Transcript I. Options I. Options • A. Definition: The right to buy or sell a specific issue at a specified price (the exercise price)

I. Options
I. Options
• A. Definition: The right to buy or sell a
specific issue at a specified price (the
exercise price) on or before a specified
date regardless of what the market price of
the security is on the date the option is
exercised.
• B. Call: The right to buy a security
(Upside).
• C. Put: The right to sell a security
(Downside).
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I. Options (continued)
• D. Option Writer
– The person who writes the call
or put and receives a premium
• E. Option Buyer
– The person who buys the call
or put and pays the premium
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I. Options (continued)

Company
Stock
Market
F. Relation of Options to Stock
Investor
Option
Market
Option
Investor
Stock and Option Markets are unrelated
except for the market price of a stock in
the stock market and the exercise price
of the stock option.
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II. Investor Profit
Profiles
• Assume you bought 1
share of T.I. at $50. This is
your profit profile given
various assumptions
about T.I.’s future market
price.
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Profit Profile for the Long Stock
Position
Profit
Gain
Gain
$20
$50 Price
0
$70
Loss
$-50
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Market
Price
II. Investor Profit
Profiles
• A. Call Option Profit Profile
of Buyer and Seller
– Situation: Investor thinks a
security will increase in price -can buy security or a call
option. If price declines,
Investor has a capital loss in
long position or loses his
option premium when expired.
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1. Profit Profile of Call
Buyer (the Upside)
Profit
Gain
Gain
Strike $50
Price
0
Loss
$3
$53
Market
Price
Premium Paid (Price to purchase Option)
– Note: Upside potential is unlimited,
Downside risk is limited
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Upside (Call)
2. Profit Profile of a Call Seller
(the other side of the mirror)
Gain Premium Received
0
$3
$53
Market
Price
Strike Price
Loss
$50
Profit
Loss
– Note: Upside potential is limited to the
premium received. Downside risk is
unlimited.
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The Downside
B. Put Option Profit Profile of
Buyer and Seller
• Situation: Investor thinks a
security will decrease in price -can short sell or buy a PUT option.
If the security increases in price,
the short position produces a
capital loss and the option position
produces a premium loss.
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1. Profit Profile of Put
Buyer
Gain
Strike Price
$50
Market
Price
0
Premium
$1.50
Loss
• Note: Upside potential is limited to the price
of the security. Downside risk is limited to the
premium.
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2. Profit Graph of Put
Seller
Gain
Premium
$1.50
0
Loss
Loss
Market
Price
Strike Price
$50
• Note: Upside potential is limited to the premium.
Downside risk is limited to the price of the
security.
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C. Listed Options Quotes
KO Spot
Price
Calls
Last Sale
Net
Bid
Ask
Vol
Open Int
$65.70
12/02/10
Puts
Net
Bid
Ask
Open Int
0
9643
537
7151
3.25
+0.44
3.15 3.30 3320
10225
10 Dec 62.50
KO1018X62.5-E
0.02
0.0
KO1018L65-E
0.72
+0.36
0.68 0.75 1099
11448
10 Dec 65.00
KO1018X65-E
0.03
-0.10 0.0
KO1018L67.5-E
0.02
0.0
0.0
0.01
0
1602
10 Dec 67.50
KO1018X67.5-E
2.35
-0.75
1.73 1.91
10
1495
KO1122A62.5-E
3.35
+0.23
3.45 3.55
26
27267
11 Jan 62.50
KO1122M62.5-E
0.29
-0.07
0.26 0.28
486
14536
KO1122A65-E
1.49
+0.12
1.49 1.52
786
40281
11 Jan 65.00
KO1122M65-E
0.82
-0.18
0.77 0.80
323
6677
KO1122A67.5-E
0.40
+0.10
0.38 0.40
589
8372
11 Jan 67.50
KO1122M67.5-E
2.27
-0.37
2.15 2.19
101
1256
KO1122A70-E
0.07
-0.02
0.06 0.09
10
5373
11 Jan 70.00
KO1122M70-E
5.20
0.0
4.30 4.40
0
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0.0 0.02
Vol
KO1018L62.5-E
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Last Sale
0.02
D. Option Premiums
• 1. Option premium is the
price an option buyer must
pay for the right and the
price an option writer
receives for selling the right.
