Question.3060 - Option Pricing Model Assignment1 : Your assignment is to value two (2) call options for Whole Foods Market, Inc. (ticker: WFM). 1) WFM August 2012 and January 2014 calls. 2) The call strike price must be in-the-money at the time you do the assignment (remember, in-the-money means the strike will be less than the stock’s price). For instance, if the stock price is $80, use $70 or $75 strike for both call options. It doesn’t matter which strike you choose as long as it is in-the-money. Just be sure you use the same strike price for both expirations. Use the Black-Scholes Option Pricing Model at the CBOE (Chicago Board Options Exchange), which can be found at www.cboe.com and then click TOOLS and then OPTIONS CALCULATOR. Find the theoretical value of both calls. You will need to enter the five Black-Scholes factors (stock price, strike price, time to expiration, risk-free interest rate, volatility, and risk-free interest rate. Use 0% for the interest rate and 30% for volatility. (In the CBOEs calculator, use the whole number 30, not 0.30). Shortcut Trick! Type the ticker symbol WFM (the former symbol was MFMI) in the “symbol” box (circled in red below). The calculator will automatically load the stock price plus all expiration months available (blue circle). When you select the expiration date you want from the drop-down menu, the calculator will automatically load the proper number of days to expiration for you. Note: it will also load the current volatility and interest rate but you must use 0% for the interest rate and 30% for the volatility. You will just need to manually override the values. Once you have the expiration date entered into the calculator from the drop-down menu (blue circle above), click the “calculate” button (the center blue button above) and you will see the theoretical option values to the right along with the corresponding Greeks (green box). Assignment: Answer the following 11 questions below. 1. Copy and paste a screen capture of the entire calculator, as shown above, for each of the calls. If you do not have the software to copy and paste the graphic as above, you can type the results in your paper. 2. What are the theoretical prices of your two calls as shown by the calculator? (This appears as “option value” in the green box.) 3. What are the actual market prices of the two calls? You will need to look up the current asking prices, which can be found from a variety of sources on the Internet including the CBOEs website as well as finance.yahoo.com. If you have a brokerage account you can certainly use real-time quotes. 4. Explain why your theoretical results in Question 2 are different from the actual market prices in Question 3. 5. What volatility is the market using? This can be found by typing the actual market price in the “implied volatility” calculator in the red box above. Click the “calculate” button in the lower right corner of the red box to find the volatility, which shows in the “vola%” output box. 6. Based on what you’ve observed in the above questions, what do you suppose the “theoretical price” of an option really means? 7. What are the deltas of the two options? (The delta is found in the green box.) Explain why the delta is larger for the August call than the January call. Be sure you are using 0% for the interest rate and 30% for the volatility. 8. On the calculator, change the strike price so that it is greater than the stock price price (the call is out-of-the-money). Using that strike, what are the values for both the August and January calls now? (Be sure the calculator does not default to a different interest rate and volatility. Keep them at 0% and 30% respectively.) 9. Why is the delta now greater for the January call than the August call? 10. Read the article Look Closely Before Biting below and assume the information is current. Based upon your opinion on what will happen to the future stock price, take a position on Whole Foods– either bullish, bearish, or neutral and, using the information learned in this class, explain how you would act on your opinion in the market. What would you buy or sell and why? You can use actual share transactions and/or naked or covered derivatives. Doing nothing is not an acceptable choice. (Note: I am looking for some depth for this answer, perhaps two to three good paragraphs. An answer of “I would buy calls since I’m bullish,” for example, is not enough. Why are you bullish? Why did you choose to buy or sell? 11. What would your potential profit and loss be (specific numbers)? Why do you feel your answer is the best choice for capitalizing on your opinion? (Note: Please be sure to clearly state max gain, max loss, and breakeven point(s). Also be clear on why you selected your strategy. An answer of “I would buy calls to limit losses” is not specific enough. Lots of strategies have limited losses. Why do you feel your strategy is best for you?) July 7, 2008 HEARD ON THE STREET Look Closely Before Biting Whole Foods Needs To Focus on Costs, Slow Store Openings By GREGORY ZUCKERMAN July 7, 2008; Page C8 Shares of Whole Foods Market Inc., down about 40% in the past year, are starting to look tempting. Some hedge funds already are licking their chops. But management needs to radically change its focus to cost cutting from growth before the stock becomes truly enticing. A highflier for much of the past decade, Whole Foods now trades at 14 times 2009's expected earnings, down from an average of well over 20 over the past decade. On a multiple of both cash flow and revenue, the premium-food purveyor is just a tad more expensive than rivals Safeway Inc. and Kroger Co., even though Whole Foods has better long-term prospects, as the appetite for organic and healthier food grows. Meanwhile, earnings should begin to perk up when Whole Foods finally integrates the stores acquired in its purchase of the Wild Oats chain last year -- a deal that was costly and misguided. As the economy slumps, however, some Whole Food customers likely will trade down to less-expensive rivals, especially those like Safeway that have introduced their own organic and takeout sections. It doesn't help that the company has earned the moniker "Whole Paycheck." That all means earnings expectations over the next 12 months might be too high. To get investors excited again, Whole Foods needs to slow its pace of growth and focus on wringing out more cash from its existing stores, say a number of investors on the fence about