Some options can be exercised at any time up until the expiration date, while others can only be exercised on the date that the option expires.
Unless otherwise stated, all exchange-listed options in the United States are American options.
The dates in the options market are standardized.
Each issue is assigned a cycle.
The exchanges still use the same three expiration cycles, but they have changed so that investors are always able to trade in the two closest months, plus the next two closest months in the option's regular cycle.
During the course of the year, the front months roll over the expired dates in this way.
The third Friday of each month is the actual day of expiration.
When buying or selling an option, option traders are subject to commission and transaction costs.
The costs represent compensation to the broker or dealer.
There is a marketplace and quotation system for listed options.
An option chain with several hundred call and put option quotes can be created by generating a quotation for all current option contracts on Facebook.
There is a column heading that says "Calls" in the upper left portion of the figure, which indicates that the first several columns contain information about call options on Facebook stock.
The right side of the figure contains information about put options on Facebook shares.
The last column shows the most recent market price for each option, and the last column shows the change in the price of each option from the previous day's closing price.
The bid and ask prices for the options, the day's trading volume, and the open interest are shown in other columns.
The underlying asset for all of these options is the ticker symbol for Facebook.
On July 6, 2015, an August Facebook call with a strike price of $85 was quoted at $4.90 and an August put option with the same strike price sold for $2.68.
The quotes for calls and puts are listed on the opposite side of the strike price.
The change from the previous day's last transaction price is shown, along with the last price the option traded at for the day and its end-of-day bid and ask price.
The price of the underlying asset is one of several factors that affect option prices.
Understanding these factors and how they affect option values is a must for being a good options trader.
Let's look at the basics of options pricing.
We will review how profits are derived from puts and calls.
We will look at several ways in which investors can use these options.
The price of the underlying common stock is the most important factor in determining the quoted market price of a call or put.
The most significant moves in an option's price are driven by this variable.
When the underlying stock price goes up, calls do well.
When the stock price is high, a call option gives an investor the right to buy a stock at a fixed price.
Puts do well when the underlying stock price goes down.
When the market price of the stock is far below the strike price, having the right to sell at a fixed price is more valuable.
Clearly investors who are buying or selling options need to be aware of the stock's behavior.
Figure 14.2 shows how the underlying stock price affects the ultimate profits that options provide.
By "profit", we mean the difference between the strike price and the stock price before the option expires, minus the initial cost of the option.
The diagram on the left shows a call and the diagram on the right shows a put.
The price of the underlying common stock affects the payoff of a call or put.
When the option passes its breakeven point, the cost of the option has been recovered.
The profit potential of a call is unlimited, but the profit potential of a put is limited because the underlying stock price cannot go lower than $0.
The call has a strike price of $50 and 100 calls at $5 per call.
The option profit increases as the stock price goes up.
The investor spent $500 on the call when the stock price was below $50.
If the market price of the stock is below $50, no rational investor would exercise the option and pay $50 to buy the stock--it would be cheaper to simply buy the stock in the open market, and therefore the call expires worthless.
The call option is not profitable until the stock price goes above $50.
The investor needs to recover the $500 premium in order to reach a breakeven point because it costs $500 to buy the call.
Even if the stock price is between $50 and $55, it's still best to exercise the option because it reduces the option holder's net loss.
The cash inflow of $200 is offset by the $500 option premium if the stock price is $52.
The call option's profit goes up if the stock price exceeds the breakeven point.
There is no upper limit on the underlying stock's price so the potential profit from the call position is unlimited.
When the stock price goes down, the put value goes up, but only if the price of the underlying stock goes up.
Unless the market price of the corresponding stock drops below the exercise price, the profit of the put is $500.
The profit of the put option increases if the stock price is below $50.
The put doesn't reach a break even point until the stock price reaches $45 because it costs $500.
The put becomes more profitable as the stock price goes down.
There is a difference between puts and calls.
