Chapter 14 Option Market Part II

Call Options Payoffs and Profits at Expiration

Payoff to call holder (buyer)
max {ST X, 0}

Payoff to call writer (seller)

- max {ST X, 0}

Profit to call holder

max {ST X, 0} - Premium

Profit to Call Writer

Premium - max {ST X, 0}
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Payoff Profiles for Calls

Profit OTM ITM Call Holder

0 X

Stock Price at time T

Call Writer

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Profit/Loss Profiles for Calls

Profit Call Holder OTM C 0 -C X Stock Price at time T ITM

Call Writer Stock Price

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Put Options Payoffs and Profits at Expiration

Payoff to put holder (buyer)
max {X - ST, 0}

Payoff to put writer (seller)

- max {X - ST, 0}

Profit to put holder

max {X - ST, 0} - Premium

Profit to put Writer

Premium - max {X - ST, 0}
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Payoff Profiles for Puts

ITM Put Holder Stock Price at time T OTM

Profits

X Put Writer

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Profit/Loss Profiles for Puts

Profits ITM OTM Put Writer P
0

-P

Stock Price at time T Put Holder Stock Price

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Put-Call Parity Relationship

ST < X Payoff for Holding a Call Payoff for Writing A Put Total Payoff
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ST > X

ST - X

- (X - ST) ST - X
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0 ST - X
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Payoff of a Long Call and A Short Put

Payoff

Long Call Combined Payoff X Stock Price Short Put -X

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Payoff of a Leverage Equity

Payoff Long Stock

Combined Payoff X Stock Price

-X
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Short Bond
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Put-Call Parity
We can replicate the payoff from a long call and a short put by:
Long 1 share of stock today and hold it to T; Borrow a margin loan in the amount of X / (1 + rf)T

Since the payoff on a long call and a short put are equivalent to leveraged equity, the prices must be equal today: C - P = S0 - X / (1 + rf)T If the prices are not equal, arbitrage will be possible
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An Example Put Call Parity Arbitrage

Q: Stock Price = 110 Call Price = 17 Risk Free = 5% Put Price = 5 Maturity = 1 yr Strike Price = 105 Is there any arbitrage opportunity? C - P > S0 - X / (1 + rf)T 17- 5 > 110 - (105/1.05) 12 > 10 Arbitrage opportunity:
The leveraged equity is less expensive Buy (long) the low cost portfolio and sell (short) the high cost alternative

A:

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An Example Put-Call Parity Arbitrage

Position Buy Stock Immediate Cashflow -110 Cashflow in Six Months ST <105 ST > 105 ST -105 0 105 - ST 0 ST -105 -(ST - 105) 0 0

Borrow X/(1+r)T = 100 +100 Sell Call Buy Put Total +17 -5 2

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Option Strategy I Protective Put

Long stock + Long (ATM) put
Pay put premium for downside protection
Payoff from Long a stock P/L from Holding stock ST X X
-P

Payoff from A Protective put

X - S0 X

P/L from A Protective put

ST

Payoff from Long a put X ST

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Option Strategy II Covered Call

Long stock + short (sell / write) call
Sacrifice upside potential for call premium
Covered Call Payoff at T X ST X Write a call

payoff profit
X ST

Payoff at T Long a stock ST

C-S0

X
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Option Strategy III - Straddle

Long call and put with same strike price
Benefit from big jumps in stock prices
Payoff at T Long Dec 160 call

X=160

ST

X X-P-C X ST

Straddle

Long Dec 160 Put

X
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ST
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Wrap-up
Payout and P/L for holders and sellers of put or call options Put-call parity Three option strategies
Protective put Covered call Straddle

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