 Hello, and welcome to the session. This is Professor Farhad in which we would look at option contracts and what's going to be a very basic session. Just to teach you about calls and puts, how to calls and puts work. These topics are covered on the CPA exam, BEC section, as well as the CFA exam. This lesson is also covered in an essential or principles of investment course, undergraduate or graduate. As always, I'm going to remind you to connect with me only then. If you haven't done so, YouTube is where you would need to subscribe. I have 1,800 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them, share them, put them in playlist. If they benefit you, it means they might benefit other people. Connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources, the complement and supplement, this course as well as your other courses. Please check out my website. So let's talk about the call option. What is a call option? What's the big idea? Well, let's assume you want to buy a stock. Well, let's assume you want to buy a car or a house or a textbook. Let's start with a textbook. Let's assume you want to buy a textbook for the next semester, and that textbook is called intermediate accounting. That's the course you're going to be taking. Don't take it unless you have to. It's a tough course. Okay. So you want to take intermediate accounting. So what you do is this, the textbook today. If you want to buy the textbook, it's $200. But you don't need it today. You can contact a student that's taken the course now and pay that student a fee. We call it a premium for you pay a premium of $5. You pay this student a premium of $5. And this student will guarantee the book for you for $170. You say, don't worry. Once the semester ends, I will sell you the book. If you have two weeks, I will sell you the book for $170 within those two weeks. That's the deal. Okay. So either is you purchase an option, you pay $5 premium and you purchase this option to buy the book. Now this call option, notice it's called an option. Option means if you don't want to buy it, you don't buy it. If you want to buy it, you can buy it. What does that mean? It means within those two weeks between the two semesters, if you can find the book for $150, guess what? You will tell your friend, thank you very much. You can keep the $5 and you will buy the book at $150. If the book rises to $205 or $220 or if the book rises, there's a shortage of the book. Guess what? You're going to tell your friend, look, we promise that within those two weeks, anytime I can come and buy it from you for $170 and I want to exercise my option. And that's basically what the option is. Now let's talk about options when it comes to actual options in the stock market. A call option gives the holder the right. Notice the right, not the obligation. The right means the option right to purchase an asset for a specified price called the exercise price or the strike price. Remember, our strike price was $170 on or before some specified expiration date. So to look at an actual example, we're going to look at this option. This is for Microsoft and this is old because from 2017, now Microsoft is above $200 and who knows where it's going to go. The strike price is $72. So for example, July 7th call option on chairs of Microsoft with exercise price of $72 to purchase Microsoft price at $72 up to including the expiration date. So you can buy it at $72 up to including July 7th. Now, there's always a price to pay. You're going to pay $1.15. Notice here, this is the premium that you have to pay. So the holder of the call is not required. You don't have to buy it at 72, but you have the option from today until that date. Whatever today is, let's assume today is June 1st. The holder would only exercise the option to buy if Microsoft cheer exceeds that price. So when does it make sense to you to buy? It only makes sense to you to exercise the option if it's above the strike price and also you want to cover your fee. So simply put, you want it to be above $73.15 to make net profit, net immediate profit, but we'll talk about the details in a moment. If the share price remains below the strike price, if it's below $72, guess what? You're going to pay $1.15 and actually its options are traded at $100. So it's $1.15 times $100. So you buy options in lots of $100. So this is how much you will pay. You'll pay $115. So if the exercise price never exceeds $72, what's going to happen is you would lose the $115. Now you can buy it maybe at $68. Yeah, right. Again, Microsoft is starting to be above $200. So you would leave it unchecked. If not, exercise before the expiration, a call option simply expires and becomes worthless. So if it does not exceed really $72 or $73.15, if you want a net profit, you just let the option go and you would lose the $115. Therefore, if the stock price is greater than the exercise price on the expiration date, the call value equals the difference between the stock price and the exercise price. So if on the exercise, by the exercise state, the price is $73, $73 minus $72, you have a dollar of profit from the option that, remember, you paid $115. So you're still at a loss. So you really want it to go above $73.15. So the net profit on the call is the value of the option minus the price originally paid to purchase it. And we're going