The stock price cannot fall below zero, so the put option has a maximum profit of $4,500.
A call's profit potential is unlimited because there is no upper limit on the stock price.
The payoff of a put or call depends on a number of factors, including the exercise price stated on the option, as well as the market price of the underlying common stock.
The value of an option is determined by its strike price and the underlying stock's market price.
Suppose a call option has a strike price of $50 and the underlying stock price is $60.
An investor who exercises this option will receive $10 for every 100 shares of stock they own.
The investor wouldn't exercise the option because the stock is cheaper in the open market, and the call's intrinsic value would be zero.
The following formula is used to determine the intrinsic value of a call.
The difference between the stock's market price and the option's strike price times 100 is known as the intrinsic value of a call.
The strike price is zero.
If the market price of the underlying financial asset exceeds the strike price stipulated on the call, the call has an intrinsic value.
If a call option has a strike price of $50 and the underlying stock sells for $60, the option's value is $1,000.
A put can't be valued in the same way as a call because it allows the holder to do different things.
If the market price of the underlying stock is less than the strike price stipulated on the put, the put has intrinsic value.
The strike prices of those call options are highlighted in yellow because on the day that they were retrieved, Facebook stock was selling just above $87.
The calls with strike prices of $82.50, $90, $92.50, and $95 are not high lighted because they were out of money at the time.
There is a chance that the stock price will rise above the strike price, so an out-of-the-money call option is not worthless.
When a call is out-of-the-money, its market value is greater than its intrinsic value.
We say that the option has time value even though it has no intrinsic value.
Even though the option's intrinsic value was zero, it still had plenty of time value.
The situation is reversed for put options.
When the strike price is greater than the market price of the stock, a put is in the money.
When the strike price is higher than the stock's current market price, a put option is more valuable.
The strike prices of the in-the-money put options are highlighted in yellow.
The options have a positive value because the strike price is above the stock's current price.
As with calls, an out-of-the-money put has a positive market value as long as there is time before it expires.
A professor is conducting a grant.
The exercise prices were generated by the research and press coverage, just before the investigations of at least 257 firms' options stock price began.
Firms might be withholding good grants.
Many companies became aware of the stock target of SEC investigations when they released their own internal news after they awarded stock option grants.
Firms that are involved in options prices would increase in price.
The consequences of backdating scandals were serious a few years later.
Some executives were fined or sent to prison.
Some firms settled lawsuits without admitting wrongdoing, backdated their option grants, and used hindsight to set the exercise price on the one date in the prior shareholder lawsuit.
Most firms investigated when the stock price was at its lowest point.
This is how backdating works.
The opportunity for senior management to engage in 1 that it had granted its executives stock options on meaningful options backdating was largely eliminated April 15, using the market price of the stock that day as by the Sarbanes-Oxley Act, which requires companies the option's exercise price.
The firm didn't publicly disclose option grants within two days.
The timing of stock option grants seemed to benefit of hindsight, as the firm knew that they would disappear soon after Sarbanes-Oxley.
When the stock price equals the strike price, a put is at-the-money.
When firms grant stock options to their employees, the strike prices of the options are the same as the price of the underlying stock on the date of the option grant.
Many companies got into trouble for using a bit of hindsight when selecting their option grant dates, as the box explains.
Backdating is a practice that came to be known as options.
The prices of put and call options are linked under certain conditions, so newcomers to options are surprised.
If a put and call option have the same underlying asset, the same strike price, and the same expiration date, they can't move in opposite directions.
Consider the following example to explain why.
The put option on the Dow expires in a year.
A different portfolio has been formed by Nick's wife.
A risk-free, zero-coupon bond with a face value of $50 is the same as the option's strike price and a maturity of one year, as well as being an exercise price of $50.
If we assume that the put and call options that Nick and Nora have pursued are European options, they can only be exercised for a year.
The value of Nick and Nora's portfolios depends on how the stock of the company performs.
