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FIN 200 Investments

CHAPTER 20CHAPTER 20

Options Markets

An Introduction

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Review Work Week for the class.

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• Call – to buy an asset

• Put - to sell an asset

• Buy - Long

• Sell - Short

• Key Elements

– Exercise or Strike Price

– Premium or Price

– Maturity or Expiration

Option Terminology that students are required to understand

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Exercise 1: CALL OPTIONS. Read the text on page 672-673.

You may use Example 20.1 to answer the questions, but your answers must be in your own words and must be written in such a way as to be useful in teaching someone that knows nothing about call options.

Explain the following scenarios, from the perspective of n call option holder.1a. Earning a profit from a call option1b. Taking a loss from a call option1c. Breaking even on a call option2.Would a call option holder ever exercise the call option if she was going to take a loss? Yes or No. Explain your answer.3.When does the writer of the call option earn a profit?4.When does the writer of the call option suffer a loss?

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Exercise 2: PUT OPTIONS. Read the text on page 673-674.

You may use Example 20.2 to answer the questions, but your answers must be in your own words and must be written in such a way as to be useful in teaching someone that knows nothing about call options. Explain the following scenarios, from the perspective of a put option holder.1a. Earning a profit from a put option1b. Taking a loss from a put option1c. Breaking even on a put option2.Would a put option holder ever exercise the put option if she was going to take a loss? Yes or No. Explain your answer.3.When does the writer of the put option earn a profit?4.When does the writer of the put option suffer a loss?

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CALL OPTIONThe holder has purchased the right to purchase an asset for an agreed upon price, on or before a agreed upon date.

EXAMPLE?

EXERCISE PRICE OR STRIKE PRICEThis is the price that was agreed to in the call option contract, which the asset can be purchased for.

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PREMIUMThe premium is the purchase price of the option.

When will the holder of a call option purchase the asset?

The call option holder will consider purchasing the asset if the market value of the asset exceeds the exercise price.

Why will the call option holder consider it and not just go ahead and make the purchase?

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When the market value of the asset exceeds the exercise price + the premium, the holder of the call option will purchase the asset and realize a profit.

If the expiry date is nearing, and the exercise price + the premium is greater than the market price, but not by more than the price of the premium, the purchase of the asset will still minimize (off set) the original premium paid. (this will be clear in the example coming up)

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Example 20.1Call Option contract with a January expiration.Exercise Price = $105Premium = $3.10

If the asset is selling for $107, the call option holder can exercise their right to purchase the asset for $105.Value at expiration = Stock price – Exercise price = $107 - $105 = $2Profit = Final value – Original investment (premium) = $2.00 – $3.10 = -$1.10

Explain the variables that we have not yet discussed in this example.

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The call option holder lost $1.10.If the asset was selling for more than $108.10, the call option holder would have made a profit.However, if the call option holder did not purchase the asset, they would have lost $3.10. In this example, the call option holder purchased the asset for $107.00 to offset part of the cost of the premium.Instead of losing $3.10, the call option holder lost $1.10.

If the asset was selling for more than $108.10, the call option holder would have a profit equal to the amount above $108.10.

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Stock Price $90 $100 $110 $120 $130Option ValuePay off to the Option Call Holder

0 0 10 20 30

When the stock price is below $100, the option is worthless. Above $100, the option is worth the excess of the stock price over $100. The option’s value increases by $1 for each dollar increase in the stock price.

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Figure 20.2 Payoff and Profit to Call Option at Expiration

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Net profit = the profit that you keep after deducting all expenses and costs associated with doing the deal.

Gross profit = the profit before deducting the transaction costs.

Example:You buy an asset for $100 and sell it for $120. Gross profit is $20.

Your net profit (what you keep) is the amount that remains after paying the commissions.

$20 gross profitLess $ 3 commission to purchase the assetLess $ 3 commission to sell the assetNet $14 Net profit

A

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Figure 20.2The solid line in Figure 20.2 shows the value of the call option at expiration date.The net profit to the holder of the call equals the gross payoff less the initial investment (premium) in the call.