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D. Option Premiums
(continued)
• 2. Effected by:
– a. The Security Price
Premiums are directly related to the relative
magnitude of the security price since the risk of
price change is a function of the price.
Example:
Stock A: P = $100
Stock B: P = $10
Loss potential as a result of changes in
security price is greater for Stock A, and
hence, the option writer will require a greater
premium.
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D. Option Premiums
(continued)
– b. Length of Option Life:
• 3, 6, 9 months
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• Longer term options on the
same security are riskier
since the probability of
adverse price changes
increases with time.
Higher premiums
compensate the seller for
this greater risk.
Professor James Kuhle
D. Option Premiums
(continued)
–c. Variability of Returns
• The greater the past variability
of return on the security the
more likely that the option will
be exercised. Greater return
variability translates into
greater option risk, for which,
the writer wants to be
compensated for.
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D. Option Premiums
(continued)
– d. Exercise Price
• 1. In-the-Money: Call exercise
price is below the current market
price.
• 2. At-the-Money: Call exercise
price is equal to the current market
price.
• 3. Out-the-Money: Call exercise
price is above the current market
price.
• Relation between Call Premium and
Exercise Price:
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LEAPS
Long-term Equity AnticiPation Securities, referred to
as “LEAPS,” are either calls or puts with expiration
dates up to 2-1/2 years in the future. Like standard
equity options, each LEAPS contract represents 100
shares of the underlying security. LEAPS offer both
option and stock investors an excellent profit vehicle
by allowing a big-picture trend on a stock to play out,
with much less capital required compared to buying
the underlying stock outright. Yet LEAPS are less risky
than their short-term options counterparts. For those
who prefer a one-to-two-year time horizon for their
investments, LEAPS offer an excellent alternative
using options.
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E. Option Trading
Strategies
• 1. Buying Call Options
– a. Buying to achieve leverage
• The price of a call of 100 shares is
significantly lower than buying the shares
outright.
• Example: Stock XYZ sells at $50/share and a
$50 call costs $5/share. The Investor can
buy the call for $500 instead of the 100
shares for $5,000. If XYZ goes to $60, the
value of the option is $1000.
• Return on option: $500/$500 = 100%
• Return on stock purchase: $1000/$5000 =
20%
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E. Option Trading Strategies
(continued)
– b. Buying call options to limit
risk
• Investor dislikes the risk of buying XYZ and
watching it go down in value. Therefore,
Investor purchases XYZ 50 call at $5 and puts
remaining $ in risk-free securities. Hence,
given the same $5,000, the Investor buys call
and puts $4,500 into Rf securities.
• Example: If XYZ goes to $60, the Investor can
buy or exercise the option to net $500 plus
interest from Rf investment. If XYZ stays at
$50 or falls below, the investor has lost his
option premium which is partly offset by
interest income.
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E. Option Trading Strategies
(continued)
– c. Buying call option to
hedge short stock position
• Investor believes XYZ will
decline. Investor sells XYZ
short to obtain total profit
potential but he is exposed to
unlimited loss from stock price
increase. The Investor buys a
call to eliminate loss.
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E. Option Trading Strategies
(continued)
• 2. Put Option Strategies
– a. Buying Put options for
leverage and limited risk
• Investor anticipates significant
decrease in the stock price but
does not have the margin money
for a short sale, and does not want
to be exposed to unlimited risk of
stock price increases. Investor
buys a put.
• NOTE: Stock price must decline
enough to break even.
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E. Option Trading Strategies
(continued)
– b. Buying Put options to
hedge against a stock price
decline
• Investor holds IBM and has already
taken a paper profit. Investor believes
IBM will go higher and would like to
participate in upside without risking a
loss on paper profit. So he buys a put.
If price goes up, the potential is only
diminished by the cost of the put,
whereas the paper profits are protected
by the put and decreased only by the
put price.
