Options - 14-1Introduction to Options and Introduction to...

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Unformatted text preview: 14-1Introduction to Options and Introduction to Options and Options PricingOptions Pricing14-2DefinitionDefinitionOptions are a right- not an obligation to receiveor deliveran underlying security at a specified priceon or before a specified date.Options are a form of derivative security: their payoff depends (derives) from the payoff of another security.14-3Option TerminologyOption TerminologyCall=C. Gives holder the right to buy stock.Put=P. Gives holder the right to sell stock.Strike or Exercise price=E (or X)Expiration dateOption premium/value (time 0); Cor POption value at expiration; C1or P1Option writer (seller)American Option (can be exercised anytime at or before maturity date)European Option (can ONLY be exercised on maturity date)14-4Use of OptionsUse of OptionsSpeculationoBet on the direction of stock movementoAmplify returns due to small investmentsoExpose to risks of losing all investmentsHedgingoSecure a target return regardless of stock movementoLimited upside potentialoLimited downside risk14-5Option Payoffs CallsOption Payoffs CallsThe value of the call at expiration is the intrinsic valueMax(0, S-E)If S<E, then the payoff is If S>E, then the payoff is S EAssume that the exercise price is $30Call Option Payoff Diagram510152025102030405060Stock PriceCall Valuee14-6Buying calls to speculateBuying calls to speculateIn the previous example, the exercise price is $30. Lets say C=$3 and S=$30. Compare the results of buying 10 calls versus buying 1 share of stock (invest $30 either way).If, say, S1=$50, I generate a 66% return on the stock, but I generate a 566% return on the options.If S1=$20, I lose 33.3% on the stock; I lose 100% on the options (they expire worthless because S1<E at expiration).14-7Option Payoffs - PutsOption Payoffs - PutsThe value of a put at expiration is the intrinsic valueMax(0, E-S)If S<E, then the payoff is E-SIf S>E, then the payoff is Assume that the exercise price is $30Payoff Diagram for Put Options5101520253035102030405060Stock PriceOption Value14-8Buying puts to speculateBuying puts to speculateIn the previous example, the exercise price is $30. Lets say P=$2 and S=$30. Compare the results of buying 15 puts versus buying 1 share of stock (invest $30 either way).If, say, S1=$50, I generate a 66% return on the stock; I lose 100% on the options (they expire worthless because S1>E at expiration).If S1=$20, I lose 33.3% on the stock; I gain 400% on the put options.14-9Buying puts to hedgeBuying puts to hedgeNow lets assume P=$2 and S=$30. Compare the results of owning a share of stock versus owning a share of stock AND a put option....
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Options - 14-1Introduction to Options and Introduction to...

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