Financial derivative securities: derive all or part of their value from another
Why trade these indirect claims?
Expand investment opportunities
Derivative – derives their value from something else
Can trade in the options market, can trade in the futures market
You don’t buy a stock; buy an option to buy a stock.
Can reduce loss
Provides leverage – get a magnified result
Options are created by investors, sold to other investors
Call: Buyer has the right, but not the obligation, to purchase a fixed quantity from
the seller at a fixed price up to a certain date
Put: Buyer has the right, but not the obligation, to sell a fixed quantity to the seller at
a fixed price up to a certain date
Options can be written on about everything
Focusing on stock: transactions happening between investors. Companies not involved.
Employee stock options – can’t sell them to anyone else
2 main types are call and put:
-Call – gives you the right but not the obligation (why it’s an option) to buy a share
-Put – gives you the right but not the obligation to sell a share
It is the buyer of the option to exercise them.
The seller/writer – in short position
The holder- in the long position. Decide what to do.
Exercise (Strike) price: the per-share price at which the common stock may be
purchased or sold
Expiration date: last date at which an option can be exercised
Option premium: the price paid by the option buyer to the writer of the option,
whether put or call
The contract will have:
An exercise price – “this is what you can buy/sell the stock with”
Exercise date: American option says that we can exercise this option anytime up to the
expiration date. A European option says you can only exercise the option on a certain date. A
Bermudan option gives you a series of dates you can exercise option on.
Option premium HOW OPTIONS WORK
Call buyer expects the price of the underlying security to increase
Call seller expects the price of the underlying security to decrease or stay the same
Put buyer expects the price of the underlying security to decrease
Put seller expects the price of the underlying security to increase or stay the same
Possible courses of action
o Options may expire worthless, be exercised, or be sold prior to expiry
If feeling bullish – feel price/market will go up so will either buy a call or sell a put
If feeling bearish – take opposite action
EXAMPLE – CALL OPTIONS
Writer sells a call option for $1.00 to you to purchase 1000 shares at $10.00
You must expect shares to increase, writer expects shares to decrease
If shares increase to $15.00 you will exercise option – buy shares at $10.00 and sell
for $ 15.00 (you earned $4.00 profit on option contract)
If shares decrease to below $10.00 you will not exercise – seller gets the $1.00
Buyer – risk is limited but the profit is unlimited.
Writer – profit is limited, risk is unlimited
Naked calls provide a lot of risk to the seller/writer
Covered call – already have the shares
In the real world, almost always goes the writers’ way
Writer - If have a call option and not going my way, all I have to do is buy a put and now I’m
EXAMPLE – PUT OPTIONS
Writer sells a put option for $1.00 to you to sell 1000 shares at $10.00
You must expect shares to decrease, writer expects shares to increase
If shares decrease to $5.00 you will exercise option – buy shares at $5.00 and sell for
$ 10.00 (you earned $4.00 profit on option contract)
If shares rise over $10.00 you will not exercise – seller gets the $1.00
Always the buyer of the option that gets to determine what. They can force writer to buy stock
at certain price.
If does go their way, doesn’t have to exercise option.
o Montreal Exchange (ME)
o Chicago Board Options Exchange (CBOE)
Standardized exercise dates, exercise prices, and quantities
o Facilitate offsetting positions through a clearing corporation
Clearing corporation is guarantor, handles deliveries
They make sure that the individual follows through with their contract.
In-the-money options have a positive cash flow if exercised immediately
o Call options: Stock price (S) > Exercise price (E)
o Put options: S < E Out-of-the-money options should not be exercised immediately
o Call options: S < E
o Put options: S > E
If S = E, an option is at the money
In-the-money means from the buyers’ perspective
Call option: can buy shares are lower price than the market
Put option: can sell shares are higher price
Out-of-the-money – did not go their way so shouldn’t exercise
FACTORS AFFECTING PRICES
Time to Maturity
As a buyer, can exercise, can sell, or can let them last
RIGHTS AND WARRANTS
Right – to purchase a stated number of common shares at a specified price with a
specified time (often a few months)
o Issued by the corporation
o Are transferrable
o Option to purchase shares a price often lower than the market price
o Certificates mailed to current shareholders on pro rata basis
Can take that right and sell it to someone else – don’t have to exercise it.
Usually at a lower price.
Can be a great way to raise quick money
The exercise price could be lower than market