Using Puts and Calls
Chapter 19
Charles P. Jones, Investments: Analysis and
Management,
Tenth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University
17-1
Why Options Markets?



Financial derivative securities: derive
all or part of their value from another
(underlying) security
Options are created by investors, sold
to other investors
Why trade these indirect claims?

Expand investment opportunities, lower
cost, increase leverage
19-2
Options Terminology

Call (Put): Buyer has the right but not
the obligation to purchase (sell) a fixed
quantity from (to) the seller at a fixed
price before a certain date



Exercise (strike) price: “fixed price”
Expiration (maturity) date: “certain date”
Option premium or price: paid by buyer
to the seller to get the “right”
19-3
How Options Work



Call buyer (seller) expects the price of
the underlying security to increase
(decrease or stay steady)
Put buyer (seller) expects the price of
the underlying security to decrease
(increase or stay steady)
At option maturity

Option may expire worthless, be exercised,
or be sold
19-4
Options Trading

Option exchanges are continuous
primary and secondary markets


Chicago Board Options Exchange largest
Standardized exercise dates, exercise
prices, and quantities

Facilitates offsetting positions through
Options Clearing Corporation

OCC is guarantor, handles deliveries
19-5
Payoff Diagram for a Call Option
Profit per
Option ($)
Buyer
4
0
25
27
29
Stock Price
at Expiration
-4
Seller
How does buying stock compare
with buying a call option?
19-6
Payoff Diagram for Put Option
Profit per
Option ($)
4
Buyer
0
23
-4
25
27
Stock Price
at Expiration
Seller
How does selling stock compare
with buying a put option?
19-7
Covered Call Writing
Profit ($)
Purchased
share
Combined
4
0
23
-4
25
27
29
Stock Price
at Expiration
Written call
19-8
Protective Put Buying
Profit ($)
Purchased
share
Combined
4
0
23
-4
25
27
29
Stock Price
at Expiration
Purchased
put
19-9
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
19-10
Portfolio Insurance
Profit ($)
Purchased
share
Combined
2
0
23
25
27
29
Stock Price
at Expiration
-2
Purchased
put
19-11
Options Terminology

In-the-money options have a positive
cash flow if exercised immediately



Call options: S >E
Put options: S <E
Out-of-the-money options should not
be exercised immediately


Call options: S <E
Put options: S >E
19-12
Options Terminology

Intrinsic value is the value realized
from immediate exercise



Call options: maximum (S0-E or 0)
Put options: maximum (E-S0 or 0)
Prior to option maturity, option
premiums exceed intrinsic value


Time value =Option price - Intrinsic value
=seller compensation for risk
19-13
Should Options be Exercised
Early?

Exercise prior to maturity implies the
option owner receives intrinsic value
only, not time value

For call options, buy stock at below market
price


Would more be earned by selling option?
For put options, receive cash from selling
stock at above market price

Could cash be reinvested for a higher return?
19-14
Option Price Boundaries

At maturity, option prices are intrinsic
values


Intrinsic value is minimum price prior to
maturity
Maximum option prices prior to
maturity


Call options: price of stock, S0
Put options: exercise price, E
19-15
Option Price Boundaries
C=S
Put
Prices
Call
Prices
E
Stock Prices
E
E
Stock Prices
19-16
Black-Scholes Valuation

Five variables needed to value a
European call option on a non-dividend
paying stock
E
C  S  N(d1 )  rt  N(d 2 )
e
2
ln ( S E )  (r  .5 σ )t
d1 
σ t
d 2  d1  σ t
19-17
Put-Call Parity




Black-Scholes valuation is for call
options
Put-call parity shows relationship
between call and put options if riskless
arbitrage is not possible
Price of put =(E/ert) - S +C
Put replicated by riskless lending, short
sale of stock, purchased call
19-18
Factors Affecting Prices
Variable
Stock Price
Exercise Price
Time to maturity
Stock volatility
Interest rates
Cash dividends
Call
+
+
+
+
-
Put
+
+
+
+
19-19
Riskless Hedging

Options can be used to control the
riskiness of common stocks


If stock owned, sell calls or buy puts
Call or put option prices do not usually
change the same dollar amount as the
stock being hedged


Shares purchased per calls written =N(d1)
Shares purchased per puts purchased
=N(d1) - 1
19-20
Stock Index Options




Options available on S&P 100 Index,
S&P 500 Index, NYSE Index, others
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
19-21
Strategies with Stock Index
Options


Speculation opportunities similar to
options on individual stocks
Hedging opportunities permit the
management of market risk


Well-diversified portfolio of stocks hedged
by writing calls or buying puts on stock
index
What return can investor expect?
19-22
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19-23