Chapter 14
Options
Options on common stocks
• Why options
• Option “Moneyness”
• Option payoffs and profits
• Option strategies
• Option prices, intrinsic values and
arbitrage
• Employee stock options
• Put-call parity
• Stock index options
• Foreign currency options
• Warrants
• The Canadian Derivatives Clearing
Corporation
•
© 2009 McGraw-Hill Ryerson
Limited
14- 1
Stock Options

In this chapter, we will discuss general features
of options, but will focus on options on
individual common stocks.

We will see the tremendous flexibility that
options offer investors in designing investment
strategies.
© 2009 McGraw-Hill Ryerson
Limited
14- 2
Option Basics


A stock option is a derivative security, because
the value of the option is “derived” from the
value of the underlying common stock.
There are two basic option types.



Call options are options to buy the underlying asset.
Put options are options to sell an underlying asset.
Listed Option contracts are standardized to
facilitate trading and price reporting.

Listed stock options give the option holder the right
to buy or sell 100 shares of stock.
© 2009 McGraw-Hill Ryerson
Limited
14- 3
Option Basics


Option contracts are legal agreements between two parties—
the buyer of the option, and the seller of the option.
The minimum terms stipulated by stock option contracts are:







The identity of the underlying stock.
The strike price, or exercise price.
The option contract size.
The option expiration date, or option maturity.
The option exercise style (American or European).
The delivery, or settlement, procedure.
Stock options trade at organized options exchanges, such as
the CBOE, as well as over-the-counter (OTC) options
markets.
© 2009 McGraw-Hill Ryerson
Limited
14- 4
Option Price Quotes



A list of available option contracts and their prices for a
particular security is known as an option chain.
Option chains are available online through many sources,
including the Montreal exchange (http://www.m-x.ca), CBOE
(http://quote.cboe.com) and Yahoo!
(http://finance.yahoo.com).
Stock option ticker symbols include:



Letters to identify the underlying stock.
A Letter to identify the expiration month as well as whether the option
is a call or a put.
A Letter to identify the strike price (a bit more complicated—see
Yahoo or Stock-Trak for tables to explain this letter.)
© 2009 McGraw-Hill Ryerson
Limited
14- 5
Listed Option Quotes on the Web
14- 6
Why Options?


A basic question asked by investors is: “Why
buy stock options instead of shares in the
underlying stock?”
To answer this question, we compare the
possible outcomes from these two investment
strategies:


Buy the underlying stock
Buy options on the underlying stock
© 2009 McGraw-Hill Ryerson
Limited
14- 7
Buying the Stock versus Buying a Call Option


IBM is selling for $90 per share and call
options with a strike price of $90 are $5 per
share.
Investment for 100 shares:



IBM Shares: $9,000
One listed call option contract: ($500)
Suppose further that the option expires in three
months.Finally, let’s say that in three months,
the price of IBM shares will either be: $100,
$90, or $80.
© 2009 McGraw-Hill Ryerson
Limited
14- 8
Buying the Underlying Stock versus
Buying a Call Option

Let’s calculate the dollar and percentage return given
each of the prices for IBM stock:
Buy 100 IBM Shares
($9000 Investment):
Buy One Call Option
($500 Investment):
Dollar
Profit:
Percentage
Return:
Dollar
Profit:
Percentage
Return:
Case I: $100
$1,000
11.11%
$500
100%
Case II: $90
$0
0%
-$500
-100%
Case III: $80
-$1,000
-11.11%
-$500
-100%
14- 9
Why Options? Conclusion

Whether one strategy is preferred over another is a matter for
each individual investor to decide.



That is, in some instances investing in the underlying stock will be
better. In other instances, investing in the option will be better.
Each investor must weight the risk and return trade-off offered by the
strategies.
It is important to see that call options offer an alternative
means of formulating investment strategies.


For 100 shares, the dollar gain and loss potential with call options is
lower.
The positive and negative percentage return with call options is
higher.
© 2009 McGraw-Hill Ryerson
Limited
14- 10
Option “Moneyness”




“In-the-money” option: An option that would yield a positive
payoff if exercised
“Out-of-the-money” option: An option that would NOT yield
a positive payoff if exercised
Use the relationship between S (the stock price) and K (the
strike price):
In-theMoney
Out-of-theMoney
Call Option
S>K
S≤K
Put Option
S<K
S≥K
Note for a given strike price, only the call or the put can be “in-themoney.”
© 2009 McGraw-Hill Ryerson
Limited
14- 11
Option Writing

The act of selling an option is referred to as option writing.
The seller of an option contract is called the writer.





