Options: An Overview

Foundations of Finance: Options: an Overview Prof.
Alex Shapiro
Lecture Notes 14
Options: an Overview
I. Readings and Suggested Practice Problems
II. Options: Characteristics and Payoffs
III. Options Portfolios
IV. Options Trading
V. Additional Readings
Buzz Words: European Options, American Options, Executive

Stock Options, Exotic Options, Naked Call/Put,
Straddle, Spread, Portfolio Insurance
1
Foundations of Finance: Options: an Overview
I. Readings and Suggested Practice Problems
BKM, Chapter 20
Suggested Problems, Chapter 20: 2, 4, 6, 8.
II. Options: Characteristics and Payoffs
A. Introduction
• Options, futures and forwards are the basic derivative

securities:
Their payoffs are closely tied to (“derived from”) the

price of an underlying security.
• Derivatives are used for Hedging / Risk Management and for

Speculation (often Hedgers and Speculators are the counter-
parties of a transaction).
• Our analysis will concentrate primarily on stock options.

(But there are also options traded on bonds, currency,
commodities, etc.)
2
• Our discussion will concentrate primarily on publicly traded

options.
But many options are nontraded or implicit, and our analysis

applies to those as well:
For example: options can be used to analyze Levered Equity,

Oil fields, Callable Bonds, etc.
In recent years, options gained popularity as a tool for

employee and executive compensation (see the Economist
and the NYT articles in the additional readings), but lately
some companies reversed to stock compensation due to
incentive problems with options, and due to debates on how
to expense option in the financial statements.
B. Stock Options
• An [American] call option gives the holder the right (but not
the obligation)
to buy a share of the underlying stock
at the prespecified exercise (or strike) price
at any time up to the expiration date.
• A put option is the right

to sell the underlying stock.
at the prespecified exercise (or strike) price
at any time up to the expiration date.
• A European option can be exercised only on the expiration

date.
3
• Exchange-traded puts and calls are standardized as to

quantity (e.g., 100 shares per option), price and expiration
dates.
[For example: See the Chicago Board Options Exchange
(CBOE) webpage (www.cboe.com) for more details.]
Over-the-counter (OTC) puts and calls are custom contracts

sold to clients by brokers.
Example: IBM and Microsoft Call and Put Options

(Monday 4/3/2000, closing prices) are given on the next
page.
The first column is the stock price:
IBM stock price: 121

Microsoft stock price: 90 7/8
[For option valuation, which we will discuss later, it may

be useful to note that Microsoft shares dropped $15 3/8
per share on that day – the day Justice Thomas Penfield
Jackson of the U.S. District Court of Washington D.C.
ruled that Microsoft violated the antitrust law (the
Sherman Act) in the way it preserved its monopoly
status.
Side Remark: Some see that day as the turning point,
which signaled the “beginning of the end” of the Bull
market of the 1990s.]
4
[options quote here]
5
C. Example: Microsoft call options
• The Oct 85 call gives us the right to purchase MSFT at

$85/share (through Saturday, Oct 21, 2000, “the Saturday
following the 3rd Friday of the month”).
• If we owned this call, we could exercise it, and sell the stock.
Proceeds = S – X
S = stock price
X = exercise price
• At close,
Proceeds = S – X = 90 7/8 - 85 = 5 7/8 (per share)
This call is in the money (X < S).
• For the Oct 95 call,

Proceeds = 90 7/8 - 95 = -4 1/8
This call is out of the money (X > S),

It wouldn’t pay to exercise.
• The intrinsic value of a call is Maximum[S-X, 0]
• The market price of an option is also called the premium.
6
• The premia (last sale prices) for the Oct 85 and Oct 95 calls
exceed their intrinsic values:
Int Val Premium

Oct 85 5 7/8 17 1/4
Oct 95 0 12 1/2
• A call option is created when someone “writes” the option.

This means:
– The writer is “short” the call.

– For everyone who owns (is “long”) the call, someone is
short.
– The net amount outstanding of the call is zero.
– Options are “zero-sum” games.
D. Example: Option Writing
• To sell (write) the Oct 85 call, we simply communicate this

intention this to our broker.
The call is sold and we receive the premium

(last sale price = 17 1/4)
We do not necessarily have to own the stock.

