Properties of Financial Options

Financial Derivatives
Properties of Financial Options
Dr Eirini Konstantinidi & Dr Ser-Huang Poon
(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 1 / 66

Outline
Video 1: Intended learning outcomes & reading list.
Video 1: Introducing options: Call and put options.
Video 2: Payoff and profit/loss function.
Video 3: Some more basics on options.

k Reasons for taking one of the four positions.
k Intrinsic value and time value.
k Institutional setting of option markets (exchange, OTC).
Video 4: Factors affecting option prices.
Video 5: Upper/lower bounds for option prices & put-call parity.
Video 6: Should you exercise an American option before maturity?
Video 7: Option trading strategies.

Intended learning outcomes
By the end of this lecture you should be able to :
Understand in depth option contracts, how option markets work &

other basics on options.
Analyse the factors affecting option prices.
Derive and use no-arbitrage relations (bounds, put-call parity).
Explain the early exercise of American options.
Apply option trading strategies.

Reading list
Hull (6th , 7th Edition): Chapters 8-10.
Hull (8th Edition): Chapters 9-11.

Call and put options

Plain vanilla call and put options: Definition
Two plain-vanilla option types:
k A call option gives the holder the right (not the obligation) to buy an
asset at a pre-specified time for a pre-specified price.
k A put option gives the holder the right (not the obligation) to sell an
asset at a pre-specified time for a pre-specified price.
Both can be European or American-style.

k European options can be exercised only at maturity.
k American options can be exercised anytime up to maturity.
Both can be held long (you own the option) or short (you sold it).
Options can be on a variety of assets, including:

k Stocks, bonds, commodities, currencies.
k Collections of assets, e.g., stock indices.
k Other derivative instruments, such as futures.
Plain vanilla call options
Call option
Buyer of the call option Seller of the call option
Right but not the obligation Obligation

to buy the underlying asset to sell the underlying asset
at the strike price. at the strike price,
if the option is exercised.

Plain vanilla call options (cont’d)
Agree on the price today.
The call buyer pays the call premium today.
If the call buyer wants, he/she buys the asset later.
TODAY 3 MONTHS LATER
If you pay me I will buy 5,000 bushels
Wheat prices rise!
£100 extra now, of wheat at £4/bushel Thanks for the £20,000! Thanks for the
(5000 x 4) 5,000 bushels of wheat!
you have got a deal! in 3 months,
if I want to then.
Wheat prices fall!

That is ok, I’ve decided
but I will keep the £100. not to buy.
The call buyer pays the call premium!

Plain vanilla put options
Put option
Buyer of the put option Seller of the put option
Right but not the obligation Obligation

to sell the underlying asset to buy the underlying asset
at the strike price. at the strike price,
if the option is exercised.

Plain vanilla put options (cont’d)
Agree on the price today.
The put buyer pays the put premium today.
If the put buyer wants, he/she sells the asset later.
TODAY 3 MONTHS LATER
I will sell 5,000 bushels If you pay me
Wheat prices rise!
of wheat at £4/bushel £100 extra now, I’ve decided not to sell. That is ok,
but I will keep the £100.
in 3 months, you have got a deal!
if I want to then.
Wheat prices fall!

Thanks for the £20,000! Thanks for the
(5000 x 4) 5,000 bushels of wheat!
The put buyer pays the put premium!

Payoff function & profit/loss

Notation used throughout this lecture
Symbol Meaning
c (C ) Value of European (American) call option
p (P) Value of European (American) put option
S0 (ST ) Value of underlying asset at time 0 (T)
K The pre-specified strike price
T The pre-specified time-to-maturity
σ The volatility of the underlying asset return
D Present value (PV) of dividends paid during the life of option
r The T -period risk-free rate of return for maturity T (continuously compounded)

Payoff function & profit/loss
Payoff function: The cash realized by the holder of the option at

maturity.
k It refers to the expiry date.
k It assumes that the investor keeps the position open up to expiry.
k It does not take into account the initial cost of the option!
k It depends on the option type (call/put) and on the position
(long/short).
Profit/loss: The payoff adjusted for the initial cost of the option.
k The initial cost of an option is also termed option price or premium.
k Be careful: The premium is quoted in time zero terms!

