MBA560 Chapter 14 10th

Copyright 2008 Pearson Addison-Wesley. All rights reserved.
Chapter 14
Options:
Puts and
Calls
14-2
Options: Puts, Calls, and Warrants
Learning Goals
1. Discuss the basic nature of options in general, and puts
and calls in particular, and understand how these
investment vehicles work.
2. Describe the options market, and note key options
provisions, including strike prices and expiration dates.
3. Explain how put and call options are valued and the
forces that drive options prices in the marketplace.
14-3
Options: Puts, Calls, and Warrants
Learning Goals (contd)
4. Describe the profit potential of puts and calls, and note
some popular put and call investment strategies.
5. Explain the profit potential and loss exposure from
writing covered call options, and discuss how writing
options can be used as a strategy for enhancing
investment returns.
6. Describe market index options, puts and calls on
foreign currencies, and LEAPS, and discuss how
investors can use these securities.
14-4
Options: Puts, Calls and Warrants
Financial Asset: asset that represents a
financial claim on an issuing organization
Stocks, bonds and convertible securities
are examples
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
14-5
Types of Options
Types of Options
Puts
Calls
Rights
Warrants
All of the above are types of derivative securities,
which derive their value from the price behavior of
an underlying real or financial asset

14-6
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
14-7
(contd)
Options allow buyers to use leverage;
investors can buy a lot of price action with
limited capital
Options allows investors to nearly always
enjoy limited exposure to risk
Puts and calls are created by individual
investors, not by the organizations that
issue the underlying financial asset
14-8
(contd)
Option Buyer:
Has the right to buy or sell an underlying asset
for a given period of time, at a price that was
fixed at the time of the option contract in
exchange for paying the seller a fee
Buyer can walk away from a bad option

14-9
(contd)
Option Seller/Maker/Writer:
Has the obligation to buy or sell the underlying
asset according to the terms of the option
contract, for which the seller has been paid a
certain amount of money
Seller cannot walk away from a bad option
14-10
(contd)
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
Values of puts and calls change with the time
period before they expire:
Closer to expiration date, option values go down
14-11
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 buyers exposure to risk is limited to
fee paid to purchase the put or call option
Investor can make money when value of
assets go up or down
14-12
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 complex and tricky
Option sellers exposure to risk may be unlimited
Options are risky because an investor has to be
correct on two decisions to make money:
Which direction the price of the asset will move
When the price change will occur

14-13
How Calls Work
Call: a negotiable instrument that gives the holder
(buyer) the right to buy the underlying security at a
specified price over a set period of time from the
seller/maker/writer in exchange for a fee paid to
the seller/maker/writer
The buyer of the call option wants the price of the
underlying assets to go up
The seller/maker/writer of the call option wants the price
of the underlying assets to go down
14-14
How Calls Work (contd)
If the price of the underlying assets goes up:
The buyer will buy the asset at the lower strike price
from the seller/maker/writer and sell it at the higher
market price, making a profit
The seller will sell the assets at a price lower than the
market price. If the seller does not already own the
assets, then the seller will have to purchase them at the
higher market price
Covered call: seller owns the asset
Naked call: seller does not own the asset
If the price of the underlying assets
go down:
The buyer will let the call option expire
worthless and lose the fee paid
The seller will keep the fee received and make
a profit
14-16
Example: Assume the market price for a share of common stock is
$50. A call option to purchase 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
purchase 100 shares at the strike price from the seller/maker/writer
and sell them at the higher market price.
The buyers profit will be:
The seller/maker/writers loss will be:
Profit = [(Market price Strike price) 100 Shares] Cost of call
$2,000 = [($75 $50) 100 Shares] $500
Loss = [(Strike price Market price) 100 Shares] + Fee for call
$(2,000) = [($50 $75) 100 Shares] + $500
14-17
How Calls Work:
The Value of Leverage
If the market price of the stock goes up to $75 per share, the buyer will
purchase 100 shares at the strike price from the seller/maker/writer
and sell them at the higher market price. The buyers profit will be
$2,000.
The buyers total return using the call option will be:
The buyers total return directly owning the stock would be:
Total Return =
Profit
Amount invested
=
$2,000
$500
= 400%
Total Return =
Profit
Amount invested
=
$2,000
$5,000
= 40%
14-18
If the market price of the stock goes down to $25 per share, the buyer
will allow the call option to expire worthless.
The buyers loss will be:
The seller/maker/writers profit will be:
Loss = Cost of call
Loss = $(500)
Profit = Fee of call
Profit = $(500)
14-19
How Puts Work
Put: a negotiable instrument that enables the
holder (buyer) to sell the underlying security at a
specified price over a set period of time to the
seller/maker/writer in exchange for a fee paid to
the seller/maker/writer
The buyer of the put option wants the price of the
underlying assets to go down
The seller/maker/writer of the put option wants the price
of the underlying assets to go up
14-20
How Puts Work (contd)
If the price of the underlying assets goes down:
The buyer will buy the asset on the market at the lower
price and force the seller/maker/writer to buy the asset
at the higher option price, making a profit
The seller will pay a price higher than the market price
and will own expensive assets or will have to sell them
at a loss
If the price of the underlying assets go up:
The buyer will let the put option expire worthless and
lose the fee paid
The seller will keep the fee received and make a profit
14-21
$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 down to $25 per share, the buyer
will purchase 100 shares at the market price and force the
seller/maker/writer to buy them at the option strike price.
The buyers profit will be:
The seller/maker/writers loss will be:
Profit = [(Strike price Market price) 100 shares] Cost of put
$2,000 = [($50 $25) 100 Shares] $500
Loss = [(Market price Strike price) 100 shares] + Fee for put
($2,000) = [($25 $50) 100 Shares] + $500
14-22
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.
The buyers loss will be:
The seller/maker/writers profit will be:
Loss = Cost of put
Loss = $(500)
Profit = Fee for put
Profit = $500
14-23
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
14-24
Stock Options
Common Stock Options
Over 1.5 billion option contracts are traded
each year
Options on common stocks is the most popular
form of option
Over 90% of all option contracts are
stock options
14-25
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
14-26
Figure 14.1 Quotations
for Listed Stock Options
14-27
Expiration Date of Listed
Stock Options
Three Expiration Cycles
The January/April/July/October cycle
The February/May/August/November cycle
The March/June/September/December cycle
The longest-term expiration dates are normally no longer
than nine months
The options that are longer than nine months are called
LEAPS, and they are only available on some of the stocks
Listed options always expire on the third Friday of the
month of expiration
14-28
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:
Fundamental (intrinsic) value: based upon
current market price of underlying assets
Time Premium: amount that option price
exceeds the fundamental value
14-29
Valuation of Stock Options:
Fundamental Value of a Call
Fundamental value of a call =
Market price of
underlying
common stock,
or other
financial asset
Strike price
on
the call
|
\
|
.
|
|
|
|
100
14-30
Valuation of Stock Options:
Fundamental Value of a Put
Fundamental value of a put =
Strike price
on
the put

