Investments, tenth edition

 Example  20.1 

Profits and Losses on a Call Option 

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Final PDF to printer

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680 

P A R T   V I

  Options, Futures, and Other Derivatives

 A     put  option    gives its holder the right to  sell  an asset for a specified exercise or strike 

price on or before some expiration date. A February expiration put on IBM with an exer-

cise price of $195 entitles its owner to sell IBM stock to the put writer at a price of $195 at 

any time before expiration in February even if the market price of IBM is less than $195. 

Whereas profits on call options increase when the asset price rises, profits on put options 

increase when the asset price  falls.  A put will be exercised only if the exercise price is 

greater than the price of the underlying asset, that is, only if its holder can deliver for the 

exercise price an asset with market value less than that amount. (One doesn’t need to own 

the shares of IBM to exercise the IBM put option. Upon exercise, the investor’s broker 

purchases the necessary shares of IBM at the market price and immediately delivers, or 

“puts them,” to an option writer for the exercise price. The owner of the put profits by the 

difference between the exercise price and market price.)  

 Now consider the February 2013 expiration put option on IBM with an exercise 

price of $195, selling on January 18 for $5.00. It entitled its owner to sell a share 

of IBM for $195 at any time until February 15. If the holder of the put buys a share of 

IBM and immediately exercises the right to sell it at $195, net proceeds will be 

$195  2  $194.47  5  $.53. Obviously, an investor who pays $5 for the put has no inten-

tion of exercising it immediately. If, on the other hand, IBM were selling for $188 at 

expiration, the put would turn out to be a profitable investment. Its value at expiration 

would be   

Value at expiration 5 Exercise price 2 Stock price 5 $195 2 $188 5 $7  

 and the investor’s profit would be $7   2   $5   5   $2. This is a holding period return of 

$2/$5  5  .40, or 40%—over only 28 days! Obviously, put option sellers on January 18 

(who are on the other side of the transaction) did not consider this outcome very likely.