The Writer of a call option contract is obligated to sell the
underlying asset to the call option holder.
The call option holder has the right to exercise the call option
(i.e., buy the underlying asset at the strike price).
The Writer of a put option contract is obligated to buy the
underlying asset from the put option holder.
The put option holder has the right to exercise the put option (i.e.,
sell the underlying asset at the strike price).
Because option writing obligates the option writer, the
writer receives the price of the option today from the buyer.
14- 12
Option Exercise
Option holders have the right to exercise their option.


If this right is only available at the option expiration date,
the option is said to have European-style exercise.
If this right is available at any time up to and including the
option expiration date, the option is said to have
American-Style exercise.

Exercise style is not linked to where the option trades.
European-style and American-Style options trade in
the U.S., as well as on other option exchanges
throughout the world.

Very Important: Option holders also have the right to sell
their option at any time. That is, they do not have to exercise
the option if they no longer want it.
© 2009 McGraw-Hill Ryerson
Limited
14- 13
Option Payoffs versus Option Profits

It is useful to think about option investment strategies in
terms of their initial cash flows and terminal cash flows.




The initial cash flow of an option is the price of the option
which is often called the option premium.
The terminal cash flow of an option is the value of an option at
expiration. (The terminal cash flow can be realized by the
option holder by exercising the option.)
The terminal cash flow is often called the option payoff.
Option Profits are calculated by subtracting the initial
cash flow (option premium) from the terminal cash flow
(option payoff).
© 2009 McGraw-Hill Ryerson
Limited
14- 14
Call Option Payoffs
© 2009 McGraw-Hill Ryerson
Limited
14- 15
Put Option Payoffs
© 2009 McGraw-Hill Ryerson
Limited
14- 16
Call Option Profits
© 2009 McGraw-Hill Ryerson
Limited
14- 17
Put Option Profits
© 2009 McGraw-Hill Ryerson
Limited
14- 18
Option Strategies




Protective put - Strategy of buying a put option on a
stock already owned. This protects against a decline in
value (i.e., it is "insurance")
Covered call - Strategy of selling a call option on stock
already owned. This exchanges “upside” potential for
current income.
Straddle - Buying or selling a call and a put with the
same exercise price. Buying is a long straddle; selling is
a short straddle.
There are many option trading strategies available to option
traders. For ideas on option trading strategies, see:
 www.commodityworld.com
 www.writecall.com © 2009 McGraw-Hill Ryerson
Limited
14- 19
Arbitrage

Arbitrage:




In finance, arbitrage is not allowed to persist.



No possibility of a loss
A potential for a gain
No cash outlay
“Absence of Arbitrage” = “No Free Lunch”
The “Absence of Arbitrage” rule is often used in finance to
figure out prices of derivative securities.
Think about what would happen if arbitrage were
allowed to persist. (Easy money for everybody)
© 2009 McGraw-Hill Ryerson
Limited
14- 20
The Upper Bound for a Call Option Price


Call option price must be less than the stock price.
Otherwise, arbitrage will be possible.
Suppose you see a call option selling for $65, and the
underlying stock is selling for $60.

The arbitrage: sell the call, and buy the stock.



Worst case? The option is exercised and you pocket $5.
Best case? The stock sells for less than $65 at option expiration,
and you keep all of the $65.
There was zero cash outlay today, there was no possibility
of loss, and there was a potential for gain.
© 2009 McGraw-Hill Ryerson
Limited
14- 21
The Upper Bound for a Put Option Price



Put option price must be less than the strike price. Otherwise,
arbitrage will be possible.
Suppose there is a put option with a strike price of $50 and this put
is selling for $60. The Arbitrage: Sell the put, and invest the $60
in the bank. (Note you have zero cash outlay).
Worse case? Stock price goes to zero.


You must pay $50 for the stock (because you were the put writer). But, you
have $60 from the sale of the put (plus interest).
Best case? Stock price is at least $50 at expiration.


The put expires with zero value (and you are off the hook).
You keep the entire $60, plus interest.
© 2009 McGraw-Hill Ryerson
Limited
14- 22
The Lower Bound on Option Prices

Option prices must be at least zero.

By definition, an option can simply be discarded.

To derive a meaningful lower bound, we need
to introduce a new term: intrinsic value.

