Investment Analysis and

Portfolio Management
Lecture 8
Options
Call Expire at close Fri, Put Expire at close Fri,
Dec 15, 2006 Dec 15, 2006
Strike Symbol Last Strike Symbol Last
15 GMLC.X 20.5 10 GMXB.X 0.05
17.5 GMLT.X 18.1 12.5 GMXS.X 0.05
20 GMLD.X 11.6 15 GMXC.X 0.05
22.5 GMLX.X 8.7 17.5 GMXT.X 0.08
25 GMLE.X 6.5 20 GMXD.X 0.05
27.5 GMLY.X 4 22.5 GMXX.X 0.05
30 GMLF.X 1.9 25 GMXE.X 0.15
32.5 GMLZ.X 0.55 27.5 GMXY.X 0.25
35 GMLG.X 0.14 30 GMXF.X 0.65
37.5 GMLU.X 0.05 32.5 GMXZ.X 1.75
40 GMLH.X 0.05 35 GMXG.X 3.9
42.5 GMLV.X 0.04 37.5 GMXU.X 6.3
45 GMLI.X 0.05 40 GMXH.X 8.6
42.5 GMXV.X 11.2
Options
 An option is a contract that:
 Either
 Gives the right to buy an asset at a specific price
within a specific time period but no obligation to buy
 This is a call option
 Or
 The right to sell an asset at a specific price within a
specific time period but no obligation to sell
 This is a put option
Call Options

 A call option is the right to buy

 The contract specifies
 1. The company whose shares are to be
bought
 2. The number of shares that can be bought

 3. The purchase (or exercise or strike) price

 4. The date when the right to buy expires

(the expiration date)
Call Options
 European call: can only be exercised at the
expiration date
 American call: can be exercised at any date up
to the expiration date
 The premium is the price paid to buy the
contract
 Exercise of the option does not imply that the
asset is actually traded
 Because of transactions costs it is better for
both parties to just transfer cash equal in value
to what would happen if the asset were traded
Call Options
 A call option is purchased in expectation that it
may be exercised
 Exercise depends on the exercise price and the
price of the asset
 Will not exercise if the asset price is below the
exercise price
 A European call is exercised if asset price is
above exercise price at expiration date
 Purchase for less than its trading price
 With an American call when to exercise is a
choice
Call Options
 Example
 On July 11 2003 Walt Disney Co. stock were
trading at $20.56
 Call options with a strike or exercise price of $22.50
traded with a premium of $0.05
 These call options will only be exercised if the price
of Walt Disney Co. stock rises above $22.50
 This raises questions about the determination of the
price
 And how the premium is affected by changes in the
exercise price and stock price
Call Options
 Example A sells B the right to “buy 100 shares
for £50 per share at any time in the next six
months”
 If current price is £45 B must expect a price rise
 If price rises above £50 B will exercise the
option and obtain assets with a value in excess
of £50
 If the price rises to £60 B purchases assets worth
£6000 for £5000
 If price falls below £50 B will not exercise the
option
Call Options
 The return to A is the premium paid by B for the option
 If this is £3 per share B pays A £300 for the contract
 Final price £60
Profit of B is £6000 - £5000 - £300 = £700
Profit of A is £300 - £1000 = - £700
 Final price £40
Profit of B is - £300
Profit of A is £300
 The loss of A (or profit for B) is potentially unlimited
 The loss of B (profit for A) is limited to the premium
Call Options
 A profit is made on a call option if the
underlying stock prices rises sufficiently above
the exercise price to offset the premium
 Example
 Call options on Boeing stock with a strike price
of $30.00 were trading at $5.20 on June 23,
2003
 If a contract for 100 stock were purchased this
would cost $520
 In order to make a profit form this, the price on the
exercise date must be above $35.20
Call Options
 Call options with lower exercise prices are
always preferable and trade at a higher price
 A lower exercise price raises the possibility of
earning a profit
 Profit is greater for any price of the underlying
 Example
 On June 23, 2003 IBM stock were trading at
$83.18
 Call options with expiry after the 18 July and a strike
price of $80 traded at $4.70
 Options with a strike price of $85 traded at $1.75
Put Options
 A put option is the right to sell
 The contract specifies
 1. The company whose shares are to be sold
 2. The number of shares that can be sold
 3. The selling (or strike) price
 4. The date when the right to sell expires (expiration
date)
 European put: can only be exercised at the
expiration date
 American put: can be exercised at any date up
to the expiration date
Put Options
 An American put must be at least as valuable
as the European given the flexibility in exercise
 Example
 On July 11 2003 Walt Disney Co. stock were
trading at $20.56
 Put options with an exercise price of $17.50 traded
with a premium of $0.10
 These will only be exercised if the price of Walt
Disney Co. stock falls below $17.50
Put Options
 A put option is profitable if the price of the
underlying asset falls far enough
 It must fall enough to cover the premium
 Example
 Put options on Intel stock with a strike price of
$25.00 were trading at $4.80 on June 23, 2003
 A contract for 100 stock would cost $480
 To make a profit from this option the price of the
underlying asset must be below $20.20
Put Options
 Example
 A sells B the right to sell 300 shares for £30
per share at any time in the next six months
 A must believe that the price will not fall below £30
 B believes it will
 If the price falls below £30, B will exercise the
option and obtain a payment in excess of the
value of the assets
Put Options
 If the price goes to £20 B will receive £9000 for
assets worth £6000
 If price stays above £30 B will not exercise the
option
 The return to A is the premium paid by B for
the option
 If this is £2 per share B pays A £600 for the contract
Put Options
 Final price £20
Profit of B is £9000 - £6000 - £600 = £2400
Profit of A is £6000 + £600 - £9000 = - £2400
 Final price £40
Profit of B is - £600
Profit of A is £600
 The loss to A (or profit to B) is limited to the
exercise price
 The loss of B (profit to A) is limited to the
premium
Put Options
 The higher is the strike price the more
desirable is a put option
 This is because a greater profit will be made
upon exercise
 Example
 On June 23, 2003 General Dynamics stock
were trading at $73.83
 Put options with expiry after the 18 July and a strike
price of $70 traded at $1.05
 Those with a strike price of $75 traded at $2.95
Trading Options
 Options are traded on a range of exchanges
 Chicago Board Options Exchange, the Philadelphia
Stock Exchange, the American Stock Exchange
and the Pacific Stock Exchange
 Eurex in Germany and Switzerland and the London
International Financial Futures and Options
Exchange
 Options contracts are for a fixed number of
stock
 An options contract in the US is for 100 stock
Trading Options
 Exercise prices are set at discrete intervals
 $2.50 interval for stock with low prices
 Up to $10 for stock with high prices
 On introduction of an option two contracts are
written
 One with an exercise prices above the stock price
 One with an exercise price below the stock price
 If the stock price goes outside this range new
contracts can be introduced
 As each contract reaches its date of expiry new
contracts are introduced for trade
Trading Options
 Quotes of trading prices for options contracts
can be found in The Wall Street Journal and
the Financial Times
 Quote the call and put contracts with exercise
prices just above and just below the closing stock
price of the previous day
 Price quoted is for a single share
 More detailed information can also be found
on Yahoo
 Lists the prices for a range of exercise values, the
volume of trade, the number of open contracts
Trading Options
 Market makers can be found on each
exchange to ensure that there is a market for
the options
 The risk inherent in trading options requires
that margin payments must be must in order to
trade
Valuation of Options