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Buying Put Options
Long
Position
Gain
Net Profit
Market
Price
Option
Profit
0
Loss
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E. Option Trading
Strategies (continued)
• 3. Option Writing
Strategies
– Definition: An investor holds
100 shares of IBM. Writes 2
calls and receives the option
call premiums. One option is
covered and the other is naked.
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E. Option Trading
Strategies
• 4. Writing Call Options
Strategies
– a. Writing covered calls
• Investor owns 100 shares of IBM ($50) and writes
a call at $55 to earn a greater return than the
stock alone. Investor earns D = $1.00 plus $5.00
on the call. Return is $6.00 plus any capital gains.
• Disadvantage: if price goes above $55, the
upside is limited to $6.00.
• Note: Covered call also provides limited
protection to writer against price decline. Price
can decline to $45 ($50-Premium) before writer
experiences paper loss.
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E. Option Trading
Strategies
–b. Writing naked calls
–Investor writes a call
on IBM and receives
a premium income
without owning the
security.
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Writing Naked Calls
Gain
0
Limited Gain
$50
Market
Price
Unlimited
Loss
Loss
• Gain is limited to the value of the premium.
Loss is unlimited because the investor must
go to the market to buy at a higher price to
deliver $50/share stock at the exercise price.
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E. Option Trading
Strategies (continued)
• 5. Writing Put Option
Strategies
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– a. Writing Puts for Premium
Income
• Investor expects the price of
the stock he holds to increase.
Therefore, he can write a
covered put to increase
income. The only risk is that
the stock falls below current
market price.
Professor James Kuhle
Profit Profile
Gain
Net Profit/Loss
Long Position
Profit
Option Profit
Market
Price
0
Loss
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E. Option Trading
Strategies (continued)
• 6. Buying or Writing an Option Straddle
– An Option Straddle is the purchase or the
writing of both a put and a call on the same
security.
– a. Buying a Straddle: Price of underlying
security is expected to move SHARPLY up
or down before option expiration date. Buy
a put and a call. Say you pay for a put and
a call premium of $3.00 each. If the stock
moves from $50 to above $56 or below
$44, a profit is made.
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Profit Profile
– b. Writing a Straddle: Price of the
underlying security is expected to
stay at its current market value until
the option expires. Write a put and
write a call at $3.00 each and
receive a total premium of $6.00.
– As long as the stock price remains
between $44 and $56, the option
straddle writer makes a profit.
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F. Other Option
Strategies
• 1. Bull Spread
– Buying a call and selling a call
with a higher strike price
– Examples:
• 1. Buy call with $90 SP
– Premium = $5
• 2. Sell a call with $95 SP
– Premium = $2
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Profit Profile
P = $90
85
90
95
100
105
110
• Question: If stock price goes to $97,
what is the net profit to the investor?
• Assignment: Determine profits from a
range of $85 to $110 & profit profile.
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F. Other Option
Strategies (continued)
• 2. Bear Spread
– Buy a put option and sell a put
with a lower strike price
– Examples:
• 1. Buy a put with $110 SP
– Premium = $5
• 2. Sell put with $105 SP
– Premium = $2
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Profit Profile
P = $110
85
90
95
100
105
110
115
• Assignment: Determine net profits from a
range of prices of $85-$115.
– Also generate a graph or “profile”.
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F. Other Option Strategies
(continued)
• 3. BUTTERFLY SPREAD
– The butterfly spread is a neutral position
that is a combination of both a bull and
bear spread.
• Example: P = $60
July 50 call:
July 60 call:
July 70 call:
$12
6
3
• Butterfly spread:
Buy 1 July 50 call:
Sell 2 July 60 calls:
Buy 1 July 70 call:
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($1200)
1200
(300)
(300)
Profit Profile (Bicycle)
50
53
60
67
70
• Assignment: Determine net profits
from a range of $40-$80. Profit
profile.
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F. Other Option
Strategies (continued)
• 4. Calendar or Time Spread
– Involves the sale of one option and
the simultaneous purchase of a
more distant option, both with the
same strike price.
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Calendar or Time
Spread
• Example
– JAN. APR50’s
– XYZ:
$5
$50
JUL50’s OCT50’s
$8
$10
• Neutral Spread: investor should
have the initial intent of closing the
spread by the time the near-term
option expires.
