Options:

Basics and Strategies

Fundamental of Finance L1.1 1

 Overview
 Option basics
 Option valuation on expiration date
 Option strategies
 Next two classes: Option valuation prior to
expiration date
 No-arbitrage bounds on option prices
 Black-Scholes-Merton Formula

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 Option Basics

 Derivatives
 Option characteristics
 Value of options at expiration
 Option strategies

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 Derivatives
 A derivative is a security with a payoff that depends on
the price of another security
 The other security is called the underlying (security)
 Examples: options, futures, swaps.
 Derivatives are used for
 Risk management, hedging

 Executive compensation

 Speculation

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 Options Characteristics
 Option types
 Call option: right to Buy underlying at

 Put option: right to Sell underlying at

 Exercise price / strike price (X)

 Can exercise at or before expiration (T)
 European: exercise only at expiration
 American: exercise any time at or before expiration
 Price or premium
 In-the-money, out-of-the-money, at-the-money
S0 > X S0 < X S0 = X
 Net profit includes cost of option

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 Value of Options at Expiration
 At expiration, if the stock price is ST, a Call option
with strike price X is worth:
 ST  X if ST  X
CT  
0 if ST  X
 At expiration, if the stock price is ST, a Put option
with strike price X is worth:

0 if ST  X
PT  
 X  ST if ST  X

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 The Value of a Call at Expiration
 Payoff and net profit for a call option with a strike/
exercise price of X=$100 and premium of $10.
20

10

0 ST
80 90 100 110 120 130

-10

ST 80 90 100 110 120 130

Payoff 0 0 0 10 20 30
Profit -10 -10 -10 0 10 20
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 The Value of a Put at Expiration
 Payoff and net profit for a call option with a strike/
exercise price of X=$100 and premium of $10

20

10

0 ST
80 90 100 110 120 130

-10
ST 80 90 100 110 120 130
Payoff 20 10 0 0 0 0
Profit 10 0 -10 -10 -10 -10 8
 Stock Option Logic
 Q: Why do you buy a call?
 A: you expect the stock price to go up.

 Q But you could buy the stock outright?

 A: A call is sometimes a better vehicle because it gives you
downside protection. You think the stock will go up, but you are
worried it may go down. You protect against the downside. The
option payoff is not symmetric, the stock payoff is symmetric. It
has an unlimited downside.

 Q: Can you replicate the call option payoff with a position in

the stock only?
 A: Long in stock with stop loss at 100. This is a dynamic trading
strategy (repeated buying and selling) that replicates the call option
payoff. Problem: price may jump (event risk)

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DIY: Value of a Short Call at Expiration
 Determine the payoff and net profit for a short a
call with a strike of X=$100 and premium of $10
10

0 ST
80 90 100 110 120 130

-10

ST 80 90 100 110 120 130

Payoff 0 0 0 -10 -20 -30
Profit 10 10 10 0 -10 -20

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 Option Strategies
1. Using calls for leverage
2. Protective put
3. Covered calls
4. Straddle/Strangle
5. Collars

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 DIY: 1. Call Options for Leverage
 Example
 Microsoft share price is S0=$70
 A call option with X=$70 and 6-month maturity costs C0=$10
 What is the payoff investing $7,000 in
A. Buy 100 shares of Microsoft
B. Buy 700 call options with X=$70
C. Buy 100 call options and invest $6,000 at the risk-free rate
(2% per 6 months).

ST 60 65 70 75 80 85 90
Payoff A: __ __ __ __ __ __ __
Payoff B: __ __ __ __ __ __ __
Payoff C: __ __ __ __ __ __ __

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 DIY: 1. Call Options for Leverage
 Example
– Microsoft share price is S0=$70
– A call option with X=$70 and 6-month maturity costs
C0=$10
 What is the payoff investing $7000 in
A. Buy 100 shares of Microsoft
B. Buy 700 call options with X=$70
C. Buy 100 call options and invest $6000 at the risk-free
rate (2% per half year).
ST 60 65 70 75 80 85 90
Payoff A: 6000
__ 6500
__ 7000
__ 7500
__ 8000
__ 8500
__ 9000
__
Payoff B: 0
__ 0
__ 0
__ 3500
__ 7000
__ 10500
__ 14000
__
Payoff C: 6120
__ 6120
__ 6120
__ 6620
__ 7120
__ 7160
__ 8120
__
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 DIY: 1. Call Options for Leverage
Return = Profit/7000 -1

ST 60 65 70 75 80 85 90
Return A: -15.4%
__ -7.1%
__ __
0 % 7.1%
__ 14.3%
__ 21.4%
__ 28.6%
__
Return B: - 100%
__ -100%
__ -100%
__ -50%
__ 0%
__ 50%
__ 100%
__
Return C: -12.6%
__ -12.6%
__ -12.6%
__ -5.4%
__ 1.7%
__ 8.9%
__ 16%
__

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 Call Option for Leverage: Conclusion

 Holding call options for leverage (portfolio B):

when price falls below 80, you lose everything,
but when price increases only modestly, e.g. an
increase from 85 to 90 (only 6% increase), your
return doubles from 50 to 100%! This is called
leverage. This is the speculative feature of
options.

