Options - Finance 4310 Options I. Definitions A. Call Call...

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1 Finance 4310 Options I. Definitions AC a l • A. Call • B. Put • II. European vs. American Options • III. Underlying instruments
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2 Option Intrinsic Value Intrinsic Value Diagram for Call Iti i Share Price Intrinsic Value E 0 IV C = Max [0, (P S -E)]
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3 Intrinsic Value Diagram for Put Intrinsic Value Share Price E 0 IV P = Max [0, (E - P S )] Option Profit Diagrams AC a l A. Call B. Put
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4 Profit Diagram for Call Buyer Profit Π CB Share Price E P C Profit for Call Buyer CB = IV C -P C CB = Max [0, (P S -E)]-P C =Max[ P (P E) P = Max [ -P C , (P S - E) - P C If the call is unexercised, you lose the premium. If the call is exercised, subtract the premium from the intrinsic value.
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5 Profit Diagram for Call Writer Profit Π CW Share Price E P C Profit for Call Writer The call writer’s profit is the the mirror The call writer s profit is the the mirror image or negative of the buyer’s profit, the buyer’s gain is the writer’s loss, etc. CW = - CB CW = Min [ P C , (E - P S ) + P C ] This is a zero sum game.
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6 Profit Diagram for Put Buyer Profit PB Share Price E P P Profit for Put Buyer PB = IV P -P P PB = Max [0, (E - P S )] - P P =Max[ P (E P ) P = Max [ -P P , (E- P S ) - P P ] If the put is unexercised, you lose the premium. If the put is exercised, subtract the premium from the intrinsic value.
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7 Profit Diagram for Put Writer Profit Π PW Share Price E P P Profit for Put Writer The put writer’s profit is the the mirror The put writer s profit is the the mirror image or negative of the buyer’s profit, the buyer’s gain is the writer’s loss, etc. PW = - PB PW = Min [ P P , (P S -E ) + P P ] This is also a zero sum game.
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8 Stock vs. Calls Investors buy calls because they expect the price of the stock to rise, so why don’t they just buy the stock? Profit Selling Price Purchase Price Profit Diagram for Stock Share Price Profit Diagram for Cal Option Profit Profit Diagram for Call Example: Stock vs. Calls Suppose that P S = $48, P C = $4, and E = $50. For $4,800 an investor could buy 100 shares of stock or 12 calls (100 shares x $4 = $400 per call). Suppose that P S rises to $57 at expiration of the option. Profit on shares = 100($57 - $48) = $900 Profit on calls = 1200{Max[-P C , (P S -E)-P C ]} = 1200{Max[-$4, ($57-$50) -$4]} = 1200 ($3) =$3,600 S th l ff t i h t ith th ll b t th ll i So the leverage effect is much greater with the call, but the call is more risky because any price below the exercise price produces a total loss. For the stock, only a price of $0 will produce a total loss. Suppose that P S at expiration was $49. Profit on shares = 100($49 - $48) = $100 Profit on calls = 1200{Max[-$4, ($49-$50) -$4]} = -$4,800
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9 Another Perspective on the Riskiness of Options April 8 April 9 Change Percent Change RIMM Stock $61.91 $64.18 +$2.27 3.7% RIMM April 65 Call $1.24 $1.52 +$0.28 22.6% Option Time Value If the option’s market value is greater than its intrinsic value, the difference is its time value. Intrinsic Value Market Value Time Value Value of Call P S E
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10 Binomial Option Pricing Models • A binomial world • Only two possible future outcomes for random events events.
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Options - Finance 4310 Options I. Definitions A. Call Call...

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