Options

Framework and Road-map

CAPSTONE

Firms Obj. Investors Obj. Markets Obj.

Max. Firm Value Portfolio Theory Market Efficiency

Capital Budgeting Capital Structure Risk Mgmt.

NPV; IRR; PI CAPM; WACC Hedging

Derivatives
Interest Rates
Futures; Options

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Options

Options: Topic Index

1 Option Contract Features

2 Option Payoffs and Profits

3 Option Trading Strategies

4 Option Pricing
Binomial Model
Black-Scholes-Merton Model

5 Put-Call Parity

6 Hedging with Options

7 Greeks and Advanced Hedging

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Options

Options: Contract Features

1 A Call option is the right to Buy the underlying.
2 A Put is the right to Sell the underlying.
3 The Price at which the underlying can be bought or sold is pre-determined and
called the Exercise or Strike Price
4 Option Positions
Long Call: Buying the Right to Buy the Underlying
Short Call: Selling the Right to Buy the Underlying

Long Put: Buying the Right to Sell the Underlying

Short Put: Selling the Right to Sell the Underlying

5 To obtain this right, the Buyer (or Long) pays the Seller (or Short) a certain
amount of cash when the contract is signed (at t = 0).
6 This amount is known as the Option Premium or Option Price.
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Options

Options: Contract Features: Cont.

1 A European option can be exercised only at Maturity.
2 An American option can be exercised at any time up to Maturity.
3 Assets Underlying Exchange-traded Options
Stocks and Stock Indices
Foreign Currency
Futures

4 Specification of Exchange-Traded Options

Exercise or Strike Price
Expiration or Maturity Date
European or American (Option Type)
Call or Put (Option Class)

5 Some Statistics on Option Trading (BIS)

BIS Option Trading Statistics

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Options

Options: Payoffs and Profits: Definition with Cashflows

Price of a Call = C ; Price of a Put = P; Strike Price = K ; Final Stock Price = ST ;
Payoff = Cashflow at Maturity; Profit/Loss = Payoff + Initial Cashflow;

Long Call at t = 0 Long Call at t = T

Position Cashflow ST <= K ST > K
Exercise No Yes
Long Call C Payoff 0 (ST K )
Profit C (ST K C )
Long Put at t = 0 Long Put at t = T
Position Cashflow ST <= K ST > K
Exercise Yes No
Long Put P Payoff K ST 0
Profit K ST P P
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Options

Options: Payoffs and Profits: Payoff Diagrams

Payoff Long Call Payoff Long Put

ST ST
K K

Payoff Short Call Payoff Short Put

K K
ST ST

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Options

Options: Payoffs and Profits: Call Option Example

Plot the Profit/Loss (Y-Axis) vs. Final Stock Price ST (X-Axis).
Given Data: Call Price = $4; Put Price = $7; Exercise/Strike Price = $25; ST = ($0 $40)

Profit/Loss Long Call and Short Call

12
10
8
6
Short Call Zero Sum Game
4
2
0
2 5 10 15 20 25 30 35 40 45 50

4
ST
6 Long Call
8
10 Breakeven =$29
12
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Options

Options: Payoffs and Profits: Put Option Example

Plot the Profit/Loss (Y-Axis) vs. Final Stock Price ST (X-Axis).
Given Data: Call Price = $4; Put Price = $7; Exercise/Strike Price = $25; ST = ($0 $50)

Profit/Loss Long Put and Short Put

18
16
14
12
10
8 Zero Sum Game Short Put
6
4
2
0
2 5 10 15 20 25 30 35 40 45 50
4
6
8
10 Long Put ST
12
14
16
18
Breakeven =$18

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Options

Options: Payoffs and Profits: Moneyness

In Summary:
Call Option Payoff: For Long = Max[(ST K ), 0]: For Short = Min[(ST K ), 0]

Put Option Payoff: For Long = Max[(K ST ), 0]: For Short = Min[(K ST ), 0]

Payoffs and Profits are Zero-Sum Games between the Long and Short Positions.

The Concept of Moneyness: Compares the CURRENT Stock Price to Strike Price.
At-the-Money: The Current Stock Price = Exercise (or Strike) Price.
In-the-Money: The Option has a Payoff > 0 (for Long) if Exercised.
Out-of-the-Money: The Option will not be Exercised.
1 Can the Moneyness of an Option (Call or Put) change over time? YES!
2 Executive Stock Options (ESOPs) are Usually Calls. Why?
3 ESOPs are also typically At-the-Money when granted. Why?
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Options

Options: Trading Strategies: Hedging Vs. Speculation

Generally, Option trading strategies represent:
Hedging: The objective here is to Minimize Risk.
Speculation:The objective here is to Make a Profit.
Option trading strategies are used by Speculators as well as by Hedgers.
Is Speculation good for Markets?

Typically, there are three types of Option Trading Strategies to execute either
Hedging or Speculation:
1 Take a position in the Option and the Underlying (Simple Hedge).
2 Take a position in two or more Options of the Same Type (Spread).
3 Take a position in a mixture of Calls, Puts, and the Underlying (Combination).

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Options

Option Trading Strategies: 1. Underlying + Option

Profit 1. Synthetic Short Put Profit 3. Synthetic Long Call

K
ST ST
K

Profit 2. Synthetic Long Put Profit 4. Synthetic Short Call

K
ST ST
K

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Options

Option Trading Strategies: 2.1 Spreads: Bull Spread

Profit Bull Spread with Calls Profit Bull Spread with Puts

ST ST
K1 K2 K1 K2

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Options

Option Trading Strategies: 2.2 Spreads: Bear Spread

Profit Bear Spread with Calls Profit Bear Spread with Puts

ST ST
K1 K2 K1 K2

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Options

Option Trading Strategies: 2.3 Spreads: Butterfly Spread

Buy 1 Call each at Strikes K1 &K3
Profit Profit Buy 1 Put each at Strikes K1 &K3
Sell 2 Calls at Strike K2 Sell 2 Puts at Strike K2

ST
K1 K2 K3

ST
K1 K2 K3

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Options

Option Trading Strategies: 3. Combinations

Straddle Strangle
Profit Profit
Buy 1 Call & 1 Put at Strike = K Buy 1 Call & 1 Put at Strikes = KC & KP

ST ST
K KP KC

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Options

S&P 500 Butterfly Spread: SPY Options

Buy 1 Call each at Strikes K1 &K3

Profit Sell 2 Calls at Strike K2

K1 = $250; K2 = $255; K3 = $260;

C1 = $8.4; C2 = $4.7; C3 = $2.0;
Maturity = 19 Jan, 2018

ST
K1 K2 K3

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