INVESTMENTS:
Analysis and Management
Second Canadian Edition
W. Sean Cleary
Charles P. Jones
Chapter 19
Options
Learning Objectives
• Define options and discuss why they are used.
• Describe how options work and give some basic
strategies.
• Explain the valuation of options.
• Identify types of options other than puts and
calls.
Rights
• An option to purchase shares directly from the
company at a specified price, usually below
current market price
• Issued to current shareholders
• Trade on an exchange
• Have a very short life (1 to 3 months)
Warrants
• Warrants are a negotiable security
Often issued as part of a “unit”
Trade on an exchange
• Holder has option to
Purchase a specific number of shares
At a specified price
For a specified period of time
• Warrants are issued as a “sweetener to new
issue units, to compensate underwriters and to
increase company’s equity base
Warrant Terminology
• Exercising a warrant
Exchange warrant for shares
Some extra cash may be needed
• Exercise Price
The price for each share of the underlying security
• Exercise Ratio
The number of shares for each warrant
• Expiry Date
Last day for exercise
Comparison of Warrants with Rights
• Warrants
Life is 6 months to 10 years
Issued as part of new issue units
Exercise price above current market price
• Rights
Life is 1 to 3 months
Issued to existing shareholders
Exercise price below current market price
Options
• Call (Put): Buyer has the right, but not the
obligation, to purchase (sell) a fixed quantity
from (to) the seller at a fixed price before a
certain date
Exercise (strike) price: “fixed price”
Expiration (maturity) date: “certain date”
• Option premium or price: paid by buyer to the
seller to get the “right”
Why Options Markets?
• Financial derivative securities: derive all or part
of their value from another (underlying) security
• Options are created by investors, sold to other
investors
• Why trade these indirect claims?
Expand investment opportunities, lower cost,
increase leverage
Option Terminology
• Exercise (Strike) price: the per-share price at
which the common stock may be purchased or
sold
• Expiration date: last date at which an option can
be exercised
• Option premium: the price paid by the option
buyer to the writer of the option, whether put or
call
How Options Work
• Call buyer (seller) expects the price of the
underlying security to increase (decrease or
stay steady)
• Put buyer (seller) expects the price of the
underlying security to decrease (increase or
stay steady)
• Possible courses of action
Options may expire worthless, be exercised,
or be sold prior to expiry
Options Trading
• Options exchanges
Chicago Board Options Exchange (CBOE)
Montreal Exchange (ME)
• Standardized exercise dates, exercise prices,
and quantities
Facilitate offsetting positions through a
clearing corporation
•
Clearing corporation is guarantor,
handles deliveries
Options Characteristics
• In-the-money options have a positive cash
flow if exercised immediately
Call options: S > E
Put options: S < E
• Out-of-the-money options should not be
exercised immediately
Call options: S < E
Put options: S > E
• If S = E, an option is at the money
Options Characteristics
• Intrinsic value is the value realized from
immediate exercise
Call options: maximum (S0-E, 0)
Put options: maximum (E-S0, 0)
• Prior to option maturity, option premiums exceed
intrinsic value
Time Value = Option Price - Intrinsic Value
Payoff Diagram for a Call Option
Profit per
Option ($)
Buyer
4
0
25
27
29
Stock Price
at Expiration
-4
Seller
How does buying a stock compare
with buying a call option?
Payoff Diagram for a Put Option
Profit per
Option ($)
4
Buyer
0
23
-4
25
27
Stock Price
at Expiration
Seller
How does selling a stock compare
with buying a put option?
Covered Call Writing
Profit ($)
Purchased
share
Combined
4
0
23
-4
25
27
29
Stock Price
at Expiration
Written call
Protective Put Buying
Profit ($)
Purchased
share
Combined
4
0
23
-4
25
27
29
Stock Price
at Expiration
Purchased
put
Portfolio Insurance
• Hedging strategy that provides a minimum
return on the portfolio while keeping upside
potential
• Buy protective put that provides the minimum
return
Put exercise price greater or less than the
current portfolio value?
• Problems in matching risk with contracts
Option Price Boundaries
• At maturity, option prices are equal to their
intrinsic values
Intrinsic value is minimum price prior to maturity
• Maximum option prices prior to maturity
Call options: price of stock, S0
Put options: exercise price, E
Hedge Ratios
• Options can be used to control the riskiness of
common stocks
If stock owned, sell calls or buy puts
• Call or put option prices do not usually change
the same dollar amount as the stock being
hedged
Shares purchased per call written = N(d1)
Shares purchased per put purchased = N(d1) - 1
Other Types of Options
• Stock-Index Options: option contracts on a stock
market index
• Interest Rate Options: option contracts on fixed
income securities
• Currency Options: Option contracts whose value
is based on the value of an underlying currency
Basics of Stock-Index Options
• Options available on S&P/TSE 60 Index, S&P
500 Index, NYSE Index, etc.
• Bullish on capital markets implies buying calls
or writing puts
• Bearish on capital markets implies buying
puts or writing calls
• At maturity or upon exercise, cash settlement
of position
Strategies with Stock-Index
Options
• Speculation opportunities similar to options on
individual stocks
• Hedging opportunities permit the management
of market risk
Well-diversified portfolio of stocks hedged by
writing calls or buying puts on stock index
What return can investor expect?
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Copyright © 2005 John Wiley & Sons Canada, Ltd. All rights
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