Tài chính doanh nghiệp - Chapter 2: Basic principles of stock options

© 2004 South-Western Publishing1Chapter 2Basic Principles of Stock Options2OutlineWhat options are and where they come fromWhy options are a good ideaWhere and how options tradeComponents of the option premiumWhere profits and losses come from with options3What Options Are and Where They Come FromCall and put optionsCategories of optionsStandardized option characteristicsWhere options come fromOpening and closing transactionsThe role of the options clearing corporation4Call and Put OptionsCall OptionsA call option gives its owner the right to buy; it is not a promise to buyFor example, a store holding an item for you for a fee is a call optionPut OptionsA put option gives its owner the right to sell; it is not a promise to sellFor example, a lifetime money back guarantee policy on items sold by a company is an embedded put option5Categories of OptionsAn American option gives its owner the right to exercise the option anytime prior to option expirationA European option may only be exercised at expiration6Categories of Options (cont’d)Options giving the right to buy or sell shares of stock (stock options) are the best-known optionsAn option contract is for 100 shares of stockThe underlying asset of an index option is some market measure like the S&P 500 indexCash-settled7Standardized Option CharacteristicsExpiration datesThe Saturday following the third Friday of certain designated months for most optionsStriking priceThe predetermined transaction price, in multiples of $2.50 or $5, depending on current stock priceUnderlying SecurityThe security the option gives you the right to buy or sellBoth puts and calls are based on 100 shares of the underlying security8Standardized Option Characteristics (cont’d)The option premium is the amount you pay for the optionExchange-traded options are fungibleFor a given company, all options of the same type with the same expiration and striking price are identical9Identifying An OptionMicrosoft OCT 80 CallExpiration (3rd Friday in October)Type of optionUnderlying asset (Microsoft common stock)Strike price ($80 per share)10Where Options Come FromUnlike more familiar securities, there is no set number of put or call optionsThe number in existence changes every day11Opening and Closing TransactionsThe first trade someone makes in a particular option is an opening transaction for that personWhen the individual subsequently closes that position out with a second trade, this latter trade is a closing transaction12Opening and Closing Transactions (cont’d)When someone buys an option as an opening transaction, the owner of an option will ultimately do one of three things with it:Sell it to someone elseLet it expireExercise itFor example, buying a ticket to an athletic event13Opening and Closing Transactions (cont’d)When someone sells an option as an opening transaction, this is called writing the optionNo matter what the owner of an option does, the writer of the option keeps the option premium that he or she received when it was sold14The Role of the Options Clearing Corporation (OCC)The Options Clearing Corporation (OCC) contributes substantially to the smooth operation of the options marketIt positions itself between every buyer and seller and acts as a guarantor of all option tradesIt sets minimum capital requirements and provides for the efficient transfer of funds among members as gains or losses occur15Why Options Are a Good IdeaIncreased riskInstantaneous informationPortfolio risk managementRisk transferFinancial leverageIncome generation16Where and How Options TradeExchangesOver-the-counter optionsStandardized option characteristicsOther listed optionsTrading mechanics17ExchangesMajor options exchanges in the U.S.:Chicago Board Options Exchange (CBOE)American Stock Exchange (AMEX)Philadelphia Stock Exchange (Philly)Pacific Stock Exchange (PSE)International Securities Exchange (ISE)Foreign options exchanges also exist18Over-the-Counter OptionsWith an over-the-counter option:Institutions enter into “private” option arrangements with brokerage firms or other dealersThe striking price, life of the option, and premium are negotiated between the parties involvedOver-the-counter options are subject to counterparty risk and are generally not fungible19Some Exotic OptionsAs-You-Like-It OptionThe owner can decide whether it is a put or a call by a certain dateBarrier OptionCreated or cancelled if a prespecified price level is touchedForward Start OptionPaid for now, with the option becoming effective at a future date20Other Listed OptionsLong-Term Equity Anticipation Security (LEAP)Options similar to ordinary listed options, except they are longer termMay have a life up to 39 monthsAll LEAPs expire in JanuaryPresently available on only the most active underlying securities21Other Listed Options (cont’d)FLEX optionFundamentally different from an ordinary listed option in that the terms of the option are flexibleAdvantage of user flexibility