Investments Chapter 14

Investments chapter 14
Investments (Northern Alberta Institute of Technology)
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Chapter 14 Options: Puts and Calls
 Outline
Learning Goals
I. Call and Put Options
A. Basic Features of Calls and Puts
1. The Option Contract
2. Seller versus Buyer
3. How Calls and Puts Work
4. Advantages and Disadvantages
B. Options Markets
1. Conventional Options
2. Listed Options
C. Stock Options
1. Stock Option Provisions
a. Strike Price
b. Expiration Date
2. Put and Call Transactions
Concepts in Review
II. Options Pricing and Trading
A. The Profit Potential from Puts and Calls
B. Intrinsic Value
1. In the Money/Out of the Money
2. Put-Call Parity
C. What Drives Option Prices?
1. Time Value and Time to Expiration
2. Volatility and Option Prices
3. Interest Rates and Options Prices
4. Option-Pricing Models
D. Trading Strategies
1. Buying for Speculation
a. Speculating with Calls
b. Speculating with Puts
2. Hedging: Modifying Risks
a. Protective Puts: Limiting Capital Loss
b. Protective Puts: Protecting Profits
3. Enhancing Returns: Options Writing and Spreading
a. Writing Options
b. Naked Options
c. Covered Options
© 2020 Pearson Education, Inc.

Chapter 14 Options: Puts and Calls 267
d. Spreading Options
e. Option Straddles
Concepts in Review
III. Stock-Index and Other Types of Options
A. Contract Provisions of Stock-Index Options
1. Valuing Stock-Index Options
a. Full Value Versus Fractional Value
B. Investment Uses
1. Index Options as Hedging Vehicles
2. A Word of Caution
C. Other Types of Options
1. Options on Exchange-Traded Funds
2. Interest Rate Options
3. Currency Options
4. LEAPS
Concepts in Review
Summary
Key Terms and Concepts
Discussion Questions
Problems
Case Problems
14.1 The Franciscos’ Investment Options
14.2 Luke’s Quandary4To Hedge or Not to Hedge
Chapter-Opening Problem
 Key Concepts
1. The world of puts and calls and their popularity in the investment community
2. Option contract pricing and valuation
3. The risk and return behavior of various put and call investment strategies
4. The increasing number of different kinds of listed options, including LEAPS, options on
stock market indexes, ETFs, debt securities, and foreign currencies
 Overview
Different types of options (puts and calls, rights and warrants) are discussed in this chapter.
1. Students sometimes have difficulty distinguishing between options and securities, so time
should be spent providing a clear explanation. The notion of derivative securities as
securities that derive their value from some other asset should be clarified. Within that
context, instructors can present options as one type of derivative. Options represent a
contract or an agreement to buy (or sell) a security in the future, whereas owning a security
means owning a part of a company (as in the case of owning a stock) or having a position in
a loan (as in the case of a bond).

268 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition
2. The chapter next discusses put and call options. Students should understand the difference
between put and call options and how they work. The distinction between the writer or
seller and the buyer should also be made clear. Examples that compute the prices of put and
call options might be worked out in class. The distinction between in-the-money and out-of-
the-money options should be explained, and the students should develop an ability to read
and understand option quotations listed in the financial pages.
3. The factors driving option prices should be explained next, along with a brief introduction
to some of the basic option pricing models.
4. After the basic characteristics of puts and calls have been reviewed, attention shifts to listed
stock options. Pricing systems, valuation concepts, and trading strategies are all discussed
in detail. It would be good at this point to emphasize to the class the strategies of
speculation, hedging, covered call writing, and spreading because these are all viable
techniques for the individual investor.
5. Stock-index options are next. Their characteristics and valuation are covered in detail, as are
some of the possible uses of these options. Information about the recent prices of the
prominent stock-index options should be shared with the class. The students should
understand that since the creation of stock-index options, it is now possible to <trade the
market= as a whole and that this presents great opportunities for both risk reduction (as in
the case of hedging stock portfolios) and return enhancement. But as we’ve learned, it has
also created some problems, as in the market volatility that comes with certain types of
program trading and the <triple witching hour.= Options on exchange-traded funds allow
investors to focus on preferred segments of <the market.=
6. Interest rate and foreign currency options are then discussed, along with LEAPS. It would
probably be useful to explain to the class the pricing and valuation systems used with these
securities. Especially important is how the concepts of bond valuation (from Chapter 11)
come into play with interest rate options.
 Answers to Concepts in Review

1. Puts and calls are negotiable options that allow the holder to sell (put) or buy (call) a
stipulated amount of a specific security/financial asset, at a specified strike price, during a
specified time period. They are unique in that puts and calls are created by investors. An
individual, for example, who wants to sell to another the right to purchase 100 shares of
stock would write a call. The writer (or option maker or seller) receives the price
(premium) paid for the call (less any commission). An individual holding the call can sell it
in the open market any time before the expiration date, or he can exercise it, at which time
the writer would have to sell his stock to the investor holding the call at the agreed-upon
exercise price.
2. Prior to April 26, 1973, all options were conventional options. These were sold over-the-
counter through a few specialized dealers. Investors who wished to purchase puts or calls
used their own brokers and these dealers to find an individual to write the option. That
individual would also be the only one with whom the put or call option could be exercised.
This led to little secondary trading. Then in April 1973, the Chicago Board Options
Exchange (CBOE) came into being with 16 listed (call) options. It was quickly followed by
the American Stock Exchange and then several other exchanges, including the NYSE.
Eventually, listed puts were added and then listed options trading began in a variety of debt
securities, foreign currencies, and stock indexes. To summarize, conventional options are
put and call options sold over-the-counter. Listed options are put and call options listed and
traded on organized security exchanges such as CBOE.