The intrinsic value of an option is the payoff
that an option holder receives if the underlying
stock price does not change from its current
value.
© 2009 McGraw-Hill Ryerson
Limited
14- 23
Option Intrinsic Values

That is, if S is the current stock price, and K is
the strike price of the option:

Call option intrinsic value = max [0, S–K]


In words: The call option intrinsic value is the
maximum of zero or the stock price minus the
strike price.
Put option intrinsic value = max [0, K–S]

In words: The put option intrinsic value is the
maximum of zero or the strike price minus the
stock price.
© 2009 McGraw-Hill Ryerson
Limited
14- 24
Option “Moneyness”

“In the Money” options have a positive intrinsic value.



“Out of the Money” options have a zero intrinsic value.



For calls, the strike price is less than the stock price.
For puts, the strike price is greater than the stock price.
For calls, the strike price is greater than the stock price.
For puts, the strike price is less than the stock price.
“At the Money” options is a term used for options when
the stock price and the strike price are about the same.
© 2009 McGraw-Hill Ryerson
Limited
14- 25
Intrinsic Values and Arbitrage, Calls



Call options with American-style exercise
must sell for at least their intrinsic value.
(Otherwise, there is arbitrage)
Suppose: S = $60; C = $5; K = $50.
Instant Arbitrage. How?



Buy the call for $5.
Immediately exercise the call, and buy the stock
for $50.In the next instant, sell the stock at the
market price of $60.
You made a profit with zero cash outlay.
© 2009 McGraw-Hill Ryerson
Limited
14- 26
Intrinsic Values and Arbitrage, Puts



Put options with American-style exercise must sell
for at least their intrinsic value. (Otherwise, there
is arbitrage)
Suppose: S = $40; P = $5; K = $50.
Instant Arbitrage. How?




Buy the put for $5.
Buy the stock for $40.
Immediately exercise the put, and sell the stock for $50
You made a profit with zero cash outlay.
© 2009 McGraw-Hill Ryerson
Limited
14- 27
Back to Lower Bounds for Option Prices

Option prices cannot be less than the option
intrinsic value.




Otherwise, arbitrage will be possible.
Note that immediate exercise was needed.
Therefore, options needed to have American-style
exercise.
Using equations: If S is the current stock price,
and K is the strike price:
Call option price  max [0, S–K]
Put option price  max [0, K–S]
© 2009 McGraw-Hill Ryerson
Limited
14- 28
Employee Stock Options, ESOs

Essentially, an employee stock option is a call
option that a firm gives to employees.



These call options allow the employees to buy
shares of stock in the company.
Giving stock options to employees is a widespread
practice.
Because you might soon be an ESO holder, an
understanding of ESOs is important.
© 2009 McGraw-Hill Ryerson
Limited
14- 29
Features of ESOs

ESOs have features that ordinary call options do not.
Details vary by firm, but:






The life of the ESO is generally 10 years.
ESOs cannot be sold.
ESOs have a “vesting” period of about 3 years.
Employees cannot exercise their ESOs until they have
worked for the company for this vesting period.
If an employee leaves the company before the ESOs are
“vested," the employees lose the ESOs.
If an employee stays for the vesting period, the ESOs
can be exercised any time over the remaining life of the
ESO.
14- 30
Why are ESOs Granted?



Owners of a corporation (i.e., the stockholders) have a
basic problem. How do they get their employees to
make decisions that help the stock price increase?
ESOs are a powerful motivator, because payoffs to
options can be large.High stock prices: ESO holders
gain and shareholders gain.
ESOs have no upfront costs to the company.

ESOs can be viewed as a substitute for ordinary
wages. Therefore, ESOs are helpful in recruiting
employees.
© 2009 McGraw-Hill Ryerson
Limited
14- 31
ESO Repricing

ESOs are generally issued exactly “at the money.”




Intrinsic value is zero.
There is no value from immediate exercise.But, the ESO is still
valuable.
If the stock price falls after the ESO is granted, the ESO
is said to be “underwater.”
Occasionally, companies will lower the strike prices of
ESOs that are “underwater.”

This practice is called “restriking” or “repricing.” This practice
is controversial.
© 2009 McGraw-Hill Ryerson
Limited
14- 32
ESO Repricing Controversy


Once an ESO is “underwater,” it loses its ability to
motivate employees.
 Employees realize that there is only a small chance for
a payoff from their ESOs. Employees may leave for
other companies where they get “fresh” options.
Lowering a strike price is a reward for failing.
 After all, decisions by employees made the stock price
fall.
 If employees know that ESOs will be repriced, the
ESOs loose their ability to motivate employees.
© 2009 McGraw-Hill Ryerson
Limited
14- 33
ESOs Today

Most companies award ESO on a regular basis.




