Derivatives Product - Call and Put Options

1. CALL AND PUT OPTIONS
__Presented by Group 1__
Chang Hyun Nahm
Asenaca Wotta
Nga Diem Hang Phan
Desi Kusumaningtyas
Group 1
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2. Introduction
• What is an Option?
Contract between a buyer & seller
gives the buyer the right, but not the
obligation, to buy (or sell) a certain asset at a
specific price at any time during the life of the
contract
E.g. game ticket
Security (similar to stock & bond)
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3. Introduction
• Option contract
gives the owners the option to purchase
(call option) or sell (put option) an asset.
Two (2) types of option contract:
1. Call option; and
2. Put option
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4. General Concepts
An option usually contains the following elements:
1.Option holder/buyer - is given the right to buy or sell an asset
2.Option writer/seller – issues option contract, has an obligation to
sell or buy the asset if the option is exercised by option’s holder.
3.Strike/Exercise Price: price at which the asset can be traded under a
option contracts
4.Limited time frame
 Expiration date – the date at which an unexercised option
becomes invalid
5. Price
• Premium - purchase price of an option
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5. Option Trading
• Trading Activity
oCurrent options trading takes place at these
financial institutions:
Chicago Board Options Exchange (CBOS);
American Stock Exchange;
Pacific Stock Exchange; and
Philadelphia Stock Exchange (especially currency
options)
•100shares/One option contract
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6. • Call option - a negotiable instrument that gives the option
buyer (holder) the right to buy the underlying asset
• at a specific price (“exercise price”)
• within a given period of time (the option expiration date)
Call Option
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7. Call Option
• Example 1: Buying a Stock
Professor purchases a call option on
shares of IBM
Strike Price of $40
Expiration date: 31 July
Option contract: right to purchase 100
shares at price of $40 on 31 July
When will this right become valuable
to exercise?
Only valuable if IBM is trading above $40
per share on 31 July
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8. Call Option
• Example 2: Buying a House
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9. Call Option
• Example 2: Buying a House
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10. • Example 2: Buying a House
Call Option
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11. Call Option
• Example 2: Buying a House
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12. Call Option
• Example 2: Buying a House
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13. Actual cost of this option (Premium)??
(Note: each options contract represents an interest in 100 ounces of gold)
= 100 ounce X $2.00 = $200
If you want to buy gold (Currently trading at $1000 per ounce),
You purchase call option contract on gold with a $1000 strike price and at a
price of $2.00 per contract
Example 3: Buying Gold
Call Option
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14. “The option is called in the money”
(Market price > Strike price)
Gold is trading
at $1050 per ounce
(More valuable than
exercise price)
The option will be worth $50 per ounce (=$1050-$1000)
And total sale price (payoff) will be $5000 (=$50X100)
The option buyer has the right to
purchase gold at $1000 per ounce
Net profit to the
buyer will be $4800
(= $5000-$200)
Example 3: Buying gold – Scenario 1
Call Option
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15. Example 3: Buying gold – Scenario 2
Gold is trading
at $1000 per ounce
(Equally valuable to
exercise price)
The option buyer has the right to
purchase gold at $1000 per ounce
The option will be worth zero per ounce (=$1000-$1000)
And total sale price (payoff) will be zero (=$0.00X100)
Net profit to the
buyer will be -$200
(= $-$200)
“The option is called at the money”
(Market price = Strike price)
Call Option
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16. Example 3: Buying gold – Scenario 3
Gold is trading
at $900 per ounce
(Less valuable than
exercise price)
You have no reason to exercise
your call option
You can let the option expire worthless
Net profit to the
buyer will be -$200
(= $-$200)
“The option is called out of the money”
(Market price < Strike price)
Call Option
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17. Put Option
What is Put Option?