The number of listed options has grown quickly. In 2003, trading of listed options took
place on five exchanges: the CBOE, Amex, ISE, Philadelphia Exchange, and Pacific
Exchange The ISE is relatively new and the first fully electronic U.S. options market All
have standardized expiration dates and specified strike prices. The exchanges provide a
clearinghouse, active secondary markets, and wide distribution of price information. Their
creation has greatly reduced the use of conventional options, while the growth in listed
options has been phenomenal.
3. The main attractions of puts and calls are the following:

a. The low unit cost: Investors can participate in the price behavior of the underlying
security at a fraction of the cost of the security, giving them the benefits of leverage
and low downside risk.
b. They can be used profitably when security prices go up or down: In a bull market,
aggressive investors can buy calls or write puts; in a bear market, they can buy puts or
write calls
Puts and calls have some disadvantages as well:
a. With puts and calls, as with any option, there is always the risk of losing the entire
premium because the option could not be exercised profitably over its limited life.
Leverage works in both directions and small adverse movements in the underlying
security price can quickly render an option worthless or create a large liability for
the writer.
b. They cannot be margined.
c. They require special knowledge to be utilized successfully.
4. Stock options are like any other put or call option except that their value is based on a
stock. Because puts and calls on a stock <derive= their value from an underlying asset (the
stock), stock options are a very common form of derivative security. Derivative securities
are securities that <derive= their value from an underlying asset or security. Some other
common examples of derivative securities include rights and warrants, convertible bonds,
and forward and future contracts.
5. The strike price of a stock option is the contracted price at which the holder of the option
can buy or sell the underlying stock. This is different from the stock’s market price, which
is the prevailing price of the stock at any given time. In fact, the difference between the
strike price and market price is the fundamental value of an option. Both puts and calls
have strike prices: The strike price on a call is the price at which the owner can purchase
the stock, and conversely, the strike price on a put is the price at which the owner can sell
the underlying stock.
6. Expiration dates are important features on options because they specify the life of the
option similar to the way that the maturity date on a bond indicates the life of a bond.
Consequently, the time to expiration has bearing on the value of the option. Once the
expiration date has passed, the market for that particular option ceases to exist, and it is
valueless; however, a market for new options with similar contract provisions may arise at
that time.
7. a. A purchaser of a call option on a stock would make money if the stock price rises far
enough above the stated strike price to recover the call’s option premium (the price
paid for the option); this stock price is the breakeven point. If the stock continues to rise
above this level, the investor makes a profit.
b. A purchaser of a put option makes money when the stock price falls far enough below
the strike price to recover the put’s premium. Any movement of the stock below this

level gives the investor a profit.

An option buyer need not exercise the option to earn his profits. He can sell the options
in the secondary market and earn a large profit. This is because he would get a premium
for the time value of the option in the secondary market. The existence of a secondary
market makes the distinction between American- and European-style options less
important than it might initially seem.
8. The intrinsic value of a call is determined by subtracting the strike price from the market
price of the underlying stock. If the strike price exceeds the market price of the stock,
the call has zero intrinsic value. However, if the market price exceeds the strike price,
the amount by which it exceeds the strike price is the call option’s intrinsic value.
The intrinsic value of a put reverses the comparison between the market and strike prices.
If the strike price exceeds the market price of the stock, unlike a call, the put has intrinsic
value. Thus, the intrinsic value is the difference between the strike price and the market
price, and the intrinsic value is zero for a put whose strike price is below the market stock
price.
Out-of-the-money options have no intrinsic value. Their value is made up of an investment
premium or time premium.
9. The following are the four most important variables that affect the price behavior of
listed options (in descending order of importance):
(1) The price behavior of the underlying common stock. For calls, the higher the stock
price, the higher the call value, and for puts, the lower the stock price, the lower the put
value. This determines the fundamental or intrinsic value of an option.
(2) The strike price. The option’s strike price influences the value of the option. A call (put)
option’s price will be higher when its strike price is lower (higher).
(3) The time remaining to expiration. Usually, the longer the time remaining to expiration,
the higher the value of the option because the option price will contain a component
valuing the time premium. The time premium reflects the belief that the fundamental
value will increase in the time remaining to expiration because the underlying stock
may move up or down in the time remaining.
(4) The price volatility of the underlying common stock. The more volatile the price of the
underlying stock, the more it enhances the speculative appeal of the options and hence
the more valuable the option.
(5) The level of interest rates. The value of a call option will generally increase with the
level of market interest rates. The higher the market interest rates rise, the higher the
option price and hence the more valuable the option becomes. With puts, higher
interest rates lead to lower put prices.
When an option has a positive intrinsic value (the stock price is higher than the strike price
in the case of calls and the opposite for puts), the option is said to be in-the-money. When
an option has zero intrinsic value, the option is out-of-the-money. Intrinsic value accounts
for most of an option’s value if its expiration date is not too far off and if it is in the money
to a substantial degree. But out-of-the-money options have no intrinsic value; hence, their
price is made up entirely of the time premium.
10. Using common stocks as a basis of discussion, stock options are used primarily in one of
three ways:
a. Speculation. This strategy is the simplest; it is just like buying common stock (the buy-
low3sell-high approach). If an investor feels a stock will appreciate, she buys a call
rather than the stock. If the investor feels the stock price will fall, she buys a put rather
than short selling the stock. This strategy says buy options, instead of stocks, as the