(But if we don’t, we will have to post margin.)
• Writing a call is like selling short: our liability is potentially

unlimited.
• If the MSFT price rises, we can avoid further loss by

repurchasing the Oct 85 call.
7
E. Example: Microsoft put options
• The Oct 95 put option gives the holder the right to sell the
stock at 95 per share (through Saturday, Oct 21).
• If we buy MSFT in the market and exercise the put,
Proceeds = X - S = 95 - 90 7/8 = 4 1/8
This put is in the money (X >S).
• The Oct 85 put is out of the money (X < S). If we bought

MSFT and exercised this option,
Proceeds = 85 - 90 7/8 = - 5 7/8
• For a put option,
Intrinsic value = Max[X-S, 0]
8
III. Options Portfolios
We now use a spreadsheet to analyze costs, payoffs and profits of

portfolios that involve options. The portfolios may consist of
puts, calls, stock, bonds (riskless borrowing or lending).
[Market prices for the options are Black-Scholes values for European options.
Market price for a $1 par bond is (with continuous compounding) e-rT, where T is
time to maturity.]
A. Long one share of stock
Stock Price 15 ($ per share) 35

Std. Dev. 20% per year 30
25
Risk-free rate 8% per year
20
Maturity (years) 1/2 15
10
Security Amt Price Cash Flow 5
Stock 1 $15.000 -$15.000 0
Portfolio
Bond ($1 par) 0 $0.961 -5
Value
Call: X= 15 0 $1.156 -10
Profits
-15
Call: X= 20 0 $0.039
-20
Put: X= 10 0 $0.000 0 10 20 30 40
Put: X= 20 0 $4.254 Stock Price at Expiration(ST)
Total: -$15.000
B. Long one call
20
Stock Price 15 ($ per share)
Std. Dev. 20% per year
15
Maturity (years) 1/2
10
Security Amt Price Cash Flow

5
Stock 0 $15.000 Portfolio
Bond ($1 par) 0 $0.961 0
Value
Call: X= 15 1 $1.156 -$1.156 Profits
Call: X= 20 0 $0.039 -5
Put: X= 15 0 $0.568 0 10 20 30 40
Put: X= 20 0 $4.254 Stock Price at Expiration (S T)
Total: -$1.156
9
C. Long one put
20
15
10

5
Bond ($1 par) 0 $0.961 0
Value
Call: X= 15 0 $1.156 Profits
Call: X= 20 0 $0.039 -5
Put: X= 15 1 $0.568 -$0.568 0 10 20 30 40
Put: X= 20 0 $4.254 Stock Price at Expiration(ST )
Total: -$0.568
D. Writing an uncovered (“naked”) call
5
0
-5

-10
Bond ($1 par) 0 $0.961 -15
Value
Call: X= 15 -1 $1.156 $1.156 Profits
Call: X= 20 0 $0.039 -20
Put: X= 15 0 $0.568 0 10 20 30 40
Put: X= 20 0 $4.254 Stock Price at Expiration (S T )
Total: $1.156
10
E. Writing and uncovered (“naked”) put
5
0
-5

-10
Bond ($1 par) 0 $0.961 -15
Value
Call: X= 15 0 $1.156 Profits
Call: X= 20 0 $0.039 -20
Put: X= 15 -1 $0.568 $0.568 0 10 20 30 40
Put: X= 20 0 $4.254 Stock Price at Expiration (ST )
Total: $0.568
F. Straddle: long one call, one put

20
15
10

5
Bond ($1 par) 0 $0.961 0
Value
Call: X= 15 1 $1.156 -$1.156 Profits
Call: X= 20 0 $0.039 -5
Put: X= 15 1 $0.568 -$0.568 0 10 20 30 40
Put: X= 20 0 $4.254 Stock Price at Expiration(ST )
Total: -$1.724
The Components of the Straddle:
+ = Straddle
X S X S
Long Call Long Put
11
G. A spread: short call (X=15), long call (X=20)
5

Stock 0 $15.000 -5 Portfolio
Bond ($1 par) 0 $0.961 Value
Call: X= 15 -1 $1.156 $1.156 Profits
Call: X= 20 1 $0.039 -$0.039 -10
Put: X= 15 0 $0.568 0 10 20 30 40
Put: X= 20 0 $4.254 T)
Stock Price at Expiration (S
Total: $1.117
The components of the spread:
15 20 15 20 15 20
+
S = S
S
Short call X=15 Long call X=20 Spread
12
H. Writing a covered call (short call, long stock)
20
Risk-free rate 8% per year 10
0
-5
Stock 1 $15.000 -$15.000 Portfolio
Bond ($1 par) 0 $0.961 -10 Value
Call: X= 15 -1 $1.156 $1.156 -15 Profits
Call: X= 20 0 $0.039 -20
Put: X= 15 0 $0.568 0 10 20 30 40
Put: X= 20 0 $4.254 Stock Price at Expiration (ST)
Total: -$13.844
The components of the covered call:
15 15 15
+ =
S S
Short Call Long Stock Covered Call
13
I. Portfolio Insurance I: long bonds and call
35
15
10
Bond ($1 par) 15 $0.961 -$14.412 5 Value
Call: X= 15 1 $1.156 -$1.156 0 Profits
Call: X= 20 0 $0.039 -5
Put: X= 15 0 $0.568 0 10 20 30 40
Put: X= 20 0 $4.254 T)
Stock Price at Expiration (S
Total: -$15.568
The components of portfolio insurance I
15 15
+ =
S X=15 S X=15 S
Bond Long Call
14
J. Portfolio Insurance II: long stock, put
35
15
10
Stock 1 $15.000 -$15.000 Portfolio
Bond ($1 par) 0 $0.961 5 Value
Call: X= 15 0 $1.156 0 Profits
Call: X= 20 0 $0.039 -5
Put: X= 15 1 $0.568 -$0.568 0 10 20 30 40
Put: X= 20 0 $4.254 Stock Price at Expiration (S T)
Total: -$15.568
Components of portfolio insurance II
15
+ =
S S
X=15 X=15
Stock Long Put
15
IV. Options Trading
A. Exchange Traded Options
• The Chicago Board Options Exchange (CBOE) started

