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INTRODUCTION TO DERIVATIVE SECURITIES Cleary Text, Chapt . 19 CALL & PUT OPTIONS Learning Objectives. Define options and discuss why they are used. Describe how options work and give some basic strategies. Explain the time value and intrinsic value of options.
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INTRODUCTION TO DERIVATIVE SECURITIESCleary Text, Chapt. 19CALL & PUT OPTIONSLearning Objectives • Define options and discuss why they are used. • Describe how options work and give some basic strategies. • Explain the time value and intrinsic value of options.
INTRODUCTION TO DERIVATIVE SECURITIESCALL & PUT OPTIONS an option grants the holder or owner, the rightto buy or sell a certain quantity of a specific security at a set price for a specified period of time like a ticket
CALL OPTIONS • A call conveys the right to buy a fixed number of shares of a stock at a predetermined price (strike or exercise price) on, or before a specific date (expiry date) in the future • when an investor buys a call they expect the price of the underlying security to rise
OPTIONS TERMINOLOGY • strike or exercise price: the price the holder of the option can buy the underlying security • price or premium: the price of the option • expiry date: when the option becomes valueless (0$ 3rd Friday of month) • American style • European style
CALL OPTIONS:CALL BUYER (Bullish) • example: Tudor buys one RIM 64$ April call option for $3 premium from Kyle. • this call option gives Tudor the right to buy one RIM share from Kyle for 64$ between now and the third Friday in April. • RIM is currently at $63 per share. RIM shares need to increase to $67 for Tudor’s calls to be in the money
call buyer example cont’d… P&L 64 67= exercise + premium RIM share price -3 Break even point
CALL OPTIONS:CALL WRITER (neutral / bearish) The writer is selling the call, thus receives the premium example: Kyle receives $3 when he sells the call to Tudor. Kyle is obligated to sell Tudor one RIM share at $64 if Tudor desires to buy that share
call writer example cont’d… +3 P&L 64 67= exercise + premium RIM share price Break even point -3
PUT OPTIONS • A put conveys the right to sell a fixed number of shares of a stock at a predetermined price (strike or exercise price) on, or before a specific date (expiry date) in the future • when an investor buys a put they expect the price of the underlying security to drop
PUT OPTIONSPUT BUYER (bearish) example:
put buyer example cont’d... + = exercise - premium Break even point P&L share price - 64
PUT OPTIONS:PUT WRITER (bullish / neutral) The writer is selling the put, thus receives the premium example:
put writer example cont’d... + + = exercise - premium Break even point P&L share price - 64 -
OPTIONS • “zero sum game” the profit made on the option is equal to the loss by the other party. example: If the holder makes $5, then the writer loses $5 refer to P&L graphs
“zero sum game” the profit made on the option is equal to the loss by the other party.
example: Jan 75 calls have a premium of $1.50 Intrinsic Value zero Time Value 1.50 example: Jan 65 calls have a premium of $6.75 Intrinsic Value five Time Value 1.75 PREMIUM (PRICE) – CALLS RIM shares at $70
example: Jan 80 puts have a premium of $12.80 Intrinsic Value ten Time Value 2.80 example: Jan 65 puts have a premium of $0.75 Intrinsic Value zero Time Value 0.75 PREMIUM (PRICE) - PUTSRIM shares at $70 17
Greater the volatility (fast price changes) of the underlying stock, the greater the premiums of the options VOLATILITY AFFECTS TIME VALUE
TIME VALUE OF OPTIONS • because options expire worthless, they have a limited lifespan • options have a time value, and as the expiry date for the option approaches, the time value decreases to zero • the decay from time value is not linear but accelerates as the expiry date approaches • this means that of two options with the same strike price, the one that has a longer time to expirey will be worth more
OPTION PRICING • time value • intrinsic value: relationship between the strike price and the share price • dividends • stock (and market) volatility • dividends • interest rates • supply & demand
OPTION COMMISSIONSThe broker always charges the buyer and the writer of options commissions • commission on buying and selling options • WLU commission = 1% of premium • TD Waterhouse = $35 + sliding scale • commission on delivery of shares if option is exercised as per regular rates
BULLISH STRATEGIES • Buying calls • Selling puts
BEARISH STRATEGIES • Buying puts • Selling calls
COVERED CALL WRITING Selling calls on shares that you already own. • You receive the premium • If they are exercised you receive the strike price (that’s OK!) • If the calls are not exercised you keep both the premium and the shares! (that’s even better!)
FINAL NOTES ON OPTIONS • option contracts expire on the third Friday of the month • unexercised options have zero value at expiry date • options held in your portfolio, may be re-sold on the market • priced per option; bought in multiples of 100 (one contract) like board lots
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
Other Types of Options • Stock-Index Options: option contracts on a stock market index • Interest Rate Options: option contracts on fixed income securities • Currency Options: Option contracts whose value is based on the value of an underlying currency
Basics of Stock-Index Options • Options available on S&P/TSE 60 Index, S&P 500 Index, NYSE Index, etc. • Bullish on capital markets implies buying calls or writing puts • Bearish on capital markets implies buying puts or writing calls • At maturity or upon exercise, cash settlement of position
Appendix 19-BRights and Warrants • Right – to purchase a stated number of common shares at a specified price with a specified time (often several months) • Warrant – to purchase a stated number or common shares at a specified price with a specified time (often several years)