options are likely to generate a higher return on investment as they enable more buying
leverage, i.e., ability to <control= the appreciation or depreciation potential of the
underlying security without buying the security.
b. Hedging. This strategy involves combining two securities into a single investment
position for the purpose of reducing risk. Hedging always involves two transactions, an
initial common stock position and a subsequent/simultaneous option purchase. The two
transactions can take place at the same time; this limits the loss in the position. In
contrast, the option purchase can occur some time after the original stock position is
taken; this is usually done to protect a profit and can be thought of as a form of
insurance.
c. Writing and spreading. These strategies are really best left to the experienced investors.
Writing options, either on stocks the investor owns (covered options) or on stocks the
investor does not own (naked options), can be profitable. The writer receives at most the
option premium and can suffer high losses, but careful analysis and stock selection can
make this a profitable strategy. Spreading options simply involves combining two or
more options into a single transaction. For example, buying a call and simultaneously
selling a call (with different strike prices or expiration dates on the same underlying
stock) is a spread. Many different spreads exist, each with a different investment goal.
Straddles are similar to spreads. They involve the simultaneous purchase (or sale) of a
put and a call at the same strike price for the same expiration date. All these strategies
can be very risky for inexperienced investors.
11. The maximum profit that an investor can make from writing calls is the call premium.
However, a call writer’s loss is potentially unlimited. This risk can be partially offset by
writing covered calls. Risk (and profit) can also be limited by simultaneously buying
cheaper out-of-the money calls at a higher strike price.
An investor who writes a covered call effectively writes a naked call but already owns the
stock on which the option is written. The investor’s objective is to write a slightly out-of-
the-money call option, pocket the premium, and hope the price of the underlying stock
will move up or down, but not above the call’s strike price.
If the stock price rises dramatically, the investor doesn’t get to enjoy the full benefit of the
stock price rise. In this case, the investor’s gain on the stock is offset by losses on the
option. Thus, writing a covered call involves losing upward price potential while providing
only limited downward risk. While the call premium collected can provide some cushion if
the stock price falls a little, it does not help much if the stock price falls a lot. Only an
investor who is sure that the stock price will not fluctuate much should consider writing a
covered call.
12. First, let’s look at the similarities between stock-index options and stock options:
a. The contracts are standardized with respect to strike prices and expiration dates.
b. They are listed on exchanges and therefore enjoy active secondary trading.
c. They are valued in a similar fashion.
d. They can be used in basically the same kinds of trading strategies.
e. The quotation system for both is virtually identical.
Differences between these securities include the following:
a. Most obviously, the underlying securities are considerably different; stock-index
options are written on the market as a whole rather than on individual equities.
b. While stock options trading is based on 100 shares of the underlying common stock,
most stock-index options are traded at 100 times the value of the market index.
However, there is no market of stocks backing the index option, so settlement is defined

in cash, while equity options are settled using the underlying stock.
c. Index options are issued with monthly rather than quarterly expiration dates, and
expiration dates go out only three months rather than nine months (as is the
practice with equity options).
d. When hedging with index options, you can protect an entire portfolio rather than
only one stock.
The similarities between foreign currency options and stock options are identical to the
similarities between stock-index options and stock options (which are listed above).
Foreign currency options differ from stock options in the following ways:
a. In this case, the underlying securities are specific foreign currencies, and the value
of the option is determined by the exchange rate between the local and the foreign
currency on the date of expiration.
b. Although stock options trade on 100 shares of the underlying stock, currency options
trade on the basis of a certain amount of the foreign currency per contract. This unit of
contract varies depending on the specific foreign currency. For example, the size of a
contract in British pounds is 10,000 pounds, while that of Swiss francs is 10,000 francs.
13. Stock-index options can be used to hedge or speculate. An investor can protect a portfolio
of common stocks against a poor market by buying puts on one of the stock market indexes.
That way, the investor’s portfolio is hedged: If the market goes up, only the cost of puts is
lost, but if the market goes down, the investor earns money on the puts to offset losses in the
portfolio of stocks.
An investor can also speculate on the market by buying index options. A call option on an
index requires relatively little capital and losses are limited, providing an attractive leverage
opportunity to speculators.
Index options and foreign currency options can be used in the same way, to speculate or
hedge. Foreign currency options can be used to protect foreign investments by ensuring
that adverse currency exchange movements do not erode value. Foreign currency options
also can be used to speculate on exchange rates, earning returns from movements in the
foreign exchange rate.
14. If an investor holds a well-balanced portfolio of common stocks, he may want to hedge his
position with a stock-index option under two conditions: The first condition is if he
expects a market decline; the second is if he wants to shift his tax obligation from one year
to the next but is unsure of the future course of the market Options on exchange-traded
funds work essentially the same as those on stock indexes.
If a market drop is expected and it would be too expensive to sell the entire portfolio, the
investor can buy a stock-index put. In this way, if the market does fall, then he’ll make a
profit on the put which will offset all (or most) of the loss in value of his portfolio Because
exchange-traded funds are a type of index fund that trades in a way similar to a stock,
options on ETFs work in much the same way as index options.
Options can be used to protect the investment principal or capital gains Even if the market
is likely to fall, the stock price still has the potential to rise By continuing to hold onto the
stock, the investor continues to receive dividend payments. Also, the investor gets to delay
recognition of the sales price and postpone paying taxes on the capital gains.
15. LEAPS, or long-term equity anticipation securities, are long-term options with expiration
dates that could extend out as far as three years. LEAPS give an investor more time to be
right about her bets on the direction of a stock or stock index than regular listed options
with their shorter maturities. Similarly, LEAPS give investors with large portfolios the
ability to


