Personal Investment Management
ADMS 3531 Fall 2011 – Professor Dale Domian
Lecture 4/5 – Options – Oct 4/Oct 18
Chapter 14 Outline
Options on common stocks.
Option payoffs and profits.
Option prices, intrinsic values and arbitrage.
Employee stock options.
Stock index options.
Foreign currency options.
The Canadian derivatives clearing corporation.
In this chapter, we will discuss general features of options, but will focus on options on
individual common stocks.
We will see the tremendous flexibility that options offer investors in designing
A stock option is a derivative security, because the value of the option is ‘derived’ from
the value of the underlying common stock.
There are two basic option types.
o Call options are options to buy the underlying asset.
o Put options are options to sell an underlying asset.
Listed option contracts are standardized to facilitate trading and price reporting.
o Listed stock options give the option holder the right to buy or sell 100 shares of
Option contracts are legal agreements between two parties – the buyer of the option, and
the seller of the option.
The minimum terms stipulated by stock option contracts are: o The identity of the underlying stock.
o The strike price, or exercise price.
o The option contract size.
o The option expiration date or option maturity.
o The option exercise style (American or European).
o The delivery, or settlement, procedure.
Stock options trade at organized options exchanges, such as the CBOE, as well as over
the counter (OTC) options markets.
Option Price Quotes
A list of available option contracts and their prices for a particular security is known as an
Option chains are available online through many sources, including the Montreal
Exchange, CBOE, and Yahoo!
Stock option ticker symbols include:
o Letters to identify the underlying stock.
o A letter to identify the expiration month as well as whether the option is a call or a
o A letter to identify the strike price.
A basic question asked by investors is ‘Why buy stock options instead of shares in the
To answer this question, we compare the possible outcomes from these two investment
o Buy the underlying stock.
o Buy options on the underlying stock.
Whether one strategy is preferred over another is a matter for each individual investor to
o That is, in some instances investing in the underlying stock will be better. In other
instances, investing in the option will be better.
o Each investor must weigh the risk and return tradeoff offered by the strategies.
It is important to see that call options offer an alternative means of formulating
o For 100 shares, the dollar loss potential with call options is lower.
o For 100 shares, the dollar gain potential with call options is lower.
o The positive percentage return with call options is higher. o The negative percentage return with call options is lower.
‘Inthemoney’ option – An option that would yield a positive payoff if exercised.
‘Outofthemoney’ option – An option that would not yield a positive payoff if
Use the relationship between S (the stock price) and K (the strike price).
Call Option S > K S ≤ K
Put Option S