Example: The option call is $100.The call (premium) cost $14. An asset value of $100 or less is worthless.An asset value of between $100 and $114 will offset the loss to something less than $14.

An asset value above $114 will result in a positive / net profit.

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Figure 20.3 Page 679 in your textbookPayoff and Profit to Call Writers at Expiration

The lower the price, the more profit earned by the call writer.

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Figure 20.4 Payoff and Profit to Put Option at Expiration

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The other party in this transaction is the call option writer.The writer of the call option will profit the most if the call option is not exercised. The gross profit will be equal to the premium.If the asset price is high and the option is called, the writer will have to provide the asset as promised, incurring a reduction in their profit equal to the amount which the asset is worth, above its value.

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In 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

Market and Exercise Price Relationships

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American - the option can be exercised at any time before expiration or maturity

European - the option can only be exercised on the expiration or maturity date

American vs. European Options

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Option versus Stock Investments

Question. Is the purchase of call options bullish or bearish?

Answer. Bullish. You are expecting the price of the stock to increase so you can buy it for the lower agreed price and sell it for a profit or keep it.

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Question. Is the purchase of a put option bullish or bearish?

Answer. Bearish. You are expecting the price of the stock to decrease so that you can sell it for the agreed upon higher price and keep the profit.

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Question. Why would you purchase a call option rather than buy shares of stock?

Answer. You have expertise in that area and believe that the value of the stock is going to increase.And / Or… your money is busy working elsewhere and you don’t have the money to invest right now OR you want to minimize your potential loss to the premium of the option call.Can you think of any other reasons?

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Page 680 in your text book. Take two minutes and review Options vs. Stock Investments.

See the three investment strategies.Let us compare them.

Read the three strategies to yourself and follow the value of each portfolio based on the price fluctuations of the stock.

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Summary of investment options.A – 100 shares x $100 = $10,000B – 1,000 calls (10 contracts) x $10 = $10,000C – 6 month T-Bill $9,000 + 100 calls ($1,000)

= $10,000

REMEMBER: The increases you see are gross profits, (before the expenses are factored in).

$95 $100 $105 $110 $115 $120Portfolio After 6 months based on the stock prices above.

A: All stock 9,500 10,000 10,500 11,000 11,500 12,000B: All options 0 0 5,000 10,000 15,000 20,000C: Call plus T- Bills

9,270 9,270 9,770 10,270 10,770 11,270?12,270

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Net ProfitsPortfolio A The transaction fee to buy and sell the stock might have been $100. The net is then $12,000 less the initial investment of $10,000 less transaction fee $100 for a net profit of $1,900.

Portfolio B$20,000 less the premium price of $10,000 to purchase the call options leaves a net profit of $10,000

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Portfolio CIs there an error in the text book?$9,000 with 3½% earned in 6 months = $270100 call options at $10 each = $1000Original investment of $10,000At $120 per share, the 100 call options are now worth $2,000.Should the gross value of the portfolio after 6 months be $12,270?If yes, then the initial cost of the call options being $1,000 (100 x $10) leaves a net profit of $1,270.

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Interest Rates Compared on the 3 PortfoliosSee Figure 20.5 on page 681.The interest rates are accurate.

Question. Even though the interest rates look good for all 3 portfolio options, realistically, can you earn a living and support yourself from option A or C.

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Answer 1.Yes. If you have a long term strategy and have other sources of income, like a good job.

Answer 2.Yes. If you have much more money to invest than the small amount that we used in this example.

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Question. What is leverage? Answer. The ability to influence a system, or an environment, in a way that multiplies the outcome of one's efforts without a corresponding increase in the consumption of resources. In other words, leverage is the advantageous condition of having a relatively small amount of cost yield a relatively high level of returns.

