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Chapter 2 Securities Markets and Transactions 15
Chapter 14
Options: Puts and Calls
Outline
Learning Goals
I. Call and PutOptions
A. Basic Features ofCalls and Puts
1. The Option Contract
2. Seller versus Buyer
3. HowCalls and Puts Work
4. Advantages and Disadvantages
B. Options Markets
1. Conventional Options
2. Listed Options
C. Stock Options
1. Stock Option Provisions
a. Strike Price
b. Expiration Date
2. Put and Call Transactions
Concepts in Review
II. Options Pricing and Trading
A. The Profit Potential from Puts and Calls
B. Intrinsic Value
1. In-the-Money/Out-of-the-Money
2. Put-Call Parity
C. What Drives Option Prices?
1. Time Value and Time to Expiration
2. Volatility and Option Prices
3. Interest Rates and Options Prices
4. Option-Pricing Models
D. Trading Strategies
1. Buying for Speculation
a. Speculating with Calls
b. Speculating with Puts
2. Hedging: Modifying Risks
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16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
a. Protective Puts: Limiting Capital Loss
b. Protective Puts: Protecting Profits
3. Enhancing Returns: Options Writing and Spreading
a. Writing Options
b. Naked Options
c. Covered Options
d. Spreading Options
e. Option Straddles
Concepts in Review
III. Stock-Index and Other Types of Options
A. Contract Provisions of Stock-Index Options
1. Putting a Value on Stock-Index Options
a. Full Value versus Fractional Value
B. Investment Uses
1. Index Options as Hedging Vehicles
2. A Word of Caution
C. Other Types of Options
1. Options on Exchange-Traded Funds
2. Interest Rate Options
3. Currency Options
4. LEAPS
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
14.1 The Franciscos’ Investment Options
14.2 Luke’s Quandary—To Hedge or Not to Hedge
Excel@Investing
Chapter-Opening Problem
Key Concepts
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 17
1. The world of puts and calls and their popularity in the investment community
2. Option contract pricing and valuation
3. The risk and return behavior of various put and call investment strategies
4. The increasing number of different kinds of listed options, including LEAPS, options on stock
market indexes, ETFs, debt securities, and foreign currencies
Overview
Different types of options (puts and calls, rights and warrants) are discussed in this chapter.
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18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
1. Students sometimes have difficulty distinguishing between options and securities, so time should
be spent providing a clear explanation. The notion of derivative securities as securities that derive
their value from some other asset should be clarified.Within that context, instructors can present
options as one type of derivative. Options represent a contract or an agreement to buy (or sell) a
security in the future, whereas owning a security means owning a part of a company (as in the case of
owning a stock) or having a position in a loan (as in the case of a bond).
2. The chapter next discusses put and call options. Students should understand the difference
between put and call options and how they work. The distinction between the writer or seller and the
buyer should also be made clear. Examples that compute the prices of put and call options might be
worked out in class. The distinction between in-the-money and out-of-the-money options should be
explained, and the students should develop an ability to read and understand option quotations listed
in the financial pages.
3. The factors driving option prices should be explained next, along with a brief introduction to some
of the basic option pricing models.
4. After the basic characteristics of puts and calls have been reviewed, attention shifts to listed stock
options. Pricing systems, valuation concepts, and trading strategies are all discussed in detail. It
would be good at this point to emphasize to the class the strategies of speculation, hedging, covered
call writing, and spreadingbecause these are all viable techniques for the individual investor.
5. Stock-index options are next. Their characteristics and valuation are covered in detail, as are some
of the possible uses of these options. Information about the recent prices of the prominent stock-index
options should be shared with the class. The students should understand that since the creation of
stock-index options, it is now possible to “trade the market” as a whole and that this presents great
opportunities for both risk reduction (as in the case of hedging stock portfolios) and return
enhancement. But as we’ve learned, it has also created some problems, as in the market volatility that
comes with certain types of program trading and the “triple witching hour.” Options on
exchange-traded funds allow investors to focus on preferred segments of “the market.”
6. Interest rate and foreign currency optionsare then discussed, along with LEAPS. It would probably
be useful to explain to the class the pricing and valuation systems used with these securities.
Especially important is how the concepts of bond valuation (from Chapter 11) come into play with
interest rate options.
