Chapter 21 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Ninth Edition

Understanding Options

Slides by

Matthew Will

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw Hill/Irwin

21- 2

Topics Covered

Calls, Puts and SharesFinancial Alchemy with OptionsWhat Determines Option Values?

21- 3

Option Terminology

Put Option

Right to sell an asset at a specified exercise price on or before the exercise date.

Call Option

Right to buy an asset at a specified exercise price on or before the exercise date.

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Option Obligations

Buyer Seller

Call option Right to buy asset Obligation to sell asset

Put option Right to sell asset Obligation to buy asset

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OptionsTerminology

Derivatives - Any financial instrument that is derived from another. (e.g.. options, warrants, futures, swaps, etc.)

Option - Gives the holder the right to buy or sell a security at a specified price during a specified period of time.

Call Option - The right to buy a security at a specified price within a specified time.

Put Option - The right to sell a security at a specified price within a specified time.

Option Premium - The price paid for the option, above the price of the underlying security.

Intrinsic Value - Diff between the strike price and the stock price

Time Premium - Value of option above the intrinsic value

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OptionsTerminology

Exercise Price - (Striking Price) The price at which you buy or sell the security.

Expiration Date - The last date on which the option can be exercised.

American Option - Can be exercised at any time prior to and including the expiration date.

European Option - Can be exercised only on the expiration date.

All options “usually” act like European options because you make more money if you sell the option before expiration (vs. exercising it).

3 vs. 70-68=2

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Genentech Stock

Option MaturityExercise

PricePrice of Call

OptionPrice of Put

Option

Dec-06 $70 $14.30 $0.7575 9.90 1.4080 6.50 2.7585 3.70 5.1090 1.90 8.70

Mar-07 $70 $15.10 $2.2075 12.20 2.6580 9.00 4.60

85 6.20 7.7090 4.10 9.46

Jan-08 $70 $20.50 $4.3075 18.0 5.780 14.9 7.385 12.0 10.490 9.9 12.7

Long term options are called 'LEAPS"

Selected prices for puts and calls September 2006

21- 8

Option Value

The value of an option at expiration is a function of the stock price and the exercise price.

Example - Option values given a exercise price of $80

00001020ValuePut

302010000Value Call

110100908070$60PriceStock

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Option Value

Call option value (graphic) given a $80 exercise price.

Share Price

Cal

l opt

ion

valu

e

80 95

$15

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Option Value

Put option value (graphic) given a $80 exercise price.

Share Price

Put

opt

ion

valu

e

70 80

$10

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Option Value

Call option payoff (to seller) given a $80 exercise price.

Share Price

Cal

l opt

ion

$ pa

yoff

80

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Option Value

Put option payoff (to seller) given a $80 exercise price.

Share Price

Put

opt

ion

$ pa

yoff

80

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Option Value

Call buyer profit – assume strike of $80 and option price of $9.00

Share Price

Pos

itio

n V

alue

Long call

80 89

- 9.00

Break even

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Option Value

Put seller profit – assume strike of $80 and option price of $4.60

Share Price

Pos

itio

n V

alue

Short put

75.40 80

+4.60

Break even

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Option Value

Masochists Strategy?- Long stock and short call

Share Price

Pos

itio

n V

alue “Silly Strategy”

Short Call

Long Stock

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Option Value

Protective Put - Long stock and long put

Share Price

Pos

itio

n V

alue Protective Put

Long Put

Long Stock

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Option Value

Straddle - Long call and long put

- Strategy for profiting from high volatility

Share Price

Pos

itio

n V

alue

Straddle

Long put Long call

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Option Value

Components of the Option Price

1 - Underlying stock price = Ps

2 - Striking or Exercise price = S

3 - Volatility of the stock returns (standard deviation of annual returns) = v

4 - Time to option expiration = t = days/365

5 - Time value of money (discount rate) = r

6 - PV of Dividends = D = (div)e-rt

21- 19

Time Decay Chart

Option Price

Stock Price

Option prices decline, ceribus paribus, when the time to expiration declines.

90 days to expiration

60 days to expiration

30 days to expiration

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Option Value

Upper Limit

Stock Price

Lower Limit

(Stock price - exercise price) or 0which ever is higher

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Option Value

The value of an option is bound, on the high end, by the value of the underlying stock. The lower bound is the value of exercising the option. In between, the major determinants are exercise price and stock price.

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Option Value

The greater the distribution of possible outcomes, relative to the final price of the stock, the higher the value of the option. This is due to the greater potential for profit. Thus, Y will have a higher option price, ceribus paribus.

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Option Value

Similar to time decay, the value of an option will be higher when more volatility exists.

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Web Resources

www.cboe.com

http://finance.yahoo.com

www.optionscentral.com

www.pcquote.com/

www.pmpublishing.com

Click to access web sitesClick to access web sites

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