Fundamentals of   Investments 14 C h a p t e r Stock Options second edition Valuation & Management Charles   J.   Corrado ...
Stock Options <ul><li>In this chapter, we will discuss options generally, but with a focus on options on individual common...
Option Basics <ul><li>A stock option is a  derivative security,  because the value of the option is “derived” from the val...
Option Basics <ul><li>In general, options on common stock must stipulate at least the following terms: </li></ul><ul><ul><...
Work the Web <ul><li>Visit these options exchanges: </li></ul><ul><ul><li>http://www. cboe .com </li></ul></ul><ul><ul><li...
Option Price Quotes 14 -
Option Price Quotes <ul><li>A list of available option contracts and their prices for a particular security arrayed by str...
Work the Web <ul><li>For information on options ticker symbols, see: </li></ul><ul><ul><li>http://www. cboe .com </li></ul...
Why Options? <ul><li>Should you buy 100 IBM shares at $90 each ($9,000 investment), or should you buy a call option with a...
Why Options? <ul><li>Whether one strategy is preferred over another is a matter for each individual investor to decide. </...
Work the Web <ul><li>For more information on options education, see: </li></ul><ul><ul><li>http://www. optionscentral .com...
Option Writing <ul><li>The seller of a call/put option is called the call/put “writer,” and the act of selling an option i...
Option Payoffs <ul><li>It is useful to think about option investment strategies in terms of their initial and terminal cas...
Payoff Diagrams
Payoff Diagrams
Option Profits
Option Profits
Work the Web <ul><li>To learn more on options, see: </li></ul><ul><ul><li>http://www. e- analytics .com </li></ul></ul><ul...
Option Strategies <ul><li>Protective put  - Strategy of buying a put option on a stock already owned. This protects agains...
Work the Web <ul><li>For ideas on option trading strategies,  see: </li></ul><ul><ul><li>http://www. commodityworld .com <...
Option Prices, Intrinsic Values, and Arbitrage <ul><li>call option price < stock price </li></ul><ul><ul><li>Otherwise, ar...
Option Prices, Intrinsic Values, and Arbitrage <ul><li>The  intrinsic value  of an option is the payoff that an option hol...
Option Prices, Intrinsic Values, and Arbitrage <ul><li>option price    option’s intrinsic value </li></ul><ul><ul><li>Oth...
Stock Index Options <ul><li>A stock index option is an option on a stock market index. </li></ul><ul><li>The most popular ...
Stock Index Options 14 -
Work the Web <ul><li>Exchanges that trade index options include: </li></ul><ul><ul><li>http://www. cboe .com </li></ul></u...
The Options Clearing Corporation <ul><li>The Options Clearing Corporation (OCC) is a private agency that guarantees that t...
Work the Web <ul><li>Visit the OCC at: </li></ul><ul><ul><li>http://www. optionsclearing . com </li></ul></ul>
Chapter Review <ul><li>Options on Common Stocks </li></ul><ul><ul><li>Option Basics </li></ul></ul><ul><ul><li>Option Pric...
Chapter Review <ul><li>Option Strategies </li></ul><ul><ul><li>The Protective Put Strategy </li></ul></ul><ul><ul><li>The ...
Chapter Review <ul><li>Stock Index Options </li></ul><ul><ul><li>Features and Settlement </li></ul></ul><ul><ul><li>Index ...