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Calendar or Time
Spread (continued)
• Assume the following:
Call Options
APRIL 50 JULY 50 OCT 50
JAN(3 mo.) (6 mo.)
(9 mo.)
50
5
8
10
APR
50
0
5
8
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Calendar or Time
Spread (continued)
• In January the investor sells the APR 50
call and buys the July 50. His debit
position is
-3 points.
• In April the price is unchanged and the 3
month call (July) should be worth 5. The
spread between the April 50 and the July
50 has now widened to 5. Since the
spread cost 3, a 2 pt. profit exists.
Investor should now close his long
position by selling his July 50 call and
reaping a 2 pt. profit.
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Bullish Calendar Spread
• Investor sells the near-term call and buys
a longer-term call when the underlying
stock is some distance below the SP of
the calls.
• Feature of low dollar investment and large
potential profit.
Example:
XYZ: $45 in Jan.
Sell April 50 for $1
Buy July 50 for $1 1/2
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Bullish Calendar Spread
(continued)
• Investor wants 2 things to happen:
– 1. Near-term call expires worthless
– 2. Stock price must rise by the time
July call expires
• Assume price goes to 52 b/w April & July.
Investor nets 1 1/2 pts. How?
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Key Terms
1. Definition of a Put and a Call Option.
2. Option Writer and an Option Buyer.
3. Investor Profit Profile and how to use.
4. Covered call and naked call.
5. Derivative security: what it means.
6. In-the-money and out-of-the-money
7. Option writing and option premium.
8. Bull and a Bear spread.
9. Calendar spread.
10.Butterfly or Bicycle spread.
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Problems
1. You purchase 25 call contracts on Blue Ox stock. The
strike price is $22, and the premium is $1. If the stock is
selling for $24 per share at expiration, what are your call
options worth? What is your net profit? What if the stock
were selling for $23? $22?
2. Stock in Bunyan Brewery is currently priced at $20 per
share. A call option with a $20 strike and 60 days to
maturity is quoted at $2. Compare the percentage gains
and losses from a $2,000 investment in the stock versus
the option is 60 days for stock prices of $26, $20, and
$18.
3. A put option on XYZ stock has a strike price of $40 and
is priced at $2 per share, while a call with a strike price
of $40 is priced at $3.50. What is the maximum per
share loss to the writer of the uncovered put and the
maximum per-share gain to the writer of the uncovered
call?
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Problems
4.
5.
6.
Bill holds 600 shares of P&G. He bought the stock several years ago at $48.50, and the shares are
now trading at 75. Bill is concerned that the market will fall over the next 60 days. He doesn’t want to
sell the stock, but he would like to be able to protect the profit he’s made. He decides to hedge his
position by buying 6 puts on P&G. The 2 month puts carry a strike price of 75 and are currently trading
at $2.50.
a. What is Bill’s total capital gain if the price of P&G drops to $60/share by the expiration date on the
puts and he liquidates his holdings in P&G? If he wants to continue holding 600 shares what would he
do?
b. How would he do if the stock kept going up in price and hit $90/share?
c. Would Bill have been better off using puts with an $70 strike price, trading at $1.00?
Madam Butterfly would like to own Coca Cola stock. She plans to purchase 100 shares at the current
price of $65. She is unsure of which way the price will move so she plans to create a Butterfly spread
with three different call options: Strike prices are $75, $65, $55. The premiums for these three options
are $2, $4, and $8, respectively. Calculate the net profit for the following market prices: $74, $70, $66,
$55, and $52.
Angelo just purchased 500 shares of AT&T at $30/share and has decided to write covered calls against
these stocks. Accordingly, he sells 5 AT&T calls at their current market price of $5.25. The calls have 3
months to expiration and carry a strike price of $35/share. The stock pays a quarterly dividend of $.60
which will be paid during the 3 month call period.
a. Determine the total dollar profits that will be made during the holding period if the price of the stock
moves to $32 just before expiration, assuming he keeps the 500 shares?
b. How high can the price of the stock go before Angelo’s return falls to zero (include dividend)?
c. What is Angelo’s HPR as a percentage of his initial investment at $32, assuming he keeps his 500
shares?
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