Payoff function & profit/loss: Call options - Long position
Payoff#
K# ST#
!c#
The call is exercised when: ST > K
PayoffT = max(ST − K, 0)
The buyer may exercise the call and make an overall loss once the call
premium is taken into account!
k Example: K = 100, ST = 102, c = 5.

Payoff function & profit/loss: Call options - Short position
The buyers gain is the sellers loss.
Payoff#
c"
K#
ST#
PayoffT = −max(ST − K, 0) = min(K − ST , 0)

Payoff function & profit/loss: Put options - Long position
Payoff#
K# ST#
!p#
The put is exercised when: ST < K
PayoffT = max(K − ST , 0)
The buyer may exercise the put and make an overall loss once the put
premium is taken into account!
k Example: K = 100, ST = 98, p = 5.

Payoff function & profit/loss: Put options - Short position
The buyers gain is the sellers loss.
Payoff#
p"
ST#
K#
PayoffT = −max(K − ST , 0) = min(ST − K, 0)

Summarising the payoff functions
Long call: PayoffT = max (ST − K , 0)
Short call: PayoffT = −max (ST − K , 0) = min (K − ST , 0)
Long put: PayoffT = max (K − ST , 0)
Short put: PayoffT = −max (K − ST , 0) = min (ST − K , 0)

Summarising the profit/loss functions
Long call: P/LT = − c + max (ST − K , 0)
Short call: P/LT = c − max (ST − K , 0) = c + min (K − ST , 0)
Long put: P/LT = − p + max (K − ST , 0)
Short put: P/LT = p − max (K − ST , 0) = p + min (ST − K , 0)

Some more basics on options

Reasons for taking one of the four positions
Long call.
k Bullish expectations.
k In a bear market the potential losses are limited.
k BUT in a bull market the call buyer gains less than a holder of the
underlying asset (cost for protection in a bear market).
Short call.
k Bearish expectations.
k Receives the premium.
k Hedging a long position in the underlying asset (covered call writing).

Reasons for taking one of the four positions
Long put.
k Bearish expectations.
k In a bull market the potential losses are limited.
k BUT in a bear market the put buyer gains less than a seller of the
underlying asset (cost for protection in a bull market).
k Hedging a long position in the underlying asset (protective).
Short put.
k Bullish expectations.
k Receives the premium.

Moneyness
Moneyness indicates the likelihood of exercise at maturity.
In-the-money (ITM): Immediate exercise yields a positive payoff.
At-the-money (ATM): Immediate exercise yields a zero payoff.
Out-of-the-money (OTM): Immediate exercise yields a negative

payoff.
St < K St = K St > K
Call: OTM ATM ITM
Put: ITM ATM OTM

Intrinsic value & time value
The price of an option consists of two parts.

k Intrinsic value and time value.
Option price = Intrinsic value + Time value
This is best understood in the American options framework.
The American option price consists of two parts.

1 The revenues from exercising immediately the option → intrinsic value.
2 The added value the option will have by postponing its exercise →
time value.

Intrinsic value & time value (cont’d)
Intrinsic value: Max(payoff, 0)

k Holds even if the option cannot be exercised at this point in time (e.g.,
a European option before the maturity date).
k ITM (OTM) options have positive (negative) payoff and hence, a
positive (zero) intrinsic value.
Time value: Value of the option associated with the possibility that
the option could move further ITM as time passes.
k The value of an OTM option derives solely from its time value (i.e. the
chance that things will improve over time).
k The time value is non-negative and is highest for ATM options.

