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Options Writing
Options Writing
15 Stock Options
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
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Stock Options
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Option Basics
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Option Basics, Cont.
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Listed Option Quotations
www.wsj.com
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Option Price Quotes
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Stock Option Ticker Symbol and Strike Price Codes
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Listed Option Quotes
at Yahoo! Finance
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The Options Clearing Corporation
• The OCC issues and clears all option contracts trading on U.S.
exchanges.
• Note that the exchanges and the OCC are all subject to regulation by
the Securities and Exchange Commission (SEC).
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Why Options?
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Example: Buying the Underlying Stock
versus Buying a Call Option
• Suppose IBM is selling for $90 per share and call options with a
strike price of $90 are $5 per share.
• Finally, let’s say that in three months, the price of IBM shares will
either be: $100, $80, or $90.
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Example: Buying the Underlying Stock
versus Buying a Call Option, Cont.
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Why Options? Conclusion
– 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.
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Stock Index Options
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Index Option Trading, Part One
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Index Option Trading, Part Two
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Option “Moneyness”
• 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
Note for a given strike price, only the call or only the put can be “in-the-money.”
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Option Writing
• Because option writing obligates the option writer, the option writer
receives the price of the option today from the option buyer.
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Option Exercise
• 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.
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Option Payoffs versus Option Profits
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Call Option Payoffs
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Put Option Payoffs
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Call Option Profits
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Put Option Profits
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Using Options to Manage Risk, I.
• Protective put - Strategy of buying put options to protect against falling
values.
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Using Options to Manage Risk, II.
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The Three Types of Option Trading Strategies
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Option Intrinsic Values
• That is, if S is the current stock price, and K is the strike price of the
option:
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More Option “Moneyness”
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Arbitrage and Option Pricing Bounds
• Arbitrage:
– No possibility of a loss
– A potential for a gain
– No cash outlay
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The Upper Bound for a Call Option Price
• How?
– 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.
– Zero cash outlay today, no possibility of loss, and potential for gain.
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The Upper Bound for
European Put Option Prices, I.
• European put option price must be less than the strike price.
• Suppose a put option with a strike price of $50 is selling for $50.
• The Arbitrage: Sell the put, and invest the $50 in the bank. (Note
you have zero cash outlay).
• So, we see that if the put option price equals the strike price, there is
an arbitrage.
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The Upper Bound for
European Put Option Prices, II.
• There will be an arbitrage if price of the put, plus the interest you could earn
over the life of the option, is greater than the stock price.
– For example, suppose the risk-free rate is 3 percent per quarter.
– We have a put option with an exercise price of $50 and 90 days to maturity.
• What is the maximum put value that does not result in an arbitrage?
• Notice that the answer, $48.54, is the present value of the strike price
computed at the risk-free rate.
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The Lower Bound on Option Prices
• American Calls. Can an American call sell for less than its intrinsic value?
No.
– Suppose S = $60, and a call option has a strike price of K = $50 and a price of $5.
– The $5 call price is less than the intrinsic value of S - K = $10.
• Therefore, an American call option price is never less than its intrinsic value.
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The Lower Bound on American Puts
• Can an American put sell for less than its intrinsic value? No.
– Suppose S = $40, and a put option has a strike price of K = $50 and a
price of $5.
– The $5 put price is less than the intrinsic value of K - S = $10.
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The Lower Bounds for European Options
• European Puts. The lower bound for a European put option price is less
than its intrinsic value.
– In fact, in-the-money European puts will frequently sell for less than their intrinsic
value. How much less?
– Using an arbitrage strategy that accounts for the fact that European put options
cannot be exercised before expiration:
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Put-Call Parity
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The Put-Call Parity Formula
T
C P S K/(1 r)
• In the formula:
– 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
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Put-Call Parity Notes
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Useful Websites
• For information on options ticker symbols, see:
– www.schaeffersresearch.com
– www.optionsxpress.com
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Chapter Review, I.
• Options on Common Stocks
– Option Basics
– Option Price Quotes
• Why Options?
• Option “Moneyness”
15-43
Chapter Review, II.
• Put-Call Parity
15-44