protect their portfolios over a longer period. But there is a price for this longer-term
protection: LEAPS have a higher time premium and are therefore more expensive.
 Suggested Answers to Discussion Questions

1.
Premium Time Premium Breakeven
Aug Put 82.50 Strike 1.85 1.85 80.65
Aug Call 85 Strike 4.90 4.90 89.90
Note: The July 6, 2015, closing price for Facebook was 87.55. This means that both the put
and the call mentioned in this question are out-of-the-money, so both have a time value that
is equal to the option premium. Students will need to look up historical prices from Yahoo!
Finance or some other source. See also problems 7 and 8.
Note: Figure 14.1 was updated to July 23, 2018, quotes for Sept. 21, 2018, expirations, but
the question was not revised from the thirteenth edition. The following solution will use the
call with a strike price of 205 and the put with a strike price of 215. Both of these option
prices are listed in Figure 14.1. The closing price for Facebook on 7/23/18 was $210.91
Premium Intrinsic Value Time Premium Breakeven
Sept Put 215 Strike 11.05 4.09 6.96 203.95
Sept Call 205 Strike 13.20 n.a. 12.30 218.20
2. Options with strike prices closest to the market price of the underlying stock will have the
highest time value because small changes in the market price will have a relatively large
impact on the value of the option.
3. a. The stock price is currently at $52.51. There is no gain on the shares, but thankfully no
loss either. Also, a call with a $55 strike price would expire out of the money, allowing
you to earn $370 ($3.70 striking price times 100 shares).
b. The total gain would come from the stock price increase and call premium
retention. Stock price increase: ($55.00  $52.51)  100 shares  $249
Call premium received: $3.70  100 shares  $370
Total income $619
c. The premium on the option would offset the loss experienced on the stock. There is
still a gain because the price decline was less than the call premium.
Stock price decrease: ($49.00  $52.51)  100 shares  $351
Call premium received: $3.70  100 shares  $370
Total income $ 19
4. a. A stock-index option is an option written on a specific market index. When the market
index moves down, the value of an index call (put) option also moves down (up). One
way to hedge would be to buy puts on the market index. Another technique would be to
sell call index options. Options on ETFs based on a broad Market Index such as the
S&P 500 or the Russell 2000 can be used in similar ways. Hedging with ETF options
would be especially suitable for portfolios of modest size.
b. If the market falls, then you make money on puts that you purchased, helping to offset
losses on your stock portfolio. Or, if you hedged by selling calls, if the market falls, the
calls that you sold may expire out-of-the-money, so the premium that you collected
when you sold the calls helps to offset your stock portfolio losses.

c. If the stock index goes up, you keep the call premium, but the gains that would have
been earned on your portfolio are offset by losses on the option position. Essentially, by
selling a covered call, you have sold away the upside potential of your portfolio.
5. Answers will vary according to student choices.
 Solutions to Problems
14.1 Intrinsic value is $120 3 $117 = $3 and time value is $12 3 $3 = $9. On a contract basis,
answers are $300 and $900.
14.2 Out-of-the-money calls have no intrinsic value, and the entire price of the option ($230 per
contract) is a time premium.
14.3 Intrinsic value  $55-$50  100  $500 per contract or $5 per option.
Time premium  $5.79  $5.00  100  $79 per contract or $0.79 per option.
14.4 The put is out of the money and therefore has no intrinsic value, and the entire price of the
option contract (0.85  100 = $85) is a time premium.
14.5 A call option purchased for $500 with a $50 strike price can later be sold (or
exercised) when the underlying stock has a $65 price; given this, it will generate the
following:
Profit = ($65 3 $50)  100 = $1500 3 $500 = $1,000
HPR = $1,000/$500 = 200%
14.6 Price of put option + Price of stock = Price of call option + Price of risk-free bond
Price of put option + $46.21 = $5.16 + $45/1.01
Price of put option = $5.16 + $45/1.01 3 $46.21 = $3.50
14.7 As is discussion question 1, the prices in the problem are from the thirteenth edition. We
will use the put and call with a strike price of 215 from Figure 14.1 in this edition.
Put call parity says that the price of a call plus the present value of the call’s strike price
should be equal to the price of an identical put plus the price of the underlying stock.
Call + PV(strike) = Put + Stock
In this problem from Figure 14.1 we have
Call = $7.80 and Put = $11.05. The strike price is $215, and the PV is also $215 if the
interest rate is 0%. Notice for the option prices we are using the last quoted price. One
might also use the midpoint of the bid and ask prices for each option.
So plug all of these into the equation.