Intrinsic value & time value: The case of a call option
Payoff#
Call(price(today( Intrinsic(value(
max(St2K,0)(
K# St#
Time(value(=(Call(price(–(Intrinsic(value(

Institutional setting

Institutional setting
Options are traded both on exchanges and over-the-counter.
Exchange-traded options are fairly standardized with respect to:

k Strike prices (usually scattered around the current stock price).
k Delivery date (e.g. the 3rd Friday during the month).
k Contract size, and so on.
Most exchanges use market makers to facilitate trading.

k Market makers must quote bid and ask prices when requested.
k They do not know whether the counter party intends to buy or sell.
Margins are required when options are sold.

Corporate events
The terms of option contracts are adjusted for some corporate events,
but not for others.
Exchange traded options are NOT adjusted for cash dividends

k An exception is sometimes made for large cash dividends.
Example.
k You own a call option on IBM stock (S0 =$120) with K=$100.
k IBM suddenly decides to pay a dividend over $50 per share.
k In the absence of taxes, IBM’s share price drops to $70 (=120-50).
k Your formerly ITM call option is suddenly OTM.

Corporate events (cont’d)
The strike price K is adjusted for stock splits.

k Do not change the assets or the earning ability of the company.
k A n-for-m split leads to a new strike price of m
n K and the number of
n
options changes to m N.
Example.
k IBM replaces one stock with two (a 2-for-1 split).
k The share price drops to $60 (=120/2).
k The strike price is also reduced to half its former value, namely to $50
(=100/2).
k Each option is exchanged for two new ones (2N).
Stock dividends are handled just like stock splits.

Factors Affecting Option Prices

Factors affecting option prices
Options prices are a function of six variables.
Option prices = f (S0 , K , T , σ, r , D )
How does the options price change when we change one of the above
variables, with all other variables being constant?

Factor 1: Underlying asset price
Call option.
k PayoffT = max (ST − K , 0)
k Becomes more valuable as S0 increases.
Put option.
k PayoffT = max (K − ST , 0)
k Becomes less valuable as S0 increases.
Similar, arguments for American calls and puts.

Factor 2: Strike price
European call option.

k PayoffT = max (ST − K , 0)
k Becomes less valuable as K increases.
European put option.

k PayoffT = max (K − ST , 0)
k Becomes more valuable as K increases.
Similar, arguments for American calls and puts.

Factor 3: Time-to-maturity
American call and put options.
k Both become more valuable (or at least do not decrease in value) as T
increases.
European call and put option.

k Usually both become more valuable as T increases.
k BUT this is not always the case!
Example.
k Consider a T1 -maturity European call & a T2 -maturity European call.
k A large dividend will be paid at time t with T1 < t < T2 .
k The stock price will fall at time t due to the dividend payment.
k As a results the short-maturity option may be worth more than the
long-maturity call.
Factor 4: Volatility
Volatility is a measure of how uncertain we are about future asset

price movements.
As volatility increases the chance that the asset will do very well or
very poorly increases.
k For the owner of the asset these two tend to offset each other.
k For the owner of an option, the effect is asymmetric.
Calls and puts become more valuable as σ increases.

k Call (put) holders benefit from price increases (decreases), but have
limited downside risk.
k If the price moves unfavourably, the most they can lose is the option
premium.

Factor 5: Risk-free rate
The relation between option value and risk-free rate is more

complicated than the others.
It depends on two effects:

k Higher interest rates increase the expected return required by investors
from the underlying asset.
k Higher interest rates increase discount rates and hence, decrease the
present value of future cash flows received by the option holder.
k Hence, call (put) options become more (less) valuable as r increases.
We have assumed that all other factor remain constant!

k This is not the case in practice!
k For instance, when interest rates increase, stock prices tend to fall.

Factor 6: Amount of future dividends
Dividends have the effect of reducing the stock price on the

ex-dividend date.
k A call (put) becomes less (more) valuable as D increases.

