Options and Investment Objectives
 

About this lecture

This introductory lecture from the course’s first part about options, swaps and futures. 

It will cover fundamentals of options and how they can be used to formulate part of institutional short or long term investment objectives.
 

Lecture Menu

Objectives

Understanding Options

Types of Options

Case Study

Summary

Assignment

After completing this lecture, you will understand the basic concepts of: 

Options and specific terminology 

Types of options and related terminology

Simple bullish and bearish strategies

Definition

An option is the right, but not the obligation, to buy or sell a stock (or other security) for a specified price on or before a specific date.

Options are contracts in which the terms of the contract are standardized and give the buyer the right, but not the obligation, to buy or sell a particular asset (e.g., the underlying stock) at a fixed price (the strike price) for a specific period of time (until expiration).
 

Specific terminology

Strike price
The price at which an underlying stock can be purchased or sold if the option is exercised is called the strike price. 
Example:  Options are available in several strike prices above and below the current price of the underlying asset.  Stocks priced below $25 per share usually have strike prices at 2 ½ dollar intervals.  Stocks priced over $25 usually have strike prices at $5 dollar intervals. 

Expiration date
The date the option expires is referred to as the expiration date.
Example:  Options are good for a specified period of time, after which they expire and you lose your right to buy or sell the underlying instrument at the specified price.

Premium
The price of an option is called the premium. An option's premium is determined by a number of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility. An option premium is priced on a per share basis. Each option on a stock corresponds to 100 shares. 
Example:  If the premium of an option is priced at 2, the total premium for that option would be $200 (2 x 100 = $200). Buying an option creates a debit in the amount of the premium to the buyer's trading account. Selling an option creates a credit in the amount of the premium to the seller's trading account:

Risk
The potential loss to the buyer of an option can be no greater than the initial premium paid for the contract, regardless of the performance of the underlying stock. This allows an investor to control the amount of risk assumed. On the contrary, the seller of the option, in return for the premium received from the buyer, assumes the risk of being assigned if the contract is exercised.

There are two types of options: Calls and Puts.
 

Definition

A call option  - gives the buyer the right, but not the obligation, to buy the underlying security at a specific price for a specified time. The seller of a call option has the obligation to sell the underlying security should the buyer exercise his option to buy.

A put option - gives the buyer the right, but not the obligation, to sell an underlying security at a specific price for a specified time. The seller of a put option has the obligation to buy the underlying security should the buyer choose to exercise his option to sell.
 

Related terminology

In-the-money
A term describing any option that has intrinsic value. A call option is in-the-money if the underlying security is higher than the striking price of the call. A put option is in-the-money if the security is below the striking price.

Intrinsic value
The value of an option if it were to expire immediately with the underlying stock at its current price; the amount by which an option is in-the-money. For call options, this is the difference between the stock price and the striking price, if that difference is a positive number, or zero otherwise. For put options it is the difference between the striking price and the stock price, if that difference is positive, and zero otherwise.

Time Value Premium
The amount by which an option's total premium exceeds its intrinsic value.

Out-of-the-money
A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the-money if the strike price is less than the market price of the underlying security.
 

How to buy a Call to participate in the upward movement of a stock while limiting your downside risk?

X is trading at $50. Instead of spending $5000 for 100 shares of X, an investor could purchase a call with a 50 strike price for $2. By purchasing a call, the investor anticipates X will rise above the strike of 50 + 2 (the option premium) by expiration. Each call represents 100 shares of stock, so 1 call could be bought in place of 100 shares of stock. The cost of 1 calls at 2 is $200 (1 calls x 2 x $100). Instead of spending $5000 on stock, only $200 is needed for the purchase of the call. This investor has unlimited profit potential as X rises above 52. The risk for the option buyer is limited to the premium paid, which in this example is $200.

We will discuss three possible scenarios at expiration. 
 

Scenario A: X is above 52 by expiration.

If X is at 54 at expiration (+$4), the option will be worth the difference between the strike and the current price of the stock: 

$54 (current price) -50 (strike price) = $ 4 (current option value) 

Scenario B: X is between 50 and 52 at expiration

The investor's option will still hold some value if the underlying is between 50 and 52 (breakeven), but not enough to breakeven on the position. The option can still be sold to recoup some of the cost. 

For example, X is at 51. X did rise in value, but not as much as anticipated. The option that cost $2 is now worth $1. Net loss will be $1. 

If just the stock had been bought and the stock rose to 51, $100 would have been earned while the holder of calls would have lost $100. 

Scenario C: X is at or below 50 at expiration.

X is now at 46 (+$4) and the option has expired worthless. The premium that was paid for the calls has been lost. By purchasing a call he had limited capital at risk. Now he still has most of the money that he would have spent to buy the stock. 

1. Options give you the right to buy or sell an underlying instrument. 

2. If you buy an option, you are not obligated to buy or sell the underlying instrument; you simply have the right to. 

3. If you sell an option and the option is exercised, you are obligated to deliver the underlying asset (call) or take delivery of the underlying asset (put) at the strike price of the option regardless of the current price of the underlying asset. 

4. Options are good for a specified period of time, after which they expire and you lose your right to buy or sell the underlying instrument at the specified price. 

5. Options are available in several strike prices representing the price of the underlying instrument. 

6. The cost of an option is referred to as the option premium.
 

1. X trading at 100, find: time value, intrinsic value for the following options.
    a) Put, strike 110, Premium(price) 12
    b) Call, strike 110, Premium(price) 1
 
 
 

Answers to Practical Test question:

a) time value = Premium – intrinsic value = $2
    intrinsic value = max(0, strike – premium) = $10
b) time value = Premium – intrinsic value = $1
    intrinsic value = max(0, strike – premium) = 0
 

1. Repeat the analysis from “Topic 3: Sample options analysis” for put option for underlying being at expiration at 50, 55, 45.

2. Given the following options find: premium, time value, intrinsic value.
Also find profit (or loss) for buying one option and the underlying being at expiration at 25, 29, 30, 31, 35

3. An investor buys a call with strike price X and sells a put with a same strike price. Describe the investor position. Hint: repeat the analysis from question 2.