Chapter 23: Options

Question 1

What is the payoff to buyers and sellers of call and put options?

Answer 1

Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer profits when the underlying asset increases in price.

A call option may be contrasted with a put, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.

For options on stocks, call options give the holder the right to buy 100 shares of a company at a specific price, known as the strike price, up until a specified date, known as the expiration date.

KEY TAKEAWAYS

• A call is an option contract giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time.
• The specified price is known as the strike price and the specified time during which a sale is made is its expiration or time to maturity.
• Call options may be purchased for speculation, or sold for income purposes. They may also be combined for use in spread or combination strategies.

Question 2

What are the determinants of option values?

Answer 2

Value depends on:

• to exercise the call option, you must pay the exercise price. The value of the option is higher when the exercise price is low relative to the stock price
• investors who buy the stock by way of a call options are buying on instalment credit. They pay the purchase price of the option today, but they do not pay the exercise price until they exercise the option. The higher the rate of interest and the longer the time to expiration, the more this ‘free credit’ is worth.
• no matter how far the stock price falls, the owner of the call cannot lose more than the price of the call.

Question 3

What are options?

Answer 3

Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.

Call options allow the holder to buy the asset at a stated price within a specific timeframe.
Put options allow the holder to sell the asset at a stated price within a specific timeframe.

Each option contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.

KEY TAKEAWAYS

• Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
• Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation.
• Although there are many opportunities to profit with options, investors should carefully weigh the risks.

Question 4

What are some of the options on real assets?

Answer 4

• the option to expand (Alberta tar sands)
• the option to abandon (building tender A needs to start right away, but building tender B starts in a year – gives you time to abandon in case you won’t need the building)

Question 5

What are some of the options on financial assets?

Answer 5

• Executive stock options (Larry Ellison’s salary - $1, stock options - $21m)
• Warrants - longterm call option on the company’s stock (US treasury receipt of 150 million Bank of America warrants in return for the bailout). Could also be used during bankruptcy as part of settlement.
• Convertible bonds - package of a straight bond and a call option. Because the option not to convert exists, bond value establishes a lower bound (floor) to the price of a convertible. But the floor is not completely flat. If the firm falls on hard time, the bond may be worth little, or even become worthless. If the firm does well, however, conversion value exceeds bond value.
• Callable bonds - rather than giving the investor an option, this gives the issuer the option rather than the investor. They have the option to buy the bond back at the ‘call’ price.