Summary of factors affecting option prices
European American
Factors Call Put Call Put
Current stock price (S0 ) + - + -
Strike price (K ) - + - +
Time to maturity (T )* ? ? + +
Volatility (σ) + + + +
Risk-free rate (r ) + - + -
Amount of future dividends (D) - + - +
Note*: Depends on when the dividend payment occurs.

Option Price Bounds

Assumptions
There are no arbitrage opportunities!

k Arbitrage imposes certain restrictions on the value of options.
If the option price bounds are violated

then there are arbitrage opportunities!

Upper bound: Call options
Calls (European and American) give the right to their holder to buy a
share at a certain price.
No matter what it cannot be worth more than the share itself!
Upper bound: c ≤ S0 and C ≤ S0
If this is violated, you can make profits without incurring risk.

Violation of upper bound: Call options
Arbitrage strategy: Buy the stock and sell the call option.
k You assume that the upper bound is violated, i.e. c > S0
Short call
Time Long stock ST < K ST > K Total
0 −S0 c c (c − S0 ) > 0
T ST 0 −(ST − K ) ST > 0 or K > 0
No matter whether the call is exercised against you or not, you always
make a profit both initially and at maturity.

Upper bound: Put options
American puts give the right to their holder to sell a share at a price
K.
k No matter what it cannot be worth more than K !
European puts give the right to their holder to sell a share at a price
K at maturity.
k No matter what it cannot be worth more than K at T or Ke −rT today!
Upper bound: p ≤ Ke−rT and P≤K

Violation of upper bound: Put options
Arbitrage strategy: Sell the put option & invest the proceeds at the
risk-free rate.
−rT
k You assume that the upper bound is violated, i.e. p > Ke
Short put
Time Bank account ST < K ST > K Total
0 −p p p 0
T pe rT −(K − ST ) 0 rT
pe + ST − K > 0
or pe rT > 0
No matter whether the put is exercised against you or not, you always
make a profit at maturity.

Lower bound: European calls on non-dividend paying stock
Lower bound: c ≥ S0 − Ke−rT
To prove the above relation, consider the following two portfolios:

Portfolio A: One European call plus
a zero-coupon bond providing a payoff of K at time T .
Portfolio B: One share of the stock.
Portfolio A Portfolio B
Time ST > K ST < K
T ST K ST
( = ( ST − K ) + K )
Portfolio A provides a higher or equal payoff to B at time T :

c + PV (K ) ≥ S0 ⇒ c + Ke −rT ≥ S0 ⇒ c ≥ S0 − Ke −rT

Lower bound: European puts on non-dividend paying stock
Lower bound: p ≥ Ke−rT − S0

Portfolio C: One European put plus one share.
Portfolio D: A zero-coupon bond providing a payoff of K at time T .
Portfolio C Portfolio D
Time ST > K ST < K
T ST K K
(= (K − ST ) + ST )
Portfolio C provides a higher or equal payoff to D at time T :

p + S0 ≥ PV (K ) ⇒ p + S0 ≥ Ke −rT ⇒ p ≥ Ke −rT − S0

Put-Call Parity

Put-call parity: European options not paying dividends
Put-call parity: c + Ke−rT = p + S0
Assumptions.
1 There are no transaction costs.
2 All trading profits are subject to the same tax rate.
3 Borrowing and lending are possible at the risk-free rate.
4 There are no arbitrage opportunities!
If the put-call parity is violated there are arbitrage opportunities!
The put-call parity provided above holds for:

k European calls and puts.
k Same strike price K .
k Same time-to-maturity T .
k The underlying asset does not pay any dividends.
Proving the put-call parity
Put-call parity: c + Ke−rT = p + S0