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The advantages of choosing portfolio B are obvious (see figure 20.5). Questions.1.What are the risks of choosing portfolio B?2.Who is most likely to choose portfolio B?3.Are you going to be the type of person that chooses a portfolio B?4.Do you remember your score on the risk tolerance quiz we took last semester? What does that score tell you about your willingness to take financial risks?5.How might your tolerance to risk increase?

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InsightsCompare A and C to B. Look at the returns.1.B returns disproportionate increases and decreases based on the same change in value of the underlying security. A 4.3% increase from $115 to $120 is equal to $5,000.

2.Figure 20.5. See the intersection of investments and how B increases much faster. All option portfolios have steeper slopes (greater risk – greater potential wins)

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Insights3.The maximum loss of Portfolio C is -7.3%, reducing the original investment to $9,270.4.The maximum risk of Portfolios A and B is -100% if the options expire or the company goes bankrupt.5.Portfolio C is the safest in terms of loss but also offers the least profit when the value of the stock increases.Question. What is your risk tolerance?

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Remember, There are ‘no free lunches’ in my classrooms.  You will earn your marks here like you will earn your salary after graduation. 

Be sure to remain focused...

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Illegal ActivityThis leverage has led to some investors to be greedy. Corrupt investors with inside information often choose options to earn big returns quickly.

Example. You work for a car manufacturer. Your big secret is that the new and improved electric car will made public knowledge in 2 months.You purchase call options and earn a quick profit.

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Question. What is wrong with doing this?Answer. 1.You had privileged information that the writer did not have and cost the writer to lose a lot of money, possibly putting them out of business. 2.If this unfair practice became common, putting call and put writers out of business, the markets could not function. 3.The investment markets are based on trust.4.People go to jail for using inside information.5.There are other ways to earn money and not damage the financial markets.

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Protective Put Strategies

You want to invest in a stock but are fearful of losing your hard earned money.

A Protective Put Strategy acts like insurance in case of a loss, but also reduces your profit when the stock increases in value.

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Example of a Protective Put

You own 500 shares of a Candy Company.

Each share has a value of $25 today for a total investment of $12,500.

You purchase Put Options with a strike price of $25 (right to sell) for 500 shares. Each put cost you $2, totaling a $1,000 premium.Question. What happens if the price falls?Question. What happens if the price rises?

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If the price of the stock falls, you can exercise your right to sell the 500 shares for $25, thereby minimizing your loss.

What is the cost to you? The cost to you is equal to the premium you

paid to purchase the Put Option.

If the price of the stock increases, and you sell the stock, you can earn a profit.

What is your profit? your profit will be reduced by the cost of the

premium.

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The lesson about Protective Puts is that, derivative securities can be used as a risk management tool.

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There will be an update to this chapter. Check for the update on March 30.

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Convertible BondsConvertible BondsCertain bond issues are convertible into common stock at the option of the bond holder.Conversion ratio is the number of shares that can be exchanged.Example: Par value of bond = $1,000 and is convertible into 40 shares.Depending on the value of each share, the bondholder will decide if it is profitable to convert or not convert.

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• Stock Options

• Index Options

• Futures Options

• Foreign Currency Options

• Interest Rate Options

Different Types of Options

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Investment Strategy Investment

Equity only Buy stock @ 100 100 shares $10,000

Options only Buy calls @ 10 1000 options $10,000

Leveraged Buy calls @ 10 100 options $1,000equity Buy T-bills @ 3% $9,000

Yield

Equity, Options & Leveraged Equity

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IBM Stock Price

$95 $105 $115

All Stock $9,500 $10,500 $11,500

All Options $0 $5,000 $15,000

Lev Equity $9,270 $9,770 $10,770

Equity, Options Leveraged Equity - Payoffs

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IBM Stock Price

$95 $105 $115

All Stock -5.0% 5.0% 15%

All Options -100% -50% 50%

Lev Equity -7.3% -2.3% 7.7%

Rates of Return

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Figure 20.5 Rate of Return to Three Strategies

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Figure 20.13 Collateralized Loan

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Exotic Options

• Asian Options

• Barrier Options

• Lookback Options

• Currency Translated Options

• Digital Options