Quarterly
Annually
Therefore, employees will always have some
“at the money” options.
Regular grants of ESOs means that employees
always have some “unvested” ESOs—giving
them the added incentive to remain with the
company.
© 2009 McGraw-Hill Ryerson
Limited
14- 34
Put-Call Parity

Put-Call Parity is perhaps the most
fundamental relationship in option pricing.

Put-Call Parity is generally used for options
with European-style exercise.

Put-Call Parity states: the difference between
the call price and the put price equals the
difference between the stock price and the
discounted strike price.
© 2009 McGraw-Hill Ryerson
Limited
14- 35
The Put-Call Parity Formula

C  P  S  Ke
In the formula:







 rT
e-rT is a discount factor,
so Ke-rT is simply the
discounted strike price.
C is the call option price today
S is the stock price today
r is the risk-free interest rate
P is the put option price today
K is the strike price of the put and the call
T is the time remaining until option expiration
Note: this formula can be rearranged:
Ke
 rT
 S PC
© 2009 McGraw-Hill Ryerson
Limited
14- 36
Why Put-Call Parity Works


If two securities have the same risk-less payoff in the future, they must sell for the same
price today.
Today, suppose an investor forms the
following portfolio:



Buys 100 shares of Microsoft stock
Writes one Microsoft call option contract
Buys one Microsoft put option contract.
© 2009 McGraw-Hill Ryerson
Limited
14- 37
Why Put-Call Parity Works
At option expiration, this portfolio will be worth:
© 2009 McGraw-Hill Ryerson
Limited
14- 38
Put-Call Parity Notes




Notice that the portfolio is always worth $K at
expiration. That is, it is riskless.
Therefore, the value of this portfolio today is $Ke-rT.
That is, to prevent arbitrage: today’s cost of buying 100
shares and buying one put (net of the proceeds of
writing one call), should equal the price of a risk-less
security with a face value of $K, and a maturity of T.
Fun fact: If S = K (and if rT > 0), then C > P.
© 2009 McGraw-Hill Ryerson
Limited
14- 39
Stock Index Options


A stock index option is an option on a stock
market index.
Because the actual delivery of all stocks
comprising a stock index is impractical, stock
index options have a cash settlement procedure.


That is, if the option expires in the money, the option
writer simply pays the option holder the intrinsic value
of the option.
The cash settlement procedure is the same for calls
and puts.
© 2009 McGraw-Hill Ryerson
Limited
14- 40
Index Option Trading
Figure 14.6
© 2009 McGraw-Hill Ryerson
Limited
14- 41
Foreign Currency Options




Foreign currency option contracts give holders the
right to buy (call) or sell certain amount of foreign
currency at the strike price until the maturity date.
In Canada foreign currency option contracts are not
traded.
In USA, Philadelphia Exchange offer six contracts of
following currencies against
U.S. $ : Australian Dollar, British Pound, Canadian
Dollar, Euro, Japanese Yen and Swiss Franc.
© 2009 McGraw-Hill Ryerson
Limited
14- 42
Warrants



Warrants are issued by companies to give the
right of buying the stock of the company at a
specified strike price.
Warrants are very similar to call options
except they are written by the companies.
If a warrant holder decides to exercise the right,
then the company has to issue new shares in
exchange of strike price. As a result, company
gets the cash inflow, but increases the number
of outstanding shares.
© 2009 McGraw-Hill Ryerson
Limited
14- 43
The Canadian Derivatives Clearing Corporation
The Canadian Derivatives Clearing Corporation is the
clearing agency for all derivatives exchanges in
Canada (Montreal and Winnipeg).
 All option contracts traded in Canada are originally
issued, guaranteed, and cleared by the CDCC.
Brokerage firms merely act as intermediaries between
investors and the CDCC.
Visit the CDCC at: www.cdcc.com.

© 2009 McGraw-Hill Ryerson
Limited
14- 44
Useful Websites
•
•
•
For information on options ticker symbols, see:
 www.cboe.com
 www.m-x.ca
To learn more about options, see:
 www.e-analytics.com
 www.tradingmarkets.com
 www.investorlinks.com
Exchanges that trade index options include:
 www.cboe.com
 www.cbot.com
 www.cme.com
 www.m-x.ca
© 2009 McGraw-Hill Ryerson
Limited
14- 45