Portfolio A: One European call plus
a zero-coupon bond providing a payoff of K at time T .
Portfolio B: One European put plus one share of the stock.
Portfolio A Portfolio B
Time ST > K ST < K ST > K ST < K
T ST K ST K
(= (ST − K ) + K ) (= (K − ST ) + ST )
Portfolios A & B produce exactly the same payoffs at time T ⇒ their

prices must be identical at time 0.
c + PV (K ) = p + S0 ⇒ c + Ke −rT = p + S0

Arbitrage when put-call parity is violated
Assume that:
k p=2.25, c=3, S0 =31, T =0.25, r =10%, K =30 and D=0.
Plug into the put/call parity formula:

c + Ke −rT = 3 + 30e −.1·.25 = 32.26 < 33.25 = 2.25 + 31 = p + S0 ;
| {z } | {z }
Portfolio A (buy low) Portfolio B (sell high)
A is undervalued compared to B, so you should buy A & sell B.

k Remember: Always buy low and sell high!
Buying A creates demand pressure (raising A’s value), whereas selling

B creates supply pressure (deflating B’s value).
Arbitrage stops when the value of A equals that of B.

Should You Exercise American Options Before Maturity?

Should you exercise an American call before maturity?
You should never exercise an American call early if the underlying

asset pays no dividend.
There are three heuristic reasons for this:

1 No income (dividends) are sacrificed.
2 You delay the payment of the strike price (one dollar today is worth
more than one dollar tomorrow. . . ).
3 Holding the call provides insurance against low ST .

Never exercise an American call before maturity: Proof
American calls are at least as valuable as the European ones:
Value(American Call) = Value(European Call) + Value(Early Exercise)
Hence: C ≥ c.
We also know that: c ≥ S0 − Ke −rT
Combining the two relations we get: C ≥ c ≥ S0 − Ke −rT
Since r > 0 ⇔ e −rT < 1, we get: C ≥ c ≥ S0 − Ke −rT ≥ S0 − K
The American call is always worth more than its intrinsic value (i.e.
the payment from immediate exercise).
k So sell the American call instead of exercising it.
Bounds for American or European calls: No dividends
Call#price#
Ke-rT# S0#

Should you exercise an American put before maturity?
It can be optimal to exercise an American put early when the

underlying asset pays no dividend.
There are two heuristic reasons for this:

1 Holding the put (in conjunction with the underlying asset) provides
insurance against low ST .
2 It may be optimal to forgo this insurance to realize the strike price
immediately (one dollar today is worth more than one dollar
tomorrow. . . ).
In general, the early exercise of a put becomes more attractive as S0

decreases, r increases and as volatility decreases.

Trading Strategies with Options

Calculating the profit of more complicated strategies
More complicated strategies often combine various assets into a
portfolio to create a desirable payoff/profit pattern at maturity.
These payoff/profit patterns can easily be established by:

1 Tabulating and plotting the payoff/profit patterns of the single assets.
2 Adding them up.
We shall look at the profit patterns of:

k Bull spreads (buy a call at K1 and sell one at K2 , with K1 < K2 ).
k Bear spreads (buy a put at K2 and sell one at K1 , with K1 < K2 ).
k Uncertainty strategies (buy a call and put with the same K ).
There are far more strategies out there (box, butterfly, calendar, etc.
spreads), but their payoffs can be established like above.
Bull spread
Bull spread strategy.

k Buy a European call with a strike price K1 .
k Sell a European call with a strike price K2 > K1 .
k Both calls have the same expiration date.
ST ≤ K1 K1 < ST < K2 ST ≥ K2
Long call (K1 ) 0 ST − K1 ST − K1
Short call (K2 ) 0 0 −(ST − K2 )
Total 0 ST − K1 K2 − K 1

Bull spread (cont’d)
Payoff figure Profit/loss figure
Payoff# Profit#
ST# ST#
K1# K2# K1# K2#
Why would you invest in such a strategy?

k Speculate that the underling asset value will increase.
k Cheaper than purchasing call because you give up some of the up-side
potential (profit flat for ST > K2 ).
k Gives downward protection compared to forwards.
Bear spread
Bear spread strategy.