to look at the numbers in a moment. So the purchase price of the option is called the premium. So this $115 is the premium. It's basically you have to pay someone to give you that option. They're not going to give it to you for free. Now, what is the psychology? What's the psychology behind your position and the other party position? You think when you buy a call option, when you buy a call option, you think the stock price, it's going to go up. Therefore, you want to lock it in. The seller of the call option is exactly thinking the opposite. The seller thinking Microsoft, it's going to drop below $72.00. Therefore, they will pocket the $115.00 and they will never have to give you the stock. Why? Because it's going to be below the $72.00. So the buy of the call option thinks the stock is going to go up. The seller of the call option thinks the price of that asset will go down. So basically put, we have a pessimist and an optimist. The buyer of the call option is optimist about the stock, thinks the stock is going to go up. The seller thinks the stock price, it's going to go down. So the seller of the call option who are set to write the call receives a premium income as payment against the possibility they will be required at some later date to deliver the asset in return for an exercise price less than the market value. So that's what they, this is the pessimist job. So the pessimist job would write it. The reason I say pessimist because they're hoping that the stock price goes down. That's why they sold you the option because you are never going to exercise it. They're going to keep the premium. If the option is left to expire worthless, the call writer would clear a profit equal to the premium collected. We said if they sold one contract, they made $115. But if the call is exercised, guess what? They have to give the stock to the optimist at 72. Now if they have the stock, it's not a big deal. But if they don't have the stock and the stock right now at 78, they have to buy at 78 and give it to the optimist at 72 who thought the stock price will go up. If the call is exercised, the option writer profit is the premium. Obviously they have $115, but if they have to buy it at 78 and they have to sell it at 72, they have a loss of $6 per stock times 100 shares. They have a loss of 600. Then they made a profit from the premium of 115. They will have a loss of the difference between the two. So the profit is the premium income minus the difference between the value of the stock that must be delivered and the exercise price is paid for those shares. Now if you already have the stock, so what some people do if they have Microsoft stock, so if you have 100 shares of Microsoft, if you have 100 shares and you bought them, for example, I'm sorry, 100 shares of Microsoft, and let's assume you bought them at $50, then it's not a big deal. You would sell this option. You would sell this option. You would sell this option to sell them at 72, and you will get $115 right now, $115, your pocket $115. Well, if the stock price goes up, that's okay. Well, if you bought them at 50, you can sell them at 72. You'd still made $22 in profit plus the $115. But if the stock price goes down, guess what happened? You keep this and you keep your stock, which is still at a profit. But the thing is if you sold the call, if you wrote the contract, and you did not have the stock, that's risky, because the stock could jump to 100 and you have to deliver it at 72. Therefore, you have to buy it at 100, deliver it at 72. If the difference is larger than the initial premium, the writer would incur a loss. So obviously, here in our situation, if you have to buy it at 78, guess what? You are at a loss. Let's take a look at some additional numbers. Consider the July 27 expiration call option with an exercise price of 72 on June 2, selling for $115. Until the expiration date, the call holder may exercise the option to buy the shares of Microsoft. So this is an American option. American versus European. American option, you can exercise this up to any time up to that date. If it's European option, you can only exercise it June 2. European is only have one specific date. Assume the stock price on June 2 is $71.75. It's below the exercise price. So it will not make any sense for the buyer of the option, the person that paid $115 to exercise the option. Why would I exercise it buy it at 72 when I can buy it at $71.15? I already lost the $115, so it will not be exercised. Indeed, if the stock remained below $72 by the expiration date, the call will be left expire worthless because no one's going to buy it for $72 when they can buy it for something else. On the other hand, if Microsoft is selling above $72, the call holder will find it optimal to exercise. Now, what's the most optimal price you wanted to be above $73.15? But let's assume the Microsoft is $73. On July 7, the option will be exercised. It will give the holder the right to buy 72, to pay 72 for a stock that's worth 73. But remember, although you thought you made a profit because you bought it at 72, but it's selling at 73, remember you do have the $115 fee. So basically net profit you made $0.15 because you end up paying a fee. So simply put, to make real net profit on this option, the price of Microsoft has to be $73.15. In other words, you have to count