$7.80 + $215 = $11.05 + Stock price
$211.75 = stock price
14.8 Our solution will use the put and call with a strike price of 220
Price of put option + Price of stock = Price of call option + Price of risk-free bond
The call is worth $5.80, the put is worth $14.20, and the PV of the strike price is $220
because the interest rate is 0%. So the stock price should be


$5.80 + 220 = $14.20 + Stock price

$211.60 = Stock price
The solutions for the stock price in this problem and the previous one should be the
same. They are close, but not identical.
14.9
A B C D E
Type of Cost of Strike Stock
Option Option option Price Price at Profit
Expiration (Loss)
A Call $ 200 $50 $55 $ 300
B Call 350 42 45 $ (50)
C Put 500 60 50 500
D* Put 300 35 40 (300)
E* Call 450 28 26 $ (450)
*Options D and E have negative intrinsic values at expiration, so they

would not be exercised. The loss is the cost of the contract.
14.10 Cost of ETF puts  100  $2.20  $220
Value at expiration  $34  $30  $4/share  100 shares  $400
Profit before trading costs  $400  $220  $180
14.11 If the price increases (actually decreases) to $25, the profit will
be: Value at expiration  $34  $25  $9/share  100 shares 
$900 Profit before trading costs  $900  $220  $680
14.12 To buy this S&P 100 put, Dorothy will have to pay 100 times the quoted price:
100  $14.50  $1,450
Now if the S&P Index drops to 850 by the put expiration date, the option will be worth:
(905  850)  100  $5,500
where 905  strike price on the option.
Thus, the profit from this investment would be
Profit  $5,500  $1,450  $4,050.
The holding period return would be
$4,050/$1,450 3 1 = 179.31%.
On the other hand, if the S&P Index rose to 925 by the expiration date, the put option
would be worth nothing, or $0, because the market index is far above the strike price of
the put option. Her loss will be limited to the cost of the put option contract of $1,450,
which represents a 3100% holding period return.
14.13 Protecting profits with a put hedge:
Original purchase price of the stock $52.75
Current market price of the stock 78.00
Market price of the three-month put 3.25

a. Stock price drops to $62 three months later

Value of the put: $78  $62  $16
Profit:
600 shares of stock  ($62  $52.75) $ 5,550
Value of puts = (6  100  $78 3 $62 9,600
Cost of six puts (6  100  $3.25) 1,950
Total profit $13,200
With the stock trading at $78, Max has already made a profit of $15,150 (i.e., 600 x
($78 3 $52.75) = $15,150). His intent is to protect this profit with a put hedge. If the
stock price drops to $62 per share, his profit will go down to $13,200, as shown above.
This is exactly the profit he would have by selling at $78 less the cost of the puts.
b. Stock price rises to $85 in three months:
Value of the put: $0
Profit:
600 shares of stock  ($85  $52.75) $19,350
Value of six puts (6  100  $0) 0
Cost of six puts (6  100  $3.25) 1,950
If the stock price goes up to $85, Max would make additional capital gains on the stock.
c. The major advantage of a put hedge is that it allows investors to enjoy the upward profit
potential while at the same time protecting the profits already made on the long
transaction. In the worst case, the put hedge would only result in the loss of the cost of
the put.
d. In-the-money options are more expensive, and as a hedging device, they are riskier than
at-the-money options (those with strike prices exactly equal to the current market price
of the underlying stock). In this case, the cost of 600 puts would be $6,150 (600 
$10.25). In the worst case, the investor would lose $6,150, compared to only $1, 950
with an at-the-money option.
Even though out-of-the-money options are inexpensive, using those options to create a put
hedge will leave part of the profits unprotected. For example, using the put with a strike
price of $73 would cost only $600 (600  $1). But if the stock price drops to $70, Myles
would lose $5 per share in unprotected capital gains. His profit on the out-of-the-money put
hedge would be the following:
Profit:
600 shares of stock  ($70  $52.75) $10,350
Value of six puts (6  100  $3.00) 300
Cost of six puts (6  100  $1) 600
This hedge reduced profits $600 (cost of puts) and left $3,000 in profits unprotected
($78 3 $73)  600.

14.14 a. (i) Market value of Fitzgerald’s portfolio $825,000

(ii) Current level of S&P 500 Index 2,854
(iii) The market value of S&P 500 Index [(ii)  100] 285,400
Hence, number of S&P 500 puts to be purchased  $825,000/285,400
 2.89 put options
Fitzgerald should buy three contracts.
Cost of buying a six-month put with strike price of 2,800 is $77  100  $7,700.
Cost of buying three six-month puts with strike price of 2,800 is $7,700  3  $23,100.
Cost of buying a six-month put with strike price of 2,725 is 56  100  $5,600.
Cost of buying three six-month puts with strike price of 2,725 is $5,600  3  $16,800.
b.
Hedging using the six-month put with a strike price of $2,800
Current value of Fitzgerald’s portfolio $825,000
Fitzgerald’s portfolio value after the 15% drop $701,250
Fitzgerald’s loss in the portfolio ($123,750)
Fitzgerald’s gain using the put option [(2,800 ) * 100]  3 $112,230
Less: Fitzgerald’s cost of the put option ($23,100)
Fitzgerald’s net gain from the put option $89,130
Fitzgerald’s total gain/loss ($34,620)
Hedging using the six-month put with a strike price of 2,075
Fitzgerald’s gain using the put option [(2,725)   100]  3 $89,730
SCENARIO II: Market drops by 5%
Fitzgerald’s gain using the put option [(2,800 ) * 100]  3 $26,610
Fitzgerald’s gain using the put option [(2,725)   100]  3 $4,110
Fitzgerald’s net gain from the put option ($12,690)


