Options are binding contracts that involve risk, and are time bound You buy an option when you want to protect a “position” (long or short on a stock)

Options are binding contracts that involve risk, and are time bound

You buy an option when you want to protect a “position” (long or short on a stock)

An option gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date (expiration)

I want to buy a Wii but I think the price of the Wii will go up in the coming months

Nintendo sells me an “option” to buy the Wii at $100 before December 30, 2016

I pay Nintendo $25 for this option What happens if the price of the Wii goes

to $175? I saved $50, or I can sell the Wii and

pocket the $50

What does Nintendo get? $25 from my option, $100 from the sale

of the Wii – they lose $50 What if the price fell to $75? I would have paid $100 for the Wii (a loss

of $25) Nintendo would have received $100 (a

gain of $25) Options are NEVER zero sum – someone

always loses

I could also decide not to buy the Wii at all

My only risk would have been what I paid for the option ($25)

Call• Gives the holder the right to buy an asset at a

certain price within a specific period of time• Calls are similar to having a long position on a

stock• Buyers of calls hope that the stock will

increase substantially before the option expires

• Sellers of calls hope that the stock price will decrease so that the call is “out of the money” and expires unclaimed

Put•Gives the holder the right to sell an asset

at a certain price within a specific period of time

•Like having a short position on a stock•Buyers of puts hope that the price of the

stock will fall before the option expires •Sellers of puts hope the price goes up so

that the option expires unclaimed or “out of the money”

Seller of Put – Writer Buyer of Put – Holder Seller of Call – Writer Buyer of Call – Holder Holders have a choice whether to

exercise their options Writers are obligated to make good on

the contract Therefore, who assumes the most risk?

Options on stock are sold in 100 share lots, so you must multiply the option price by 100

Example: an option is $2.00 Your total cost is $200.00 for 100

shares Most option holders sell their options on

the secondary market before expiration (about 90%)

Only 10% hold until expiration

Outlay is minimal• If you had to buy 100 of the the underlying

shares of a stock for $50, you would be spending $5,000 out of pocket

• With an option, you don’t have to own the underlying stock

• You buy an option @$2.00 per share (for 100 shares), cost you a total of $200

• But because options are so volatile, you have a better chance of losing your $200 than your $5,000

BUY SHARES LONG UNCOVERED CALL OPTION Buy 100 shares @ $50 =

$5,000

Price of stock goes up to $62

Now worth $6,200

Sell and make $1,200

Rate of return = 24%

($6,200 - $5,000)/$5000

Purchase Option @$2 = $200

Price of stock goes up to $62

Option now worth $5 = $500

Sell and make $300

Rate of return = 150%

($500-$200)/$200

Strike Price – the price at which the underlying asset can be purchased/sold

Exercise – when you fulfill the contract by buying or selling the underlying asset according to the option terms

Expiration Date – last day you can exercise the option

Premium – cost of the option, which can change during the life of the contract

Intrinsic Value•For call options, the option is said to be

in-the-money if the share price is above the strike price

•A put option is in-the-money when the share price is below the strike price

•The amount by which an option is in-the-money is referred to as intrinsic value

Time Value•Dollar value assigned to the potential

that the option has to continue to make gains before expiration

Share Market Price $ 10 - Exercise Price ($ 5)

Intrinsic Value $ 5

Premium $ 7 - Intrinsic Value ($ 5)

Time Value $ 2

In-the-Money• The underlying stock is above the strike

price At-the-Money

• The underlying stock is at the strike price Out-of-the-Money

• The underlying stock is below the strike price

In-the-Money• The underlying stock is below the strike

price At-the-Money

• The underlying stock is at the strike price Out-of-the-Money

• The underlying stock is above the strike price

Merck has a ticker symbol of MRK It’s option ticker can have several

different versions The symbol depends on

• Type of option (call or put)• Strike price • Month of expiration

The strike price is always the one closest to the current stock price

You think the price might go up or down dramatically

You want to make money without a big cash outlay

You want to protect a current position against a big loss

You want to make some money back after a previous loss