The table shows what each portfolio will be worth next year, just as the options are about to expire.
Nick's portfolio is the first thing we should look at.
If the stock does not perform well, it will be trading at $35 next year.
Nick will be lucky to have purchased a put option.
The put option will be in the money if the stock is trading at $35, and the market value will be $15 since it is about to expire.
The total portfolio value is $50 with the share of stock that Nick has.
Nick's portfolio value is fixed at $50 if the stock price is less than $50.
The put option guarantees that Nick can sell his share for $50.
The put option will be worth less if the stock finishes the year above $50 per share, but the share that Nick owns gives him upside potential.
One year from now, Nick's portfolio will be worth at least $50, and it could be worth more if the stock price ends the year above $50.
Let's start by asking what happens to her portfolio when the stock ends the year at $35 and the performance is poor.
The call option has no value if it expires out of the money.
Her total portfolio value is $50 because she gets the $50 payment from her risk-free bond.
The call option will be worthless if the price is $50 or lower, and the bond payment will be the same.
In that scenario, the call option will be worth $5 and the portfolio will be worth $55.
The call value will increase in step with the underlying stock if the stock ends the year even higher.
If the stock price of the company ends the year above $50, the portfolio will be worth at least $50.
By now it should be clear that the portfolios created by Nick and Nora have future values, no matter what happens to the stock price.
Both investors have guaranteed that their portfolio will be worth at least $50, and both will benefit from an even higher payoff if the stock ends the year above $50.
Put-call parity is an important con cept in option pricing.
The put and call options have to have the same underlying asset, the same exercise price, and the same expiration date.
If those conditions hold, put-call parity will hold.
Put-call parity tells us something about the market prices of puts and calls.
If the future payoff of a put option and a stock equals the future payoff of a call option and a risk-free bond, then the prices of those two portfolios must be the same at any moment in time.
There would be an opportunity if that was not true.
It is possible to earn an instant, risk-free profit by buying and selling tical assets at different prices.
If the value of the portfolio containing a put and a share of stock exceeded the value of the portfolio containing a call and a risk-free bond, the traders could sell short the first portfolio and buy the second one to make a profit.
Such transactions would put upward pressure on the prices of the call and the bond, and they would put downward pressure on the prices of the stock and put, until the values of the two portfolios were equal again.
Put-call parity says that because the portfolio containing the put and the stock is essentially the same as the portfolio containing the call and the risk-free bond, the prices of those portfolios must also be the same.
There is a stock that sells for $71.75.
If the strike price is $70 and the expiration date is three months from now, you should know the value of the put option on this stock.
A call option on the same underlying stock has a strike price of $70 and it expires in three months.
The call option sells for $6.74.
There is a risk-free, zero-coupon bond in the market with a maturity in three months and a face value of $70, which is the same as the option's strike price.
The market price of the bond is just the present value of $70 discounted for three months.
There is a way to find the value of an option.
If we know the price of the underlying stock, the risk-free interest rate, and the price of a call option, we can use put call parity to find the value of a put.
If we know the put's value, we can use it to find the call's value.
Let's look at the underlying forces that affect option prices.
The option prices can be reduced.
The intrinsic value of the option is determined by the gap between the current market price of the underlying financial asset and the option's strike price.
The greater the difference between the market price of the underlying asset and the strike price on the option, the greater the intrinsic value of the call or put.
When the strike price is lower or the stock price is higher, the call value is greater.
When the strike price is higher or the stock price is lower, the put value is greater.
The time value is part of the option price.
It shows the amount by which an option's price surpasses its value.
Table 14.2 shows the concept by showing market prices, intrinsic values, and time values for six different call options.
Three of the options last one month, and the other three last three months.
There are two call options with a strike price of $65, two with a strike of $70, and two with a strike price of $75.
The call options with $65 and $70 strike prices are in the money, but the options with a $75 strike price are out of the money.