Market price of
underlying
common stock,
or other
financial asset
|
\
|
.
|
|
|
|
100
V = SPP MP ( ) 100
14-31
Figure 14.2 The Valuation
Properties of Put and Call Options
14-32
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
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
14-33
Table 14.1 Option Price Components
for an Actively Traded Call Option
14-34
Option Trading Strategies
Buying for Speculation
Hedging to modify risks
Writing Options to enhance returns
Spreading Options to enhance returns
14-35
Speculating with Stock Options
Similar to investing in common stocks
Goal is to buy low, sell high
Buyer does not need as much capital since can
use leverage
Buyer cannot lose more than cost of the option
14-36
Table 14.2 Speculating with Call
Options
14-37
Hedging with Stock Options
Purpose is to reduce or eliminate risk
Combines two or more securities into a single investment
position
Hedging a Long Position
Buying a put and holding appreciated stock in the same company
Buying a put would provide insurance in case the stock price went
down before you sold the stock
Hedging a Short Position
Selling stock short and buying a call
Buying a call would allow you to buy stock to cover the short sale if
the stock price went up instead of down
14-38
Table 14.3 Limiting Capital Loss
with a Put Hedge
14-39
Table 14.4 Protecting Profits
with a Put Hedge
14-40
Writing Stock Options
The seller/maker/writer is betting that the option buyer will
be wrong about the direction of the stock price or the time
period the price change will occur
Statistically, the odds favor the writer over the buyer
Easy money if the option expires worthless. The writer cannot
make more than the fee received
High risk if the option is in-the-money
Naked options: writer does not own the optioned securities and has to
buy them. No limit on loss exposure
Covered options: writer owns the optioned securities. Loss exposure is
limited to the price originally paid for the securities
14-41
Table 14.5 Covered Call
Writing
14-42
Spreading Options
Purpose is to take advantage of differences in prevailing
option prices and premiums
Combines two or more options into a single transaction
Vertical Spread
Buying a call at one strike price and writing a call (on same stock
for same expiration date) at a higher strike price
Option Straddle
Simultaneous purchase (or sale) of both a put and a call on the
same underlying common stock
Spreading options is extremely tricky and should be used
only by knowledgeable investors
14-43
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
14-44
Stock-Index Options (contd)
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
14-45
Other Types of Options
Exchange traded funds: put and call options
written on exchange traded funds (EFTs)
Very similar to market index options
Interest rate options: put and call options written
on fixed-income (debt) securities
Small market involving only U.S. Treasury securities
Option prices change with yield behavior of
debt securities
14-46
Other Types of Options (contd)
Currency options: put and call options written on
foreign currencies
Available on most major world currencies
Option prices change as exchange rates between
currencies fluctuate
LEAPS: long-term options that may extend out
to 3 years
Available on several hundred stocks and over two
dozen stock indexes and ETFs
14-47
Chapter 14 Review
Learning Goals
1. Discuss the basic nature of options in general, and puts
and calls in particular, and understand how these
investment vehicles work.
2. Describe the options market, and note key options
provisions, including strike prices and expiration dates.
3. Explain how put and call options are valued and the
forces that drive options prices in the marketplace.
14-48
Chapter 14 Review (contd)
Learning Goals (contd)
4. Describe the profit potential of puts and calls, and note
some popular put and call investment strategies.
5. Explain the profit potential and loss exposure from
writing covered call options, and discuss how writing
options can be used as a strategy for enhancing
investment returns.
6. Describe market index options, puts and calls on
foreign currencies, and LEAPS, and discuss how
investors can use these securities.
Chapter 14
Additional
Chapter Art
14-50
Figure 14.3 Quotations on Index
Options
14-51
Table 14.6 Foreign Currency Option
Contracts on the Philadelphia Exchange

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