Principles of Finance with Excel (Основы финансов c Excel)
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PFE Chapter 22, Dividend policy and firm valuation Page 22
Don Luskin is president and CEO of MetaMarkets.com and a portfolio manager of
OpenFund, an aggressive growth fund investing in the New Economy. OpenFund
strives to be fully invested, expecting to be at least 90% invested under most market
conditions. At time of publication, OpenFund was long futures contracts on the S&P
500 and Microsoft, although holdings can change at any time. Luskin appreciates
your feedback and invites you to send it to Don Luskin.
PFE, Chapter 22: Introduction to options page 1
CHAPTER 22: INTRODUCTION TO OPTIONS
*
this version: September 2002
Chapter contents
Overview......................................................................................................................................... 1
22.1. What’s an option? ................................................................................................................. 2
22.2. Why buy a call option? ......................................................................................................... 7
22.3. Why buy a put option?........................................................................................................ 10
22.4. General properties of option prices..................................................................................... 12
22.5. Writing options, shorting stock........................................................................................... 16
22.6. Option strategies—more complicated reasons to buy options............................................ 24
22.7. Spread ................................................................................................................................. 30
22.8. Butterfly .............................................................................................................................. 33
Summary....................................................................................................................................... 35
EXERCISES ................................................................................................................................. 35
Overview
In this chapter we introduce the concept of stock options. We show you the basic
definitions and introduce you to the cash flows of options. In addition we show you how option
*
Notice: This is a preliminary draft of a chapter of Principles of Finance by Simon Benninga
(benninga@wharton.upenn.edu
). Check with the author before distributing this draft (though
you will probably get permission). Make sure the material is updated before distributing it. All
the material is copyright and the rights belong to the author.
PFE, Chapter 22: Introduction to options page 2
strategies—the ability to combine options and stocks in portfolios—can change the payoff
patterns available to investors.
Finance concepts discussed
• Call and put options
• Option strategies: protective puts, spreads, butterflies
Excel functions used
• Max
• Min
22.1. What’s an option?
A call option on a stock is the right to buy a stock on or before a given date at a pre-
determined price. A separate page gives options prices for options on Cisco stock on August 7,
2002; we will use these prices in the examples which follow.
For example, row 24 of the Cisco spreadsheet tells you that on 7 August 2001, a call
option on Cisco stock with an exercise price of $20.00 and an exercise date of 21 September
2001 was selling for $1.35:
7
23
24
25
ABCDEF
Stated expiration date
Exercise
price, X
Call price Put price
Actual
expiration
date
Days to
maturity
Sep01 17.50 2.75 0.90 21 Sep01 45
Sep01 20.00 1.35 2.00 21 Sep01 45
Sep01 22.50 0.55 3.80 21 Sep01 45
Suppose you purchased this call option on 7 August. Here’s the cash flow pattern:
PFE, Chapter 22: Introduction to options page 3
CALL OPTION CASH FLOW PATTERN
7-Aug-01 21-Sep-01
Pay: $1.35 If Cisco's stock price > $20,
you'll exercise your call
to buy the stock for $20.
Your gain on 21 Sept:
Actual stock price - $20
If Cisco's stock price <
$20,
you will not exercise your
call option.
Your gain on 21 Sept: 0.
In principle, you have the right to
buy Cisco stock for $20 on any
date before 21 September. In
actual fact, you'll only want to
exercise the call
option at its terminal date (see
Section ?? of Chapter 22).