•An option contract in which the holder (buyer) has the
right (but not the obligation) to sell a specified quantity of a
security at a specified price (strike price) within a fixed
period of time (until its expiration)
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18. Put Option
Example 1: Buying put option/ insurance policy
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19. Put Option
Example 1: Buying put option/ insurance policy
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20. Put Option
• Example 1: Buying put option/ insurance policy
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21. Put Option
• Example 1: Buying put option/ insurance policy
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22. Example 2: Selling stocks
Suppose that you believe yahoo stock is going to fall in the near future. And
you can buy put options on YAHOO.
If you want to sell YAHOO stock (Currently trading at $12 per shares),
You purchase put option contract on yahoo stock with a $10 strike price and
at a price of $0.01 per share for a 100 share contract
Actual cost of this option (Premium)??
(Note: each options contract represents an interest in 100 shares of stock)
= 100 shares X $0.01 = $1
Put option
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23. “The option is called in the money”
(Market price < Strike price)
The stock is trading
at $8 per share
(Less valuable than
exercise price)
The option will be worth $2 per share (=$10-$8)
And total sale price (payoff) will be $200 (=$2X100shares)
The option buyer has the right to sell
the stock at $10 per share
Net profit to the
buyer will be $199
(= $200-$1)
Example 2: Selling stocks – Scenario 1
Put Option
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24. Example 2: Selling stocks - Scenario 2
The stock is trading
at $10 per share
(Equally valuable to
exercise price)
The option buyer has the right to sell
the stock at $10 per share
The option will be worth zero per share (=$10-$10)
And total sale price (payoff) will be zero (=$0.00X100)
Net profit to the
buyer will be -$1
(= $-$1)
“The option is called at the money”
(Market price = Strike price)
Put Option
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25. Example 2: Selling stocks - Scenario 3
The stock is trading
at $15 per ounce
(More valuable than
exercise price)
You have no reason to exercise
your put option
You can let the option expire worthless
Net profit to the
buyer will be -$1
(= $-$1)
“The option is called out of the money”
(Market price > Strike price)
Put Option
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26. Why Investors Use
Options?
1. Speculation
•Speculators make bets/ guesses on where
they believe the market is headed
•Seek profit from fluctuating prices of
securities (buy low, sell high)
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27. Why Investors Use
Options?
• Speculation: Example
I am an investor
I think that Desi’s Brewing Business (DBB) is
overvalued at $25
I bet/guess that P in future
So I borrow the stock & sell it for $25 per share (short
sell)
Once P to $20, I will buy it back and return to
owner, making $5 profit
If P in future, say $30, then I lose $5 per share
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28. Why Investors Use Options?
2. Hedging
•Reducing risk, i.e like buying insurance, protection
against unforeseen events; reduce risks associated with
uncertainty
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29. • Hedging: Example 1 Buying Call Option
Asenaca’s Tequila Company depends on agave plants
Why Investors Use Options?
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30. Suppose you bought 100 shares of Apple computer (AAPL) at $500 but wanted
to make sure you don't lose more than 10% on this investment
You could buy an AAPL hedging option with a strike of $450
Hedging: Example 2: Selling stocks
Why Investors Use Options?
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31. If the price drops
below $450 a share
You will be able to exercise your hedging
option and sell your stock for $450
If the price increases
above $450 a share
Your hedging option would
become worthless
(At least you had the protection)
Hedging - Example 2: Selling stocks – Scenario 1
Why Investors Use Options?
Hedging - Example 2: Selling stocks – Scenario 2
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32. Value of an Option
Option value and the Volatility of the underlying asset
Example 1: Buying cameras
http://www.bestbuy.com/site/promo/select-dslr-2-lens-kits
We want to buy camera, there are many alternatives
Example 2: Flight ticket
https://faq.orbitz.com/app/answers/detail/a_id/23662/~/how-much-does-it-cost-to-change-
Cancellable and Non-Cancellable ticket.
Cancellable Airline Tickets: When the volatility of an underlying is zero, we can
easily find the option value most of the time. For example, the options on items
for shopping have no value because the volatility of the underlying item is
usually zero. However, in case of a cancellable airline ticket, the value of the
cancellable option is NOT zero even when the price of the airline ticket has no
volatility. Note that if everybody cancels, the airline company may not sell all
the cancelled seats within a short period of time. Consider an at-the-money
equity option. Then if the volatily of the equity is zero, there is no value for the
option. But this argument is NOT always valid, say, a cancellable airline ticker.
