Personal Investment Management
ADMS 3531 - Fall 2011 – Professor Dale Domian
Lecture 4/5 – Options – Oct 4/Oct 18
Chapter 14 Outline
- 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.
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.
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.
o Call options are options to buy the underlying asset.
o Put options are options to sell an underlying asset.
- Listed option contracts are standardized to facilitate trading and price reporting.
o Listed stock options give the option holder the right to buy or sell 100 shares
of stocks.
- 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:
o The identity of the underlying stock.
o The strike price, or exercise price.
-
o The option contract size.
o The option expiration date or option maturity.
o The option exercise style (American or European).
o 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.
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, CBOE, and Yahoo!
- Stock option ticker symbols include:
o Letters to identify the underlying stock.
o A letter to identify the expiration month as well as whether the option is a
call or a put.
o A letter to identify the strike price.
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:
o Buy the underlying stock.
o Buy options on the underlying stock.
- Whether one strategy is preferred over another is a matter for each individual
investor to decide.
o That is, in some instances investing in the underlying stock will be better. In
other instances, investing in the option will be better.
o Each investor must weigh 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.
o For 100 shares, the dollar loss potential with call options is lower.
o For 100 shares, the dollar gain potential with call options is lower.
o The positive percentage return with call options is higher.
o The negative percentage return with call options is lower.
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-The-Money
Out-of-the-money
Call Option
S>K
S≤K
Put Option
S<K
S≥K
Option Writing
- The act of selling an option is referred to as option writing. The seller of an option
contract is called the writer.
o The writer of a call option contract is obligated to sell the underlying asset to
the call option holder.
o The call option holder has the right to exercise the call option (i.e. buy the
underlying asset as the strike price).
o The writer of a put option contract is obligated to buy the underlying asset
from the put option holder.
o 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 option writer receives the
price of the option today from the option buyer.
Option Exercise
- Option holders have the right to exercise their option.
o If this right is only available at the option expiration date, the option is said to
have European-style exercise.
o 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.
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.
o The initial cash flow of an option is the price of the option.
o The initial cash flow is often called the option premium.
-
o 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).
o 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).
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.
Arbitrage
- Arbitrage:
o No possibility of a loss.
o A potential for a gain.
o No cash outlay.
- In finance, arbitrage is not allowed to persist.
o ‘Absence of Arbitrage’ = ‘No free lunch’
o 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).
The Upper Bound for a Call Option Price
- Call option price must be less than the stock price. Otherwise, arbitrage will be
possible.
The Upper Bound for a Put Option Price
- Put option price must be less than the strike price. Otherwise, arbitrage will be
possible.
The Lower Bound on Option Prices
- Option prices must be at least zero.
o 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.
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]
o 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]
o In words: The put option intrinsic value is the maximum of zero or the strike
price minus the stock price.
Option ‘Moneyness’
- ‘In the Money’ options have a positive intrinsic value.
o For calls, the strike price is less than the stock price.
o For puts, the strike price is greater than the stock price.
- ‘Out of the Money’ options have a zero intrinsic value.
o For calls, the strike price is greater than the stock price.
o For puts, the strike price is less than the stock price.
- ‘At the Money’ options are a term used for options when the stock price and the
strike price are about the same.
Back to Lower Bounds for Option Prices
- Option prices cannot be less than the option intrinsic value.
o Otherwise, arbitrage will be possible.
o Note that immediate exercise was needed.
o Therefore, options needed to have American-style exercise.
- Using equations: If S is the current stock price, and K is the strike price:
o Call option price ≥ max [0, S – K]
o Put option price ≥ max [0, K – S]
Employee Stock Options, ESOs
- Essentially, an employee stock option is a call option that a firm gives to employees.
o These call options allow the employees to buy shares of stock in the
company.
o Giving stock options to employees is a widespread practice.
- Because you might soon be an ESO holder, an understanding of ESOs is important.
Features of ESOs
-
-
ESOs have features that ordinary call options do not. Details vary by firm, but:
o The life of the ESO is generally 10 years.
o ESOs cannot be sold.
o 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.
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.
o ESOs can be viewed as a substitute for ordinary wages. Therefore, ESOs are
helpful in recruiting employees.
ESO Re-pricing
- ESOs are generally issued exactly ‘at the money’.
o Intrinsic value is zero.
o 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’.
o This practice is called ‘restriking’ or ‘repricing’. This practice is controversial.
ESO Repricing Controversy
- PRO – Once an ESO is ‘underwater’ it loses its ability to motivate employees.
o 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.
- CON – lowering a strike price is a reward for failing.
o After all, decisions by employees made the stock price fall.
o If employees know that ESOs will be repriced, the ESOs lose their ability to
motivate employees.
ESOs Today
- Most companies award ESO on a regular basis.
-
o Quarterly
o 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.
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.
Why Put-Call Parity Works
- If two securities have the same risk-less pay-off in the future, they must sell for the
same price today.
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.
o That is, if the option expires in the money, the option writer simply pays the
option holder the intrinsic value of the option.
o The cash settlement procedure is the same for calls and puts.
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.
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.