FINANCE IN A FINANCE IN A CANADIAN SETTINGCANADIAN SETTING

Sixth Canadian EditionSixth Canadian Edition

Lusztig, Cleary, Lusztig, Cleary, SchwabSchwab

CHAPTER CHAPTER

EIGHTEENEIGHTEEN

OptionsOptions

Learning ObjectivesLearning Objectives

1. Explain the difference between a call 1. Explain the difference between a call option and a put option.option and a put option.

2. Identify four advantages of options.2. Identify four advantages of options.

3. Describe how options can be used to 3. Describe how options can be used to hedge a portfolio.hedge a portfolio.

4. Describe the factors that affect option 4. Describe the factors that affect option prices.prices.

5. Discuss the five aspects of the Black-5. Discuss the five aspects of the Black-Scholes option-pricing model.Scholes option-pricing model.

IntroductionIntroduction

Various types of options and related Various types of options and related financial instruments have emerged as financial instruments have emerged as tools financial managers use to control tools financial managers use to control their firms risk exposuretheir firms risk exposure

Derivative securitiesDerivative securities – derive their value – derive their value from the value of an underlying assetfrom the value of an underlying asset

OptionsOptions – contracts that grant the holder – contracts that grant the holder the right to buy or sell a particular asset at the right to buy or sell a particular asset at a given price on or before a specified datea given price on or before a specified date

General ConceptsGeneral Concepts

An option usually contains the following An option usually contains the following elements:elements:

1. The right to buy or sell a security1. The right to buy or sell a security Call optionsCall options – grants the right to buy – grants the right to buy Put optionsPut options – grants the right to sell – grants the right to sell

2. A specified price at which the option can be 2. A specified price at which the option can be exercised known as the strike or exercise priceexercised known as the strike or exercise price

3. Limited time frame3. Limited time frame Expiration dateExpiration date – the date at which an – the date at which an

unexercised option becomes voidunexercised option becomes void

General ConceptsGeneral Concepts

Two types of equity options:Two types of equity options: American optionsAmerican options – exercisable any time up to or on – exercisable any time up to or on

the expiration datethe expiration date European optionsEuropean options – exercised only on expiration date – exercised only on expiration date

Options trade on organized exchanges or Options trade on organized exchanges or in the OTC marketin the OTC market

The majority of options are traded on:The majority of options are traded on: Montreal exchange (Canada)Montreal exchange (Canada) American exchange and CBOT (US)American exchange and CBOT (US)

General ConceptsGeneral Concepts

Clearing houses are used to maintain Clearing houses are used to maintain the integrity of the option marketsthe integrity of the option markets CDCC (Canada)CDCC (Canada) DCC (US)DCC (US)

US option markets are approximately US option markets are approximately 40 times larger than Canada’s40 times larger than Canada’s

Stock options for any given month Stock options for any given month expire the third Friday of every monthexpire the third Friday of every month

General ConceptsGeneral Concepts

Writing options:Writing options: generally , the options investors buy are written by generally , the options investors buy are written by

other investorsother investors

Leverage:Leverage: options are popular because of the high return options are popular because of the high return

potential, but there is downside magnification that potential, but there is downside magnification that must be considermust be consider

Hedging:Hedging: options are good for managing corporate risk options are good for managing corporate risk Example: locking in prices for raw commoditiesExample: locking in prices for raw commodities

Basic Option Basic Option CharacteristicsCharacteristics

Terminology describing the Terminology describing the relationship between the exercise relationship between the exercise price of the option and current stock price of the option and current stock price includes:price includes: In the moneyIn the money – When the price of the stock (S) – When the price of the stock (S)

exceeds the exercise price of a call (E)exceeds the exercise price of a call (E) Out of the moneyOut of the money – when the stock price (S) is – when the stock price (S) is

less than the exercise price (E)less than the exercise price (E) At the moneyAt the money – when the exercise price (E) – when the exercise price (E)

equals the stock price (S)equals the stock price (S)

