Copyright © 2008, The McGraw-Hill Companies, Inc.
(a) If the stock price rises to $75, you can exercise your option to buy 100 shares at $60,
costing you $6,000. But you can then immediately turn around and sell them for $75 per
share, or $7,500, providing yourself with a profi t of $1,500 $150 $1,350. You’ve grown
your money 10-fold!(b) In this case you can still exercise your option for $6,000 and then immediately sell the
stock for $6,450, a $450 $150 $300 profi t. You’ve tripled your money.(c) There is no point in exercising your option to buy at $60 if the open market price is lower.
The contract expires worthless. You’ve lost your entire investment.We can see how this leverage works if we compare the scenarios of Example 6.3.6 to simply
buying 100 shares. Buying 100 shares would tie up $4,800 in the investment, enormously
more than the option approach required. If the stock rose to $75 a share, you could sell your
stock for a $7,500 $4,800 $2,700 profit. This is larger than the $1,500 profit made with
the option, but it is a far smaller profit in comparison to the size of the investment. With the
option you grew your money 10-fold, with the actual stock you did not even come close to
doubling it. In scenario (b), where the stock rose to $64.50 a share, you would profit $1,650 by
owning the actual stock. Once again this profit is larger in absolute terms, but in comparison to
the amount invested it does not even come close to the tripling that the option provided.
On the other hand, if the stock rises to $55 a share, by owning the stock you could earn
a $700 profit, while with the option you actually lose all your money despite the fact that
the stock price rose in value. While options offer the potential for greatly magnified returns
based on the money invested, they also offer a much greater risk of enormous losses as
well. While options contracts sometimes pay off handsomely, in actuality most options
contracts expire worthless.
Puts work similarly.Example 6.3.7 The stock of Global Consolidated Meganormo Corp. presently sells
for $73 per share. You believe that the stock price is likely to drop, and so you buy a
$60 put option for 500 shares. The option premium is $2. How will you make out if the
stock price drops to (a) $50 and (b) $60.In either case, the total cost of the options contract is (500 shares)($2 per share)
$1,000.(a) If the stock drops to $50 per share, you could buy 500 shares at this price for a total
of $25,000, and then exercise your put and sell them for $60 per share, or $30,000. This
would give you a gain of $30,000 $25,000 $5,000. Since you paid $1,000 for the
option, your profi t is $4,000.(b) If the stock price drops to $60 per share, an option to sell at that price is nothing special,
and so the contract expires worthless. Even though you were right about the stock price drop,
you will lose your entire $1,000.Writers of options hope to profit by pocketing the premiums and then having the options
written expire worthless. By some estimates, anywhere from 85 to 95% of all options do
in fact expire unexercised.
Profits or losses from options investments can be calculated as rates in much the same
way as we did with futures. The difference is that for options it would be the option premium
that should be used as principal.Example 6.3.8 Calculate the simple rates of return for both scenarios in
Example 6.3.7. Assume that the term of the investment was 3 months.(a) I PRT
$4,000 ($1,000)(R)(3/12)
R 1,600%(b) $1,000 ($1,000)(R)(3/12)
R 400%6.3 Commodities, Options, and Futures Contracts 281