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  • 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. Stock Options
    • 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.
    Goal
  • 3. Option Basics
    • A stock option is a derivative security, because the value of the option is “derived” from the value of the underlying common stock.
    • There are two basic option types. Call options are options to buy, while put options are options to sell.
    • Option contracts are standardized to facilitate trading and price reporting.
      • A single standard option is an option to buy/sell 100 shares of stock.
  • 4. Option Basics
    • In general, options on common stock must stipulate at least the following terms:
      • The identity of the underlying stock.
      • The strike price, or exercise price.
      • The option contract size.
      • The option expiration date, or option maturity.
      • The option exercise style ( American or European ).
      • The delivery or settlement procedure.
    • There are organized options exchanges as well as over-the-counter (OTC) options markets where stock options may be traded.
  • 5. Work the Web
    • Visit these options exchanges:
      • http://www. cboe .com
      • http://www. amex .com
      • http://www. phlx .com
      • http://www. nyse .com
      • http://www. pacificex .com
  • 6. Option Price Quotes 14 -
  • 7. Option Price Quotes
    • 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 .
  • 8. Work the Web
    • For information on options ticker symbols, see:
      • http://www. cboe .com
      • http://www. optionsites .com
  • 9. Why Options?
    • 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)?
    • Three months later,
    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. Why Options?
    • Whether one strategy is preferred over another is a matter for each individual investor to decide.
    • What is important is the fact that options offer an alternative means of formulating investment strategies.
  • 11. Work the Web
    • For more information on options education, see:
      • http://www. optionscentral .com
  • 12. Option Writing
    • 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 .
    • 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.
  • 13. Option Payoffs
    • It is useful to think about option investment strategies in terms of their initial and terminal cash flows.
    • The initial cash flow of an option is the price of the option, also called the option premium.
    • The terminal cash flow of an option is the option’s payoff that can be realized from the exercise privilege.
  • 14. Payoff Diagrams
  • 15. Payoff Diagrams
  • 16. Option Profits
  • 17. Option Profits
  • 18. Work the Web
    • To learn more on options, see:
      • http://www. e- analytics .com
      • http://www. tradingmarkets .com
      • http://www. investorlinks .com
  • 19. Option Strategies
    • Protective put - Strategy of buying a put option on a stock already owned. This protects against a decline in value.
    • Covered call - Strategy of selling a call option on stock already owned. This exchanges “upside” potential for current income.
    • Straddle - Buying or selling a call and a put with the same exercise price. Buying is a long straddle; selling is a short straddle.
  • 20. Work the Web
    • For ideas on option trading strategies, see:
      • http://www. commodityworld .com
      • http://www. writecall .com
      • http://www. giscor .com
  • 21. Option Prices, Intrinsic Values, and Arbitrage
    • call option price < stock price
      • Otherwise, arbitrage will be possible.
    • put option price < strike price
      • Otherwise, arbitrage will be possible.
    • option price  0
      • By definition, an option can simply be discarded.
  • 22. Option Prices, Intrinsic Values, and Arbitrage
    • 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.
    • Call option intrinsic value = max [0, S – K ]
      • Put option intrinsic value = max [0, K – S ]
      • where S = current stock price
      • K = option’s strike price
  • 23. Option Prices, Intrinsic Values, and Arbitrage
    • option price  option’s intrinsic value
      • Otherwise, arbitrage will be possible.
    • So,
      • Call option price  max [0, S – K ]
      • Put option price  max [0, K – S ]
      • where S = current stock price
      • K = option’s strike price
  • 24. Stock Index Options
    • A stock index option is an option on a stock market index.
    • The most popular stock index options are options on the S&P 100, S&P 500, and Dow Jones Industrial Average.
    • Since the actual delivery of all stocks comprising a stock index is impractical, a cash settlement procedure is adopted for stock index options.
  • 25. Stock Index Options 14 -
  • 26. Work the Web
    • Exchanges that trade index options include:
      • http://www. cboe .com
      • http://www. cbot .com
      • http://www. cme .com
  • 27. The Options Clearing Corporation
    • 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.
    • The OCC issues and clears all option contracts trading on U.S. exchanges.
    • Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC).
  • 28. Work the Web
    • Visit the OCC at:
      • http://www. optionsclearing . com
  • 29. Chapter Review
    • Options on Common Stocks
      • Option Basics
      • Option Price Quotes
    • Why Options?
    • Option Payoffs and Profits
      • Option Writing
      • Option Payoffs
      • Payoff Diagrams
      • Option Profits
  • 30. Chapter Review
    • Option Strategies
      • The Protective Put Strategy
      • The Covered Call Strategy
      • Straddles
    • Option Prices, Intrinsic Values, and Arbitrage
      • The Upper Bound for a Call Option Price
      • The Upper Bound for a Put Option Price
      • The Lower Bounds on Option Prices
  • 31. Chapter Review
    • Stock Index Options
      • Features and Settlement
      • Index Option Price Quotes
    • The Options Clearing Corporation