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Chap14

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Chap14

  1. 1. Fundamentals of Investments 14 C h a p t e r Stock Options second edition Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
  2. 2. Stock Options <ul><li>In this chapter, we will discuss options generally, but with a focus on options on individual common stocks. We will see the tremendous flexibility that options offer investors in designing investment strategies. </li></ul>Goal
  3. 3. Option Basics <ul><li>A stock option is a derivative security, because the value of the option is “derived” from the value of the underlying common stock. </li></ul><ul><li>There are two basic option types. Call options are options to buy, while put options are options to sell. </li></ul><ul><li>Option contracts are standardized to facilitate trading and price reporting. </li></ul><ul><ul><li>A single standard option is an option to buy/sell 100 shares of stock. </li></ul></ul>
  4. 4. Option Basics <ul><li>In general, options on common stock must stipulate at least the following terms: </li></ul><ul><ul><li>The identity of the underlying stock. </li></ul></ul><ul><ul><li>The strike price, or exercise price. </li></ul></ul><ul><ul><li>The option contract size. </li></ul></ul><ul><ul><li>The option expiration date, or option maturity. </li></ul></ul><ul><ul><li>The option exercise style ( American or European ). </li></ul></ul><ul><ul><li>The delivery or settlement procedure. </li></ul></ul><ul><li>There are organized options exchanges as well as over-the-counter (OTC) options markets where stock options may be traded. </li></ul>
  5. 5. Work the Web <ul><li>Visit these options exchanges: </li></ul><ul><ul><li>http://www. cboe .com </li></ul></ul><ul><ul><li>http://www. amex .com </li></ul></ul><ul><ul><li>http://www. phlx .com </li></ul></ul><ul><ul><li>http://www. nyse .com </li></ul></ul><ul><ul><li>http://www. pacificex .com </li></ul></ul>
  6. 6. Option Price Quotes 14 -
  7. 7. Option Price Quotes <ul><li>A list of available option contracts and their prices for a particular security arrayed by strike price and maturity is known as an option chain . </li></ul>
  8. 8. Work the Web <ul><li>For information on options ticker symbols, see: </li></ul><ul><ul><li>http://www. cboe .com </li></ul></ul><ul><ul><li>http://www. optionsites .com </li></ul></ul>
  9. 9. Why Options? <ul><li>Should you buy 100 IBM shares at $90 each ($9,000 investment), or should you buy a call option with a strike price of $90 expiring in three months at $500 ($5 per share)? </li></ul><ul><li>Three months later, </li></ul>Buy Shares Buy Option Profit Return Profit Return Case 1: $100 $1,000 11.11% $500 100% Case 2: $90 $0 0% -$500 -100% Case 3: $80 -$1,000 -11.11% -$500 -100%
  10. 10. Why Options? <ul><li>Whether one strategy is preferred over another is a matter for each individual investor to decide. </li></ul><ul><li>What is important is the fact that options offer an alternative means of formulating investment strategies. </li></ul>
  11. 11. Work the Web <ul><li>For more information on options education, see: </li></ul><ul><ul><li>http://www. optionscentral .com </li></ul></ul>
  12. 12. Option Writing <ul><li>The seller of a call/put option is called the call/put “writer,” and the act of selling an option is referred to as option writing . </li></ul><ul><li>Option writing involves receiving the option price and, in exchange, assuming the obligation to satisfy the buyer’s exercise rights if the option is exercised. </li></ul>
  13. 13. Option Payoffs <ul><li>It is useful to think about option investment strategies in terms of their initial and terminal cash flows. </li></ul><ul><li>The initial cash flow of an option is the price of the option, also called the option premium. </li></ul><ul><li>The terminal cash flow of an option is the option’s payoff that can be realized from the exercise privilege. </li></ul>
  14. 14. Payoff Diagrams
  15. 15. Payoff Diagrams
  16. 16. Option Profits
  17. 17. Option Profits
  18. 18. Work the Web <ul><li>To learn more on options, see: </li></ul><ul><ul><li>http://www. e- analytics .com </li></ul></ul><ul><ul><li>http://www. tradingmarkets .com </li></ul></ul><ul><ul><li>http://www. investorlinks .com </li></ul></ul>
