Download Project 2: Options

Project 2: Options
What is an Option?
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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
The Strike (or Exercise) Price is the
price at which the underlying security
(shares of a certain stock) can be
bought or sold as specified in the
option contract.
What is an Option?
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Unlike stock shares, options can be exercised
on or before a certain date. This date is called
the expiration date.
A buyer of a stock option has until the expiration
date to buy or sell shares of a stock at the strike
price on before the day the option expires. If an
investor doesn’t exercise his/her option, the
option no longer exists.
Types of Options
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There are basically two types of options a
buyer can hold:
 Call
option: gives the buyer the right, but not
the obligation, to buy shares of a certain stock
at a pre-specified price (i.e. the strike price)
 Put option: gives the buyer the right, but not
the obligation, to sell shares of a certain stock
at a pre-specified price (i.e. the strike price)
Which Option is the best?
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Call options do the best when the
underlying asset (usually shares of a
stock) increase in value.
 You
decide to buy a call option on IBM stock
for $2.00 per share with a strike price $30.
Suppose that IBM’s stock is at $29 a share
when you purchase the option.
 When the option expires, let’s say that IBM
stock is trading at $35 a share.
Call Options
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Because you have a stock option for IBM, this
gives you the right, but not the obligation, to buy
IBM stock at $30 a share even though IBM is
trading at $35 a share.
In this case you exercise your option, buying
IBM stock at $30 a share. You could then take
the stock you’ve purchased and then sell it on
the open market for profit of $5.00 - $2.00 =
$3.00 per share.
Put Options
Put options work in the reverse of call
options. A put option give you the right,
but not the obligation, to sell a stock at a
pre-specified price (i.e. the strike price)
 Generally put options do better as the
value of the stock decreases.
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Put Options
Suppose IBM stock is at $30 a share. You
think that the stock will go down after 10
weeks.
 This is when you would buy a put option.
Let’s say you buy a put option for $1.00 a
share with a strike price of $30.
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Put Options
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This put options give you the right, but not the
obligation to sell stock in IBM at $30 a share no
matter how low IBM’s stock goes in 10 weeks.
After 10 weeks go buy, let’s say that IBM is
trading at $20 a share. You decide to buy IBM
stock at this price. You then exercise your put
option and sell IBM stock for $30.00 a share.
This would give you a profit of $10 - $1 or $9 per
share.
Project 2: European Call Options
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For our project we will be limiting ourselves to
European call options. This means the option
can only be exercised on the expiration date.
Your 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 company
Class Project
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Our goal is to find the present value, per
share, of a European call on Walt Disney
Company stock. Currently the stock is
trading at $21.87 on January 11, 2002.
The call is to expire 20 weeks later, with a
strike price of $23. Our work is to be
based upon the stock’s price record of
weekly closes for the past 8 years.
Project Assumptions
1.
Past history cannot be used to predict the future price of a stock. If it did,
then investors would move their money to the stock that would yield the
best return, thereby driving up the price of that stock and destroying its
value since no one would want to buy such a stock.
2.
The past history of prices for a given stock can be used to predict the
amount of future variation in the price of that stock. The greater the
volatility the greater the stock will fluctuate in price.
3.
All investments, whose values can be predicted probabilistically, are
assumed to give the same rate of return. If this were not so, then
investors would move their money to stocks that would give them the
highest predicted rate of return, raising the cost of the investment and
destroying its predicted rate of return
Project Assumptions
4.
We will assume that the common growth rate for all
investments whose future values can be predicted is
the rate of return on a United States Treasury Bill. This
rate is guaranteed by the federal government
5.
All investments with the same expected rate of growth
are considered to be of equal value to investors. We
are choosing to ignore the fact that investors have
different investing tastes and preferences. This is
called the risk-neutral assumption.
What this project is NOT?
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We only want to determine a fair price for our European
Call option on a particular company the day we purchase
our option (March 25th, 2005).
We don’t want to know whether the option should be
purchased
We don’t want to know whether stock the company
should be purchased
We don’t want to know the closing value of company’s
stock once the option expires. How can we?
Assumption 1 says we can’t !
Team Data
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Each team will be given a certain company to
price the value of a European call option. Each
team will get:
 Company ticker symbol
 Start date of the option:
Friday March 25th, 2005
 Strike Price
 Length of the Option (Expiration
 N years of historical data
 The
Date)
current rate guaranteed by the federal
government
Preliminary Report
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Your team’s preliminary report will be delivered
on Monday March 28th, 2005
As before, you will want to meet with your team
to examine the data that you’ll be downloading
(more about this later)
Your team will again need to put together a
presentation in powerpoint to deliver your report
to determine a reasonable price for a European
call option that was purchased on March 25th,
2005
Downloading Historical Data
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Let’s look at the class project:
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Let’s imagine it is January 11th, 2002. We are working at
the Chicago Board of Options Exchange and need to
find a reasonable price that investor would be willing to
pay for European call option on Walt Disney stock.
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Currently the stock is trading at $21.87 on January 11,
2002. The call is to expire 20 weeks later, with a strike
price of $23. Our work is to be based upon the stock’s
price record of weekly closes for the past 8 years.
Visiting a Web Site
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Yahoo Finance Page
 http://finance.yahoo.com/q/hp
 Type
in DIS for the ticker symbol of Walt Disney Stock
 Click on “Historical Prices” link at the top left of the
page.
 Type in end date of January 11th, 2002.
 Since we want to look at 8 years of historical data,
type in January 11th, 1994 as your start data
Citations
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All slides seen here are courtesy of and
inspired by the incredibly useful learning
center offered by the CBOE website.