CH 15: Stock Options

Option Review

A stock option is a derivative security because the value of the option is “derived” from the value of the underlying common stock.

There are 2 basic option types:

  • Call options are options to buy the underlying asset

  • Put options are options to sell the underlying asset

Listed option contracts are standardized to facilitate trading and price reporting. Listed stock options give the option holder the right to buy or sell 100 shares of stock.


Option Basics

Option contracts are legal agreements between two parties - The buyer of the option and the seller of the option.

Stock options trade at organized options exchanges, such as the Montreal Exchange, as well as OTC options markets.

Option chain is a list of available option contracts and their prices for a particular security arrayed by strike price and maturity.


Why Options?

Options offer an alternative means of formulating investment strategies.


Compare buying call options vs directly buying 100 shares:

  • The dollar loss potential with call options is lesser.

  • The dollar gain potential with call options is lesser.

  • The positive % gain with call options is greater.

  • The negative % return with call options is greater


The Canadian Derivatives Clearing Corporation

The Canadian Derivatives Clearing Corporation (CDCC) is a subsidiary of the Montreal Exchange that guarantees the terms of an option contract will be fulfilled if the option is exercised.

Acts as the central clearing agency and guarantor of all exchange-traded derivative products in Canada.

No such guarantee on the OTC market.


Stock Index Options

A stock index option is an option on a stock market index.

Because the actual delivery of all stocks comprising a stock index is impractical, stock index options have a cash settlement procedure.

  • That is, if the option expires in the money, the option writer simply pays the option holder the intrinsic value of the option.

  • The cash settlement procedure is the same for calls and puts.


Option Intrinsic Values

The intrinsic value of an option is the payoff that an option holder receives based on the difference between current underlying stock price and the strike price.


Option Time Value

For American-style options, the longer the time to expiration, the higher the option time value because there is more time for the stock price to fluctuate.

Before expiration, the value of an option is equal to its intrinsic value + its time value.

At or near expiration, an options time value is roughly zero so the value of the option is just equal to its intrinsic value.

Whenever there is a positive option time value, it may be beneficial for the option holder to sell the option at a premium.


Option “Moneyness”

“In the money” option: An option that would yield a positive payoff if exercised.

“Out of the money” option: An option that would NOT yield a positive payoff if exercised.

“At the Money” options is a term used for options when the stock price and the strike price are about the same.


*Note for a given strike price, either only the call or only the put can be “In the money.” Option Premium is not taken into account in “Moneyness.”


Option Writing

The act of selling an option is referred to as option writing.

The seller of an option contract is called the writer.

  • The call option holder has the right to exercise/buy the underlying asset at the strike price.

  • The writer of a call option contract is obligated to sell the underlying asset to the call option holder if the option is exercised.


  • The put option holder has the right to exercise/sell the underlying asset at the strike price.

  • The writer of a put option contract is obligated to buy the underlying asset from the put option holder if the option is exercised.


**Option holders also have the right to sell their option to another investor at any time. That is, they do not have to exercise the option if they no longer want it.


Option Payoffs vs Option Profits

Option investment strategies involve initial and terminal cash flows.

Initial cash flow: Option price (Aka option premium).

Option premium is paid by the buyer to the seller.


Terminal cash flow: The value of an option at exercise (Aka option payoff)

Option payoff is paid by the seller to the buyer.


The terminal cash flow can be realized by the option holder by exercising the option.


There will be a profit if the Terminal cash flow > Initial cash flow


3 Types of Option Trading Strategies

  1. Traders add an option position to their stock position.

    Help traders modify their stock risk

    Example: Covered calls

    • Selling a call option on a stock already owned

    • Earn option premium as a seller of call option

    • Best scenario: The buyer of the call option does not exercise the option (when the market price is lower than the exercise price) and you get to keep the premium.

    • Worst scenario: The buyer exercises the call option, and you have to sell the stock to the buyer at the exercise price, but you still get to keep the premium.


  2. Spreads

    Taking a position on two or more options of the same type (only calls or only puts).

    Example: Butterfly Spread

    • If you believe a specific stock price will not fluctuate much by expiration, you can use 4 options to create the butterfly spread.

    • Sell 2 options at the expected stock price (middle strike price)

    • Buy 1 option with a lower strike price

    • Buy 1 option with a higher strike price

    The 3 option positions should have equally-spaced strike prices with the same expiration.

    Best scenario: The stock price at expiration is exactly equal to the middle strike price so you earn the spread on one of the options as well as the premiums on the 2 options that you sold.


Combinations

Take a position in a mixture of call and put options.

Example: Straddle

Buy one call and one put with the same strike and expiration (long).

  • Only useful if you believe there is going to be a major change in the stock price but are unsure of which direction it will move in.

  • Best Scenario: The stock price rises to a price equal to or higher than the option strike price + option premiums OR the stock price falls to equal to or lower than the option strike price - options premiums.


Sell one call and one put with the same strike and expiration (Short).

  • Useful if you believe there is not going to be a major change in the stock price and earn the option premiums.

  • Best scenario: The stock price is the same as the strike price, then both options would expire worthless.



Summary

Protective put - A Strategy of buying put options to protect against falling values of a stock that you own. Provide “insurance” for the value of an asset or a stream of cash flows.


Protective call - A strategy of buying call options to protect against rising prices when you have taken a short position on a stock. Provide a way to “lock in” the value of a liability or a stream of cash outflows.