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Stocks versus stock options

Your client is a private investor, making his own stock selections. A friend of his told him about the investment opportunity of stock options. He wants to pursue that kind of opportunity but knows little about them. He is visiting tomorrow and asked you to discuss the following with him:

a) In layman's terms, explain the big advantage in terms of risk vs. return, of buying stock options as compared to buying shares of the stock itself. Give a simple numerical example.

b) Pick and explain why any 3 of the 6 main variables in the Black Scholes option pricing model should affect the value of an option:
- exercise price
- value of underlying stock
- days till expiration
- current marketplace average interest rates or rates of return
- dividend yield
- volatility (standard deviation of returns)

Word each of your 6 answers like this:
"This variable is important to the value of an option because if it were to be bigger/smaller, the price or value of the option should get______(bigger/smaller) because________________"

c) Which of the 6 do you think is the most important in determining the pricing or value of an option? Why?

Solution Preview

A stock option gives the buyer the right, but not the obligation, to purchase the associated stock at a set price. A major advantage is that the stock options allows a purchaser to use leverage to purchase up to 100 stock shares for a lower price, but provides for higher returns than purchasing stocks. Leverage allows a stock option buyer to purchase stock options at a small amount of investment to own a large amount of assets.

Let's take a look at an example. If a stock sells for $50 and is set to trade higher, the purchaser buys ...

Solution Summary

A stock versus stock options are examined.

$2.19