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Chapter 15

Options Markets

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Option Terminology• Buy - Long • Sell - Short• Call Option: gives its holder the right to purchase an

asset for a specified price before or on a specified expiration date.

• Put Option: gives its holder the right to sell an asset at a specified price before or on a specified expiration date.

• Key Elements– Exercise or Strike Price– Premium or Price– Maturity or Expiration

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Market and Exercise Price RelationshipsIn the Money - exercise of the option would be

profitableCall: market price>exercise pricePut: exercise price>market price

Out of the Money - exercise of the option would not be profitableCall: market price<exercise pricePut: exercise price<market price

At the Money - exercise price and asset price are equal

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American vs European OptionsAmerican - the option can be exercised at any

time before expiration or maturityEuropean - the option can only be exercised on

the expiration or maturity date

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Different Types of Options• Stock Options• Index Options• Futures Options• Foreign Currency Options• Interest Rate Options

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Payoffs and Profits on Options at Expiration - Calls

Notation Stock Price = ST Exercise Price = XPayoff to Call Holder

(ST - X) if ST >X

0 if ST < Xor Max {ST – X, 0}

Profit to Call HolderPayoff - Purchase Price

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Payoffs and Profits on Options at Expiration - Calls

Payoff to Call Writer - (ST - X) if ST >X

0 if ST < Xor Min {X – ST, 0}

Profit to Call WriterPayoff + Premium

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Profit

Stock Price

0

Call Writer

Call Holder

Profit Profiles for Calls

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Payoffs and Profits at Expiration - PutsPayoffs to Put Holder

0 if ST > X(X - ST) if ST < Xor Max {X-ST, 0}

Profit to Put Holder Payoff - Premium

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Payoffs and Profits at Expiration - PutsPayoffs to Put Writer

0 if ST > X-(X - ST) if ST < Xor Min {ST - X, 0}

Profits to Put WriterPayoff + Premium

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Profit Profiles for Puts

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Profits

Stock Price

Put Writer

Put Holder

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Exercise in class1. You purchase one IBM July 120 call contract for a premium of $5. You hold

the option until the expiration date when IBM stock sells for $123 per share. You will realize a ______ on the investment. A) $200 profit B) $200 loss C) $300 profit D) $300 loss

2. You purchase one IBM July 120 put contract for a premium of $5. You hold the option until the expiration date when IBM stock sells for $123 per share. You will realize a ______ on the investment. A) $300 profit B) $200 loss C) $500 loss D) $200 profit

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Exercise in classA call option on Brocklehurst Corp. has an exercise price of $30. The current

stock price of Brocklehurst Corp. is $32. The call option is __________. A) at the money B) in the money C) out of the money D) none of the above

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Equity, Options & Leveraged Equity - Text Example

Investment Strategy Investment

Equity only Buy stock @ 80 100 shares $8,000

Options only Buy 80 calls @ 10 800 options $8,000

Leveraged Buy 80 calls @ 10 100 options $1,000equity Buy T-bills @ 2% $7,000

Yield

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Equity, Options & Leveraged Equity - Payoffs

Microsoft Stock Price

$75 $80 $100

All Stock $7,500 $8,000 $10,000

All Options $0 $0 $16,000

Lev Equity $7,140 $7,140 $9,140

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Equity, Options & Leveraged Equity - Rates of Return

Microsoft Stock Price

$75 $80 $100

All Stock -6.25% 0% 25%

All Options -100% -100% 100%

Lev Equity -10.75% -10.75% 14.25%

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Put-Call Parity Relationship

ST < X ST > X

Payoff for

Call Owned 0 ST - X

Payoff for

Put Written -( X -ST) 0

Total Payoff ST - X ST - X

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Payoff of Long Call & Short Put

Long Call

Short Put

Payoff

Stock Price

Combined =Leveraged Equity

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Arbitrage & Put Call ParitySince the payoff on a combination of a long call

and a short put are equivalent to leveraged equity, the prices must be equal.

C - P = S0 - X / (1 + rf)T

If the prices are not equal arbitrage will be possible

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Put Call Parity - Disequilibrium ExampleStock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 10.25%Maturity = .5 yr X = 105

C - P > S0 - X / (1 + rf)T

17- 5 > 110 - (105/1.05) 12 > 10

Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative

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Put-Call Parity Arbitrage

Immediate Cashflow in Six MonthsPosition Cashflow ST<105 ST> 105

Buy Stock -110 ST ST

BorrowX/(1+r)T = 100 +100 -105 -105

Sell Call +17 0 -(ST-105)

Buy Put -5 105-ST 0

Total 2 0 0

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Option StrategiesProtective Put

Long Stock Long Put

Covered Call Long StockShort Call

Straddle (Same Exercise Price)Long Call Long Put

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Exercise in class1 You buy one Chrysler August 50 call contract and one Chrysler August 50

put contract. The call premium is $4.25 and the put premium is $5.00. Your highest potential loss from this position is __________. A) $75 B) $925 C) $5,000 D) unlimited

2 An investor purchases a long call at a price of $2.50. The expiration price is $35.00. If the current stock price is $35.10, what is the break even point for the investor? A) $32.50 B) $35.00 C) $37.50 D) $37.60

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Option StrategiesSpreads - A combination of two or more call options or

put options on the same asset with differing exercise prices or times to expirationVertical or money spread

Same maturityDifferent exercise price

Horizontal or time spreadDifferent maturity dates

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Exercise in class

You buy one Chrysler August 50 call contract and one Chrysler August 50 put contract. The call premium is $4.25 and the put premium is $4.50. Your strategy is useful if you believe that the stock price __________. A) will be lower than $41.25 in August B) will be between $41.25 and $58.75 in August C) will be higher than $58.75 in August D) either a or c