FINA3303: INVESTMENTS
1
Bodie, Kane, and Marcus, 12th Edition
Chapter 20: Options Markets - Introduction
Options
➢ Options:
➢ Derivatives derive their value from the price (ST ) of other securities and
are traded both on organized exchanges and over the counter.
➢ They are powerful tools for hedging and/or speculation.
➢ Key variables
➢ Premium: The purchase price of the call option (C) or put option (P) .
➢ Exercise (aka. Strike) price: An agreed upon price (X) per share at which
the option holder is entitled to buy or sell the security.
➢ Expiration date: The time at which the option expires (T).
➢ Option contract: One option contract involves 100 shares of stock at one
option for one share.
Option Contracts
➢ Call option buyer: Has the right to buy an asset at X on or before T.
➢ In-the-money if ST > X (Exercise): Payoff = Max(ST - X, 0) = ST - X.
➢ Out-of-the money if ST < X (Do not exercise): Payoff= Max(ST - X, 0) = 0.
➢ At-the-money if ST = X (Indifference): Payoff = Max(ST - X, 0) = 0.
➢ Profit = Payoff - Premium
➢ Put option buyer: Has the right to sell an asset at X on or before T.
➢ In-the-money if ST < X (Exercise): Payoff = Max(X - ST , 0) = X - ST .
➢ Out-of-the money if ST > X (Do not exercise): Payoff= Max(X - ST , 0) = 0.
➢ At-the-money if ST = X (Indifference): Payoff = Max(X - ST , 0) = 0.
➢ Profit = Payoff - Premium
➢ Option seller: Must sell (buy) the asset if call (put) options are exercised.
➢ Payoff = - (Option buyer’s payoff)
➢ Profit = Payoff + Premium
Call Option - Examples
➢ Example 1: An at-the-money three-month 150 call on IBM sells at $4.10
➢ If IBM remains below $150, the call will expire worthless. Profit = -$4.10
➢ Suppose IBM sells for $152 on the expiration date (Option will be exercised to
offset loss of premium)
➢ Option value = ST - X = $152 - $150 = $2.00
➢ Profit = (ST – X) – C = $2.00 - $4.10 = -$2.10
➢ Holding Period Return = -$2.10 / $4.10 = -0.5122 or -51.22%
➢ Example 2: An at-the-money three-month 120 call contract on IBM sells at $3 .
➢ If IBM remains below $120, the call will expire worthless. Profit = -$300
➢ If IBM sells for $125 on the expiration date
➢ Total premium = $3 x 100 options = $300
➢ Total option value = ($125 – $120) x 100 shares = $500.
➢ Profit = $500 - $300 = $200
➢ Holding period return = $200 / $300 = 0.6667 or 66.67%
Put Option - Example
➢ Example 1: An at-the-money three-month 150 put on IBM sells at $5.91
➢ If IBM remains above $150, the put will expire worthless. Profit = -$5.91
➢ Suppose IBM sells for $141 on the expiration date
➢ Option value = X - ST = $150 - $141= $9.00
➢ Profit = (X - ST) – P = $9.00 - $5.91= $3.09
➢ Holding Period Return = $3.09 / $5.91 = 0.5228 or 52.28%
➢ Example 2: An at-the-money three-month 120 put contract on IBM sells at $5 .
➢ If IBM remains above $120, the put will expire worthless. Profit = - $500
➢ If IBM sells for $113.75 on the expiration date
➢ Total premium = $5 x 100 options = $500
➢ Total option value = ($120 – $113.75) x 100 shares = $625.
➢ Profit = $625 - $500 = $125
➢ Holding period return = $125 / $500 = 0.25 or 25%
Option Strategies
Payoff
➢ Protective Puts (Stock+Put)
➢ Puts used as insurance
against stock price declines.
➢ They lock in a minimum
portfolio value.
➢ Their cost is the put
premium.
➢ Options can be used for risk
management, not just for
speculation.
➢ Total cost = S0 + P
Profit = Payoff – (S0 + P)
Option Strategies
Payoff
➢ Call + Bond Portfolio
➢ Buy a call option + Bills with
face value equal to the strike
price of the call.
➢ Both Call and Bills have the
same maturity.
➢ Cost of bills = X/(1+rf)T
➢ Total cost = C+ X/(1+rf )T
Profit = Payoff – [C+ X/(1+rf )T ]
Option Strategies
Payoff
➢ Covered Calls
➢ Purchase stock and write calls
against it.
➢ Net cost = S0 - C
➢ Call writer receives C but gives
up any stock value above X.
Profit = Payoff – (S0 - C)
Option Strategies
Payoff
➢ Straddle
➢ Buy call + put w/same X and T.
➢ Total cost = C + P.
➢ It is a bet on volatility.
➢ Profit > 0 if absolute ∆ST > C+P.
➢ The writer bets that ∆ST will be
insignificant.
Profit = Payoff – (C + P)
Option Strategies
Payoff
➢ Spreads
➢ Buy 1 call at C1 and sell 1
call at C2 on same stock with
➢ X1 ≠ X2 (Money spread)
or
➢ T1 ≠ T2 (Time spread)
➢ Net cost = C1 - C2
Profit = Payoff – (C1 – C2)
Put-Call Parity
➢ Two portfolios providing equal values must cost the same amount to
establish.
➢ Therefore, the call + bond portfolio must cost the same as the stock + put
portfolio:
X
C+ = S0 + P 𝑃 = 𝐶 − 𝑆0 +
𝑋
(1 + rf ) T (1+𝑟𝑓 )𝑇
➢ If a dividend is paid during the option life:
P = C − S + PV ( X ) + PV ( D)