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FINC4101 Investment Analysis

FINC4101 Investment Analysis. Instructor: Dr. Leng Ling Topic: Introduction to options. Learning objectives. Define call and put options. Understand the various features of options: exercise price, option premium, option exercise, American vs. European.

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FINC4101 Investment Analysis

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  1. FINC4101 Investment Analysis Instructor: Dr. Leng Ling Topic: Introduction to options

  2. Learning objectives • Define call and put options. • Understand the various features of options: exercise price, option premium, option exercise, American vs. European. • Describe how options trading is organized. • List the various types of option contracts. • Compute the payoff and profit of call option holder, call option writer, put option holder and put option writer. • Describe the composition of various option strategies. • Compute the payoff and profit of various option strategies.

  3. Portfolio Theory Foreign Exchange Asset Pricing FI400 Equity Derivatives Fixed Income Market Efficiency Concept Map

  4. Derivative security A derivative transaction involves no actual transfer of ownership of the underlying assets at the time the contract is initiated. A derivative represents an agreement to transfer ownership of underlying assets at a specific place, price, and time specified in the contract. Its value (or price) depends on the value of the underlying assets. The underlying assets: stocks, bonds, interest rates, foreign exchanges, index, commodities, some derivatives, etc.

  5. What is an option? A derivative security that gives the holder the right to buy / sell an asset (the “underlying”) at a specified price (“exercise price”) on or before the option expiration date.

  6. Two types of options:Call vs. Put options • Call option • Gives holder the right to buy an asset at a specified exercise price on or before a specified expiration date. • Put option • Gives holder the right to sell an asset at a specified exercise price on or before a specified expiration date.

  7. Exercise price • Exercise price • For a call option, it is the price set for buying the underlying asset. • For a put option it is the price set for selling the underlying asset. • Exercise price is also called the strike price.

  8. Option premium • Options are financial assets. If you want an option, you have to buy it from an option seller (counterparty). • The purchase price or cost of an option is the option premium. • The option seller earns the option premium. • The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the owner (buyer) ever exercises the option. • In option markets, to sell an option is to “write” an option. An option seller is also called an “option writer”.

  9. Examples • At March 1, XYZ stock’s spot price = $110. A trader buys a call option on XYZ at strike (exercise) price = $100/share. The right lasts until August 15, and the price (option premium) of this call option is $15/share. • At March 1, ABC stock’s spot price = $100. A trader buys a put option to on ABC at strike (exercise) price = $120/share. The right lasts until August 15, and the price (option premium) of this put option is $22/share.

  10. The long and short of it… • If you buy an option, then you are • “long the option” or “long option” or you have a “long position”. • If you sell an option, then you are • “short the option” or “short option” or you have a “short position”. Example: if you buy a call option, you are “long call”.

  11. Options trading (1) • Option contracts are traded in two types of markets: • Over-the-counter (OTC) markets • Exchanges, such as: • Chicago Board Options Exchange (CBOE) • Chicago Mercantile Exchange (CME) • International Securities Exchange • Option Clearing Corporation (OCC)

  12. OTC Option contract can be customized to needs of trader. Difficult to trade. Secondary market illiquid. Exchanges Option contracts are standardized by maturity dates and exercise price. Easy to trade. Secondary market is liquid. Options trading (2)

  13. Options on IBM June 7, 2004Source: Wall Street Journal Online Edition, June 8, 2004.

  14. Underlying asset • Individual stocks • Stock market indexes • S&P 100, S&P 500, DJIA, Nikkei 225, FTSE 100 etc. • Futures • Foreign currency • Treasury bonds, Treasury notes And many others.

  15. Option exercise (1) To “exercise a call option” means to use the option to buy the underlying asset at the exercise price. To “exercise a put option” means to use the option to sell the underlying asset at the exercise price.

  16. Option exercise (2) Question: When do you exercise an option? Answer: Simple. Only when it’s optimal to do so. That is, when you are better off exercising the option. “Buy low, sell high” Question: What if exercising the option does not make me better off? Answer: Simple. Don’t exercise. After all, it’s just an option.

  17. American vs. European options • American option: Holder has the right to exercise the option on or beforethe expiration date. • European option: Holder has the right to exercise the option only on the expiration date. • Most traded options in the US are American-style. Exceptions: foreign currency options, some stock index options.

  18. Payoff of Long Bond Position at Expiration

  19. Payoffs of a Call Option Long Call at $20 Short Call at $20

  20. Profit/Loss of a Call Option Long Call at $20 Short Call at $20

  21. Profit/Loss of Long and Short on Call Option

  22. Payoffs of a Put Option Long Put at $20 Short Put at $20

  23. Profit/Loss of a Put Option Long Put at $20 Short Put at $20

  24. Profit/Loss of Long and Short on Put Option

  25. Call Option’s Payoff/Profit at Expiration • Payoff for a Long Call: • Profit for a Long Call: payoff - option premium • Payoff for a Short Call: • Profit for a Short Call: option premium + payoff

  26. Put Option’s Payoff/Profit at Expiration • Payoff for a Long Put: • Profit for a Long Put: payoff – option premium • Payoff for a Short Put: • Profit for a Short Put: option premium + payoff

  27. Example • A trader short a Call at X=20 with a premium of $5. At maturity, the stock price is 30. What is the profit/loss to this trader? Profit/Loss = 5 + [-(30-20)] = 5 -10 = -5 • A trader long a Put at X=30 with a premium of $5. At maturity, the stock price is 15. What is the profit/loss to this trader? Profit/Loss = (30-15) - 5 = 15 - 5 = 10

  28. Call option: Payoff & Profit at expiration (1) • Consider a call option on a share of IBM stock with an exercise price of $80 per share. Suppose this call option expires on July 16, 2004. Suppose today is the expiration date. The call option price (premium) was $5.

