G401 September 24, 1998 Professor Rasmusen NOTES ON OPTIONS CALL OPTION: Smith gives the holder of this option the right to buy 1 share of IBM from him at a price of 40 dollars per share at any time up until October 1, 1998. PUT OPTION: Smith gives the holder of this option the right to sell 1 share of IBM to him at a price of 30 dollars per share at any time up until October 1, 1998. EXERCISE PRICE or STRIKE PRICE: The prices of 40 dollars and 30 dollars in the examples are the exercise or strike prices. The price of the option itself is different; it is what the holder pays for the option. Suppose the current price of IBM is 45 and the current date is July 1. The call option will have a price of at least 5 dollars, because it could be exercised immediately for a gain of 5 dollars (45-40). The price will be higher, though, because there is some chance the price will rise further before October 1. Generally, it is best to hold onto an option until th expiration date and exercise then. So the July 1 price might be 12 dollars. As time passes, the price of the option drops. By September 1, if the price of IBM is still 45, the call option's price will drop to, perhaps, 7 dollars. If the price of IBM were 30 dollars and the current date were July 1, the call option would still have a positive price-- perhaps 2 dollars. It would not be profitable to exercise it until the price of IBM rose to 40, which might never happen, but the price might rise that much by September 1. The put option would not be profitable to exercise until the price of IBM fell to below 30. If the current price is 45 and the date is September 1, the put would still have a positive, if low, price, though--perhaps 1 dollar. OTHER POINTS. 1. Options like the call and put above are listed in the Wall Street Journal in standard formats that are traded in big financial markets. Thus, there would be IBM call options with strike prices of 30, 35, and 40 expiring in September, October, November, but not with strike prices of 37, for example. 2. You could design your own option contract, but it would be hard to resell if it weren't standard. 3. Option contracts are heavily used in real estate deals. A typical option would look like this: "Smith agrees to sell the property at 1200 First Street to Jones for $230,000 if he chooses to buy before September 1, 1998. In exchange for this option, Jones gives Smith $500." 4. Options are useful in real estate deals because a lot of things need to be lined up for a deal to work, and Jones, the developer, does not want to put out the $230,000 until he is sure everything else will work out. Jones may need zoning permission from the government, a bank loan for the $230,000, more bank loans for the building costs, equity capital from partners to whom he is showing the idea, and further study of what similar projects are being planned by competitors. He wants to nail down the First Street property, though, because if somebody else bought it, all his other preparations would come to naught. 5. Index options are calls and puts on stock indices rather than individual stocks. Thus, instead of IBM, the option could be on the S+P 500. Delivery is not of the actual stocks if the option is exercised-- it is just the money that the stocks would be worth at market prices. Some uses of index options are: A. You can bet on the market rising more than certain amount even if you have no opinion on whether it will rise a small amount (you win if the market rises more than 20 percent, but lose if it rises 15 percent). B. You can hedge against market crashes. If the market is currently at 100, and you own a lot of stocks, you can buy a Put with a strike price of 80, and if the market crashes to 70, you make money on your Put to balance your loss on your stocks. (This is "Portfolio insurance") C. You can effectively leverage yourself, buying control over stocks with very little cash outlay at the present. (This is like in the real estate option.) As with all leveraging, this increases your chances of losing 100 percent of your investment.