Derivative Securities (Options): Puts & Calls

2. Derivative Securities (Options): Puts & Calls

3. Lockheed Martin (LMT) Transactions

4. Lockheed Martin (LMT) Transactions

5. Lockheed Martin (LMT) Transactions

6. Lockheed Martin (LMT) Transactions

7. Rights Warrants Convertibles Puts Calls Types of Options

8. Common Stock Stock Indexes Debt Instruments Foreign currencies Commodities Financial futures A Growing Market – puts and calls can be traded on:

9. Why so much interest in options? • “…investors can buy a lot of priceaction with a limited amount of capital, while nearly always enjoying limited exposure to risk.”

10. 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

11. 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.

12. Example: Buying the Underlying Stock versus Buying a Call Option, Cont. • Let’s calculate the dollar and percentage return given each of the prices for IBM stock:

14. Characteristics of Options • “Derivative” Securities - obtain their value from the underlying issue • Contract to buy or sell other securities

15. Characteristics of Options • Noownership interest in the underlying company (dividends; voting rights, etc.) • Provide leverage through a fixed purchase price - exaggerates any gain or loss

16. Option Exchanges • Chicago Board Options Exchange (CBOE) • Established in 1973 • cboe.org - professional traders • cboe.com - private investors

17. Option Exchange Features • Central marketplace vs. O-T-C • Secondary market • Option Clearing Corporation (OCC)

18. The Options Clearing Corporation • The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised. • The OCC issues and clears all option contracts trading on U.S. exchanges. • Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC). Visit the OCC at: www.optionsclearing.com.

19. Buyer-Seller Relationship(pre-CBOE)

20. Buyer-Seller Relationship(Post-CBOE)

21. Option Exchange Features • Standardized Terms: • contract size • expiration dates • exercise (striking) price

22. Basic Option Terms(listed equity options) • Call Option: • contract to buy stock • 100 shares of stock • exercise price set by exchange • expires on fixed date – 3rd Friday of the expiration month

23. Basic Option Terms(listed equity options) • Put Option: • contract to sell stock • 100 shares of stock • exercise price set by exchange • expires on fixed date – 3rd Friday of the expiration month

24. Call - contract to: Buy 100 shares Fixed price Specified term Put - contract to: Sell 100 shares Fixed price Specified term Basic Option Terms

25. Option Jargon • “Striking Price” - price at which the contract is exercised or carried out • Example: • XYZ-AUG-30; “30” is the striking price, or exercise price of the option

26. Option Jargon • “Expiration Date” - maturity date; the third Friday of the expiration month • Example: • XYZ-AUG-30; option expires on the third Friday of August

27. Option Jargon • “Option Writer (Maker)” - seller of an option contract

28. Option Jargon • “Covered Writer” - already owns shares of the underlying stock; can deliver shares if exercised

29. Option Jargon • “Naked Writer” - does not own shares of the underlying stock; must buy shares if exercised

30. Option Jargon[Call Options] • “In the Money” - stock price greater than exercise price

31. Option Jargon[Call Options] • “Out of the Money” - stock price less than exercise price

32. Option Jargon[Call Options] • “At the Money” - stock price = exercise price

33. Option Pricing[Three Prices to Consider] • Underlying stock price per share • Exercise (striking) price of the option contract • Price (Premium) of the option contract

34. Call Option Pricing • Option premium reflects: • Intrinsic valueof the option, • plus the option’s time value • Premium = IV + TV • Time Value = Premium - IV

35. Call Option Pricing[ABC-MAY-80] • Intrinsic value (IV): • IV = Stock price - exercise price • IV = $81.75 - $80.00 = $1.75

36. Call Option Pricing[ABC-MAY-80] • Time value (TV): • TV = premium - intrinsic value • TV = $3.75 - $1.75 = $2.00

38. Listed Option Quoteson the Web

39. Put Option Pricing[ABC-JUL-80] • Intrinsic value (IV): • IV = Exercise price - stock price • IV = $80.00 - $79.00 = $1.00

40. Put Option Pricing[ABC-JUL-80] • Time value (TV): • TV = premium - intrinsic value • TV = $3.00 – 1.00 = $2.00

41. Option Strategies

42. Option Strategies

43. Option Strategies

44. Option Strategies

45. Option Strategies

46. FIGURE 11.2 The Valuation Properties of Put and Call Options

48. Option Trading Strategies • Buying options for speculation • Hedging with puts and calls • Option writing and spreading

49. Buying Options for Speculation • Same motivation as buying stock • “Buy low, sell high” • Smaller investment - greater leverage • Limited loss

50. Hedging with Puts and Calls • Combination of two or more securities • Objectives: • To earn or protect a profit • Limit losses