PFE, Chapter 22: Introduction to options page 4
[Separate page]
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ABCDEF
August 7, 2001, CSCO closing price
19.26
Stated expiration date
Exercise
price, X
Call price Put price
A
ctual
expiration
date
Days to
maturity
Aug01 7.50 11.90 0.05 17 Aug01 10
Aug01 10.00 9.60 0.20 17 Aug01 10
Aug01 12.50 6.50 0.10 17 Aug01 10
Aug01 15.00 4.20 0.10 17 Aug01 10
Aug01 17.50 2.10 0.40 17 Aug01 10
Aug01 20.00 0.65 1.45 17 Aug01 10
Aug01 22.50 0.15 3.40 17 Aug01 10
Aug01 25.00 0.05 5.00 17 Aug01 10
Aug01 27.50 0.10 7.50 17 Aug01 10
Aug01 30.00 0.10 11.90 17 Aug01 10
Aug01 32.50 0.05 17 Aug01 10
Aug01 35.00 0.05 16.20 17 Aug01 10
Sep01 10.00 9.50 21 Sep01 45
Sep01 12.50 6.30 0.15 21 Sep01 45
Sep01 15.00 4.50 0.40 21 Sep01 45
Sep01 17.50 2.75 0.90 21 Sep01 45
Sep01 20.00 1.35 2.00 21 Sep01 45
Sep01 22.50 0.55 3.80 21 Sep01 45
Sep01 25.00 0.20 5.50 21 Sep01 45
Sep01 27.50 0.10 21 Sep01 45
Sep01 30.00 0.05 21 Sep01 45
Oct01 10.00 10.00 0.10 19 Oct01 73
Oct01 12.50 6.90 0.25 19 Oct01 73
Oct01 15.00 5.00 0.65 19 Oct01 73
Oct01 17.50 3.20 1.40 19 Oct01 73
Oct01 20.00 1.80 2.55 19 Oct01 73
Oct01 22.50 0.95 4.10 19 Oct01 73
Oct01 25.00 0.45 6.00 19 Oct01 73
Oct01 27.50 0.20 7.50 19 Oct01 73
Oct01 30.00 0.15 10.70 19 Oct01 73
Oct01 35.00 0.05 16.30 19 Oct01 73
Oct01 40.00 0.05 21.50 19 Oct01 73
Oct01 45.00 0.05 29.50 19 Oct01 73
Oct01 50.00 0.05 31.12 19 Oct01 73
Oct01 55.00 0.10 37.50 19 Oct01 73
Oct01 60.00 0.05 36.75 19 Oct01 73
Oct01 65.00 0.05 19 Oct01 73
CISCO OPTIONS, August 7, 2001
CLOSING PRICE ON CHICAGO
BOARD OF OPTIONS EXCHANGE
Notes: A blank in the price (for example the Oct01 puts with exercise price 65) indicates that no
options were traded. The table includes only some of the traded Cisco options; on this date (7
August 2001), Cisco option with maturities as far out as January 2004 were traded. The Excel
notebook for this chapter includes all the option prices for Cisco.
PFE, Chapter 22: Introduction to options page 5
Notice what happens on September 21:
• Suppose the Cisco stock price on September 21 is $35. In this case you get to buy one
share of Cisco for $20. Your gain is $35 - $20 = $15.
• If the Cisco stock price on September 21 is $18, you would not exercise your call option
to buy a share of Cisco for $20 (why should you? you could buy it on the open market
for less). The option expires unexercised, and your gain is $0.
What about the Cisco put option with an exercise price of $20? It was selling, on 7
August 2001, for $2.00. The put option gives you the right to sell a share of Cisco on or before
the terminal date for its exercise price:
PUT OPTION CASH FLOW PATTERN
7-Aug-01 21-Sep-01
Pay: $2.00 If Cisco's stock price < $20,
you'll exercise your put
to sell the stock for $20.
Your gain on 21 Sept:
$20 - Actual stock price
If Cisco's stock price >
$20,
you will not exercise your
put option.
Your gain on 21 Sept: 0.
In principle, you have the right to
sell Cisco stock for $20 on any
date before 21 September. In
actual fact, you will only rarely want
to exercise the put option before
its terminal date (see Section ?? of
Chapter 23).
If Cisco’s stock price on September 21 is $15, you will exercise your put option and sell a
share of Cisco for $20, thus gaining $5.
1
On the other hand if Cisco’s share price on September
1
What if you don’t own a share of Cisco on 21 September? No problem: You buy a share on the open market for
$15 and use your option to sell it for $20.
PFE, Chapter 22: Introduction to options page 6
21 is $30, you will not exercise the put option (why sell a share using the option for $20 when
you can sell it on the open market for $30?).
Option websites
All the data in this chapter was gathered from public sources on the Web. Many of these
websites have superb data and also educational features. Here are some websites we especially
enjoy.
• The website of the Chicago Board of Options Exchange (CBOE): http://www.cboe.com
• Option metrics: http://www.impliedvol.com/
• Equity analytics: http://www.e-analytics.com/optaaa.htm
European versus American options
Cisco’s stock options are American stock options—they can be exercised on or before the
option maturity date T. A European stock option can be exercised only on its maturity date T.
