Derivative Securities (Options): Puts & Calls Lockheed Martin (LMT) Transactions TransactionCost BasisSale PriceGain (Loss) Short 1,000 LMT @ 51.99 -$54,225+$51,965-$2,260.

Derivative Securities (Options): Puts & Calls

Lockheed Martin (LMT) Transactions

Transaction Cost Basis Sale Price Gain (Loss)

Short 1,000 LMT @ 51.99

-$54,225 +$51,965 -$2,260

Net Gain or (Loss)

-$2,260

Lockheed Martin (LMT) Transactions

Transaction Cost Basis Sale Price Gain (Loss)

Short 1,000 LMT @ 51.99

-$54,225 +$51,965 -$2,260

Buy 10 LMT-Mar-55 Calls

-$925 +$3,175 +$2,250

Net Gain or (Loss)

+$1,165

Lockheed Martin (LMT) Transactions

Transaction Cost Basis Sale Price Gain (Loss)

Short 1,000 LMT @ 51.99

-$54,225 +$51,965 -$2,260

Buy 10 LMT-Mar-55 Calls

-$925 +$3,175 +$2,250

Sell 10 LMT-Jun-45 Puts

-$425 +$1,225 +$800

Net Gain or (Loss)

+$1,165

Lockheed Martin (LMT) Transactions

Transaction Cost Basis Sale Price Gain (Loss)

Short 1,000 LMT @ 51.99

-$54,225 +$51,965 -$2,260

Buy 10 LMT-Mar-55 Calls

-$925 +$3,175 +$2,250

Sell 10 LMT-Jun-45 Puts

-$425 +$1,225 +$800

Sell 10 LMT-Jun-50 Puts

-$800 +$1,175 +$375

Net Gain or (Loss)

+$1,165

Types of Options

• Rights

• Warrants

• Convertibles

• Puts

• Calls

A Growing Market – puts and calls can be traded on:

• Common Stock

• Stock Indexes

• Debt Instruments

• Foreign currencies

• Commodities

• Financial futures

Why so much interest in options?

• “…investors can buy a lot of price action with a limited amount of capital, while nearly always enjoying limited exposure to risk.”

Why Options?

• A basic question asked by investors is: “Why buy stock options instead of shares in the underlying stock?”

• To answer this question, we compare the possible outcomes from these two investment strategies:– Buy the underlying stock– Buy options on the underlying stock

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.

• Investment for 100 shares:– IBM Shares: $9,000– One listed call option contract: $500

• Suppose further that the option expires in three months.

• Finally, let’s say that in three months, the price of IBM shares will either be: $100, $80, or $90.

Example: Buying the Underlying Stock versus Buying a Call Option, Cont.

• Let’s calculate the dollar and percentage return given each of the prices for IBM stock:

Buy 100 IBM Shares ($9000 Investment):

Buy One Call Option ($500 Investment):

Dollar Profit:

Percentage Return:

Dollar Profit:

Percentage Return:

Case 1: $100 $1,000 11.11% $500 100%

Case 2: $80 -$1,000 -11.11% -$500 -100%

Case 3: $90 $0 0% -$500 -100%

Bob LeClair's Finance and Markets NewsletterChange Change

1/1/13 4/13/13 4/20/13 (Week) (Yr-to-Date)Dow Jones Ind. Avg. 13,104 14,865 14,548 (318) 1,443

(% Change) -2.14% 11.01%S & P 500 Index 1,426 1,589 1,555 (34) 129

(% Change) -2.11% 9.05%NASDAQ Composite 3,020 3,295 3,206 (89) 187

(% Change) -2.70% 6.18%

S & P 500 P/E Ratio 16.8 18.3 17.9 -0.3 1.1S & P 500 Div. Yield 2.25% 2.12% 2.10% -0.02% -0.15%T-bill - S&P 500 Yield -2.21% -2.06% -2.05% 0.01% 0.17%

30-Year T-Bond Yield 2.95% 2.92% 2.88% -0.04% -0.07%10-Year T-Bond Yield 1.76% 1.72% 1.70% -0.02% -0.06%91-Day T-Bill Yield 0.04% 0.07% 0.06% -0.01% 0.02%Yield Spread 2.91% 2.86% 2.83% -0.03% -0.08%

