CHAPTER 17
AN INTRODUCTION TO OPTIONS
Teaching Guides for Questions and Problems in the Text
QUESTIONS
1. An option is a right to do something. With regard to investing, an option is the right to buy
(or to sell) stock at a specified price within a specified time period.
The intrinsic value of an option to buy stock is the difference between the price of the stock
and the exercise price (i.e., the strike price) of the option. The intrinsic value of an option to
sell stock is the difference between the strike price and the price of the stock.
If the price of an option were less than its intrinsic value, an opportunity for a risk-free profit
would exist (i.e., an opportunity for arbitrage). This part of the question asks the student to
2. An option may offer the investor the opportunity to make a large percentage return on a
small investment (i.e., offer potential leverage). Options tend to sell for prices that are a
fraction of the stock’s price. This smaller price means that the cash outflow to control a share is
However, the possibility of loss is substantial, and in many cases the investor loses the entire
amount invested in the option. For this reason many option positions are considered to be
speculative.You may also wish it add that options tend to sell for a price that exceeds their
intrinsic value (i.e., the option commands a time premium). The amount of this time premium
3. The CBOE (Chicago Board Options Exchange) was the first secondary market in options.
Prior to the creation of the CBOE, there were no secondary markets in puts and calls. If an
investor wanted to invest in a put or call, the option had to be purchased from a dealer who did
not make a market in the option. The creation of a secondary market increased the individual
4. A covered call position occurs when the investor owns the stock and executes a short
position in the call. To execute a covered call position, the investor buys the stock and sells the
When the investor writes (i.e., sells) a call naked, the investor does not own the underlying
5. If an investor purchases a call option and the price of the stock falls, the price of the option
will also fall. The maximum amount the investor can lose is the cost of the option or 100
6. Both warrants and calls are options to buy stock at a specified exercise price within a
specified time period. Calls tend to have a short life (three, six, or nine months) while warrants
(when issued) may be outstanding for many years. Only firms may issue warrants to buy their
7. The intrinsic value of a call is the price of the stock minus the strike price. As the price of
8. The time premium disappears as an option approaches expiration. At expiration, an option is
9. If an individual sells (“writes”) a call or put option, that investor closes the position by
repurchasing the option. The purchase cancels (offsets) the sale. (While the position is also
10. If an investor buys individual stocks in anticipation of a rising market, it does not follow
that the prices of specific stocks must rise. Buying a stock index call option avoids determining
The prime disadvantage of buying the stock index call option in anticipation of an increase in
11. With a long position in a stock, the investor sustains a loss when the price of the stock
declines. If an investor purchases a put, the value of the put rises as the price of the underlying
12. This question asks the student to track and compare the performance of stock options, index
PROBLEMS
17-1. a. At $29, the gain on the stock is $7. The percentage return is $7/$22 = 31.8%.
The call is worth $29 – 20 = $9.
b. At $18, the loss on the stock is $4, and the percentage loss is ($4)/$22 = (18.2%).
c. At $22, there is no gain or loss on the stock.
d. In part (a), the price of the stock rose which caused the value of the call option to rise. The
In part (b), the price of the stock declined sufficiently that the option was out of the money and
In part (c), the price of the stock was stable and the call lost value as the time premium
17-2. a. Intrinsic value of the call: $26 – 25 = $1
b. Price of the stock Value of the call at expiration
$20 $0
25 0
c. If the price of the stock rises from $26 to $40 (a 54 percent increase), the price of the call
d. If the investors buys the stock and sells the call, the net cash outflow is $26 – 4 = $22.
Profit to the seller of the covered call:
Price of Profit Proceeds Value of Profit on Total
the stock on the from the the call at the sale gain
stock sale of expiration of the or
the call call loss
$10 ($16) $4 $0 $4 ($12)
e. Profit to the seller of the call naked:
Price of Proceeds Value of Profit on
the stock from the the call at the sale
sale of expiration of the
the call call
$20 $4 0 $4
17-3. Intrinsic value of the calls:
Price of the stock – Strike price = Intrinsic value
XYZ 30: $34 – 30 = $4
Intrinsic value of the puts:
Strike price – Price of the stock = Intrinsic value
Time premium of the calls:
Price of the call – Intrinsic value = Time premium
Time premium of the puts:
Price of the put – Intrinsic value = Time premium
If at expiration the stock price is $31, each option is worth:
Profit for the buyers (price at expiration minus the cost):
Profits for the sellers (initial price minus the price at expiration):
Notice (1) the price of each option equals the intrinsic value at expiration, (2) the time premium
disappears at the option’s expiration, and (3) the losses of the buyers are equal to the profits of
the writers (excluding commissions). If the buyer sustains a loss, the writer profits. If the buyer
earns a profit, the writer loses.
e. As the price of the stock falls, the value of the put rises (i.e., there is a negative relationship
between the value of the stock and the put).
f. If the investor sells the call covered, the maximum possible loss is the cost of the stock
minus the proceeds of the sale of the call: $51 – 5 = $46.
g. If the price of the stock fell to $0, the profit (and the maximum possible profit) on the short
position is $51.
Questions h – k assume the passage of six months.
h. The intrinsic value (price) of the call is
i. The put is worthless; loss is the purchase price: $2.
17-5. a. The call is “in” the money because it has a positive intrinsic value of $1.
b. The intrinsic value of the put is $0; the time premium is $4.
c. If the call is sold “naked,” the write receives $5.
Questions f – j assume the passage of six months.
f. Since the price of the stock declined form $101 to $93, the buyer loses $8.
g. The call is out of the money, and the buyer loses the entire cost: $5.
the stock price value put
$45 $40 $0 $2 ($2)
40 40 0 2 ( 2)
35 40 5 2 3
b. Profit from writing the put:
Price of Strike Intrinsic Proceeds Profit
the stock price value of the sale
c. A comparison of the two positions indicates that the profit for the seller is the loss for the
buyer and vice versa.
17-7. a. The LEAP’s intrinsic value:
b. The time premium:
c. After two years, the LEAP sells for its intrinsic value because the option is at expiration and
commands no time premium. If the price of the stock is $50, then the LEAP must sell for $26
d. The LEAP’s time remium must disappear because no one would be willing to pay this
premium at the option’s expiration. An option only sells for its intrinsic value at its expiration.
e. If the price of the stock were $22 at the LEAP’s expiration, the LEAP would expire