trading in 1973 (http://www.cboe.com).
It is currently the largest options exchange.
• Listed options are standardized by contract size, strike price,

expiration.
Some companies have options listed on several exchanges.

This multiple trading is a recent phenomenon. Only in 1999
options of companies with large open interest (number of
contracts outstanding) have been cross listed (e.g., IBM,
Lucent, Nike).
• Trading occurs between brokers or between brokers and

market makers on the floor of the exchange (but electronic
trading is also being introduced; e.g., RAES – Retail
Automatic Execution System on the CBOE for order of 10
contracts or less).
• Options Clearing Corporation assumes credit risk.
16
B. The Role of the Options Clearing Corporation (OCC)
In the absence of a clearing corporation, the buyer of the

option assumes the seller’s credit risk:
At time of trade:
Negotiate price
Call Buyer premium

Call Seller
At exercise: X
stock
At the time of exercise, there is a chance that the call seller

might default.
17
With exchange-traded options, the clearing corporation becomes

an intermediary in the deal, immediately after the price is agreed:
At time of trade:
Negotiate price
Call Buyer Call Seller
Option
Clearing
Corporation
The buyer’s contract is now with the clearing corporation.

The seller’s contract is also with the clearing corporation.
Formally, OCC is the sole issuer of all exchange traded options.

The OCC has a AAA credit rating from S&P’s Corp.
V. Additional Readings
18

Options: An Overview

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Options: An Overview

Uploaded by

Copyright:

Available Formats

Foundations of Finance: Options: an Overview Prof.

I. Readings and Suggested Practice Problems

II. Options: Characteristics and Payoffs

III. Options Portfolios

IV. Options Trading

Buzz Words: European Options, American Options, Executive

I. Readings and Suggested Practice Problems

Suggested Problems, Chapter 20: 2, 4, 6, 8.

II. Options: Characteristics and Payoffs

• Options, futures and forwards are the basic derivative

Their payoffs are closely tied to (“derived from”) the

• Derivatives are used for Hedging / Risk Management and for

• Our analysis will concentrate primarily on stock options.

• Our discussion will concentrate primarily on publicly traded

But many options are nontraded or implicit, and our analysis

For example: options can be used to analyze Levered Equity,

In recent years, options gained popularity as a tool for

• A put option is the right

• A European option can be exercised only on the expiration

• Exchange-traded puts and calls are standardized as to

Over-the-counter (OTC) puts and calls are custom contracts

Example: IBM and Microsoft Call and Put Options

The first column is the stock price:

IBM stock price: 121

[For option valuation, which we will discuss later, it may

[options quote here]

C. Example: Microsoft call options

• The Oct 85 call gives us the right to purchase MSFT at

This call is in the money (X < S).

• For the Oct 95 call,

This call is out of the money (X > S),

• The intrinsic value of a call is Maximum[S-X, 0]

• The market price of an option is also called the premium.

Int Val Premium

• A call option is created when someone “writes” the option.

– The writer is “short” the call.

D. Example: Option Writing

• To sell (write) the Oct 85 call, we simply communicate this

The call is sold and we receive the premium

We do not necessarily have to own the stock.

• Writing a call is like selling short: our liability is potentially

• If the MSFT price rises, we can avoid further loss by

E. Example: Microsoft put options

• If we buy MSFT in the market and exercise the put,

Proceeds = X - S = 95 - 90 7/8 = 4 1/8

This put is in the money (X >S).

• The Oct 85 put is out of the money (X < S). If we bought

Proceeds = 85 - 90 7/8 = - 5 7/8

• For a put option,

Intrinsic value = Max[X-S, 0]

III. Options Portfolios

We now use a spreadsheet to analyze costs, payoffs and profits of

A. Long one share of stock

Stock Price 15 ($ per share) 35

B. Long one call

Security Amt Price Cash Flow

C. Long one put

Security Amt Price Cash Flow

D. Writing an uncovered (“naked”) call

Security Amt Price Cash Flow

E. Writing and uncovered (“naked”) put

Security Amt Price Cash Flow

F. Straddle: long one call, one put