30-Year Mortgage 3.35% 3.43% 3.41% -0.02% 0.06%15-Year Mortgage 2.65% 2.65% 2.64% -0.01% -0.01%1-Year Adjustable Rate 2.56% 2.62% 2.63% 0.01% 0.07%30-Yr. - 1-Yr. ARM Rate 0.79% 0.81% 0.78% -0.03% -0.01%

$ Value of Euro (€) $1.3221 $1.3113 $1.3052 -$0.0061 -$0.0169Japanese Yen (¥/$) 86.74 98.37 99.52 1.15 12.78Crude Oil, Spot Price $91.82 $90.66 $88.00 -$2.66 -$3.82Gasoline, Reg. ($/Gal.) $3.30 $3.53 $3.51 -$0.03 $0.21

For the Week Ending:

Characteristics of OptionsCharacteristics of Options

• “Derivative” Securities - obtain their value from the underlying issue

• Contract to buy or sell other securities

Characteristics of Options

• No ownership interest in the underlying company (dividends; voting rights, etc.)

• Provide leverage through a fixed purchase price - exaggerates any gain or loss

Option Exchanges

• Chicago Board Options Exchange (CBOE)

• Established in 1973

• cboe.org - professional traders

• cboe.com - private investors

Option Exchange Features

• Central marketplace vs. O-T-C

• Secondary market

• Option Clearing Corporation (OCC)

The Options Clearing Corporation

• The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised.

• 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).

Visit the OCC at: www.optionsclearing.com.

Buyer-Seller Relationship(pre-CBOE)

BUYER SELLER

Buyer-Seller Relationship(Post-CBOE)

BUYERCBOE

[OCC]

CBOE

[OCC]SELLER

Option Exchange FeaturesOption Exchange Features

• Standardized Terms:

–contract size

–expiration dates

–exercise (striking) price

Basic Option Terms(listed equity options)

• Call Option:

• contract to buy stock

• 100 shares of stock

• exercise price set by exchange

• expires on fixed date – 3rd Friday of the expiration month

Basic Option TermsBasic Option Terms(listed equity options)(listed equity options)

• Put Option:

• contract to sell stock

• 100 shares of stock

• exercise price set by exchange

• expires on fixed date – 3rd Friday of the expiration month

Basic Option Terms

• Call - Call - contractcontract to: to:

• Buy 100 sharesBuy 100 shares

• Fixed priceFixed price

• Specified termSpecified term

• Put - Put - contractcontract to: to:

• Sell 100 sharesSell 100 shares

• Fixed priceFixed price

• Specified termSpecified term

Option Jargon

• “Striking Price” - price at which the contract is exercised or carried out

• Example:– XYZ-AUG-30; “30” is the striking price,

or exercise price of the option

Option Jargon

• “Expiration Date” - maturity date; the third Friday of the expiration month

• Example:– XYZ-AUG-30; option expires on the

third Friday of August

Option Jargon

• “Option Writer (Maker)” - seller of an option contract

Option Jargon

• “Covered Writer” - already owns shares of the underlying stock; can deliver shares if exercised

Option Jargon

• “Naked Writer” - does not own shares of the underlying stock; must buy shares if exercised

Option JargonOption Jargon[Call Options][Call Options]

“In the Money” - stock price greater than exercise price

Option JargonOption Jargon[Call Options][Call Options]

“Out of the Money” - stock price less than exercise price

Option JargonOption Jargon[Call Options][Call Options]

“At the Money” - stock price = exercise price

Option Pricing[Three Prices to Consider]

1. Underlying stock price per share

2. Exercise (striking) price of the option contract

3. Price (Premium) of the option contract

Call Option PricingCall Option Pricing

• Option premium reflects:

• Intrinsic value of the option,

• plus the option’s time value

• Premium = IV + TV

• Time Value = Premium - IV

Call Option Pricing[ABC-MAY-80]

• Intrinsic value (IV): IV = Stock price - exercise price IV = $81.75 - $80.00 = $1.75

Call Option Pricing[ABC-MAY-80]

• Time value (TV): TV = premium - intrinsic value TV = $3.75 - $1.75 = $2.00

Listed Option Quoteson the Web

Put Option Pricing[ABC-JUL-80]

• Intrinsic value (IV): IV = Exercise price - stock price IV = $80.00 - $79.00 = $1.00

Put Option PricingPut Option Pricing[ABC-JUL-80][ABC-JUL-80]

• Time value (TV): TV = premium - intrinsic value TV = $3.00 – 1.00 = $2.00

Option Strategies

Buy

Sell

Call

?