how much you're paying for the stock, which is the exercise price plus the premium. So you have to cover both to make a profit. Okay? Nevertheless, exercise of the call is optimal at the expiration of the stock price, exceeds the exercise price because the exercise price exceeds the proceeds will offset at least part of the purchase price. So the call buyer will clearly profit if Microsoft is above $73.15, as I told you. The net proceeds will just cover the original cost of the call plus the premium. This is what happened. So again, this is the call option. Now let's take a look at the put option. What's the big idea of a put option? So this is basically different than the call option. Put option is when you want to protect against the downside. Let's assume you do have Microsoft stock or you don't. Let's assume you have Microsoft stock. So we're going to talk about covered put option. You have Microsoft stock. You have 100 shares of Microsoft. And here's the fear. You purchase them at $72. All right. Yes, let's assume you purchase them at $55. It doesn't matter what price. That's the price. Your fear is right now, let's assume it's trading at $75. So right now, it's the Microsoft is trading at $75. You purchase them at $55. Now you have a profit of $20. But guess what? You fear that the stock price within the next two months might drop down below $55 or below a certain number. So here's what you do. You would sell a put option. You would sell a put option and you would tell someone, look, I will give you Microsoft stock between now and July 7th for $72. So the strike price is $72. If you pay me $32, I'm sorry. Let's talk about a put option. How does a put option work? The put option, basically you are protecting yourself from a downside and your asset from the downside. So you fear the asset that you have might go down in price. Let's assume you purchase some Microsoft shares at $68. That's your cost. That's your cost. The price right now is $75. But you're not ready to sell. But you fear the stock price might drop to $65. And if it drops to $65, guess what? You are at a loss. So here's what you do. You want to protect this. What you do is you buy July 7th strike price of $72. But it's a put option. What does that mean? It means you pay today for $1.32 per contract times 100 shares. You pay today $132 to someone. And you will tell that someone between now and July 7th, I can shove down your throat or sell you, basically. I'm sorry about the expression. But the point is I can sell Microsoft shares to you at any time between now and July 7th at $72. My 100 shares at $72. And you have to buy them. Now, what is your fear? Your fear is or what is your motivation? Your motivation is if the stock price keeps dropping to $69, $68, you can sell it at $72. You have a peace of mind that you are protected. The other person, what's the other person thinking? What's the other person that got that $132? The other, so here you are a pessimist. Here, when you buy the option, the buyer, the buyer of the put option is a pessimist, is the pessimist. The seller of the put option is optimist. The seller saying, yes, give me $132 and I will buy Microsoft from you for $72 up until July 7th. Now, what is the seller thinking? The seller thinking, look, Microsoft, it's going to go up to $100. I'm never going to see this individual again. So bring it on. Give me $132 and I will sell it to you first. I will buy it from you at $72. So this is the psychology on both ends. So what is a put option? Put option is the right to, the right gives the right to sell an asset for a specified price or strike price on or before the expiration date. Here we're talking strike price of $72, expiration date July 7th, and you have to pay a premium of $1.32. That's the big idea. On July, expiration put on Microsoft an exercise price of $72, entitled the owner to sell Microsoft to the put writer for $72, even if the market drops below that price. Whereas the profit on a call option increases with the asset increases in price. So if you have a call option, you want the stock price to go up because you can buy it at a lower price. And a put option, you want the stock price to go down. Why? Because it goes down. You could still sell it at $72. A put will be exercise only if the price of the underlying asset is less than the strike, less than the exercise price. So if this price went down to $70, you tell them, you need, I can sell it to you for $72. Okay, that's below the exercise price. Now bear in mind, when someone buys a put option, they don't have to own the shares. So they can buy the put option. And what happened, you don't have to own the shares. So upon exercise, what you would say, the investor's broker purchased the necessary shares of Microsoft. Let's assume it's trading at $68. At that point, you will buy it at $68. And you have the right to sell it at $72. You say, you don't have to, you don't have to have the stocks. At the beginning, I told you, you have to, you know, when I explained it, I said, if you have 100 shares, you don't have to have 100 shares. So you can buy a put without having the shares. And basically you'll buy it at $68, sell it at $72. But remember, you paid $132 in profit. So you will make $400 profit, you know, the difference between $68 and $72, $4 times $100. Then you have a premium of $132. So let's take a look at another exercise. Consider the July 27th expiration put option with an exercise price of $72, selling on June 2nd, $4.32. So that's the premium. It entitled the owners to sell Microsoft shares at $72 at any time up until July 7th. So from June till July 7th, if the holder of the put buys the shares and immediately exercise the right to sell it at $72, let's assume they will do that. The exercise proceeds will be 25, 25 cents. Now, obviously no one will do that. You know, an investor who pays $1.32 for the put had no intention of exercising it immediately. It means you want to sell it at $72, okay? So you will not sell it at $71, 25, but that's what it is. If on the other hand, Microsoft is selling for $70, well, that's good. If it's selling for $70, I can sell it for $72. I have a $2 profit under those circumstances. The put will turn out to be a profitable investment if the value at the expiration will be $70. Well, you want it to be below $72. But specifically, I'm sorry, below $72, but really you want it to be below $72. And remember you paid $1.32. So you want it to be even below that because you paid a premium. Okay, so the investor, so you made a profit of $2. Then you have to cover your premium $1.32. So you made 68 cents per share. And if you bought 100 shares, you multiply that by 100. But simply put, that's if you want a percentage wise, this is a holding period of 68 cents by paying $1.32. That's 51% over 35 days. That's pretty good. That's not a bad return at all. Okay, now obviously the other party is not thinking that's what's going to happen. Again, when you have a put option, you think the price will go down. When you have a, yes, when you have a put option. So let's talk about an option. When we say an option is in the money, what does it mean an option in the money? That's good. An option in the money, it means when you exercise it, you would have a positive cash flow. You will have a profit. Positive cash flow means you have a profit. Therefore, a call option in the money, when the asset price exceeds the exercise price. So if you remember the exercise price, x equal to 72, when would that option be in the money, when the price is 72 plus? Any price above 72 is in the money. Well, a call out of the money, it's the exact opposite. So if the exercise price is 72 and the current price is 71 or 70 or any price below 72, we'll say that the option is out of the money. Why? Because if you exercise it, it's not profitable for you. We say the option is at the money. Guess what? When the exercise price, when the exercise price equal to the market price, equal to the market price, to the asset price, to the asset price. When that's the case, we say the option is at the money. Let's take a look at these numbers real quick. What will the proceeds and the net profit to an investor who purchased the July 27 expiration Microsoft call with an exercise price of 72 if the stock price at the expiration is 70? So if you bought a call option, the call option and the call option is at 72 and remember for that you paid $1.15 but the price is 70. You have no profit whatsoever. You have a loss because you will never exercise and you lost $1.15 times $100. You lost $115. Now if the stock price is 74, if the exercise price is 74, guess what? You can buy it at 72, sell it at 74 and you make a profit of $2 then you have to pay your fee. Then you have to cover your fees. Then after covering your fees, what's left is 85 cent and this is your profit. This is your profit, net profit. Well, 85 and you've multiplied by 100 shares if it's a one contract. Now insert part B for an investor who purchased the July expiration put with an exercise price. Again, the same thing here. The exercise price, it's going to be 70 and the exercise price is 74. Here what's going to happen is this. When the exercise price is 70, you make a profit. It's 72 minus 70. Here you make a profit. So you have a profit of $2. Then again, you have to pay $1.32. So what's left to you is 68 pennies, 68 pennies in net profit. If the exercise price is 74, well, guess what? You make no profit if you have a put. Why? Because why would you sell it at 72? If you could sell it at 74. Therefore what you would lose is your $1.32 times 100. So you would lose your premium $132. So notice here, notice here, notice here, this is a loss. So for the call, when the stock price, when the exercise, when the price is 74, sorry, this is the price, exercise price is 72, again, exercise price is 72, exercise price is 72. When it's at 74 for the call, you have a gain. When it's 74, you have a put, you have a loss. The opposite is true. The opposite is true for the put option. The put option, when the call, when the exercise is 72 and the stock price is 70, you have a gain. Here, when the price is 70 at a call and the exercise is 72, you have a loss. You don't do anything. You let the call expire. In the next up, in the next session, we would look at values of options, not of options, of options at expiration. Once again, if you like this recording, please like it, share it. I'm going to remind you again to connect with me on social media and visit my website, farhatlectures.com, where you have additional resources to supplement and complement this course as well as other courses. Good luck, study hard and stay.