Intrinsic ValuesIntrinsic Values

Intrinsic valueIntrinsic value – an options’ minimum value – an options’ minimum value If a call is “in the money”, it has an immediate If a call is “in the money”, it has an immediate

intrinsic value equal to the difference intrinsic value equal to the difference between the market price of the stock and between the market price of the stock and the exercise value of the optionthe exercise value of the option Intrinsic value of a call = Maximum {(SIntrinsic value of a call = Maximum {(S0 0 - E), 0}- E), 0}

Puts work in reversePuts work in reverse Intrinsic value of a put = Maximum {(E - SIntrinsic value of a put = Maximum {(E - S00), ),

0}0}

Payoffs From Payoffs From Basic Option PositionsBasic Option Positions

To understand the characteristics of options To understand the characteristics of options we examine their value at expirationwe examine their value at expiration

SSTT = the value of the stock at expiration = the value of the stock at expiration date T date T

E = the exercise price of the optionE = the exercise price of the option Buying a callBuying a call

Pay off to a call buyer at expirationPay off to a call buyer at expiration

= S= STT - E if S - E if St t > E> E

= 0 if S= 0 if STT E E

Payoffs From Payoffs From Basic Option PositionsBasic Option Positions

Payoff Profiles for Call and Put Payoff Profiles for Call and Put Options at ExpirationOptions at Expiration

BCE Inc. Call Option BCE Inc. Call Option ExampleExample

BCE Inc. Nov. call with exercise price of $30 is selling for BCE Inc. Nov. call with exercise price of $30 is selling for $5.75$5.75

BCE stock at expirationBCE stock at expiration $20 25 30 35 40 $20 25 30 35 40

Call value at expiration $ 0 0 0 5 10Call value at expiration $ 0 0 0 5 10

If at expiration BCE stock is trading at $40 then:If at expiration BCE stock is trading at $40 then:

Net profit = option payoff - option costNet profit = option payoff - option cost

= $10 - $5.75 = $4.25= $10 - $5.75 = $4.25

Up to $30 the call option investor’s maximum loss isUp to $30 the call option investor’s maximum loss is

$5.75$5.75

The breakeven point for the investor is at $35.75The breakeven point for the investor is at $35.75

BCE Inc. Call Option BCE Inc. Call Option ExampleExample

Profit and Losses to the Buyer of a Profit and Losses to the Buyer of a Call OptionCall Option

Selling (Writing) a CallSelling (Writing) a Call

A naked or uncovered option writer is one who A naked or uncovered option writer is one who does not hold a position in the underlying assetdoes not hold a position in the underlying asset

Naked call option writers incur losses if the Naked call option writers incur losses if the stock price increasesstock price increases

Payoff to naked call writer at expiration Payoff to naked call writer at expiration

= -(S= -(STT - E) if S - E) if ST T E E

= 0 if S= 0 if ST T E E The net profit line for a naked call writer is a The net profit line for a naked call writer is a

mirror image of a call buyermirror image of a call buyer

Selling (Writing) a CallSelling (Writing) a Call

Profit and Losses to the Writer of a Profit and Losses to the Writer of a Call OptionCall Option

Buying a Put OptionBuying a Put Option

Put option makes money when Put option makes money when stock price declinesstock price declines

Payoff to put buyerPayoff to put buyer

= 0 if S= 0 if STT E E

= E - S= E - ST T if Sif ST T E E

BCE Inc. Put Option BCE Inc. Put Option ExampleExample

BCE Inc. Nov. put with exercise price of $30 is BCE Inc. Nov. put with exercise price of $30 is selling for $0.30selling for $0.30

BCE stock at expirationBCE stock at expiration $20 25 30 35 $20 25 30 35 4040

Call value at expiration $10 5 0 0 0Call value at expiration $10 5 0 0 0

If at expiration BCE stock is trading at $20 then:If at expiration BCE stock is trading at $20 then:

Net profit = option payoff - option costNet profit = option payoff - option cost

= $10 - $0.30 = $9.70= $10 - $0.30 = $9.70

The breakeven point for the investor is at $29.70The breakeven point for the investor is at $29.70

BCE Inc. Put Option BCE Inc. Put Option ExampleExample

Profit and Losses to the Buyer of a Profit and Losses to the Buyer of a Put OptionPut Option

The payoff pattern for a naked put investor is the The payoff pattern for a naked put investor is the mirror image of a put buyermirror image of a put buyer

