**Exploring Stock Options: A Comprehensive Guide**

1. Stocks as an Option Just a little on Option Language • A Requirementversus an Option The Draft vs. The All Volunteer Military • Call– option to buy 100 shares @ a price • Put – option to sell 100 share @ a price • Strike or Exercise price of the option (E) • Expiration date– when the option expires • Option premium – amount above intrinsic value as called the Time Value of the Option • Option writer – who sells the option

2. Payoff Profiles for Buying a Share of Stock Profit profile of selling a share of stock (dashed line) Spot price of Stock price paid for the stock Sculpture at Atwater Park in Shorewood

3. Option Payoffs for Calls • The value of the $30 call option at expiration is the intrinsic value • Max(0, S-E) • If S<E, then the payoff is 0 • If S>E, then the payoff is S – E • If the price ends up at $35, the intrinsic value would be $5 per share.

4. Payoff Profiles of Purchased Options: Exercise price-- E, and premium--p, and Stock price--S. BUY a BUY a CALL OPTION PUT OPTION S E E spot price of the stock p p

5. Option Payoffs for Puts • The value of a put at expiration is the intrinsic value • Max(0, E-S) • If S<E, then the payoff is E-S • If S>E, then the payoff is 0 • If the price of the stock goes to $22, the intrinsic value is $8 per share

6. Types of Currency Options American = exercise date may occur any time up to the expiration date (most options are American style). European= exercise date occurs only at the expiration date. Exercise Price, X • X is also known as the strike price. • The price at which the option holder can buy or sell the stock. American Option ≥ European Option

7. Payoff Profiles of Written Options:Exercise price-- E, and premium--p, and Stock price--S. WRITE or SELL a WRITE or SELL a CALL OPTION PUT OPTION p p spot price of the stock E E S

8. Options on the Web • Where can we find option prices? • On the Internet, of course. One site that provides option prices is Yahoo Finance • Go to: http://www.nasdaq.com/symbol/hog/option-chain • Enter a ticker symbol to get a basic quote (HOG, GE, MSFT, etc.) • Try HOG, GE, AAPL, or MSFT

9. Stock Option Quotations • Look at Following Slides for HOG selling at about $36.35 per share • Examine price for calls and puts as the strike price rises. Call prices fall. Put prices rise. • Examine the impact of longer expiration for the same strike price. Both calls and puts tend to rise. Things to notice • Pricesare higher for options with the same strike price but longer expirations • Call options with strikes less than the current price are worth more than the corresponding puts • Call options with strikes greater than the current price are worth less than the corresponding puts

10. In the money is above the line. Out of the money is below the line.

11. Call prices for $45 is higher for May than April – longer maturity.

12. The higher the strike price, the greater the put price.

13. Call Option Bounds • Upper bound • Call price must be less than or equal to the stock price • Lower bound – Intrinsic Value • Call price must be greater than or equal to the stock price minus the exercise price or zero, whichever is greater • If either of these bounds are violated, there is an arbitrage opportunity

15. A Simple Model • An option is “in-the-money” if the payoff is greater than zero • If a call option is sure to finish in-the-money, the option value would be • C0 = S0 – PV(E) • If the call is worth something other than this, then there is an arbitrage opportunity

16. What Determines Option Values? • Stock price • As the stock price increases, the call price increases and the put price decreases • Exercise price • As the exercise price increases, the call price decreases and the put price increases • Time to expiration • Generally, as the time to expiration increases both the call and the put prices increase • Risk-free rate • As the risk-free rate increases, the call price increases and the put price decreases

17. What about Variance? • An option currently be out-of-the-money (close to expiring without being exercised), there is another factor -the variance in underlying asset returns is an important, determinant of option values • The greater the variance, the more the call and the put are worth • If an option finishes out-of-the-money, the most you can lose is your premium, no matter how far out it is • The more an option is in-the-money, the greater the gain • The owner of a call option gains from volatility on the upside, but don’t lose anymore from volatility on the downside

18. Factors Impacting Option Values 1 2 3 4 5

19. CBOE Options Calculator • CBOE.com • http://www.cboe.com/framed/IVolframed.aspx?content=http%3a%2f%2fcboe.ivolatility.com%2fcalc%2findex.j%3fcontract%3dDF888A39-0877-4B91-9E5D-F5BF0C4411C5&sectionName=SEC_TRADING_TOOLS&title=CBOE%20-%20IVolatility%20Services

20. What is the VIX? Pronounced as “Vicks” • CBOE volatility index measures implied volatilityof 30 day S&P 500 options • Volatility index of the market • VIX measures fear or complacencyin market • VIX rose after the Japan event and has been declining • Cash VIX seems to be mean reverting • Range 9.8 to 35 over past 4 years (2016-19) • There are frequent spikes, characterized has having fat tails. • Trading strategy could be buy below 16 and sell above 25?