SCENARIO III: Market goes up 10%
Fitzgerald’s portfolio value after the 10% gain $907,500
Fitzgerald’s gain in the portfolio $82,500
Fitzgerald’s gain using the put option. Not exercised $0
Fitzgerald’s net loss from the put option ($23,100)
Fitzgerald’s total gain/loss $59,400
Fitzgerald’s loss in the portfolio $82,500
Fitzgerald’s gain using the put option: not exercised $0
Fitzgerald’s net loss from the put option ($16,800)
Fitzgerald’s total gain/loss $65,700
c. The major advantage of a put hedge is that it allows investors to to enjoy the upward
profit potential while at the same time protecting the profits already made on the long
transaction. In the worst case, the put hedge would only result in the loss of the cost
of the put. The put with the strike price of $2,800 seems to provide the best outcomes
except in the case where the market actually rises by 10%.
d.
SCENARIO I: Market drops by 15%
Hedging using the six-month DJIA put option with a strike price of 255
Fitzgerald’s portfolio value after the 15% drop 701,250
Fitzgerald’s loss in the portfolio 3123,750

Fitzgerald’s gain using the put option [(255  216.8265)  100]  32 122,155
Less: Fitzgerald’s cost of the put option 25,856
Fitzgerald’s net gain from the put option 96,299
Fitzgerald’s total gain/loss 3$ 27,451
Fitzgerald would be better off with the DJIA put option (strike price  255) rather than
the S&P 500 put 2800 option. DJIA puts provide a higher payoff when the market drops
which more than compensates for their higher cost.

14.15 Covered call writing:

Current market price of the stock $54.00
Current market price of the call $4.75
Initial investment: $54.00  300  $16,200
a. If the stock price rises to $57 per share, the call options expire
worthless: Value of the call  $0
Profit:
Quarterly dividends received $ 150
Proceeds from sale of call 2,375
Capital gains on stock [($57  $54)  300] 900
Total profit $3,425
Holding period return (for three months):

HPR = $3,425/$16,200 = 21.14%
b. For any price above $57, the loss on the call option will be exactly offset by the
additional capital gains made on the long position in the stock, leaving the profit
of
$3,425 unchanged. The HPR also remains the same, 21.14%.
c. The covered call position offers limited protection against a drop in stock price. The
capital loss on the stock can be protected to the extent of the option premium received,
namely $2,375. In this case, the investor is protected against losses until the stock price
drops to $46.08, the breakeven price. The breakeven stock price decline is $2,375 / 300
= $7.92, which means the breakeven stock price is $54 3 $7.92 = $46.08. If the stock
drops below this price, the investor would have to bear the additional losses. Thus, the
upward potential of this covered call is limited to $3,425 while the potential losses are
only partly covered.
14.16 Luke can either short RTH or use put options on RTH If he is correct and the retail sector
declines, he will profit from either trade and thereby offset a decline in his stock.
14.17 a. LONG STRADDLE
Cost of 1 Oct 255 call option $550.00
Cost of 100 Oct 255 call options $55,000.00
Cost of 1 Oct 255 put option $425.00
Cost of 100 Oct 255 put options $42,500.00
Cost long straddle $97,500.00
If the market falls by 750 points

Loss from 100 Call options $0
Profit from 100 put options $75,000
Total profit from straddle $75,000
Cost of straddle $97,500
Net profit (loss) ($22,500)

If the market goes up 750 points

Gain from 100 call options $75,000
Loss from 100 put options $0
Total gain from straddle $75,000
Cost of straddle $97,500
Net profit (loss) ($22,500)
If the market stays at 25500 points

Cost of 100 call options $55,000.00
Cost of 100 put options $42,500.00
Loss from straddle $97,500.00
b. SHORT STRADDLE (you are the writer)

Profit from 1 Oct 255 call option $550.00
Profit from 100 Oct 255 call options $55,000.00
Profit from 1 Oct 255 put option $425.00
Profit from 100 Oct 255 put options $42,500.00
Profit short straddle $97,500.00
If the market falls by 750 points

Loss from 100 Call options $0
Loss from 100 put options $75,000
Total loss from straddle $75,000
Profit from Sale of straddle $97,500
Net profit (loss) $22,500
If the market goes up 750 points

loss from 100 call options $75,000
Loss from 100 put options $0
Total loss from straddle $75,000
Profit from Sale of straddle $97,500
Net profit (loss) $22,500
c. Option straddles are extremely risky investment strategies; hence, an investor using
this strategy must completely understand the risk involved. For larger movements in
the market, the short straddle will start losing money, and the long straddle will start
gaining money.
(The instructors may use this example to illustrate that options are a zero-sum game. If
an option writer makes money, the option buyer would lose money, and vice versa).

