One of your clients is a private investor, making his own stock selections. A friend of his told him...

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One of your clients 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 asks you to discuss the following with him: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 examplePick 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 pricevalue of underlying stockdays till expirationcurrent marketplace average interest rates or rates of returndividend yieldvolatility (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________________”Which of the 6 do you think is the most important in determining the pricing or value of an option? Why?

David · Accepted Answer

Part 1: Advantage in terms of risk Vs return in buying stock options. 
Stocks options are used by the investors to hedge against the risk of uncertainty and yet 
take the advantage of the returns that the market has to offer. There are two primary option type 
i.e. call option and put option. The call option gives an investor right to buy an underlying stock 
at a specified price for a certain period of time (Stock Options, 2012). So in bull market or 
volatile market scenario an investor can take the advantage of upside by buying a call option. 
The put option gives an investor right to sell an underlying stock at a specified price for a certain 
period of time. So an investor can take advantage of put options in falling markets and yet hedge 
for the risk of downside (Hussain, 2006). The following example would clear the picture related 
to risk Vs return in buying stock options.

One of your clients 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...

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