Introduction to Options and Futures

Options
(& others)
Hedging
Financial with…
markets and
Swaps
corporate
applications
Pricing…
Forwards
and Futures
¡ Types of options

¡ (Very few) institutional aspects

¡ Basic arbitrage relations

¡ Trading strategies involving options

¡ Call option
Gives the holder the right, but not the
obligation, to buy an asset (𝑆) at or before a
given date (𝑇), at a given strike price (𝐾)
¡ Ex. Call option Option
payoff
on IBM stock
(𝑆), maturity 3m
(𝑇), strike 𝐾 Payoff Payoff
here? here?

𝐾
Underlying price
at maturity: 𝑆!
¡ Ex. Call option P&L

on IBM stock
(𝑆), maturity 3m
(𝑇), strike 𝐾

¡ Entering an
option contract
requires paying 𝐾
Underlying price
a premium at maturity: 𝑆!
¡ Out of the Option
payoff
money: 𝑆! < 𝐾

¡ In the money:
𝑆! > 𝐾

¡ At the money:
𝑆! = 𝐾 𝐾
Underlying price
at maturity: 𝑆!
¡ How about P&L

selling (writing)
a call option?

𝐾
Underlying price
at maturity: 𝑆!
¡ Put option
Gives the holder the right, but not the
obligation, to sell an asset (𝑆) at or before a
given date (𝑇), at a given strike price (𝐾)
¡ Ex. Put option P&L

on IBM stock
(𝑆), maturity 3m
(𝑇), strike 𝐾

𝐾
𝑆!
¡ Out of the Payoff

money: 𝑆! > 𝐾

¡ In the money:
𝑆! < 𝐾

¡ At the money:
𝑆! = 𝐾 𝐾
𝑆!
¡ How about P&L

selling (writing)
a put option?

𝐾
𝑆!
 Long Short

Call 𝐾 𝑆! 𝐾 𝑆!

Put 𝐾 𝑆! 𝐾 𝑆!
 Long Short

Call max 𝑆!𝐾 − 𝐾, 0 𝑆 min 𝐾𝐾− 𝑆! , 0 𝑆

! !

Put max 𝐾𝐾− 𝑆! , 0 𝑆 min 𝑆!𝐾 − 𝐾, 0 𝑆

! !
 Long Short

Fwd 𝐾 𝑆! 𝐾 𝑆!
¡ European option: Can be exercised only at
maturity 𝑇
¡ American option: Can be exercised at any
time until maturity
¡ European options are usually easier to
analyze
¡ Underlying assets
§ Stocks
§ Stock indices
§ Foreign currencies
§ Futures

¡ Trading
§ Organized exchanges (CBOE, AMEX, PHLX, …)
§ OTC
¡ Quotes
§ Strikes
§ Maturities

¡ Most popular
contract?

Source: Wall St. Journal

¡ Ex. Call option to buy 100 shares, with strike
𝐾 = $30.
§ 2-for-1 stock split
§ Nr. shares acquired with the option becomes …
§ Strike becomes …
¡ Stock dividends are handled in a similar
manner
¡ No such provision for cash dividends
¡ When investor writes an option
§ “Covered” position (underlying + short position in
the call): No margin requirement
§ “Naked” call (short call not covered) or put (not
covered): margin requirement
¡ Buying on margin
§ Price must be paid in full – no buying on margin is
allowed
§ Why? Option already embeds leverage
 ¡ Just how risky is an option?
¡ You can invest $100
A. Buy 1 stock for 𝑆 = $100
B. Buy 40 calls (𝐾 = $100) for 𝐶 = $2.5

Stock price $90 $100 $110

1 stock Payoff Payoff Payoff
Return Return Return

40 calls Payoff Payoff Payoff

Return Return Return
¡ Companies write options on their own stocks
¡ Executive stock options
§ Part of compensation packages
§ Cannot be sold
§ Long maturities, vesting periods
§ When exercised, company issues stock and sells it
to executives at the strike price
¡ Companies write options on their own stocks
¡ Warrants
§ Issued by a corporation on its own stock, and
exercise leads to new treasury stock being issued
¡ Convertible bonds
§ Often: Callable
§ Call provision: A way for the issuer to force early
conversion
𝑐: European call price 𝐶: American call price