 The value of an option is related to the

value of the underlying security
 At expiration
Consider a call option, exercise price £100
 Asset price below £100: option worthless

 Asset price above £100: can profit from

owning option, so valuable
Valuation of Options
 The value (which is
equal to the "fair" Vc
price) at expiration is
given by
Vc = max{S – E, 0}
 Vc is the value of the
call option, S the
price of the
underlying asset and E S
E the exercise price
Valuation of Options
 Example On June 26 2003 GlaxoSmithKline stock
was trading at $41
 The exercise prices for the option contracts directly
above and below this price were $40 and $42.50
 The table displays the value at expiry for these
contracts for a selection of prices of
GlaxoSmithKline stock at the expiration date
S 37.50 40 41 42.50 45 47.50
max{S-40,0} 0 0 1 2.50 5 7.50
max{S-42.50,0} 0 0 0 0 2.50 5
Valuation of Options
 The profit, c, from c
holding the option is
c = Vc – V0
= max{S – E, 0}- V0
= max{S – E - V0, -V0}
 V0 is the price (premium)
paid for the call option
V0c E S
Valuation of Options

 Consider a put option, exercise price

£100
 This is worthless if the price of the asset is
greater than £100
 It is valuable if the price of the asset is less
than £100
Valuation of Options
 The value or fair Vp
price at expiration is
given E
Vp = max{E – S, 0}
 The value is
whichever is larger
of 0 and E – S
E S
Valuation of Options
 Shares in Fox Entertainment
IV Group Inc.
p

traded at $29.72 on 7 July 2003

 The expiry value of put options with exercise
prices of $27.50 and $30.00 are given in the
table for a range of prices
S 20 22.50 25 27.50 30 32.50
max{27.50-S,0} 7.50 5 2.50 0 0 0

max{30-S,0} 10 7.50 5 2.50 0 0

Valuation of Options

 The profit from p

purchasing it is
p = Vp - V0p
E V
0
p

= max{E - S, 0}- V0p

= max{E – S - V0p, -V0p}
 V0p is the purchase price
V0p
of the put option E S
Combining Puts and Calls
 Combinations of puts
and calls engineer P
different structures of
payoffs
 The straddle involves
buying a put and a call
on the same stock
 If these have the same E
exercise price, the profit
V0p  V0c S
is
 = max{E - S, 0}
+ max{S - E, 0} - V0p - V0c