Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionV. Risk and Return 14. Options and Corporate
Finance(^486) © The McGraw−Hill
Companies, 2002
The option position clearly magnifies the gains and losses on the stock by a substantial
amount. The reason is that the payoff on your 50 option contracts is based on 50 100
5,000 shares of stock instead of just 929.37.
In our example, notice that, if the stock price ends up below the exercise price, then
you lose all $30,000 with the option. With the stock, you still have about what you
started with. Also notice that the option can never be worth less than zero because you
can always just throw it away. As a result, you can never lose more than your original
investment (the $30,000 in our example).
It is important to recognize that stock options are a zero-sum game. By this we mean
that whatever the buyer of a stock option makes, the seller loses, and vice versa. To il-
lustrate, suppose, in our example just preceding, you sell50 option contracts. You re-
ceive $30,000 up front, and you will be obligated to sell the stock for $30 if the buyer of
the option wishes to exercise it. In this situation, if the stock price ends up below $30,
you will be $30,000 ahead. If the stock price ends up above $30, you will have to sell
something for less than it is worth, so you will lose the difference. For example, if the
stock price is $50, you will have to sell 50 100 5,000 shares at $30 per share, so
you will be out $50 30 $20 per share, or $100,000 total. Because you received
$30,000 up front, your net loss is $70,000. We can summarize some other possibilities
as follows:
Notice that the net profits to the option buyer (calculated previously) are just the oppo-
sites of these amounts.
CONCEPT QUESTIONS
14.1a What is a call option? A put option?
14.1bIf you thought that a stock was going to drop sharply in value, how might you
use stock options to profit from the decline?
Ending Stock Net Profit to
Price Option Seller
$10 $30,000
20 30,000
30 30,000
40 20,000
50 70,000
60 120,000
458 PART FIVE Risk and Return
Put Payoffs
Looking at Table 14.1, suppose you buy 10 AOL January 42.50 put contracts. How much does
this cost (ignoring commissions)? Just before the option expires, AOL is selling for $22.50 per
share. Is this good news or bad news? What is your net profit?
The option is quoted at 11, so one contract costs 100 11 $1,100. Your 10 contracts
total $11,000. You now have the right to sell 1,000 shares of AOL for $42.50 per share. If the
stock is currently selling for $22.50 per share, then this is most definitely good news. You can
buy 1,000 shares at $22.50 and sell them for $42.50. Your puts are thus worth $42.50
22.50 $20 per share, or $20 1,000 $20,000 in all. Because you paid $11,000, your
net profit is $20,000 11,000 $9,000.
EXAMPLE 14.1