Question

"Options Markets" Please respond to the following: Justify why an investor may prefer stock splits versus stock dividends as an effective way to increase their portfolio. Provide an example for your justification. Analyze the terms “in the money option” and “out of the money option.” Provide two examples of their applications.

Answer 1

Stock splits can make the shares more affordable to the market participants & that also provides greater marketability & liquidity to the participants resulting in price discovery. The concept of stock split is that it issues new shares to the existing shareholders. As the number of shares goes up, the portfolio of the shareholder also increases, the market capitalization of the company would remain the same & also the price of the share comes down. Hence stock splits are good when compared to stock dividend. But in case of stock dividends it is issued by the company when the company falls short of the liquid cash to make the payment to the shareholders.

For example, a company which has 100 issued shares priced at $50 per share has a market capitalization of $5000 = 100 × $50. If the company splits its stock 2-for-1, there are now 200 shares of stock and each shareholder holds twice as many shares. The price of each share is adjusted to $25 = $5000 / 200. The market capitalization is 200 × $25 = $5000, the same as before the split.

Options in the money & out of the money:

In the money:

An option is said to be in the money if it has a intrinsic value. For example a call option is said to be in the money if the price of the underlying asset is higher than the stroke price of the option contract. On the other hand a put option is said to be in the money if the price of the underlying is less than the strike price.

It is called as in the money because traders speculate on the price direction of the underlying asset. If the strike price of a call option is $5, and the underlying stock is currently trading at $4.70, that option is out of the money. The buyer of the call isn't going to make any significant money until the price starts rising above $5 (ITM). The higher above $5 the price goes, the more in the money the option is.

Out of the money:

An option contract is said to be out of money if it doesn’t have an intrinsic value. A call is said to be out of money when the price of the underlying is less than the strike price. On the other hand a put is said to be out of the money when the price of the underlying is high than the strike price.

Examples of ITM & OTM:

Let's look at few more examples to help clarify in the money options and out of the money options. If a stock--the underlying asset--is trading at $50, all call options with a strike price below $50 are in the money. Call options with a strike price above $50 are out of the money. For example, a call option with a strike price of $30 has $20 of intrinsic value, because the strike price is $20 below the $50 stock price.

All put options with a strike price above $50 are in the money, and put options with a strike price below $50 are out of the money. For example, a put option with a $60 strike price has $10 of intrinsic value, because the stock is trading at $50, $10 below the strike price. A call or put option is at the money (ATM) if it has a $50 strike price, and the underlying stock is also trading at $50.