Payoff to a naked put writer at expiration:Payoff to a naked put writer at expiration:

= 0 if S= 0 if STT E E = -(E - S= -(E - STT) if S) if STT E E The writer is obligated to buy the stock at the The writer is obligated to buy the stock at the

specified price during the life of the put contractspecified price during the life of the put contract If the stock price falls the put buyer may buy the If the stock price falls the put buyer may buy the

stock and exercise the put by making the writer stock and exercise the put by making the writer pay the specified pricepay the specified price

Selling (Writing) a PutSelling (Writing) a Put

Selling (Writing) a PutSelling (Writing) a Put

Profit and Losses to the Writer of a Profit and Losses to the Writer of a Put OptionPut Option

Protective PutsProtective Puts

Involves buying stock and a put Involves buying stock and a put option for the same companyoption for the same company

The put acts as insurance against a The put acts as insurance against a decline in the underlying stock price decline in the underlying stock price to limit lossesto limit losses

Profit is infinite but reduced by the Profit is infinite but reduced by the amount by the cost of the put optionamount by the cost of the put option

Protective PutsProtective Puts

The payoff profile: The payoff profile:

Payoff of stock Payoff of stock SSTT E E SST T E E

SSTT S STT

+ Payoff of put + Payoff of put E - SE - STT 00

E SE STT

Protective PutsProtective PutsPayoff Profile and Profit/Losses for a Protective Put Payoff Profile and Profit/Losses for a Protective Put

PositionPosition

Covered CallsCovered Calls

Covered callCovered call –– involves buying a stock and involves buying a stock and the simultaneous sale (or writing) of a call the simultaneous sale (or writing) of a call on that stockon that stock

The position is covered because the writer The position is covered because the writer owns the stock and it could be delivered if owns the stock and it could be delivered if calledcalled

The gains are limited if the stock rises, in The gains are limited if the stock rises, in exchange for cushioning the loss by the exchange for cushioning the loss by the amount of the call premium if the stock amount of the call premium if the stock declinesdeclines

Covered CallsCovered Calls

The payoff profile: The payoff profile:

Payoff of stock Payoff of stock SSTT E E SSTT E E

SSTT S STT

+ Payoff of put + Payoff of put E - SE - STT 00

E SE STT

Covered CallsCovered Calls

Payoff Profiles for a Covered Call Payoff Profiles for a Covered Call PositionPosition

Option ValuationOption Valuation

Option premiums almost never fall Option premiums almost never fall below their intrinsic value because of below their intrinsic value because of arbitrageursarbitrageurs

ArbitrageursArbitrageurs – seek to earn profits – seek to earn profits without assuming risk by constructing without assuming risk by constructing riskless hedgesriskless hedges

Options almost always exceed intrinsic Options almost always exceed intrinsic value due to the time valuevalue due to the time value

Factors Affecting Factors Affecting Option PricesOption Prices

Profit and Losses to the Writer of a Profit and Losses to the Writer of a Call OptionCall Option

SummarySummary

1. An option is a contract. It either grants the 1. An option is a contract. It either grants the holder the right to purchase (call option) or holder the right to purchase (call option) or to sell (put option) a given asset at a to sell (put option) a given asset at a particular price for a specified time period.particular price for a specified time period.

2. Buyers of calls expect the underlying stock 2. Buyers of calls expect the underlying stock to perform in the opposite direction from the to perform in the opposite direction from the expectations of buyers.expectations of buyers.

3. Although options have a value, it is a net 3. Although options have a value, it is a net zero transaction zero transaction –– what the holder gains, the what the holder gains, the other loses.other loses.

SummarySummary

4. Options provide investors with 4. Options provide investors with opportunity to create leverage, to opportunity to create leverage, to know their maximum loss in know their maximum loss in advance, and to expand their advance, and to expand their investment opportunity set.investment opportunity set.

SummarySummary

5. Option prices are affected by:5. Option prices are affected by: underlying stock priceunderlying stock price exercise priceexercise price time expirationtime expiration underlying stock volatilityunderlying stock volatility interest ratesinterest rates and cash dividends paid on the and cash dividends paid on the

underlying assetsunderlying assets