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Chapter 14

Chapter 14 Detailed Note.docx

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Department
Administrative Studies
Course
ADMS 3531
Professor
Dale Domian
Semester
Winter

Description
Chapter 14 – Options 14.1 Options on Common Stocks Option Basics - 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: > Call options are options to buy the underlying asset. > Put options are options to sell the underlying asset. - Listed option contracts are standardized to facilitate trading and price reporting. > Listed stock options give the option holder the right to buy or sell 100 shares of stock. - 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: 1. The identity of the underlying stock. 2. The strike price, or exercise price. 3. The option contract size. 4. The option expiration date, or option maturity. 5. The option exercise style (American or European). 6. 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 chain. - Option chains are available online through many sources, including the CBOE (http://quote.cboe.com), Montreal Exchange (http:// www.m-x.ca), and Yahoo! Finance (http://finance.yahoo.com). - The format for option symbols had been the same for many years. - In early 2010, however, the Options Clearing Corporation instituted a new, expanded approach for option symbols. - This change was driven by the increasing size of the option market. - Let’s looks at both the “former” and “current” approaches. 14.2 The Options Clearing Corporation - The Options Clearing Corporation (OCC) and Canadian Derivatives Clearing Corporation (CDCC) are agencies that guarantee that the terms of an option contract will be fulfilled if the option is exercised. 14.3 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. - Let’s calculate the dollar and percentage returns given each of the prices for IBM stock: So, Why Options? - Whether one strategy is preferred over another is a matter for each individual investor to decide. > That is, in some instances, investing in the underlying stock will be better. In other instances, investing in the option will be better. > Each investor must weigh the risk and return trade-off offered by the strategies. - It is important to see that call options offer an alternative means of formulating investment strategies. Versus buying100 shares: > The dollar loss potential with call options is lower. > The dollar gain potential with call options is lower. > The positive percentage gains with call options is higher. > The negative percentage return with call options is lower (i.e., as a percentage, you can loss moyourf investment using options). 14.4 Stock Index Options Index Options - A stock index option is an option on a stock market index. - The most popular stock index options are options on the S&P 100, S&P 500, S&P Canada 60 and Dow Jones Industrial Average. - Because the actual delivery of all stocks comprising a stock index is impractical, stock index options have a cash settlement procedure. > That is, if the option expires in the money, the option writer simply pays the option holder the value ofc the option. > The cash settlement procedure is the same for calls and puts. 14.5 Option Intrinsic Value and “Moneyness” Option Intrinsic Value - The intrinsic value of an option is the payoff that an option holder receives if the underlying stock price does not change from its current value. - That is, if S is the current stock price, and K is the strike price of the option:  Call option intrinsic value = MAX[0, S – K ]  In words: The call option intrinsic value is the maximum of zero or the stock price minus the strike price.  Put option intrinsic value = MAX[0, K – S ]  In words: The put option intrinsic value is the maximum of zero or the strike price minus the stock price. Option “Moneyness” - “In-the-money” option: An option that would yield a positive payoff if exercised - “Out-of-the-money” option: An option that would NOT yield a positive payoff if exercised - Use the relationship between S (the stock price) and K (the strike price): Note for a given strike price, only the call or only the put can be “in-the-money.” - “In the Money” options have a positive intrinsic value. > For calls, the strike price is less than the stock price. > For puts, the strike price is greater than the stock price. - “Out of the Money” options have a zero intrinsic value. > For calls, the strike price is greater than the stock price. > For puts, the strike price is less than the stock price. - “At the Money” options is a term used for options when the stock price and the strike price are about the same. 14.6 Option Payoffs and Profits - The act of selling an option is referred to as option writing. - The seller of an option contract is called the writer. > The writer of a call option contract is obligated to sell the underlying asset to the call option holder. > The call option holder has the right to exercise the call option (i.e., buy the underlying asset at the strike price). > The writer of a put option contract is obligated to buy the underlying asset from the put option holder. > The put option holder has the right to exercise the put option (i.e., sell the underlying asset at the strike price). - Because option writing obligates the option writer, the option writer receives the price of the option today from the option buyer. Option Exercise - Option holders have the right to exercise their option. > If this right is only available at the option expiration date, the option is said to have a European-style exercise. > If this right is available at any time up to and including the option expiration date, the option is said to have an American-style exercise. - Exercise style is not linked to where the option trades. European-style and American-style options trade in the U.S., as well as on other option exchanges throughout the world. - Very Important: Option holders also have the right to sell their option at any time. That is, they do not have to exercise the option if they no longer want it. Option Payoffs versus Option Profits - Option investment strategies involve initial and terminal cash flows. > Initial cash flow: option price (often called the option premium). > Terminal cash flow: the value of an option at expiration (often called the option payoff). - The terminal cash flow can be realized by the option holder by exercising the option. - The profit from an option strategy is the difference from the cash flows at expiration and the cash flow needed to initiate the option strategy. Call Option Payoffs (Buying) Notice that the call option payoffs are zero for all stock prices below the $50 stock price. This is because the call option holder will not exercise the option to buy stock at the $50 strike price when the stock is available in the stock market at a lower price. In this case, the option expires worthless. If the stock price is higher than the $50 strike price, the call option payoff is equal to the difference between the market price of the stock and the strike price of the option. For example, if the stock price is $60, the call option payoff is equal to $10, which is the difference between the $60 stock price and the $50 strike price. This payoff is a cash inflow to the buyer, because the option buyer can buy the stock at the $50 strike price and sell the stock at the $60 market price. However, this payoff is a cash outflow to the writer, because the option writer must sell the stock at $50 strike price when the stock’s market price is $60. Let’s use a real life example: Aritzia manufactured a jacket at $50 (strike price). Let’s say, the market price went up to $60. The buyer of the call gains $10 because this option buyer can buy the stock at the $50 strike price and then sell the stock at the $60 market price, therefore there’s a cash inflow of $10 to the buyer. However, this payoff is a cash flow to Aritzia because the option writer (Aritzia) must sell the stock at $50 strike price when the stock’s market price is $60. Put Option Payoffs (Selling) Once again, these examples assume that the put has a strike price of $50, and that the option will be exercised only on its expiration date. The put option payoffs are zero for all stock prices above the $50 strike price. This is because a put option holder will not exercise the option to sell stock at the $50 strike price when the stock can be sold in the stock market at a higher price. In this case, the option expires worthless. In contrast, if the stock price is lower than the $50 strike price, the put option payoff is equal to the difference between the market price of the stock and the strike price of the option. For example, if the stock price is $40, the put option payoff is equal to $10, which is the difference between the $40 stock price and the $50 strike price. This payoff is a cash inflow to the buyer, because the option buyer can buy the stock at the $40 market price and sell the stock at the $50 strike price. However, this payoff is a cash outflow to the writer, because the option write must buy the stock at the $50 strike price when the stock’s market price
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