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33. Value of an Option
Option Intrinsic Value
Call option Max(ST – E ;0)
Put option Max (E - ST ; 0)
 To understand the characteristics of options, we examine their
value at expiration
ST = the value of the underlying at expiration date
E = the exercise price of the option
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34. Terminology
• At-the-money: Market price = Strike price
• In-the-money: Positive intrinsic value
• Call option: when the strike price is less than the market
price of the underlying security
• Put option: when the strike price is greater than the market
price of the underlying security
• Out-of-the-money: Zero intrinsic value
• Call option: when the strike price is greater than the market
price of the underlying security
• Put option: when the strike price is less than the market
price of the underlying security
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35. Payoff from Call options
Buying a call
Pay off to a call buyer at expiration: Max(ST – E ;0)
= ST - E if St> E
= 0 if ST≤ E
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36. Call Option example
BCE Inc. Nov. call with exercise price of $30 is selling for $5.75
BCE stock at expiration $20 25 30 35 40
Payoff at expiration $ 0 0 0 5 10
If at expiration BCE stock is trading at $40 then:
Net profit = option payoff – option price
= ($40 - $30) - $5.75 = $4.25
Up to $30 the call option investor’s maximum loss is $5.75
(which is the option price)
The breakeven point for the investor is at $35.75
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37. Call Option example
• Profit and Loss to the Buyer of a Call Option
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38. Selling (writing) a Call
A option writer is one who does not hold a position in the
underlying asset
call option writers incur losses if the stock price increases
Payoff to call writer at expiration Max (-(ST - E) ; 0)
= -(ST - E) if ST> E
= 0 if ST≤ E
The net profit line for a call writer is a mirror image of a call
buyer
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39. Selling (Writing) a Call
• Profit and Losses to the Writer of a Call option
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40. Buying a Put Option
• Put option makes money when stock price
declines
Payoff to put buyer: Max (E - ST; 0)
= 0 if ST >= E
= E - STif ST< E
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41. Put Option example
BCE Inc. Nov. put with exercise price of $30 is selling for
$0.30
BCE stock at expiration $20 25 30 35 40
Pay-off at expiration $10 5 0 0 0
If at expiration BCE stock is trading at $20 then:
Net profit = option payoff – option price
= ($20-$10) - $0.30 = $9.70
The breakeven point for the investor is at $29.70
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42. Profit and Losses to the Buyer of a Put Option
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43. Selling (Writing) a Put
The payoff pattern for a put investor is the mirror image
of a put buyer
Payoff to a put writer at expiration: Max (-(E- ST);0)
= 0 if ST >= E
= -(E - ST) if ST < E
The writer is obligated to buy the stock at the specified
price during the life of the put contract
If the stock price falls the put buyer may buy the stock
and exercise the put by making the writer pay the
specified price
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44. Profit and Losses to the Writer of a Put
Option
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45. Option Styles
• EUROPEAN is an option that can be exercised only on
its expiration date
• AMERICAN is an option that can be exercised any time
up until and including its expiration date
Question: Is American Option worth more than European? Should
we exercise when American options is in the money?
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46. Option Styles
Answer: Not necessary. Why?
1.For call options we want to delays the payment of strike price
(as forward example). We can earn an interest on strike price
throughout the life of an option
2.For Put value exercise of an American put option is a trade-off
between the time value of money and an insurance value. The
time decreases the value of an option. However, an option
holder gets an insurance value instead.
(assumption options with no dividends)
*When we buy American options, selling options rather than
exercising them before the maturity is also feasible. 46

47. To summarize...
CALL PUT
BUYER Right to Buy Right to Sell
ISSUER/SELLER Obligation to Sell Obligation to Buy
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48. Ready for a small quiz?
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