Intro to Project 2: OptionsWhat is an Option?Stocks vs. OptionsTermsAmerican Call OptionsSlide 6American Put OptionsSlide 8Strike PriceSlide 10An ExampleExample ContinuedProject 2: European Call OptionsSlide 14Slide 15Class ProjectProject AssumptionsSlide 18What this project is NOT?What’s on the horizon?Upcoming . . .Preliminary ReportCitationsIntro to Project 2: OptionsWhat is an Option?An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset).An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.Stocks vs. OptionsSimilarities:Listed Options are securities, just like stocks.Options trade like stocks, with buyers making bids and sellers making offers.Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.DifferencesOptions are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).Options have expiration dates, while stocks do not.There is not a fixed number of options, as there are with stock shares available.Stockowners have a share of the company, with voting and dividend rights.Options convey no such rights.TermsCall Option – The right to buy a stockPut Option – The right to sell a stockAmerican Option – may be exercised at any time prior to its expiration date, usually the 3rd Friday of the monthEuropean Option – may only be exercised on its expiration date, usually the 3rd Friday of the monthAmerican Call OptionsAn American Call Option is an option to buy a stock at a specific price on or before a certain date. Call options are like security deposits. If you wanted to rent a certain property, and left a security deposit, the money would be used to insure that you could rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument increases.American Call OptionsWhen you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price, called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.American Put OptionsPut Options are options to sell a stock at a specific price on or before a certain date. Put options are like insurance policies If you buy a new car, and then buy auto insurance on the car, you pay a premium to protect yourself if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.American Put OptionsWith a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk.Strike PriceThe Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract.For example, with the XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 per share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock at $30 per share.Strike PriceThe strike price also helps to identify whether an option is In-the-Money or Out-of-Money when compared to the price of the underlying security. A call option is in-the-money if the strike price is below the current market price of the underlying security.It is out-of-the-money if the strike price is above the current market price of the security.The extent of a stock price’s variability is called its volatility.An ExampleAssume for a moment that it is April 5th, and you are following XYZ, which is presently at $29 a share. You think that this stock will go up in price in the next month and a half or so, to well past $30 a share. Knowing about options, you choose to buy an XYZ May 30 Call for 2, instead of buying the stock outright.This option gives you the right to buy 100 shares of XYZ Stock at $30 a share any time before May expirationExample ContinuedOn expiration Friday, assume XYZ is at $35 per share. You have a Call option, which can be exercised to purchase 100 shares of XYZ Stock at $30 per share. If you do that, you can then sell that stock back in the market and make a $5 return per share, or $500. Since your initial Call premium was $200, your net profit is $300.You could also sell the option on the market get your profits from the increased value of your optionIf XYZ’s stock traded to $25 per share, you would only be charged for the money you spent to purchase the option.Project 2: European Call OptionsFor our project we will be limiting ourselves to European call optionsYour are employed at the Chicago Board of Options Exchange, one of the largest traders of options in America.Your goal is to find reasonable price, per share, on a European call option for a certain companyMarket experience, financial theory and mathematics have helped to develop systematic processes for pricing optionsProject 2: European Call OptionsOptions Pricing was revolutionized in 1973 with the publication of the Black-Scholes Model, the Nobel-prize winning equation which virtually created the options marketplace.Project 2: European Call OptionsUnfortunately, the mathematics behind this formula goes way beyond the scope of this course.To simplify things, we will employ what is known as the boot-strapping methodWarning!: Because of this, you should not use this project to
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