14

Stock Options

McGraw-Hill/Irwin

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Stock Options
In this chapter, we will discuss general features of options, but will focus on options on individual common stocks. We will see the tremendous flexibility that options offer investors in designing investment strategies.

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Option Basics
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 two basic option types.
Call options are options to buy the underlying asset. Put options are options to sell an 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.
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Option Basics, Cont.

Option contracts are legal agreements between two partiesthe buyer of the option, and the seller of the option. The minimum terms stipulated by stock option contracts are:
The identity of the underlying stock. The strike price, or exercise price. The option contract size. The option expiration date, or option maturity. The option exercise style (American or European). The delivery, or settlement, procedure.

Stock options trade at organized options exchanges, such as the CBOE, as well as over-the-counter (OTC) options markets.

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Listed Option Quotations

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Example: Buying the Underlying Stock versus Buying a Call Option

Suppose IBM is selling for $90 per share and call options with a strike price of $90 are $5 per share. Investment for 100 shares:
IBM Shares: $9,000 One listed call option contract: ($500)

Suppose further that the option expires in three months. Finally, lets say that in three months, the price of IBM shares will either be: $100, $90, or $80.
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Example: Buying the Underlying Stock versus Buying a Call Option, Cont.
Lets calculate the dollar and percentage return given each of the prices for IBM stock:
Buy 100 IBM Shares ($9000 Investment): Dollar Profit: Case I: $100 $1,000 Percentage Return: 11.11% Buy One Call Option ($500 Investment): Dollar Profit: $500 Percentage Return: 100%

Case II: $90

$0

0%

-$500

-100%

Case III: $80

-$1,000

-11.11%

-$500

-100%

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Call Option Payoffs

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Put Option Payoffs

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Call Option Profits

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Put Option Profits

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Option Strategies
Protective put - Strategy of buying a put option on a stock already owned. This protects against a decline in value (i.e., it is "insurance") Covered call - Strategy of selling a call option on stock already owned. This exchanges upside potential for current income. Straddle - Buying or selling a call and a put with the same exercise price. Buying is a long straddle; selling is a short straddle.
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More Option Trading Strategies

There are many option trading strategies available to option traders. For ideas on option trading strategies, see: www.commodityworld.com www.writecall.com www.giscor.com

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Arbitrage
Arbitrage:
No possibility of a loss A potential for a gain No cash outlay

In finance, arbitrage is not allowed to persist.

Absence of Arbitrage = No Free Lunch The Absence of Arbitrage rule is often used in finance to figure out prices of derivative securities.

Think about what would happen if arbitrage were allowed to persist. (Easy money for everybody)
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The Upper Bound for a Call Option Price

Call option price must be less than the stock price. Otherwise, arbitrage will be possible. How?
Suppose you see a call option selling for $65, and the underlying stock is selling for $60. The arbitrage: sell the call, and buy the stock.
Worst case? The option is exercised and you pocket $5. Best case? The stock sells for less than $65 at option expiration, and you keep all of the $65.

There was zero cash outlay today, there was no possibility of loss, and there was a potential for gain.
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The Upper Bound for a Put Option Price

Put option price must be less than the strike price. Otherwise, arbitrage will be possible. How? Suppose there is a put option with a strike price of $50 and this put is selling for $60. The Arbitrage: Sell the put, and invest the $60 in the bank. (Note you have zero cash outlay).
Worse case? Stock price goes to zero.
You must pay $50 for the stock (because you were the put writer). But, you have $60 from the sale of the put (plus interest).

Best case? Stock price is at least $50 at expiration.

The put expires with zero value (and you are off the hook). You keep the entire $60, plus interest.

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The Lower Bound on Option Prices

Option prices must be at least zero.
By definition, an option can simply be discarded.

To derive a meaningful lower bound, we need to introduce a new term: intrinsic value. The intrinsic value of an option is the payoff that an option holder receives if the underlying stock price does not change from its current value.

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Option Intrinsic Values

That is, if S is the current stock price, and K is the strike price of the option: Call option intrinsic value = max [0, S K ]
In words: The call option intrinsic value is the maximum of zero or the stock price minus the strike price.

Put option intrinsic value = max [0, K S ]

In words: The put option intrinsic value is the maximum of zero or the strike price minus the stock price.

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Option Moneyness
In the Money options have a positive intrinsic value.
For calls, the strike price is less than the stock price. For puts, the strike price is greater than the stock price.

Out of the Money options have a zero intrinsic value.

For calls, the strike price is greater than the stock price. For puts, the strike price is less than the stock price.

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

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Intrinsic Values and Arbitrage, Calls

Call options with American-style exercise must sell for at least their intrinsic value. (Otherwise, there is arbitrage) Suppose: S = $60; C = $5; K = $50. Instant Arbitrage. How?
Buy the call for $5. Immediately exercise the call, and buy the stock for $50. In the next instant, sell the stock at the market price of $60.

You made a profit with zero cash outlay.

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Intrinsic Values and Arbitrage, Puts

Put options with American-style exercise must sell for at least their intrinsic value. (Otherwise, there is arbitrage) Suppose: S = $40; P = $5; K = $50. Instant Arbitrage. How?
Buy the put for $5. Buy the stock for $40. Immediately exercise the put, and sell the stock for $50.

