Intro to Project 2:
Options
What is an Option?


An option is a contract giving the buyer
the right, but not the obligation, to buy
or sell an underlying asset (a stock or
index) at a specific price on or before a
certain date (listed options are all for
100 shares of the particular underlying
asset).
An option is a security, just like a stock
or bond, and constitutes a binding
contract with strictly defined terms and
properties.
Stocks vs. Options

Similarities:

Listed Options are securities,
just like stocks.
 Options trade like stocks, with
buyers making bids and
sellers making offers.
 Options are actively traded in
a listed market, just like
stocks. They can be bought
and sold just like any other
security.

Differences





Options are derivatives, unlike
stocks (i.e, options derive their
value from something else,
the underlying security).
Options have expiration dates,
while stocks do not.
There is not a fixed number of
options, as there are with
stock shares available.
Stockowners have a share of
the company, with voting and
dividend rights.
Options convey no such
rights.
Terms

Call Option – The right to buy a stock

Put Option – The right to sell a stock

American Option – may be exercised at any time prior to
its expiration date, usually the 3rd Friday of the month

European Option – may only be exercised on its
expiration date, usually the 3rd Friday of the month
American Call Options



An American Call Option is an option to buy a stock at
a specific price on or before a certain date.
Call options are like security deposits. If you wanted to
rent a certain property, and left a security deposit, the
money would be used to insure that you could rent that
property at the price agreed upon when you returned.
If you never returned, you would give up your security
deposit, but you would have no other liability. Call
options usually increase in value as the value of the
underlying instrument increases.
American Call Options
When you buy a Call option, the price you
pay for it, called the option premium,
secures your right to buy that certain stock
at a specified price, called the strike
price.
 If you decide not to use the option to buy
the stock, and you are not obligated to,
your only cost is the option premium.

American Put Options



Put Options are options to sell a stock at a specific price
on or before a certain date.
Put options are like insurance policies If you buy a new
car, and then buy auto insurance on the car, you pay a
premium to protect yourself if the asset is damaged in an
accident. If this happens, you can use your policy to
regain the insured value of the car. In this way, the put
option gains in value as the value of the underlying
instrument decreases.
If all goes well and the insurance is not needed, the
insurance company keeps your premium in return for
taking on the risk.
American Put Options



With a Put Option, you can "insure" a stock by fixing a
selling price. If something happens which causes the
stock price to fall, and thus, "damages" your asset, you
can exercise your option and sell it at its "insured" price
level.
If the price of your stock goes up, and there is no
"damage," then you do not need to use the insurance,
and, once again, your only cost is the premium.
This is the primary function of listed options, to allow
investors ways to manage risk.
Strike Price


The Strike (or Exercise) Price is the
price at which the underlying security
(in this case, XYZ) can be bought or
sold as specified in the option contract.
For example, with the XYZ May 30
Call, the strike price of 30 means the
stock can be bought for $30 per share.
Were this the XYZ May 30 Put, it would
allow the holder the right to sell the
stock at $30 per share.
Strike Price




The strike price also helps to identify whether an
option is In-the-Money or Out-of-Money when
compared to the price of the underlying security.
A call option is in-the-money if the strike price is
below the current market price of the underlying
security.
It is out-of-the-money if the strike price is above
the current market price of the security.
The extent of a stock price’s variability is called
its volatility.
An Example




Assume for a moment that it is April 5th, and
you are following XYZ, which is presently at $29
a share.
You think that this stock will go up in price in the
next month and a half or so, to well past $30 a
share.
Knowing about options, you choose to buy an
XYZ May 30 Call for 2, instead of buying the
stock outright.
This option gives you the right to buy 100
shares of XYZ Stock at $30 a share any time
before May expiration
Example Continued



On expiration Friday, assume XYZ is at $35
per share. You have a Call option, which can
be exercised to purchase 100 shares of XYZ
Stock at $30 per share. If you do that, you can
then sell that stock back in the market and
make a $5 return per share, or $500. Since
your initial Call premium was $200, your net
profit is $300.
You could also sell the option on the market
get your profits from the increased value of
your option
If XYZ’s stock traded to $25 per share, you
would only be charged for the money you
spent to purchase the option.
Project 2: European Call Options




For our project we will be limiting ourselves to
European call options
Your are employed at the Chicago Board of
Options Exchange, one of the largest traders of
options in America.
Your goal is to find reasonable price, per share,
on a European call option for a certain company
Market experience, financial theory and
mathematics have helped to develop systematic
processes for pricing options
Project 2: European Call Options

Options Pricing was
revolutionized in 1973
with the publication of the
Black-Scholes Model, the
Nobel-prize winning
equation which virtually
created the options
marketplace.
Project 2: European Call Options



Unfortunately, the mathematics behind this
formula goes way beyond the scope of this
course.
To simplify things, we will employ what is known
as the boot-strapping method
Warning!: Because of this, you should not use
this project to price options on your own. As the
saying goes, “Don’t try this at home.”
Class Project

Our goal is to find the present value, per
share, of a European call on Walt Disney
Company stock. Currently the stock is
trading at $21.87 on January 11, 2002.
The call is to expire 20 weeks later, with a
strike price of $23. Our work is to be
based upon the stock’s price record of
weekly closes for the past 8 years.
Project Assumptions
1.
Past history cannot be used to predict the future price of a stock. If it did,
then investors would move their money to the stock that would yield the
best return, thereby driving up the price of that stock and destroying its
value since no one would want to buy such a stock.
2.
The past history of prices for a given stock can be used to predict the
amount of future variation in the price of that stock. The greater the
volatility the greater the stock will fluctuate in price.
3.
All investments, whose values can be predicted probabilistically, are
assumed to give the same rate of return. If this were not so, then
investors would move their money to stocks that would give them the
highest predicted rate of return, raising the cost of the investment and
destroying its predicted rate of return
Project Assumptions
4.
We will assume that the common growth rate for all
investments whose future values can be predicted is
the rate of return on a United States Treasury Bill. This
rate is guaranteed by the federal government
5.
All investments with the same expected rate of growth
are considered to be of equal value to investors. We
are choosing to ignore the fact that investors have
different investing tastes and preferences. This is
called the risk-neutral assumption.
What this project is NOT?




We only want to determine a fair price for our
European Call option on a particular company.
We don’t want to know whether the option
should be purchased
We don’t want to know whether stock the
company should be purchased
We don’t want to know the closing value of
company’s stock once the option expires. How
can we? Assumption 1 says we can’t !
What’s on the horizon?


For this project, you will be assigned new teams
Each team will be given a certain company to price the
value of a European call option. Each team will get:






Company ticker symbol
Start date of the option: Friday March 25th, 2005
Strike Price
Length of the Option (Expiration Date)
N years of historical data
The current rate guaranteed by the federal government
Upcoming . . .




Begin reading your text and familiarize yourself
with how options work
Visit the Chicago Board of Options Exchange at:
www.cboe.com to read further information
Your team assignments will be determined by
Wednesday’s class
Your team’s data will also be given by
Wednesday’s class
Preliminary Report



Your team’s preliminary report will be delivered
on Monday March 28th, 2005
As before, you will want to meet with your team
to examine the data that you’ll be downloading
(more about this later)
Your team will again need to put together a
presentation in powerpoint to deliver your report
to determine a reasonable price for your
particular call option
Citations

All slides seen here are courtesy of and
inspired by the incredibly useful learning
center offered by the CBOE website.