Options Markets Explained: Calls, Puts, and Options Pricing

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 Series: Chapter 14 Review

Options give you the right, but not the obligation, to buy or sell something at a specific price by a specific date. That “not the obligation” part is what makes them different from futures. Chapter 14 covers call options, put options, what drives their prices, and how they are used to speculate and hedge.

The Basics

A call option gives you the right to buy a stock at a set price (the exercise price or strike price) before the expiration date. You pay a premium to get this right.

A put option gives you the right to sell a stock at a set price before the expiration date. Again, you pay a premium.

Each option contract covers 100 shares. American-style options can be exercised any time before expiration. European-style options can only be exercised right before they expire.

A call is “in the money” when the stock price is above the exercise price. A put is “in the money” when the stock price is below the exercise price.

The big difference from futures: with futures, you are obligated to follow through. With options, you can just let them expire. The most you can lose is the premium you paid. The seller (writer) of the option, on the other hand, is obligated to fulfill the contract if the buyer exercises it.

Where Options Trade

The Chicago Board Options Exchange (CBOE), created in 1973, is the primary exchange for stock options. The CME Group also trades options. Electronic trading has become dominant, with most small orders executed automatically. The Options Clearing Corporation (OCC) guarantees all U.S. option contracts, so buyers do not need to worry about sellers backing out.

What Drives Option Premiums

Three factors determine how much an option costs.

For Call Options

Stock price relative to exercise price. The higher the stock price relative to the strike, the more expensive the call. A call option on KSR stock (trading at $140) with a $130 strike costs about $10 more than one with a $150 strike. This makes sense because the lower strike lets you buy cheaper.

Volatility of the stock. More volatile stocks have more expensive options. Higher volatility means a bigger chance the stock will move well above the exercise price, making the option more valuable. Options on small, volatile stocks cost more than options on stable blue chips.

Time to expiration. More time means a higher premium. A KSR call with an April expiration costs $7.50 while the same strike with a March expiration costs only $4.50. More time gives the stock more chances to move in your favor.

For Put Options

The same three factors apply, but the direction of the first one is reversed. For puts, a lower stock price relative to the strike makes the option more valuable because the stock is already close to (or below) the price at which you can sell.

Volatility and time work the same way as for calls. More of either means a higher premium.

Implied Volatility

Since you can observe the premium, the strike price, the stock price, and the time to expiration, you can work backward to figure out what volatility level the market is implying. This implied volatility tells you how much the market expects the stock to swing. It is widely used as a risk indicator.

During the 2008 credit crisis, implied volatility shot up because stock markets became much more unpredictable. Put option premiums soared because more portfolio managers wanted protection, and sellers demanded higher premiums to compensate for the increased risk.

Speculating with Options

Buying Call Options

If you think a stock will go up, buy a call option instead of the stock itself. You need less capital and your percentage returns can be much larger.

Say Steelco is at $113. You buy a call with a $115 strike for $4. If the stock goes to $121, you exercise, buy at $115, and sell at $121. Your net gain is $2 per share (the $6 gain minus the $4 premium), or a 50% return on your $4 investment.

If the stock never goes above $115, you let the option expire and lose the entire $4 premium. That is a 100% loss.

Options with higher strike prices cost less but need bigger stock movements to become profitable. Options with lower strike prices cost more but generate profits more easily. It is a risk-return trade-off.

Buying Put Options

If you think a stock will fall, buy a put. You buy the stock at the lower market price and sell it at the higher exercise price.

With Steelco at $113, a put with a $110 strike costs $2. If the stock drops to $104, you buy at $104 and exercise to sell at $110. Your net gain: $4 per share, a 200% return on your $2 investment.

If the stock stays above $110, you lose your $2 premium.

Writing (Selling) Options

Sellers of options collect the premium upfront. Their maximum gain is the premium received. But their potential loss can be much larger. A call writer’s losses are theoretically unlimited (the stock could keep rising). A put writer could lose up to the exercise price minus the premium if the stock goes to zero.

Hedging with Options

This is where options become tools for portfolio managers rather than gamblers.

Covered Calls

You own a stock and sell call options on it. This is the “covered call” strategy. If the stock drops, the premium you received partially offsets the loss. If the stock rises above the strike price, the option gets exercised and you have to sell your stock at the strike price.

Portland Pension Fund owns Steelco at $112 and sells calls with a $110 strike for $5. If the stock drops to $104, they lose $8 on the stock but keep the $5 premium, so the net loss is only $3. If the stock rises to $120, they sell at $110 (exercise price) plus the $5 premium, for a net gain of $3. The maximum gain is capped at $3 no matter how high the stock goes.

Covered calls limit both your upside and your downside. They are popular with institutions that want income and are willing to cap their gains.

Protective Puts

Instead of selling calls, you can buy puts on stocks you own. If the stock drops, the put gains value and offsets the loss. If the stock rises, you let the put expire and keep the upside (minus the premium you paid).

This is like insurance. You pay a premium for protection. The cost of the premium reduces your net return, but it puts a floor under your losses.

The Barings PLC Disaster

The most dramatic story in this chapter is about Nicholas Leeson and Barings Bank. In 1992, Leeson was sent to Singapore to manage accounting for Barings Futures. He passed the trading exam and started trading options on the Nikkei stock index. He was also in charge of accounting, which meant he could hide his losses.

By January 1995, he had accumulated over $300 million in hidden losses. Barings PLC kept sending money for margin calls without questioning why they were needed. In February 1995, an accounting clerk noticed discrepancies and scheduled a meeting with Leeson. He left the meeting, fled Singapore that night, and faxed his resignation from Malaysia.

Total losses exceeded $1 billion. Barings PLC became insolvent. Leeson went to prison for six and a half years.

The lessons: separate trading from accounting, monitor derivative positions closely, and investigate margin calls immediately. Barings failed at all three.

My Take

Options are the most flexible derivative instrument covered so far in the book. Unlike futures, where you are locked in, options give you the choice to walk away. You pay for that flexibility through the premium, but the asymmetric payoff structure is genuinely useful.

The covered call strategy is the most practical takeaway for everyday investors. If you own a stock and think it will go sideways or slightly down for a while, selling calls against your position generates income. You cap your upside, but you get paid while you wait.

The Barings story should be required reading for anyone in financial services. One person, no oversight, and the ability to hide his own mistakes. The result was the destruction of a 233-year-old bank. The controls matter as much as the instruments.

I find it interesting that Madura puts the Black-Scholes model in the appendix rather than the main text. It is one of the most famous formulas in finance, but for a practical understanding of options, knowing the directional relationships between the factors and the premium is more useful than memorizing the formula.

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