14.18 The value of a call option using the Black-Scholes option-pricing model:
Stock price  $45
Strike price  $50
Time to expiration  1 year
Standard deviation of returns  0.30
Risk-free rate of return  0.02
d1 = [ ln(45/50) + (0.02 + 0.302/2)1]/(0.30 x 11/2) = 30.1345
d2 = 30.1345 3 (0.3 x 11/2) = 30.4345
N(d1) = 0.4465 (from EXCEL or table of Z values)
N(d2) = 0.3320
Call price = $45 (0.4465) 3 $50/1.02(0.3320) = $3.82
14.19 The value of a call option using the Black-Scholes option-pricing model:
Stock price  $45
Strike price  $50
Time to expiration  1 year
Standard deviation of returns  0.40
Risk-free rate of return  0.02
d1 = [ ln(45/50) + (0.02 + 0.40 /2)1]/(0.40 x 11/2) = 30.0134
2
d2 = 30.0134 3 (0.40 x 11/2) = 30.4134

N(d1) = 0.4950 (from EXCEL or table of Z values)
N(d2) = 0.3400
Call price = $45 (0.4950) 3 $50/1.02(0.3400) = $5.61
As expected, the value of the call increases with the volatility of the stock’s returns. In
this case, the call value increases by $1.79 or about 47%.
14.20 a. Scenario one
A B C D E F G H I J
1
2 Long 100 3-Month Call Option
3 Position Shares of on the Stock
4 No Underlying Strike Price
5 Option Common Stock $51
6
7 Today
8
9 Market value of stock $49 $4,900 $4,900
10 Call strike price $51 $5,100
11 Call option premium $2 $200
12
13
14 Scenario One: 3 months later
15 Expected market value of stock $5,800 $5,800

A B C D E F G H I J
16 Stock value at strike price $5,100
17 Call premium $200
18 Breakeven point $5,300
19
20 Profit (Loss) $900 $500
HPR long position = $900/$4,900=18.37% for 3 months
HPR call option = $900/$200=250% for 3 months
1
2 Long 100 3-Month Call Option
3 Position Shares of on the Stock
4 No Underlying Strike Price
5 Option Common Stock $51
6
7 Today
8
9 Market value of stock $49 $4,900 $4,900
10 Call strike price $51 $5,100
11 Call option premium $2 $200
12
13
14 Scenario One: 3 months later
15 Expected market value of stock $4,200 $4,200
16 Stock value at strike price $5,100
17 Call premium $200
18 Breakeven point $5,300
19
20 Profit (Loss) ($700) ($200)
HPR long position = $(700)/$4,900=18.37% for 3 314.29%
months
HPR call option = ($200)/$200=250% for 3 months 3100.00%
Call expires with no value

 Solutions to Case Problems

Case 14.1 The Franciscos’ Investment Options
This case is designed to show the student that more than one vehicle is sometimes available to
investors who anticipate a price movement in a common stock and wish to act on this belief. An
investor can purchase a common stock directly or buy a call option. Clearly, when such
alternatives exist, they must be carefully evaluated, just as this case requires.
a. If Hector wants to invest in RPP for six months, he could use any of the vehicles
mentioned: purchase the common stock, purchase the $50 call, or purchase the $60 call. For
a two-year investment horizon, he could use common stock (the expiration dates on the
calls are not long enough to enable Hector to invest for the full two years of this investment
horizon).
b. 1. Value of the first call ($50 exercise price):
V  ($80  $50)  100  $3,000
Value of second call ($70 exercise price):
V  ($80  $60)  100  $2,000
2. HPR (stock investment)  [(0.50  $2.40)*  ($80  $57.50)]/$57.50
 [$1.20  22.50]/$57.50  41.22%
*Dividends will be received for only six months, or two quarters.
($3,000 *  $800)
HPR (call with $50 exercise price)   275%
$800
($2,000 *  $500)
HPR (call with $60 exercise price)   300%
$500
*Calculated in 2b. above.
c. Let’s examine this question on profitability in two different ways to show the benefits of
leverage with options. First, consider 100-share investments using each of the four vehicles
and assuming Hector is correct about the price appreciation, and the other figures in
question 2 are correct.
Investment Vehicles
Per Share Common Stock $50 Call $60 Call
Investment $57.50 $ 8.00 $ 5.00
Dividends 1.20 0 0
Price in six months 80.00 30.00 20.00
Capital gain 22.50 22.00 15.00
Profits 23.70 22.00 15.00
Times 100 shares  Total profits $2,370 $2,200 $1,500
Dollar profits are highest for the common stock. However, recall that HPR is highest for the
$60 call and that it requires the smallest investment. Now let us assume we put the same
amount into each investment, $5,750 (assuming we can purchase fractional options for
illustration only).

Investments
Totals Common Stock $50 Call $60 Call
Investment $5,750 $5,750 $ 5,750
Dividends 120 0 0
Value in six months 8,000 21,563 23,000
Capital gain 2,250 15,813 17,250
Total profits $ 2,370 $15,813 $17,250
With equal dollar investment, the $60 call options would have the largest profit (in both
dollar and percentage terms); therefore, if Hector wants to maximize profits, he would invest
in the $60 calls. However, they (along with the $50 calls) also possess the greatest risk4the
total investment can be lost if the stock fails to move over the six-month life on the options.
Thus, given risk-return considerations, we may want to consider another course of action.
This leads us back to the first illustration. In effect, we could consider the leverage attributes
of calls and seek investment outlets that reduce our required investment but capture all or
most of the capital gains potential. Of the two calls, the $50 option is in the money, and the
$60 option is out of the money; we actually have the most (profit) to gain and the least to
lose with the in-the-money option, so it should be preferred over the $60 call. Note that if
the price of the stock does not move by the expiration date, the value of the $50 call at
expiration is $750 = ($57.50  $50.00)  100, and the most we will lose is $800  $750 
$50 versus a total loss of $500 with the out-of-the-money option.
Unless current income and preservation of capital are key investment objectives, which
can be obtained only through the stocks, it looks like Hector should select the $50 calls and
the warrants based on his risk-return preferences.
Case 14.2 Luke’s Quandary: To Hedge or Not to Hedge