the stock. Whole Foods expects to open as many as 51 stores this year and next, despite the downbeat economic outlook and the capital-intensive nature of these launches. That compares with 34 stores over the past two years. But if fewer stores are opened, it would free up more cash for the bottom line. And only those locations where management is confident it can achieve superior returns in the short term should be considered. Whole Foods also "must cut its expenses," perhaps by re-examining its distribution methods, and choosing smaller locations that aren't always in the prime spots, argues Stephen Long, of New York hedge fund Hanover Square Capital, among those lukewarm about the stock. Whole Foods has had a return on equity of about 14% in recent years, in line with other grocers, and its profit margins are just a tad higher than the competition. But curbing growth and further cost cuts will help these measures improve. Rationalizing Whole Foods' business without alienating customers will be a tough challenge. Robert Nardelli failed to do that at Home Depot Inc., the home-improvement chain that also once was a fast grower but saw customers flee for rival Lowe's Cos. At the same time, Whole Foods' push to open foreign stores should be curbed. The London store is losing money, running into tough competition from well-run U.K. grocery chains. Wouldn't a move to slow the rollout of new stores scare off growth-focused investors? Probably. But these types of investors already have been bailing, even as value investors have yet to roll up their sleeves on the stock. That transition period is a time when a stock is overlooked, making it a ripe opportunity for investors. While the grocery chain has made improvements in its cost structure, more needs to be done. --Arindam Nag Write to Gregory Zuckerman at gregory.zuckerman@wsj.com1 URL for this article: http://online.wsj.com/article/SB121539656470431557.html Hyperlinks in this Article: (1) mailto:gregory.zuckerman@wsj.com Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved This copy is for your personal, non-commercial use only. 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Answer Below:
Answer 1: Call Option August 2013 Call Option Jan 2014 Answer 2: Theoretical prices of call options with strike price USD 100 – 1. Option for August 2013, price = USD 8.94 2. Option for January 2014, price = USD 12.68 Answer 3: Actual market prices of call options with strike price USD 100 – 1. Option for August 2013, price = USD 8.40 2. Option for January 2014, price = USD 12.21 Source: Yahoo Finance Answer 4: The difference between the actual price and the option calculated price is due to the volatility used and interest rate (also possibly could be the dividend amount used to calculate the option price). Answer 5: Volatility used by the market – 1. Option for August 2013 = 26.89% 2. Option for January 2014 = 28.49% Answer 6: The theoretical price of an option is actually based on the factor of inputs and the closer the factor of inputs to the real number the better the option pricing forecast. We can definitely rely on the theoretical price if our estimates are close by and well researched. However, it cannot be sure of exactly the equal of market price. Answer 7: Delta for the two options with strike price USD 100 – 1. Option for August 2013 = 0.6779 2. Option for January 2014 = 0.6343 Delta measures the sensitivity of an option's theoretical value to a change in the price of the underlying asset. Delta is normally represented as a number between minus one and one, and it indicates how much the value of an option should change when the price of the underlying stock rises by one dollar. Call options have positive deltas and put options have negative deltas. Delta is dependent on where the stock is trading relative to the strike price, and the time to expiration. The time to expiration is shorter in the August option as a result the delta is high. Answer 8: Theoretical prices of call options with strike price USD 110 – 1. Option for August 2013, price = USD 4.05 2. Option for January 2014, price = USD 8.09 Answer 9: Delta for the two options with strike price USD 110 – 1. Option for August 2013 = 0.41 2. Option for January 2014 = 0.47 The two options have now become out of the money options. So the delta shall tend to behave in the opposite direction. As a result, the delta for the farther period shall be higher than the delta of the shorter period. Answer 10: After reading the article, at this stage it doesn’t seem wise to be bullish on the stock. There are many if’s and but’s with the company and incase tall these go well, the company could be said to be a wise investment. Till that time, it’s better to stay away from it or go with a bearish cum neutral call. In this scenario, I shall apply a “Short Call Strategy”. The trade would be : Sell a call, buy call at higher strike. I choose this strategy because I expect the stock to be bearish with neutral volatility. The Short Call is to take advantage of a bearish side and the premium gained affords some upside protection with a Long Call of greater strike. The spread offers a limited profit if the underlying falls and a limited loss exposure if the underlying rises. Answer 11: Profit & loss characteristics at expiry: Profit: Limited to the net premium credit. Maximum profit occurs where underlying falls to the level of the lower strike or below. Loss: Limited to the difference between the two strikes minus the net credit received in establishing the position. Maximum loss occurs where the underlying rises to the level of the higher strike or above. Break-even: Reached when the underlying is above strike price of selling call by the same amount as the net credit of establishing the position. The CMP is $51.51 We shall buy a July 20 call of strike price 55 at 0.43 and sell a July 20 call of strike price 47.5 at 4.3. Net payoff to us will be 3.87. The price of stock subsequently drops to $46.5 at expiration. As both options expire worthless, we get to keep the entire credit as profit. If the stock had rallied to $57 instead, both calls will expire in-the-money. The spread would then have a net value which is equal to the difference in strike price. Net loss would be $+1.57 – 4.3 = - 2.73. Source for option prices: http://markets.ibtimes.com/ibtimes/quote/optionchain?StrikeDate=1374292800&Symbol=537%3A 986306&Filter=NEARMore Articles From Finance
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