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Unformatted text preview: 141Introduction to Options and Introduction to Options and Options PricingOptions Pricing142DefinitionDefinitionOptions 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.143Option 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)144Use 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 risk145Option Payoffs – CallsOption Payoffs – CallsThe value of the call at expiration is the intrinsic valueMax(0, SE)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 Valuee146Buying calls to speculateBuying calls to speculateIn the previous example, the exercise price is $30. Let’s 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).147Option Payoffs  PutsOption Payoffs  PutsThe value of a put at expiration is the intrinsic valueMax(0, ES)If S<E, then the payoff is ESIf S>E, then the payoff is Assume that the exercise price is $30Payoff Diagram for Put Options5101520253035102030405060Stock PriceOption Value148Buying puts to speculateBuying puts to speculateIn the previous example, the exercise price is $30. Let’s 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.149Buying puts to hedgeBuying puts to hedgeNow let’s 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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 Winter '08
 WELLMAN, J
 Options

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