?

Put

?

?

Option Strategies

Buy

Sell

Call

Capital Gain Limited Risk Leverage

Put

Option Strategies

Buy

Sell

Call

Capital Gain Limited Risk Leverage

Income; Downside Protection

Put

Option Strategies

Buy

Sell

Call

Capital Gain Limited Risk Leverage

Income; Downside Protection

Put Downside Protection

Option Strategies

Buy

Sell

Call

Capital Gain Limited Risk Leverage

Income; Downside Protection

Put Downside Protection

Income; Bargain Purchase

FIGURE 11.2

The Valuation Properties of Put and Call Options

FIGURE 11.2

The Valuation Properties of Put and Call Options

Option Trading Strategies

• Buying options for speculation

• Hedging with puts and calls

• Option writing and spreading

Buying Options for Speculation

• Same motivation as buying stock

• “Buy low, sell high”

• Smaller investment - greater leverage

• Limited loss

Hedging with Puts and Calls

• Combination of two or more Combination of two or more securitiessecurities

• Objectives::– To earn or protect a profitTo earn or protect a profit

– Limit lossesLimit losses

Hedging with Puts and Calls

• ExamplesExamples::

–buy stock; sell a putbuy stock; sell a put

–sell short; buy a callsell short; buy a call• Lockheed Martin transactions

Lockheed Martin (LMT) Transactions

Transaction Cost Basis Sale Price Gain (Loss)

Short 1,000 LMT @ 51.99

-$54,225 +$51,965 -$2,260

Buy 10 LMT-Mar-55 Calls

-$925 +$3,175 +$2,250

Sell 10 LMT-Jun-45 Puts

-$425 +$1,225 +$800

Sell 10 LMT-Jun-50 Puts

-$800 +$1,175 +$375

Net Gain or (Loss)

+$1,165

Call Option Spread StrategiesCall Option Spread Strategies

• Spread: buying and selling different options at the same time

Call Option Spread Strategies

• Money, or vertical spreads

• Time, or calendar spreads

• “Butterfly” spreads

Call Option Spread Strategies

• “Money” or “vertical” spread: same month, different exercise prices

Call Option Spread Strategies

• Example:– buy Compq-May-40

– sell Compq-May-45

– objective: price between $40 - $45

Call Option Spread Strategies

• “Time” or “calendar” spread: different expiration dates

Call Option Spread Strategies

• Example:

–buy Compq-Jun-40

–sell Compq-May-40

–objective: timed appreciation

Call Option Spread Strategies

• ““Butterfly” spread: buy and sell Butterfly” spread: buy and sell different options at same timedifferent options at same time

• Example:Example:– buy 1 XYZ-Jul-80 ($7.375)buy 1 XYZ-Jul-80 ($7.375)

– sell 2 XYZ-Jul-90 ($6.500)sell 2 XYZ-Jul-90 ($6.500)

– buy 1 XYZ-Jul-100 ($1.250)buy 1 XYZ-Jul-100 ($1.250)

Index Options

• Put or call written on a market index

–S & P 500

–S & P 100

–DJIA

Index Options

• Settled in cash

• 100 times index value

• Example (S & P 500):– 1,418 (Value) – 1,400 (Strike) = 18

– 18 x 100 = $1,800

Stock Index Options

• Because the actual delivery of all stocks comprising a stock index is impractical, stock index options have a cash settlement procedure.– if the option expires in the money,

the option writer simply pays the option holder the intrinsic value of the option.

“LEAPS” Options

• Long-term Equity AnticiPation Securities

• Maturities up to 3 years• Similar to options in other

respects:– 100 shares– buy or sell at a specified price– stated maturity date

Black-Scholes Option Pricing ModelBlack-Scholes Option Pricing Model

• Stock PriceStock Price

• Exercise PriceExercise Price

• Time RemainingTime Remaining

• Risk-free rateRisk-free rate

• Variability of Variability of stock (stock ())

Black-Scholes Option Pricing Model

c S t N d Xe N dtr T t ( ) ( ) ( )( )

1 2