𝑝: European put price 𝑃: American put price

𝑆#: underlying price today 𝑆$ : underlying price at

maturity
𝐾: strike price
𝐷: PV of dividends paid over
𝑇: maturity of the option the life of the option

𝜎: volatility of the 𝑟: risk-free rate for maturity 𝑇

underlying’s price (continuous compounding)
 𝑡=0 𝑡=𝑇
Price Payoff

Call ?
𝐾 𝑆" 𝐾 𝑆!

Put ?
𝐾 𝑆" 𝐾 𝑆!
 𝒄 𝒑 𝑪 𝑷
𝑆"
𝐾
𝑇
𝜎
𝑟
𝐷
¡ Assumptions on the statistical distribution of
the underlying asset price
Arbitrage
No assumption
relations
𝑝 𝑢𝑆 Binomial
𝑆
1−𝑝 𝑑𝑆 model

Black-Scholes
model
¡ What’s the fair price for an option?
¡ First approach: (just) require no arbitrage
¡ Pros
§ Flexible
§ No strong assumptions
¡ Cons
§ Doesn’t always give us a precise price
¡ One European put, one call; same underlying,
no dividends, same strike and maturity
¡ The put-call parity holds:
!"#
𝑐 + 𝐾𝑒 = 𝑝 + 𝑆$

Call PV of Put Underlying

price strike price price
¡ Why does it work? No arbitrage!
!"#
𝑐 + 𝐾𝑒 = 𝑝 + 𝑆$
# #
𝑆! − 𝐾 +𝐾 𝐾 − 𝑆! + 𝑆!

𝐾 𝐾

𝐾 𝑆! 𝐾 𝑆!
 ¡ Suppose 𝑐 + 𝐾𝑒 $%& > 𝑝 + 𝑆"

At maturity
Today
𝑺𝑻 < 𝑲 𝑺𝑻 > 𝑲
Buy put
Buy 𝑆
Write call
Borrow 𝐾𝑒 $%!
Net payoff
1. Suppose 𝑐 = 3, 𝑇 = 0.25 (3 m), 𝐾 = 30,
𝑆" = 31, 𝑟 = 10%, 𝐷 = 0. What is 𝑝?
2. What are the arbitrage possibilities when:
a) 𝑝 = 2.25
b) 𝑝=1
¡ What if 𝐷 > 0? The stock pays a dividend
before the maturity of the option
!"#
𝑐 + 𝐾𝑒 + 𝐷 = 𝑝 + 𝑆$
¡ Intuition: Just go back to the no-arbitrage
argument
¡ Put is worth more, call less
𝑆$ ≥ 𝑐 ≥ 𝑆$ − 𝐾𝑒 !"#
 ¡ 𝑆" ≥ 𝑐
§ If not: Arbitrage opportunity
§ Buy 𝑆, write 𝑐, and invest 𝑐 − 𝑆! at riskfree rate 𝑟
At maturity
Today
𝑺𝑻 < 𝑲 𝑺𝑻 > 𝑲
Write call
Buy 𝑆
Invest 𝑐 − 𝑆"
Net
 ¡ 𝑐 ≥ 𝑆" − 𝐾𝑒 $%!
§ If not: Arbitrage opportunity
§ Buy call, short 𝑆, invest 𝐾𝑒 "#$ at riskfree rate 𝑟
At maturity
Today
𝑺𝑻 < 𝑲 𝑺𝑻 > 𝑲
Buy call
Short 𝑆
Invest 𝐾𝑒 #$%
Net
 𝑆" ≥ 𝑐 ≥ 𝑆" − 𝐾𝑒 $%!
𝑐

$!
#
𝑆" 𝑒
𝐾
= −
𝑐 𝑆"
=
𝑐

𝑆"
$%! 𝐾
𝐾𝑒
¡ The price of a non-dividend-paying stock is
$30, and for a one-year European call 𝐾 =
$25. 𝑟 = 4% (cont. compounding). If 𝑐 = $5,
are there arbitrage opportunities?
𝐾𝑒 !"# ≥ 𝑝 ≥ 𝐾𝑒 !"# − 𝑆$
¡ 𝐾𝑒 $%! ≥ 𝑝
§ Why?

