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Options

Options. Chapter 19 Charles P. Jones, Investments: Analysis and Management, Eleventh Edition, John Wiley & Sons. 17- 1. Why Options Markets?. Financial derivative securities: derive all or part of their value from another (underlying) security

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Options

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  1. Options Chapter 19 Charles P. Jones, Investments: Analysis and Management, Eleventh Edition, John Wiley & Sons 17-1

  2. Why Options Markets? • Financial derivative securities: derive all or part of their value from another (underlying) security • Options are created by investors, sold to other investors • Why trade these indirect claims? • Expand investment opportunities, lower cost, increase leverage

  3. Options Terminology • Call (Put): Buyer has the right but not the obligation to purchase (sell) a fixed quantity from (to) the seller at a fixed price before a certain date • Exercise (strike) price: “fixed price” • Expiration (maturity) date: “certain date” • Option premium or price: paid by buyer to the seller to get the “right”

  4. How Options Work • Call buyer (seller) expects the price of the underlying security to increase (decrease or stay steady) • Put buyer (seller) expects the price of the underlying security to decrease (increase or stay steady) • At option maturity • Option may expire worthless, be exercised, or be sold

  5. Options Trading • Option exchanges are continuous primary and secondary markets • Chicago Board Options Exchange largest • Standardized exercise dates, exercise prices, and quantities • Facilitates offsetting positions through Options Clearing Corporation • OCC is guarantor, handles deliveries

  6. Profit per Option ($) 4 0 -4 Stock Price at Expiration 25 27 29 How does buying stock compare with buying a call option? Payoff Diagram for a Call Option Buyer Seller

  7. Profit per Option ($) Buyer 4 0 -4 Stock Price at Expiration 23 25 27 Seller How does selling stock compare with buying a put option? Payoff Diagram for Put Option

  8. Profit ($) Purchased share Combined 4 0 -4 Stock Price at Expiration 23 25 27 29 Written call Covered Call Writing

  9. Profit ($) Purchased share 4 0 -4 Combined Stock Price at Expiration 23 25 27 29 Purchased put Protective Put Buying

  10. Portfolio Insurance • Hedging strategy that provides a minimum return on the portfolio while keeping upside potential • Buy protective put that provides the minimum return • Put exercise price greater or less than the current portfolio value? • Problems in matching risk with contracts

  11. Profit ($) Purchased share Combined 2 0 -2 Stock Price at Expiration 23 25 27 29 Purchased put Portfolio Insurance

  12. Options Terminology • In-the-money options have a positive cash flow if exercised immediately • Call options: S >E • Put options: S <E • Out-of-the-money options should not be exercised immediately • Call options: S <E • Put options: S >E

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