Lecture no42 basics of financial options

Basics of Financial Options

Lecture No. 42
Chapter 13
Contemporary Engineering Economics
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Chapter Opening Story
Travel is adventure. Prepare for the
unexpected.

o
o
o

Have you ever considered about buying a
trip insurance?
You want to minimize the downside risk
in case of cancelation or change in your
travel plan.
Can we think something like this in
protecting your investment in business?

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Financial Option Theory

•
•

•

Call option: A right (not obligation) to purchase a stock at a predetermined price
(exercise/strike price) before or on the date specified (maturity date)
Put option: A right (not obligation) to sell a stock at a predetermined price before or on
the date specified

Main issues

o
o

What is the value of this option?
How do you price this option?

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The Language of Options
Call

Put

Buy

The right to buy the underlying item at the strike price

The right to sell the underlying item at the strike price until

until the expiration date

the expiration date

Sell

Selling the right to buy the underlying item from you at

Selling the right to sell the underlying item to you until the

the strike price until the expiration date; known as

expiration date; known as writing a put

writing a call

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Process of Buying and Selling a Financial Option

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Option Notation
The following notaton will be used throughout the remainder of this text: 

o
o
o
o
o
o

S = Underlying asset price today
0
S = Underlying asset price at expiration
T
K = Exercise price
T = Time to expiration
r = Risk-free rate
q = Continuous dividend yield

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Financial Options Terminologies
•

The Contracting Parties

o

Option seller

o

o

•

Option buyer

o

Taking a long position

The Right or Obligation

o

Option buyer

o

o

•

Taking a short position

Right to purchase

Option seller

o

Obligation to sell

Option Premium

o
o
o
o
o
o

Underlying asset (S)
Strike or exercise price (K)
Maturity (T)
Option premium (C)
Intrinsic value
Time value

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Financial Option Terminologies (continued)

•

Types of financial option

o American option

o An option that can be exercised earlier than its maturity date

o European option

•

o An option that can be exercised only at the maturity date

Payof (S = stock price, C = option premium)

o At the money, if S−C = K
o In the money, if S−C > K
o Out of money, if S−C < K

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Option Positions

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Example 13.1: Profit from Call Option
 Given:
o Buying 100 shares (one contract)
o K = $625
o T = January 22,2016
o S = $579.11 (September 11, 2014)
o C = $45.60
o The initial investment = 100 × ($45.60) = $4,560
 Find: Profit from exercising the European call option when the stock price is $700 at maturity

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Solution

Profit = ($700 - $625 - $45.60) × 100
= $2,940
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Example 13.2: Profit from Put Option

Given:

o Buying 100 shares (one contract)
o K = $580
o T = January 22,2016
o S = $579.11 (September 11, 2014)
o C = $58.30
o The initial investment = 100 × ($58.30) = $5,830

Find: Profit from exercising the European put option when the stock price is
$500 at maturity

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Solution

Profit = ($580 − $500 − $58.30) × 100

= $2,170
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Buy Option Strategies: Three Ways to Buy Call Options

Investor buys for Call Options

(a) Hold to Maturity and trade at

(1,000 shares) on Stock Z

strike price

Price: $55

(b) Trade for profit before option

Strike price: $60

expires

Premium: $750
(c) Let the option expire

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If stock rises to 65

$5,000 − $750 = $4,250

If stock rises to 60

$0 − $750 = $750 loss

If stock rises to 62

$2,000 − $750 =$1,250

If stock rises to 60 1/2

$500 − $750 = $250 loss

If stock drops to 55

$750 loss

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Sell Option Strategies: Two Ways to Sell Call Options (Writing Call Options)
Investor owns 1,000 shares of Stock

Write 10 covered calls

(a) If stock rises to $57

Keep the premium

Z

Strike price: $60

No takes; option expires

($750 profit)

Price:

(b) If stock rises to $60

$750 (premium collected) − $750

$55/share

Buy 10 calls to cancel obligations and prevent

(premium on ofsetting calls) =

losing stocks.

Breakeven

Write 10 naked calls

(a) If stock rises to $57

Keep the premium ($750 profit)

Strike price: $60

No takes; option expires

Collect premium $750

Collect premium $750
Investor owns no share of Stock Z

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(b) If stock rises to $65

$750 premium − $65,000 to buy

Option is exercised. You must buy 1,000

+ $60,000 = $4,250 net loss (You need to

shares to sell to meet call.

line up $64,250.)

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Example 13.3: Limiting Downside Risk

 Given:
o
o
o

Option 1: Purchase 500 shares of GILD stock at $106
Option 2: Purchase 5 GILD five-month $110 calls at $8
Three possible scenarios for stock price at expiration

o $118 < ST
o $100 < ST < $118
o $100 > ST

 Find: Profit or loss from three possible scenarios

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Solution

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Example 13.4: How to Use a Protective Put as Insurance

 Given:
o Option 1: Buy QCOM at $76, without
o

owning a put for protection.

Option 2: Buy QCOM at $76 and buy a
QCOM six-month $75-put contract at
$4.40.

 Find: Compare two options for risk exposure.

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Solution

o
o

Upside potential unlimited
Downside risk only $5.40

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How Option Premium Fluctuates

o

The greater the diference between the exercise price and the actual current price
(exercise price > actual current price) of the item, the cheaper the premium, because
there is less chance the option will be exercised.

o

The closer the expiration date of an out-of-the money option (where the market price is

higher than the strike price), the cheaper the price is.

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Duration of Exercise Date

o
o

The more time there is until expiration, the larger the premium, because the chance of
reaching the strike price is greater and the carrying costs are more.
Call and put options move in opposition. Call options rise in value as the underlying
market prices go up. Put options rise in value as market prices go down.

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Option Premium = Option Price

Option Premium = Intrinsic Value

+

Time Value

What the position would be

Market’s assessment

worth if exercised now

of future underlying
value

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