21. The Vix on March 19, 2019http://www.indexindicators.com/charts/sp500-vs-vix-1d-sma-params-3y-x-x-x/ SPY vs. Vix

22. Option Implied Volatility • Implied volatilityisn’t based on historical pricing data on the stock – it is forward looking. • Based on fact or just rumor, option prices change. • If there’s an earnings announcement or a major court decision coming up, traders purchase options independent of stock price movements. • If there were no options traded on a given stock, there would be no way to calculate implied volatility.

23. Employee Stock Options • Options that are given to employees as part of their benefits package • Often used as a bonus or incentive • Designed to align employee interests with stockholder interests and reduce agency problems • Empirical evidence suggests that they don’t work as well as anticipated due to the lack of diversification introduced into the employees’ portfolios • The stock isn’t worth as much to the employee as it is to an outside investor because of the lack of diversification – this suggests that options may work in limited amounts, but not as a large part of the compensation package

24. Stock itself is a Call Option • Equity can be viewed as a call option on the company’s assets when the firm is leveraged • Black and Scholes 1973 option pricing paper • The exercise price is the face value of the debt • If the assets are worth more than the debt when it comes due, the option will be exercised and the stockholders retain ownership • If the assets are worth less than the debt, the stockholders will let the option expire and the assets will belong to the bondholders • Homeowners are sometimes finding this to be happening to them, and decide to walk away.

25. Capital Budgeting Options • Almost all capital budgeting scenarios contain implicit options • Sometimes these are called Real Options. • Because options are valuable, they make the capital budgeting project worth more than it may appear • Failure to account for these options can cause firms to reject good projects

26. Timing Options • We normally assume that a project must be taken today or forgone completely • But almost all projects have the embedded option to wait • Agood project may be worth more if we wait • A seemingly bad project may actually have a positive NPV if we wait due to changing economic conditions • We should examine the NPV of taking an investment now, or in future years, and plan to invest at the time that the project produces the highest NPV

27. Example of a Timing Option • Consider a project that costs $5,000 and has an expected future cash flow of $700 per year forever. • Or if we wait one year, the cost will increase to $5,500 and the expected future cash flow will increase to $800. • If the required return is 13%, should we accept the project? If so, when should we begin? • NPV starting today = -5,000 + 700/.13 = 384.62 • NPV waiting one year = (-5,500 + 800/.13)/(1.13) = 578.62 • It is a good project either way, but we shouldwait until next year

28. Managerial Options • Managers often have options after a project has been implemented that can add value • It is important to do some contingency planning ahead of time to determine what will cause the options to be exercised • Some examples include • The option to expand a project if it goes well • The option to abandon a project if it goes poorly • The option to suspend or contract operations particularly in the manufacturing industries Strategic options– how taking this project opens up other opportunities that would be otherwise unavailable

29. Warrants • A Warrant is a call option issued by corporations in conjunction with other securities to reduce the yield required on the other securities • Differences between warrants and traditional call options • Warrants are generally very long term • They are written by the company and warrant exercise results in additional shares outstanding • The exercise price is paid to the company, generates cash for the firm, and alters the capital structure • Warrants can normally be detached from the original securities and sold separately • Exercise of warrants reduces EPS, so warrants are included when a firm reports “diluted EPS”

30. Convertibles • Convertible bonds (or convertible preferred stock) may be converted into a specified number of common shares at the option of the bondholder • The conversion price is the effective price paid for the stock • The conversion ratio is the number of shares received when the bond is converted • Convertible bonds will be worth the straight bond value or the conversion value, whichever is greater

31. Other Options • Call provision on a bond • Allows the company to repurchase the bond prior to maturity at a specified price that is generally higher than the face value • Increases the required yield on the bond – this is effectively how the company pays for the option • Put bond • Allows the bondholder to require the company to repurchase the bond prior to maturity at a fixed price • Insurance and Loan Guarantees • These are essentially put options

32. Review Questions • What is the difference between a call option and a put option? • What is the intrinsic value of call and put options and what do the payoff profiles look like? • What are the five major determinants of option prices and their relationships to option prices? • What are some of the major capital budgeting options?