Instructor: Bill Johnson

Four Levels of CompetencyFour Levels of Competency

Unconscious Incompetent

Conscious Incompetent

Conscious Competent

Unconscious Competent

What is an Option?What is an Option?

Options are contractual agreements to buy or Options are contractual agreements to buy or sell stock at a predetermined price over a sell stock at a predetermined price over a given time period.given time period.

Derivative instrumentsDerivative instruments

Danger depends on how they are used!Danger depends on how they are used!

Options created to hedge risk.Options created to hedge risk.

Two types of optionsTwo types of options

Call options:Call options: Give the owner the right, not Give the owner the right, not the obligation, to the obligation, to buybuy stock at a fixed price stock at a fixed price over a given period of time. over a given period of time. ““CallCall”” away away from owner.from owner.

Put options:Put options: Give the owner the right, not Give the owner the right, not the obligation to the obligation to sellsell stock at a fixed price stock at a fixed price over a given period of time. over a given period of time. ““Put it back to Put it back to owner.owner.””

Call OptionCall Option

Expires 10/31/04 Expires 10/31/04

Put Option = Car InsurancePut Option = Car Insurance

Rights vs. ObligationsRights vs. Obligations

If you buy an option, you are long the If you buy an option, you are long the position. You have the position. You have the rightright to buy to buy (call) or sell (put).(call) or sell (put).

The seller of the contract, or short The seller of the contract, or short position, has an position, has an obligationobligation..

CallCall PutPut

LongLong Right to buyRight to buy Right to sellRight to sell

ShortShort Obligation to sellObligation to sell Obligation to buyObligation to buy

Long calls have a right to buyLong calls have a right to buy……

Expires 10/31/04 Expires 10/31/04

……short calls have an obligation to sell short calls have an obligation to sell

Long puts have the right to sellLong puts have the right to sell……

……short puts have the obligation to buy short puts have the obligation to buy

The Options Clearing Corporation The Options Clearing Corporation (OCC)(OCC)

The OCC guarantees The OCC guarantees performanceperformance of all contracts. of all contracts.

This means if you wish to use your This means if you wish to use your ““couponcoupon”” to to buy or sell stock, you can be assured the buy or sell stock, you can be assured the transaction will go through.transaction will go through.

Options are similar to stock:Options are similar to stock:

Options are securities. They trade in Options are securities. They trade in ““contractscontracts”” rather rather than shares.than shares.

Options trade on national SEC (Securities Exchange Options trade on national SEC (Securities Exchange Commission) regulated exchanges.Commission) regulated exchanges.

Option orders are transacted through market makers Option orders are transacted through market makers and retail participants with bids to buy and offers to sell and retail participants with bids to buy and offers to sell and can be traded like any other security.and can be traded like any other security.

Options are different from stock:Options are different from stock:

Options have an expiration date.Options have an expiration date.

Options only exist as "book entry." There are no Options only exist as "book entry." There are no certificates.certificates.

There is no limit to the number of options that can be There is no limit to the number of options that can be traded on an underlying stock. Common stocks have a traded on an underlying stock. Common stocks have a fixed number of shares outstanding.fixed number of shares outstanding.

Options do not confer voting rights or dividends. Options do not confer voting rights or dividends.

Options are standardized contractsOptions are standardized contracts

Each contract controls 100 shares of the Each contract controls 100 shares of the underlyingunderlying stock.stock.

There are at least four expiration months.There are at least four expiration months.

Terminology:Terminology:PremiumPremium

The price you pay for an option is called the The price you pay for an option is called the premiumpremium. .

Remember that each contract controls 100 Remember that each contract controls 100 shares so the premium must be multiplied by shares so the premium must be multiplied by 100 to get the 100 to get the total contract valuetotal contract value..

Terminology:Terminology:Exercise vs. AssignExercise vs. Assign

If you wish to use your option, you must submit If you wish to use your option, you must submit exerciseexercise instructions to your broker. Long instructions to your broker. Long positions exercise.positions exercise.

If you are forced to buy or sell the stock, you If you are forced to buy or sell the stock, you have been have been assignedassigned. Short positions get . Short positions get assigned.assigned.

Terminology:Terminology:American vs. EuropeanAmerican vs. European

American: Owner can exercise at any time.American: Owner can exercise at any time.European: Owner can exercise ONLY at European: Owner can exercise ONLY at expiration.expiration.All equity (stock) options are American style.All equity (stock) options are American style.

Terminology:Terminology:Exercise Price or Strike PriceExercise Price or Strike Price

If you exercise your option, you will pay the If you exercise your option, you will pay the strike price (for call options) or receive the strike strike price (for call options) or receive the strike price (for put options).price (for put options).

Exercise price = Strike price.Exercise price = Strike price.

What do these options allow the What do these options allow the owner to do?owner to do?

Long MSFT Dec. $30 callLong MSFT Dec. $30 call

Long MSFT Dec. $25 putLong MSFT Dec. $25 put

What do these options create?What do these options create?