Clearly an American stock option is worth at least as much as a European stock option.
Two notes about American versus European stock options:
• The terminology has nothing to do with geography. Most traded options, whether in the
U.S., Europe, or Asia, are American and not European.
• A remarkable fact about American call options is the following: In many cases an
American call option is worth exactly the same as an equivalent European call option.
This happens if the stock on which the option is written does not pay a dividend before
the option expiration date T . Since Cisco stock does not pay dividends, the “American”
PFE, Chapter 22: Introduction to options page 7
feature of Cisco stock options is worthless, and the options on Cisco stock are worth the
same as if they are European options. We discuss the reasons for this in Chapter 22.
22.2. Why buy a call option?
There are many conceivable reasons why you might want to buy a call option:
Reason 1: A call option allows you to delay the purchase of a stock: It’s 7 August
2001, and you’re thinking about buying a share of Cisco for its current market price of $19.26.
As an alternative, you can buy a September call option with X = $20. This option will cost you
$1.35. Here’s your thinking:
• If, on 21 September 2001, Cisco’s stock price is > $20.00, you’ll exercise the option
and purchase the share for $20. If you’re careful, you’ll realize that there are several
“sub-possibilities”:
o Cisco’s 21 Sept. stock price = $35. Now you’ve made out like a bandit: You
spent $1.35 for the option, but you bought the stock for $20, saving $15.00. Your
net profit is $13.35 ($15.00 - $1.35 cost of the option).
o If Cisco’s 21 Sept. stock price = $21.00, you’ll still exercise the option and
purchase the stock for $20.00. You’ve saved $1.00 on the purchase price of the
stock , but this time you will have lost a bit of money, since the option cost you
$1.35. Your net profit will be -$0.65.
• If on 21 September Cisco’s stock is selling for less than $20, you will not exercise
your call option. If you still want to purchase the stock, you’ll buy it on the open
market. In all cases, you will be out only the $1.35 cost of the option.
PFE, Chapter 22: Introduction to options page 8
Reason 2: A call option allows you to make a bet on the stock price going up. This
bet is: a) Low cost, b) high upside potential, and c) one-sided
Suppose you buy the Cisco call option above: You spend $1.35 on 7 August 2001 to
purchase an option which—on 21 September—gives you the right to purchase Cisco stock for
$20. Your purpose is to bet on the price of Cisco stock in September. As you can see in the
table below:
• This bet has a low cost: You’ve put up only $1.35 to make it.
• You will never lose more than the $1.35. This is what we mean when we say that the
bet is “one-sided”: You can only lose a limited amount of money.
• The bet has very high upside potential: The profits, both in dollars and as a
percentage of the money you put up, rise very rapidly when the stock price in
September increases over $20.
PFE, Chapter 22: Introduction to options page 9
ANALYZING THE PROFIT FROM A CALL OPTION
Price of
Cisco on
21
September
Exercise the option? Your profit or loss In percentage
$15 No—the option gives you the right to buy
Cisco for $20, but the market price is less,
so you would not exercise the option
-$1.35
/1.35
100%
1.35
Profit loss
Option cost
−
==−
$20 Yes/No—doesn’t matter (you’re buying
the stock at its market price)
-$1.35
/1.35
100%
1.35
Profit loss
Option cost
−
==−
$22 Yes—the option lets you buy the stock for
$20, but the market price is $21. So you
should exercise (even though you’ve lost
money—see next column)
()
21 20 1.35 0.35
Profit on exercise option cost−
=−− =−
(21 20) 1.35 0.35
26%
1.35 1.35
Profit on exercise option cost
option cost
−
=
−− −
==−
$25 Yes
()
25 20 1.35 3.65
Pro
f
it on exercise option cost−
=−− =
(25 20) 1.35 3.65
270%
1.35 1.35
Pro
f
it on exercise option cost
option cost
−
=
−−
==
$30 Yes
()
30 20 1.35 8.65
Pro
f
it on exercise option cost−
=−− =
(30 20) 1.35 8.65
641%
1.35 1.35
Pro
f
it on exercise option cost
option cost
−
=
−−
==