This case illustrates a basic option strategy, hedging. Students review the hedging process and
then analyze the costs and benefits of a specific hedging situation.
a. Luke has an unrealized capital gain of 300  ($75  $40)  $10,500, and he naturally wants
to protect the gain. One way to do this is to sell the stock and realize the actual gain. To do
so in these circumstances would mean Luke would have to pay taxes in the current year. He
would benefit, for tax purposes, by delaying the sale for two or three months. By purchasing
three puts with a three-month expiration date, he can lock in his profit and carry it into the
next year, thereby deferring his taxes for a year. This will also allow him to realize any
additional capital gains should the stock continue to appreciate. There are drawbacks to
purchasing a put, of course. First, these puts cost money: $1,650 (i.e., 3  $550  $1,650);
and second, the commissions on puts and calls are relatively high.
b. If Luke purchases the three puts, the minimum before-tax profit he can realize is:
Current market value of the stock  $75  300 $22,500
Less: Purchase price of the stock  $40  300 12,000
Capital gain $10,500
Less: Price of three put options  $550  3* 1,650
Minimum profit $ 8,850
*Note: Because the put is an out-of-the-money option, its purchase price is made up
exclusively of investment premium and as such is a sunk cost.

If the stock were sold immediately without hedging, Luke’s profit before taxes would be
($75  $40)  300  $10,500. Note that the taxes on the latter ($10,500) would be due this
year, and the taxes on the former ($8,850) would be due next year.
c. If Luke purchases three options and the stock price goes to $100, the market value of
his investments at the expiration date of the option would be:
Value of stock  300  $100 $30,000
Less: purchase price of stock  300  $40
12,000
Capital gains $18,000
Less: cost of puts  3  $550* 1,650
Net profit $16,350
*Note: The puts will be worthless upon expiration; Luke will lose the cost of the puts.
If the stock falls to $50, Luke will lose money on the stocks (from their current price of $75)
but make money on the puts:
Stock:
Value of stock  300  $50 $15,000
Less: purchase price  300  $40 12,000
Profit of stock $ 3,000
Puts:
Value of put  ($75  $50)  300 $ 7,500
Cost of the puts  3  $550 1,650
Profit on put 5,850
Total profit $ 8,850
*Note: The instructor might want to emphasize that this is the same total profit we came up
with in part 2 (above). It is the minimum profit the investor will make regardless of how far
the price of the stock falls. Interestingly, while Luke’s stock gain of $3,000 will now be
eligible for the preferential tax treatment of long-term capital gains, the remainder of his
profit, $5,850 from the puts, will be subject to the short-term capital gains tax rate.
d. Because Luke is uncertain about the market, he should seriously consider the use of puts to
hedge the profit he has already made on his investment. If he is wrong and the stock price
continues to go up, there is really no limit to the amount of profit he can make. On the other
hand, if the stock price falls, he is still assured of a minimum profit. Of course, if Luke feels
very strongly that the price of his stock is going to go up (i.e., there’s virtually no chance of
a drop in price), then he should not waste his money on a put hedge. If he expects the stock
price to fall by only a very small amount, we might urge Luke not to use the put for hedging
(the cost of the put might be more than the potential losses from a small decline in stock
prices). Another circumstance that would have made the use of puts unfavorable would have
been if the puts were selling in-the-money, with strike price well above the current market
price. If the premium had been quite high, the costs of eliminating risk could have been too
expensive.

 Answer to Chapter-Opening Problem

Value of Jan. Stock August stock
Contract (100 stock value value 100 Strike Price x Profit on Profit (loss
shares 100 shares shares 100 stock on position)
a. Buy a call contract $21,500 $118,900 $191,100 $120,000 $71,100 $49,600
b. Sell a call contract $21,500 $118,900 $191,100 $120,000 ($71,100) ($49,600)
Buy a put contract $19,500 $118,900 $191,100 $120,000 not exercised ($19,500)
Sell a put contract $19,500 $118,900 $191,100 $120,000 not exercised $19,500

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 Answers to Concepts in Review

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3. The main attractions of puts and calls are the following:

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level gives the investor a profit.

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 Suggested Answers to Discussion Questions

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Call + PV(strike) = Put + Stock

In this problem from Figure 14.1 we have

So plug all of these into the equation.

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$5.80 + 220 = $14.20 + Stock price

*Options D and E have negative intrinsic values at expiration, so they

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a. Stock price drops to $62 three months later

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14.14 a. (i) Market value of Fitzgerald’s portfolio $825,000

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Fitzgerald’s total gain/loss ($53,940)

Current value of Fitzgerald’s portfolio $825,000

Fitzgerald’s portfolio value after the 15% drop 701,250

Fitzgerald’s loss in the portfolio 3123,750

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14.15 Covered call writing:

Holding period return (for three months):

Cost long straddle $97,500.00

If the market falls by 750 points

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If the market goes up 750 points

If the market stays at 25500 points

b. SHORT STRADDLE (you are the writer)

Profit short straddle $97,500.00