Short MSFT Dec. $30 callShort MSFT Dec. $30 call

Short MSFT Dec. $25 putShort MSFT Dec. $25 put

Terminology:Terminology:Expiration DateExpiration Date

Expiration dateExpiration date: The date on which the : The date on which the option expires. You cannot buy or sell an option expires. You cannot buy or sell an option on or after the expiration date, which option on or after the expiration date, which is Saturday following the third Friday.is Saturday following the third Friday.

Your last day to trade an option is the Your last day to trade an option is the third third FridayFriday of the expiration month.of the expiration month.

When is Expiration?When is Expiration?

Can you identify the highlighted fields?Can you identify the highlighted fields?

MSFT MSFT Dec.Dec. $30$30 call = call = $4$4

MSFT MSFT Apr.Apr. $25$25 put = put = $1$1

How much would 2 contracts of each option cost? How many shares of MSFT would you be controlling?

Terminology:Terminology:MoneynessMoneyness

Options are classified as:Options are classified as:

InIn--thethe--moneymoney

OutOut--ofof--thethe--moneymoney

AtAt--thethe--moneymoney

Exchanges always try to maintain at least one of Exchanges always try to maintain at least one of each.each.

Would you have an Would you have an immediate desireimmediate desire to own to own this coupon if pizzas were selling for $8?this coupon if pizzas were selling for $8?

$10.00Expires 12/31/04

This coupon is out-of-the-money

Would you have an Would you have an immediate desireimmediate desire to own to own this coupon if pizzas were selling for $15?this coupon if pizzas were selling for $15?

$10.00Expires 12/31/04

This coupon is in-the-money

Would you have an Would you have an immediate desireimmediate desire to own to own this coupon if pizzas were selling for $10.00?this coupon if pizzas were selling for $10.00?

$10.00Expires 12/31/04

This coupon is at-the-money

Terminology:Terminology:Time DecayTime Decay

Because options expire, a portion of their Because options expire, a portion of their price will erode with each passing day. This price will erode with each passing day. This is called is called time decaytime decay..

Is time decay necessarily bad? Can you Is time decay necessarily bad? Can you think of an asset youthink of an asset you’’ve purchased that is ve purchased that is exposed to short time decay?exposed to short time decay?

Time Values vs. Intrinsic ValuesTime Values vs. Intrinsic Values

An optionAn option’’s price can be broken down into s price can be broken down into time valuetime value and and intrinsic valueintrinsic value..

$8

$5 $3

Intrinsic ValueIntrinsic Value

To determine if there is intrinsic value in To determine if there is intrinsic value in an option, determine if there is an an option, determine if there is an immediate benefit immediate benefit in owning the option.in owning the option.

Assume pizzas are selling for $15. Is there an Assume pizzas are selling for $15. Is there an immediate benefit in owning this coupon?immediate benefit in owning this coupon?

$10.00Expires 12/31/03

There is $5 intrinsic value in this coupon

Time ValueTime Value

Any value in the coupon above intrinsic value is due to time. Traders are willing to pay for time.

Assume pizzas are selling for $8 and this Assume pizzas are selling for $8 and this coupon trades for $1. coupon trades for $1.

$10.00Expires 12/31/03

This coupon has $1 time value

Time ValueTime Value

It is the time value portion of an optionIt is the time value portion of an option’’s price s price that erodes with time.that erodes with time.

You do not lose the intrinsic value.You do not lose the intrinsic value.

Can you find the time and intrinsic values?Can you find the time and intrinsic values?

$10.00Expires 12/31/04

Pizzas are selling for $15.

This coupon is selling on the street for $7.

$5 intrinsic value and $2 time value

Pizzas are $15 and this coupon is trading for $7. What will thisPizzas are $15 and this coupon is trading for $7. What will thiscoupon be worth if pizza prices are the same at expiration?coupon be worth if pizza prices are the same at expiration?

$10.00Expires 12/31/04

There is $5 intrinsic value and zero time value so coupon must be worth exactly $5.

As time to expiration increasesAs time to expiration increases……

Call and put options get more expensiveCall and put options get more expensive

VolatilityVolatility

Volatility is the major determining factor of an Volatility is the major determining factor of an optionoption’’s price.s price.

If pizzas are $8, why might you pay for this If pizzas are $8, why might you pay for this coupon anyway?coupon anyway?

$10.00

If pizza prices jump around a lot, you may find it useful to buy this coupon. The jumpiness is called volatility.

Puts are like car insurancePuts are like car insurance……

The price you pay is called the The price you pay is called the ““premium.premium.””The policy expires at some timeThe policy expires at some timeIf you If you ““wreckwreck”” you stock, you can always put it you stock, you can always put it back to the insurance company for the face back to the insurance company for the face value of the policy.value of the policy.If you donIf you don’’t use your insurance, you lose the t use your insurance, you lose the premiumpremiumYou can absorb some of the risk (by accepting a You can absorb some of the risk (by accepting a deductible) and pay a smaller premiumdeductible) and pay a smaller premium