cancellable Airline Tickets: When the volatility of an underlying is zero, we can easily find the option value most of the time. For example, the options on items for shopping have no value because the volatility of the underlying item is usually zero. However, in case of a cancellable airline ticket, the value of the cancellable option is NOT zero even when the price of the airline ticket has no volatility. Note that if everybody cancels, the airline company may not sell allthe cancelled seats within a short period of time. Consider an at-the-money equity option. Then if the volatily of the equity is zero, there is no value for the option. But this argument is NOT always valid, say, a cancellable airline ticker.

32

Value of an Option

Option Intrinsic Value

Call option Max(ST – E ;0)

Put option Max (E - ST ; 0)

To understand the characteristics of options, we examine their value at expiration

ST = the value of the underlying at expiration date E = the exercise price of the option

33

Terminology• At-the-money: Market price = Strike price • In-the-money: Positive intrinsic value

• 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

• Out-of-the-money: Zero intrinsic value • 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

34

Payoff from Call optionsBuying a call

Pay off to a call buyer at expiration: Max(ST – E ;0) = ST - E if St > E = 0 if ST E

35

Call Option exampleBCE Inc. Nov. call with exercise price of $30 is selling for $5.75BCE stock at expiration $20 25 30 35 40Payoff at expiration $ 0 0 0 5 10If at expiration BCE stock is trading at $40 then:Net profit = option payoff – option price = ($40 - $30) - $5.75 = $4.25Up to $30 the call option investor’s maximum loss is $5.75

(which is the option price)The breakeven point for the investor is at $35.75

36

Call Option example• Profit and Loss to the Buyer of a Call Option

37

Selling (writing) a CallA option writer is one who does not hold a position in the

underlying assetcall option writers incur losses if the stock price increases

Payoff to call writer at expiration Max (-(ST - E) ; 0) = -(ST - E) if ST E = 0 if ST E The net profit line for a call writer is a mirror image of a call

buyer

38

Selling (Writing) a Call• Profit and Losses to the Writer of a Call option

39

Buying a Put Option

• Put option makes money when stock price declines

Payoff to put buyer: Max (E - ST ; 0) = 0 if ST >= E = E - ST if ST E

40

Put Option example

BCE Inc. Nov. put with exercise price of $30 is selling for $0.30

BCE stock at expiration $20 25 30 35 40Pay-off at expiration $10 5 0 0 0If at expiration BCE stock is trading at $20 then:Net profit = option payoff – option price = ($20-$10) - $0.30 = $9.70The breakeven point for the investor is at $29.70

41

Profit and Losses to the Buyer of a Put Option

42

Selling (Writing) a Put The payoff pattern for a put investor is the mirror image

of a put buyer Payoff to a put writer at expiration: Max (-(E- ST);0)

= 0 if ST >= E = -(E - ST) if ST EThe writer is obligated to buy the stock at the specified

price during the life of the put contractIf the stock price falls the put buyer may buy the stock

and exercise the put by making the writer pay the specified price

43

Profit and Losses to the Writer of a Put Option

44

Option Styles

• EUROPEAN is an option that can be exercised only on its expiration date

• AMERICAN is an option that can be exercised any time up until and including its expiration date

Question: Is American Option worth more than European? Should we exercise when American options is in the money?

45

Option StylesAnswer: Not necessary. Why?1.For call options we want to delays the payment of strike price (as forward example). We can earn an interest on strike price throughout the life of an option2.For Put value exercise of an American put option is a trade-off between the time value of money and an insurance value. The time decreases the value of an option. However, an option holder gets an insurance value instead. (assumption options with no dividends)

*When we buy American options, selling options rather than exercising them before the maturity is also feasible. 46

To summarize...

CALL PUT

BUYER Right to Buy Right to Sell

ISSUER/SELLER Obligation to Sell Obligation to Buy

47

Ready for a small quiz?

48