k Sell a European put with a strike price K1 .
k Buy a European put with a strike price K2 > K1 .
k Both puts have the same expiration date.
ST ≤ K1 K1 < ST < K2 ST ≥ K2
Short put (K1 ) −(K1 − ST ) 0 0
Long put (K2 ) K2 − ST K2 − ST 0
Total K2 − K1 K2 − ST 0

Bear spread (cont’d)
Payoff# Profit#
ST# ST#
K1# K2# K1# K2#

k Speculate that the underling asset value will decrease.
k Cheaper than purchasing a put because you give up some of the
up-side potential (profit flat for ST < K1 ).
k Gives downward protection compared to forwards.
Straddle
Straddle strategy.
k Buy a European call with a strike price K .
k Buy a European put with a strike price K .
k Both options have the same expiration date and the same strike price.
ST ≤ K ST > K
Long call 0 ST − K
Long put K − ST 0
Total K − ST ST − K

Straddle (cont’d)
Payoff# Profit#
ST# ST#
K# K#

k Speculate that the underling asset value will move by a large amount
(either up or down).
k To profit from this strategy, your forecast of volatility must be higher
than that of the market.
Summary
In this lecture, we learned about some simple basics of options:

k Their payoffs at maturity.
k Factors affecting option prices.
k The institutional setup of option markets.
k Bounds on the values of call/put options.
k Put-call parity.
k Should you exercise early American options?
k Option trading strategies.
In the next lecture, we shall learn how to value options using

discrete-time approaches.

˜ End ˜

Properties of Financial Options

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Properties of Financial Options

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Financial Derivatives

Properties of Financial Options

Dr Eirini Konstantinidi & Dr Ser-Huang Poon

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 1 / 66

Video 1: Introducing options: Call and put options.

Video 2: Payoff and profit/loss function.

Video 3: Some more basics on options.

Video 4: Factors affecting option prices.

Video 5: Upper/lower bounds for option prices & put-call parity.

Video 6: Should you exercise an American option before maturity?

Video 7: Option trading strategies.

By the end of this lecture you should be able to :

Understand in depth option contracts, how option markets work &

Analyse the factors affecting option prices.

Derive and use no-arbitrage relations (bounds, put-call parity).

Explain the early exercise of American options.

Apply option trading strategies.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 3 / 66

Hull (6th , 7th Edition): Chapters 8-10.

Hull (8th Edition): Chapters 9-11.

Hull (9th Edition): Chapters 10-12.

Hull (10th Edition): Chapters 10-12.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 4 / 66

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 5 / 66

Both can be European or American-style.

Options can be on a variety of assets, including:

Buyer of the call option Seller of the call option

Right but not the obligation Obligation

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 7 / 66

Wheat prices fall!

The call buyer pays the call premium!

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 8 / 66

Buyer of the put option Seller of the put option

Right but not the obligation Obligation

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 9 / 66

Wheat prices fall!

The put buyer pays the put premium!

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 10 / 66

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 11 / 66

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 12 / 66

Payoff function: The cash realized by the holder of the option at

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 13 / 66

The call is exercised when: ST > K

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 14 / 66

The buyers gain is the sellers loss.

PayoffT = −max(ST − K, 0) = min(K − ST , 0)

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 15 / 66

The put is exercised when: ST < K

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 16 / 66

The buyers gain is the sellers loss.

PayoffT = −max(K − ST , 0) = min(ST − K, 0)

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 17 / 66

Long call: PayoffT = max (ST − K , 0)

Short call: PayoffT = −max (ST − K , 0) = min (K − ST , 0)

Long put: PayoffT = max (K − ST , 0)

Short put: PayoffT = −max (K − ST , 0) = min (ST − K , 0)

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 18 / 66

Long call: P/LT = − c + max (ST − K , 0)

Short call: P/LT = c − max (ST − K , 0) = c + min (K − ST , 0)

Long put: P/LT = − p + max (K − ST , 0)

Short put: P/LT = p − max (K − ST , 0) = p + min (ST − K , 0)

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 19 / 66

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 20 / 66