  29. Call option: Payoff & Profit at expiration (2) • Are you better off exercising the option? • What is the payoff from the option exercise? • What is the profit from the option exercise? Answer these questions if IBM’s stock price is (a) 95, (b) 76 and (c) 81. • What is the breakeven point for this call option? • Breakeven point is the stock price at which profit is zero.

  30. Payoff & profit diagram of call option holder at expiration

  31. Payoff and profit of call option writer • Compute payoff, profit and breakeven point, if the stock price at expiration is • (a) 95, (b) 76 and (c) 81.

  32. Payoff & profit diagram of call option writer at expiration

  33. Call Review • Which of the following statements about the value (i.e., payoff) of a call option at expiration is false? • A short position in a call option will result in a loss if the stock price exceeds the exercise price. • The value of a long position equals zero or the stock price minus the exercise price, whichever is higher. • The value of a long position equals zero or the exercise price minus the stock price, whichever is higher. • A short position in a call option has a zero value for all stock prices equal to or less than the exercise price.

  34. Put option: Payoff & Profit at expiration (1) • Consider a put option on a share of IBM stock with an exercise price of $80 per share. Suppose this put option expires on July 16, 2004. Suppose today is the expiration date. The put option price (premium) was $3.

  35. Put option: Payoff & Profit at expiration (2) • Are you better off exercising the option? • What is the payoff from the option exercise? • What is the profit from the option exercise? Answer these questions if IBM’s stock price is (a) 89, (b) 70 and (c) 79. • What is the breakeven point for this put option? • Breakeven point is the stock price at which profit is zero.

  36. Payoff & profit diagram of put option holder at expiration

  37. Payoff and profit of put option writer • Compute payoff, profit and breakeven point, if the stock price at expiration is (a) 89, (b) 70 and (c) 79.

  38. Payoff & profit diagram of put option writer at expiration

  39. Put Review • Consider a put option written on ABC Inc.’s stock. The put option’s exercise price is $80. Which of the following statements about the value (payoff) of the put option at expiration is true? • The value of the short position in the put is $4 if the stock price is $76. • The value of the long position in the put is -$4 if the stock price is $76. • The long put has value when the stock price is below the $80 exercise price. • The value of the short position in the put is zero for stock prices equaling or exceeding $76.

  40. In-class Practice You purchased one IBM July 100 call contract for a premium of $4.00. Assuming that the stock price on the expiration date is $105. What is the payoff and net profit/loss? What is the break even point? Draw the payoff and net profit/loss lines on the diagram.

  41. Practice 9 • Chapter 15: 4, 5, 6.

  42. Moneyness (1)—intrinsic value • An option (call or put) is: • In the money (ITM) if exercising it produces a positive payoff to the holder • At the money (ATM) if the asset price and exercise price are equal. • Out of the money (OTM) if exercising it produces a negative payoff to the holder.

  43. Moneyness (2)

  44. Moneyness questions (1) • Consider two call options written on ABC Inc.’s stock. The first call, C1, has an exercise price of $50. The second call, C2, has an exercise price of $70. Both calls have the same expiration date. Today is the expiration date. C1 is in the money while C2 is out of the money. Which of the following is true about ST, the stock price on the expiration date? • ST > $50 • ST > $70 • $70 > ST > $50 • ST < $50

  45. Moneyness questions (2) • Consider two put options written on XYZ Inc.’s stock. The first put, P1, has an exercise price of $20. The second put, P2, has an exercise price of $35. Both puts have the same expiration date. Today is the expiration date. P1 is out of the money while P2 is in the money. Which of the following is true about ST, the stock price on the expiration date? • ST < $20 • ST < $35 • $20 < ST < $35 • ST > $35

  46. Option vs. Stock Investment (1) • Compared to a stock investment, options offer 1) Leverage • Pure option investment magnifies gains and losses compared to pure stock investment. 2) Insurance • Combining options with T-bills (money market fund) limits losses compared to pure stock investment. Consider the following…

  47. Option vs. Stock Investment (2) • Suppose you think Wal-Mart stock is going to appreciate substantially in value in the next year. The stock’s current price, S0, is $100, and the call option expiring in one year has an exercise price, X, of $100 and is selling at a price, C, of $10. With $10,000 to invest, you are considering three alternatives: • Invest all $10,000 in the stock, buying 100 shares. • Invest all $10,000 in 1,000 options (10 contracts) • Buy 100 options (one contract) for $1,000 and invest the remaining $9,000 in a money market fund paying 4% interest annually.

  48. Option vs. Stock Investment (3) • Compute the rate of return for each alternative for four stock prices one year from now: • $80 • $100 • $110 • $120

  49. Option vs. Stock Investment (4)

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