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 2. Protective Put
 You own a share of Microsoft with current price
S0=$70. You are afraid that the stock price will
drop. How do you limit your possible losses by
trading options?
ST 40 50 60 70 80 90 100
Payoff Stock: 40 50 60 70 80 90 100
Payoff Put,X=70: 30 20 10 0 0 0 0
Payoff Total: 70 70 70 70 80 90 100
 This payoff is the same as that of a long call with
X=70 + a bond with a face value of 70!
Next week: put-call parity.
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 Protective Put

Combined
payoff

Net profit on
combo

Put payoff

Premium
for buying Stock payoff
put
 3. Covered Call
 Suppose that you buy a share of Microsoft for
S0=$70. You think that at-the-money call
options trading at $10 seem excessively
expensive, and you want to profit from this.
ST 40 50 60 70 80 90 100
Payoff Stock: 40 50 60 70 80 90 100
Payoff Short Call: 0 0 0 0 -10 -20 -30
Payoff Total: 40 50 60 70 70 70 70
Profit Total: 50 60 70 80 80 80 80
 You sold your upside.
 Compare: “naked option writing”

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 Covered Call

Stock payoff Combined profit

on combo

Combined payoff

Premium for Short Call payoff

writing call

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 4. Straddle and Strangle
 You have private information that a particular
stock’s price will change dramatically soon, but
you do not know if it will go up or down. So you
buy
 Straddle: Put (X=X1) + Call (X=X2), X1=X2
 Strangle: Put (X=X1) + Call (X=X2), X1<X2
ST 30 40 50 60 70 80 90
Payoff Call: 0 0 0 0 10 20 30
Payoff Put: 30 20 10 0 0 0 0
Payoff Total: 30 20 10 0 10 20 30

 Illustrated a straddle with X1=X2 =60:

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 Straddle

Put Call
Payoff Payoff

X1 =
Cost of
X2
options Net Profit

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 Markets: Nick Leeson
The beginning of the end occurred on January 16,
1995, when Leeson placed a short straddle in the Stock
Exchange of Singapore and Tokyo stock exchanges,
essentially betting that the Japanese stock market
would not move significantly overnight. However, the
Kobe earthquake hit early in the morning on January
17, sending Asian markets, and Leeson's investments,
into a tailspin. Realizing the gravity of the situation,
Leeson left a note reading "I'm Sorry" and fled on
February 23. Losses eventually reached £827 million
($1.4 billion), twice the bank's available trading
capital. After a failed bailout attempt, Barings was
declared insolvent on February 26.
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 DIY: 5. Collar

 What should you do if

– you want to buy shares of Microsoft for $70 per share
– you want to make sure that in 6 months the value of
your position is at least $60 per share
– you think that the stock price will go up, but that it will
at most reach (about) $80
ST 40 50 60 70 80 90 100
Payoff Stock: __
40 __
50 __
60 __
70 __
80 __
90 __
100
Long Put Payoff X=60 : __20 __
10 __
0 __
0 __
0 __
0 __
0
Short Call Payoff X=80 : __
0 __
0 __
0 __
0 __
0 __
-10 __
-20
Payoff Total: 60 60 60 70 80 80 80
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 Overview of Option Strategies
1. Calls get you leverage
2. Protective put = stock + put

3. Covered call = stock + short call

4. Straddle (Strangle) = ATM (OTM) put + call

5. Collar = stock + put + short call

6. Bull spread: long call X1 + short call X2, with X1<X2

7. Bear spread: long call X2 + short call X1, with X1<X2

8. Butterfly spread: long call X1 + 2*short call X2 + long call X3,

X1<X2<X3

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 Bull Spread
Payoff

ST
X2
X1
Net Profit

Note: C (X1) > C (X2) (Cost of option with strike X1

is greater than option with strike X2 )

Otherwise there is an arbitrage

( Otherwise you would buy C (X1) and sell C (X2)

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 Concepts to Know

 Option basics
 Call option
 Put option
 Draw payout profile
 Option strategies
 Which are common option strategies?
 What are they used for?

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