You made a profit with zero cash outlay.

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Back to Lower Bounds for Option Prices

As we have seen, to prevent arbitrage, option prices cannot be less than the option intrinsic value.
Otherwise, arbitrage will be possible. Note that immediate exercise was needed. Therefore, options needed to have American-style exercise.

Using equations: If S is the current stock price, and K is the strike price: Call option price max [0, S K ] Put option price max [0, K S ]
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Employee Stock Options, ESOs

Essentially, an employee stock option is a call option that a firm gives to employees.
These call options allow the employees to buy shares of stock in the company. Giving stock options to employees is a widespread practice.

Because you might soon be an ESO holder, an understanding of ESOs is important.

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Features of ESOs
ESOs have features that ordinary call options do not. Details vary by firm, but:
The life of the ESO is generally 10 years. ESOs cannot be sold. ESOs have a vesting period of about 3 years.
Employees cannot exercise their ESOs until they have worked for the company for this vesting period. If an employee leaves the company before the ESOs are vested," the employees lose the ESOs. If an employee stays for the vesting period, the ESOs can be exercised any time over the remaining life of the ESO.

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Why are ESOs Granted?

Owners of a corporation (i.e., the stockholders) have a basic problem. How do they get their employees to make decisions that help the stock price increase? ESOs are a powerful motivator, because payoffs to options can be large.
High stock prices: ESO holders gain and shareholders gain.

ESOs have no upfront costs to the company.

ESOs can be viewed as a substitute for ordinary wages. Therefore, ESOs are helpful in recruiting employees.
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ESO Repricing
ESOs are generally issued exactly at the money.
Intrinsic value is zero. There is no value from immediate exercise. But, the ESO is still valuable.

If the stock price falls after the ESO is granted, the ESO is said to be underwater.
Occasionally, companies will lower the strike prices of ESOs that are underwater.
This practice is called restriking or repricing. This practice is controversial.
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ESO Repricing Controversy

PRO: Once an ESO is underwater, it loses its ability to motivate employees.
Employees realize that there is only a small chance for a payoff from their ESOs. Employees may leave for other companies where they get fresh options.

CON: Lowering a strike price is a reward for failing.

After all, decisions by employees made the stock price fall. If employees know that ESOs will be repriced, the ESOs loose their ability to motivate employees.

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ESOs Today
Most companies award ESO on a regular basis.
Quarterly Annually

Therefore, employees will always have some at the money options. Regular grants of ESOs means that employees always have some unvested ESOsgiving them the added incentive to remain with the company.

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Put-Call Parity
Put-Call Parity is perhaps the most fundamental relationship in option pricing. Put-Call Parity is generally used for options with European-style exercise.

Put-Call Parity states: the difference between the call price and the put price equals the difference between the stock price and the discounted strike price.

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The Put-Call Parity Formula

C P S Ke rT
In the formula:
C is the call option price today S is the stock price today r is the risk-free interest rate P is the put option price today K is the strike price of the put and the call T is the time remaining until option expiration
rT
e-rT is a discount factor, so Ke-rT is simply the discounted strike price.

Note: this formula can be rearranged:

Ke

SPC
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Why Put-Call Parity Works

If two securities have the same risk-less pay-off in the future, they must sell for the same price today. Today, suppose an investor forms the following portfolio:
Buys 100 shares of Microsoft stock Writes one Microsoft call option contract Buys one Microsoft put option contract.

At option expiration, this portfolio will be worth:

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Put-Call Parity Notes

Notice that the portfolio is always worth $K at expiration. That is, it is riskless. Therefore, the value of this portfolio today is $Ke-rT. That is, to prevent arbitrage: todays cost of buying 100 shares and buying one put (net of the proceeds of writing one call), should equal the price of a risk-less security with a face value of $K, and a maturity of T. Fun fact: If S = K (and if rT > 0), then C > P.
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Stock Index Options

A stock index option is an option on a stock market index. The most popular stock index options are options on the S&P 100, S&P 500, and Dow Jones Industrial Average. 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.
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Index Option Trading

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The Options Clearing Corporation

The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised. The OCC issues and clears all option contracts trading on U.S. exchanges. Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC). Visit the OCC at: www.optionsclearing.com.
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Useful Websites
For information on options ticker symbols, see: www.cboe.com www.optionsites.com For more information on options education: www.optionscentral.com To learn more about options, see: www.e-analytics.com www.tradingmarkets.com www.investorlinks.com

Exchanges that trade index options include: www.cboe.com www.cbot.com www.cme.com

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Chapter Review, I.
Options on Common Stocks
Option Basics Option Price Quotes

Why Options? Option Payoffs and Profits

Option Writing Option Payoffs Payoff Diagrams Option Profits

Option Strategies
The Protective Put Strategy The Covered Call Strategy Straddles
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Chapter Review, II.

Option Prices, Intrinsic Values, and Arbitrage
The Upper Bound for a Call Option Price The Upper Bound for a Put Option Price The Lower Bounds on Option Prices

Employee Stock Options (ESOs)

Features Repricing

Put-Call Parity Stock Index Options

Features and Settlement Index Option Price Quotes

The Options Clearing Corporation

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