¡ 𝑝 ≥ 𝐾𝑒 $%! − 𝑆"
§ What do you do otherwise?
 𝐾𝑒 $%! ≥ 𝑝 ≥ 𝐾𝑒 $%! − 𝑆"
𝑝

𝐾𝑒 $%!
𝑝 = 𝐾𝑒 #$!

𝑝 = max 0, 𝐾𝑒 #$! − 𝑆"

𝑆"
$%! 𝐾
𝐾𝑒
¡ The price of a non-dividend-paying stock is
$50, and for a two-year European put 𝐾 =
$54. 𝑟 = 3% (cont. compounding). If 𝑝 =
$0.90, are there arbitrage opportunities?
 Call price Call payoff
𝑐 𝑐

𝑆" 𝑆!

Put price Put payoff

𝑝 𝑝

𝑆" 𝑆!
 𝑆$ ≥ 𝑐 ≥ 𝑆$ − 𝐾𝑒 !"# − 𝐷

𝐾𝑒 !"# ≥ 𝑝 ≥ 𝐾𝑒 !"# − 𝑆$ + 𝐷
¡ American options worth at least as much as
the corresponding European ones
𝐶≥𝑐
𝑃≥𝑝
¡ Usually some chance of early exercise –
except for American call on non-dividend
paying stock
¡ Formally

¡ Thus: Early exercise never optimal

¡ American put options can be exercised early
¡ Why?
§ Suppose 𝐾 = 10 and 𝑆! ≈ 0

§ Early exercise: Profit of 10

§ Postpone: Profit ≤ 10 (price cannot be negative!)

§ Also, receiving 10 now is better than in the future

¡ Trading strategy = combination of positions
in option(s) and other securities
¡ I.e. a portfolio
¡ Key tool to understand their use: payoff
profile at maturity
¡ Covered call: Long underlying, short call
¡ Pick up some
income
¡ But lose any
profits above 𝐾

𝐾
¡ Protective put: Long underlying, long put
¡ Protect portfolio
against losses
¡ Hedge stock
price drops by
buying a put
𝐾
¡ Bull and bear spreads: Long/short two calls or two
puts, with different strike prices

¡ Butterfly spread: Positions in 3 options, with

different strikes

¡ Calendar spread: Positions in options with the same

𝐾 but different maturities
¡ Bull spread
¡ Long call with low 𝐾%

¡ Short call with high 𝐾&

¡ Limited downside and

profit
𝐾&
𝐾'
¡ Bull spread
¡ With two puts?

¡ Long put with low 𝐾%

¡ Short put with high 𝐾&

𝐾&
𝐾'
¡ Bear spread
¡ Short put with low 𝐾%

¡ Long put with high 𝐾&

¡ Limited downside and

profit
𝐾'
𝐾&
¡ Bear spread
¡ With two calls?

¡ Short call with low 𝐾%

¡ Long call with high 𝐾&

𝐾'
𝐾&
¡ Butterfly spread: Long call 𝐾% , long call 𝐾& ,
2× short calls 𝐾'

𝐾& 𝐾(
𝐾'
¡ Butterfly spread: Using puts?

𝐾& 𝐾(
𝐾'
¡ Straddle: Long call + long put, same strike

¡ Strangle: Long call + long put, different strikes

¡ Strip: Long call + 2 long puts, same strike

¡ Strap: Long 2 calls + long put, same strike

¡ Straddle
¡ Long call, long put

¡ When does this make

sense?

𝐾
¡ Straddle
¡ Short call, short put

¡ When does this make

sense?

𝐾 ¡ With short positions?