while eliminating counterparty riskIn general, a FLEX option trade must be for at least 250 contracts22Trading MechanicsBid Price and Ask PriceThere are two option prices at any given time:Bid price: the highest price anyone is willing to pay for a particular optionAsk price: the lowest price at which anyone if willing to sell a particular option23Trading Mechanics (cont’d)Types of ordersA market order expresses a wish to buy or sell immediately, at the current priceA limit order specifies a particular price (or better) beyond which no trade is desiredTypically require a time limit, such as “for the day” or “good ‘til canceled (GTC)”24Trading Mechanics (cont’d)Trading Floor SystemsUnder the specialist system, there is a single individual through whom all orders to buy or sell a particular security must passUsed at the AMEX and the PhillyThe specialist keeps an order book with limit order from all over the countryThe specialist’s job is to maintain a fair and orderly market25Trading Mechanics (cont’d)Trading Floor Systems (cont’d)Under the marketmaker system, the specialist’s activities are divided among three groups of people:Marketmakers Floor brokers Order Book Official26The Option PremiumIntrinsic value and time valueOption price quotations27Intrinsic Value and Time ValueIntrinsic value is the amount that an option is immediately worth given the relation between the option striking price and the current stock priceFor a call option, intrinsic value = stock price – striking priceFor a put option, intrinsic value = striking price – stock priceIntrinsic value cannot be < zero28Intrinsic Value and Time Value (cont’d)Intrinsic value (cont’d)An option with no intrinsic value is out-of-the-moneyAn option whose striking price is exactly equal to the price of the underlying security is at-the-moneyOptions that are “almost” at-the-money are near-the-money29Intrinsic Value and Time Value (cont’d)Time value is equal to the premium minus the intrinsic valueAs an option moves closer to expiration, its time value decreases (time value decay)An option is a wasting asset30Option Price QuotationsEvery service that reports option prices will show, at a minimum, theStriking priceExpirationPremium31Option Price Quotations (cont’d)Intraday Prices from September 15, 2003Microsoft Stock Price = $28.51 StrikeExpirationCallPutVolumeLastOpen InterestVolumeLastOpen Interest20SEP 0308.6046200 5120OCT08.623079001301322.50SEP06.0478100592022.50OCT06.06705020.053502432Profits and Losses With OptionsUnderstanding the exercise of an optionExercise proceduresProfit and loss diagramsA note on margin requirements33Understanding the Exercise of an OptionAn American option can be exercised anytime prior to the expiration of the optionExercising an American option early amounts to abandoning any time value remaining in the optionA European option can only be exercised at maturity34Exercise ProceduresNotify your brokerBroker notifies the Options Clearing CorporationSelects a contra party to receive the exercise noticeNeither the option exerciser nor the option writer knows the identity of the opposite party35Exercise Procedures (cont’d)The option premium is not a down payment on the purchase of the stockThe option holder, not the option writer, decides when and if to exerciseIn general, you should not buy an option with the intent of exercising it36Profit and Loss DiagramsVertical axis reflects profits or losses on the expiration day resulting from a particular strategyHorizontal axis reflects the stock price on the expiration dayAny bend in the diagram occurs at the striking priceBy convention, diagrams ignore the effect of commissions that must be paid37Buying a Call Option (“Going Long”)Example: buy a Microsoft October 25 call for $3.70 Maximum loss is $3.70Profit potential is unlimitedBreakeven is $28.7038Buying a Call Option (cont’d) Breakeven = $28.700 20 40 60 80 100Maximumloss = $3.7039Writing a Call Option (“Short Option”)Ignoring commissions, the options market is a zero sum gameAggregate gains and losses will always net to zeroThe most an option writer can make is the option premiumWriting a call without owning the underlying shares is called writing a naked (uncovered) call40Writing a Call Option (cont’d) Breakeven = $28.70Maximum Profit = $3.700 20 40 60 80 10041Buying a Put Option (“Going Long”)Example: buy a Microsoft April 25 put for $1.10Maximum loss is $1.10Maximum profit is $23.90Breakeven is $23.9042Buying a Put Option (cont’d) $23.90 Breakeven = $23.900 20 40 60 80 100$1.1043Writing a Put Option (“Short Option”)The put option writer has the obligation to buy if the put is exercised by the holder44Writing a Put Option (cont’d) Breakeven = $23.90$1.100 20 40 60 80 100$23.9045A Note on Margin RequirementsA margin requirement is analogous to posting collateral and can be satisfied by a deposit of cash or other securities into your brokerage accountThe margin system is to reduce the likelihood that option writers will be unable to fulfill their obligations