Answers to Concepts in Review
1. Puts and calls are negotiable options issued in bearer form that allow the holder to sell (put) or
buy (call) a stipulated amount of a specific security/financial asset, at a specified strike price, during a
The writer (or option maker or seller) receives the price (premium) paid for the call (less any
commission). An individual holding the call can sell it in the open market any time before the
The number of listed options has grown quickly. In 2003, trading of listed options took place on
five exchanges: the CBOE, Amex, ISE, Philadelphia Exchange, and Pacific ExchangeThe ISE is
An option premium is simply the price of the option; it is what the purchaser would pay the writer
3. The main attractions of puts and calls are the following:
a. The low unit cost: Investors can participate in the price behavior of the underlying security at a
fraction of the cost of the security, giving them the benefits of leverage and low downside risk.
b. They can be used profitably when security prices go up or down:In a bull market, aggressive
investors can buy calls or write puts; in a bear market, they can buy puts or write calls
Puts and calls have some disadvantages as well:
a. With puts and calls, as with any option, there is always the risk of losing the entire premium
4. Stock options are like any other put or call option except that their value is based on a stock.
5. The strike price of a stock option is the contracted price at which the holder of the option can buy
or sell the underlying stock. This is different from the stock’s market price, which is the prevailing
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20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
6. Expiration dates are important features on options because they specify the life of the option
to expiration has bearing on the value of the option. Once the expiration date has passed, the market
An option buyer need not exercise the option to earn his profits. He can sell the options in the
8. The intrinsic value of a call is determined by subtracting the strike price from the market price of
The intrinsic value of a put reverses the comparison between the market and strike prices. If the
9. The following are the four most important variables that affect the price behavior of listed options
(in descending order of importance):
(1) The price behavior of the underlying common stock. The greater the difference between the
(2) The time remaining to expiration.Usually, the longer the time remaining to expiration, the higher
(3) The price volatility of the underlying common stock. The more volatile the price of the underlying
(4) The level of interest rates. The value of a call option will generally increasethe level of market
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Chapter 2 Securities Markets and Transactions 21
When an option has a positiveintrinsic value (the stock price is higher than the strike price in the
case of calls and the opposite for puts), the option is said to be in-the-money. When an option has
10. Using common stocks as a basis of discussion, stock options are used primarily in one of three ways:
a. Speculation. This strategy is the simplest; it is just like buying common stock (the
buy-low–sell-high approach). If an investor feels a stock will appreciate, she buys a call rather
b. Hedging. This strategy involves combining two securities into a single investment position for
the purpose of reducing risk. Hedging always involves two transactions, an initial common stock
c. Writing and spreading. These strategies are really best left to the experienced investors. Writing
options, either on stocks the investor owns (covered options) or on stocks the investor does not
own (naked options), can be profitable. The writer receives at most the option premium and can
11. The maximum profit that an investor can make from writing calls is the call premium. However, a
An investor who writes a covered call effectively writes a naked call but already owns the stock on
If the stock price rises dramatically, the investor doesn’t get to enjoy the full benefit of the stock
12. First, let’s look at the similarities between stock-index options and stock options:
a. The contracts are standardized with respect to strike prices and expiration dates.
b. They are listed on exchanges and therefore enjoy active secondary trading.
c. They are valued in a similar fashion.
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22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
d. They can be used in basically the same kinds of trading strategies.
e. The quotation system for both is virtually identical.
Differences between these securities include the following:
a. Most obviously, the underlying securities are considerably different; stock-index options are
b. While stock options trading is based on 100 shares of the underlying common stock, most
c. Index options are issued with monthly rather than quarterly expiration dates, and expiration dates
d. When hedging with index options, you can protect an entire portfolio rather than only one stock.
Foreign currency options differ from stock options in the following ways:
a. In this case, the underlying securities are specific foreign currencies, and the value of the option
b. Although stock options trade on 100 shares of the underlying stock, currency options trade on the
13. Stock-index options can be used to hedge or speculate. An investor can protect a portfolio of common
An investor can also speculate on the market by buying index options. A call option on an index
Index options and foreign currency options can be used in the same way, to speculate or hedge.
14. If an investor holds a well-balanced portfolio of common stocks, he may want to hedge his position
with a stock-index option under two conditions: The first condition is if he expects a market decline;
If a market drop is expected and it would be too expensive to sell the entire portfolio, the investor
can buy a stock-index put. In this way, if the market does fall, then he’ll make a profit on the put
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 23
Options can be used to protect the investment principal or capital gainsEven if the market is
15. LEAPS, or long-term equity anticipation securities, are long-term options with expiration dates that
could extend out as far as three years. LEAPS give an investor more time to be right about her bets on
Suggested Answers to Discussion Questions
1.
Premium Time Premium Breakeven
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24 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
Note:The July 6, 2015, closing price for FB was 87.55.This means that both the put and the call
2. Options with strike prices closest to the market price of the underlying stock will have the highest
3. a. The stock price is currently at $52.51. There is no gain on the shares, but
b. The total gain would come from the stock price increase and call premium retention.
c. The premium on the option would offset the loss experienced on the stock. There is still a gain
4. a. A stock-index option is an option written on a specific market index. When the
market index moves down, the value of an index call (put) option also moves down (up). One
b. If the market falls, then you make money on puts that you purchased, helping to offset losses on
c. If the market goes up, you will be out only the cost of the puts, the premiums. However, on the
5. Answers will vary according to student choices.
©2017 Pearson Education, Inc.