  19. 19. Option Strategies <ul><li>Protective put - Strategy of buying a put option on a stock already owned. This protects against a decline in value. </li></ul><ul><li>Covered call - Strategy of selling a call option on stock already owned. This exchanges “upside” potential for current income. </li></ul><ul><li>Straddle - Buying or selling a call and a put with the same exercise price. Buying is a long straddle; selling is a short straddle. </li></ul>
  20. 20. Work the Web <ul><li>For ideas on option trading strategies, see: </li></ul><ul><ul><li>http://www. commodityworld .com </li></ul></ul><ul><ul><li>http://www. writecall .com </li></ul></ul><ul><ul><li>http://www. giscor .com </li></ul></ul>
  21. 21. Option Prices, Intrinsic Values, and Arbitrage <ul><li>call option price < stock price </li></ul><ul><ul><li>Otherwise, arbitrage will be possible. </li></ul></ul><ul><li>put option price < strike price </li></ul><ul><ul><li>Otherwise, arbitrage will be possible. </li></ul></ul><ul><li>option price  0 </li></ul><ul><ul><li>By definition, an option can simply be discarded. </li></ul></ul>
  22. 22. Option Prices, Intrinsic Values, and Arbitrage <ul><li>The intrinsic value of an option is the payoff that an option holder receives if the underlying stock price does not change from its current value. </li></ul><ul><li>Call option intrinsic value = max [0, S – K ] </li></ul><ul><ul><li>Put option intrinsic value = max [0, K – S ] </li></ul></ul><ul><ul><li>where S = current stock price </li></ul></ul><ul><ul><li>K = option’s strike price </li></ul></ul>
  23. 23. Option Prices, Intrinsic Values, and Arbitrage <ul><li>option price  option’s intrinsic value </li></ul><ul><ul><li>Otherwise, arbitrage will be possible. </li></ul></ul><ul><li>So, </li></ul><ul><ul><li>Call option price  max [0, S – K ] </li></ul></ul><ul><ul><li> Put option price  max [0, K – S ] </li></ul></ul><ul><ul><li> where S = current stock price </li></ul></ul><ul><ul><li> K = option’s strike price </li></ul></ul>
  24. 24. Stock Index Options <ul><li>A stock index option is an option on a stock market index. </li></ul><ul><li>The most popular stock index options are options on the S&P 100, S&P 500, and Dow Jones Industrial Average. </li></ul><ul><li>Since the actual delivery of all stocks comprising a stock index is impractical, a cash settlement procedure is adopted for stock index options. </li></ul>
  25. 25. Stock Index Options 14 -
  26. 26. Work the Web <ul><li>Exchanges that trade index options include: </li></ul><ul><ul><li>http://www. cboe .com </li></ul></ul><ul><ul><li>http://www. cbot .com </li></ul></ul><ul><ul><li>http://www. cme .com </li></ul></ul>
  27. 27. The Options Clearing Corporation <ul><li>The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised. </li></ul><ul><li>The OCC issues and clears all option contracts trading on U.S. exchanges. </li></ul><ul><li>Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC). </li></ul>
  28. 28. Work the Web <ul><li>Visit the OCC at: </li></ul><ul><ul><li>http://www. optionsclearing . com </li></ul></ul>
  29. 29. Chapter Review <ul><li>Options on Common Stocks </li></ul><ul><ul><li>Option Basics </li></ul></ul><ul><ul><li>Option Price Quotes </li></ul></ul><ul><li>Why Options? </li></ul><ul><li>Option Payoffs and Profits </li></ul><ul><ul><li>Option Writing </li></ul></ul><ul><ul><li>Option Payoffs </li></ul></ul><ul><ul><li>Payoff Diagrams </li></ul></ul><ul><ul><li>Option Profits </li></ul></ul>
  30. 30. Chapter Review <ul><li>Option Strategies </li></ul><ul><ul><li>The Protective Put Strategy </li></ul></ul><ul><ul><li>The Covered Call Strategy </li></ul></ul><ul><ul><li>Straddles </li></ul></ul><ul><li>Option Prices, Intrinsic Values, and Arbitrage </li></ul><ul><ul><li>The Upper Bound for a Call Option Price </li></ul></ul><ul><ul><li>The Upper Bound for a Put Option Price </li></ul></ul><ul><ul><li>The Lower Bounds on Option Prices </li></ul></ul>
  31. 31. Chapter Review <ul><li>Stock Index Options </li></ul><ul><ul><li>Features and Settlement </li></ul></ul><ul><ul><li>Index Option Price Quotes </li></ul></ul><ul><li>The Options Clearing Corporation </li></ul>

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