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Chapter 18:Options Basics

Corporate Finance, 3eGraham, Smart, and Megginson

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Economic Benefits Provided by Options

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Derivative securities are instruments that derive their value from the value of other

assets.Derivatives include options, futures, and

swaps.

Options and other derivative securities have several important economic functions:

– Can help align managerial interests with those of shareholders– Help bring about more efficient allocation of risk– Save transactions costs…sometimes it is cheaper to trade a

derivative than its underlying asset.– Permit investment strategies that would not otherwise be possible

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Call option • Gives the holder the right to

purchase an asset at a specified price on or before a certain date

Put option • Gives the holder the right to sell an

asset at a specified price on or before a certain date

Strike price or exercise price: The price specified for purchase or sale in an option contract

American or European

option

• American options allow holders to exercise at any point prior to expiration.

• European options allow holders to exercise only on the expiration date.

Options Vocabulary

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Options Trading

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Long position

• The buyer of an option has a long position, and has the ability to exercise the option.

Short position

• The seller (or writer) of an option has a short position, and must fulfill the contract if the buyer exercises.

• As compensation, the seller receives the option premium from the buyer.

Options trade on an exchange (such as CBOE) or in the over-the-counter market.

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Option Prices

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Call Put

S > X In the moneyOut of the

money

S = X At the money At the money

S < XOut of the

moneyIn the money

S = Current stock price

X = Strike price

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Intrinsic and Time Value of Options

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Intrinsic value

• For in the money options: The difference between the current price of the underlying asset and the strike price

• For out of the money options, the intrinsic value is zero.

Time value• The difference between the option’s

intrinsic value and its market price (premium)

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Payoff Diagrams

7

Show the value of an option, or the value at expiration

Y-axis plots exercise value or “intrinsic value.”

X-axis plots price of underlying asset.

Use payoff diagrams for:

Long and short positions

Gross and net positions (the net positions subtract the option

premium)

Payoff: The price of the option at expiration date

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Naked Option Positions

Naked call option position – Occurs when an investor buys or sells an option on a stock without having a position in the underlying stock

Naked put option positions – Occurs when a trader buys or sells a put option without having a position in the underlying stock

These positions are purely speculative.

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Portfolios of Options

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Look at payoff diagrams for combinations of options rather than just one

Diagrams show the range of potential strategies made possible by options.

Some positions, in combination with other positions, can be a form of portfolio insurance.

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Straddle Positions

Long straddle A portfolio consisting of long positions in calls and puts on the same stock with the same strike price and expiration date

Short straddle A portfolio consisting of short positions in calls and puts on the same stock with the same strike price and expiration date

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Covered Call Strategy

Writing covered calls – Common trading strategy that mixes stock and call options An investor who owns a share of stock

sells a call option on that stock. The investor receives the option

premium immediately. The trade-off is that if the stock price

rises… the holder of the call option will exercise the

right to purchase it at the strike price, and the investor will lose the opportunity to

benefit from the appreciation in the stock.11

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Put-Call Parity

For this formula to hold, the call and put options must… be on the same underlying stock, have the same exercise price, share the same expiration date, and be European options.

In addition, the following conditions must hold: The underlying stock must not pay a dividend during the

life of the options. The bond must be a risk-free, zero-coupon bond with a face

value equal to the strike price of the options and with a maturity date identical to the options’ expiration date.

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Factors Affecting Option Values

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Price of underlying

asset

• Asset price and call price are positively related.

• Asset price and put price are negatively related.

Time to expiration

• More time usually makes options more valuable.

Strike price

• Higher X means higher put price; lower X means higher call price.

Volatility• Options are more valuable when the

underlying asset’s price is more volatile.

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Binomial Option Pricing

The binomial options model recognizes that investors can combine options (either calls or puts) with shares of the underlying asset to construct a portfolio with a risk-free payoff.

Data needed: The current price of the underlying stock The time remaining before the option expires The strike price of the option The risk-free rate The possible values of the underlying stock in the

future14

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Risk-Neutral Method If a combination of stock and options is

risk-free, it must earn the same return as a risk-free bond.

If an asset promises a risk-free payoff, risk-averse and risk-neutral investors agree on how it should be valued.

Whether investors are risk averse or risk neutral, the binomial model’s calculations are the same.

We can assume investors are risk neutral, which gives us a new way to value options. 15