Options Basics

Teaching Agenda
✓ What is Options?
✓ Terminology and feature of Options
✓ What is Option price?
✓ Factor affecting Option price
✓ Basic Vanilla Option strategy
◼ Long Call / Long Put / Short Call / Short Put
✓ Complex strategy
◼ Straddle / Strangle / Protective Put / Covered Call

Recommended Reference:
Mastering Financial Calculations, Chapter – Options:
Overview, the ideas behind option pricing, some trading strategies

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What is Option?
A contract between a buyer (holder) and a seller
(writer), that gives the buyer the right but not the
obligation to buy or sell a specified quantity of an
underlying asset at a specific price (strike price)
within a specified period of time, regardless of the
market price of the underlying asset.

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What is Option?
Stock Option Price quotation

OI = Open Interest
IV = Implied Volatility
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Terminology
◼ Strike price / Exercise price : Price at which the option buyer has the right to buy or
sell the underlying
◼ Expiration : Date on which the holder / buyer of the option loses the right to buy or
sell
◼ Premium : The amount paid by the option buyer to the option writer for the right
◼ Exercise: Process of deciding and advising option seller of intention to exercise the
right under the option
◼ Moneyness of Option: measure the difference between the current underlying market
price and the strike price. In case of Call Option:
➢ In-the-money (ITM) : when the current underlying market price > the strike price
(this is likely the option will be exercised)
➢ Out-of-the-money (OTM) : when the current underlying market price < the strike
price (this is unlikely that the option will be exercised)
➢ At-the-money (ATM) : The strike price of option = the current underlying market
price
➢ In case of Put Option, this is vice versa for In-the-money and Out-of-the-money
case.
◼ Call option : Option buyer has the right to buy the underlying
◼ Put option : Option buyer has the right to sell the underlying
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Feature of Option
◼ Exercise style
➢ European option : An option that can only be exercised on the day of expiry
➢ American option: An option that can be exercised at anytime from the date of
purchase until it expires
◼ Option Exercise Settlement
➢ Physical Settlement : the option is actually delivered with the underlying. The
option seller of the option must deliver to the buyer of the option with the pre-
defined amount of underlying
➢ Cash Settlement : cash is settled for the difference between the underlying
market price and the option strike price
◼ OTC vs Exchange
➢ Exchange Trade Contract
➢ the standardized contracts listed in Exchange
➢ Margin call system with daily mark-to-market
➢ Exchanges include: SIMEX, LIFFE, CBOT, CME , etc
➢ OTC: customized contacts between 2 counterparties

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Option Price
◼ What is option price?
➢ the probability of option exercised by the buyer

➢ if exercised, how much need to pay to the buyer

◼ Option price (Premium) = Intrinsic value + Time value

◼ Intrinsic Value
➢ the difference between the underlying market price and the option strike prices
(always >=0 in long option)
➢ Call option: Intrinsic value = Underlying price – Strike price

➢ Put option : Intrinsic value = Strike price – Underlying price

◼ Time Value
➢ Time value = Option price – Intrinsic value

➢ the risk that the option will move in the money before expiry

➢ Time value is positively related to the life of an option - the longer the life of the
option, the greater the time value of money. (or increased probability that the
option will move in-the-money before expiry)
➢ Time value is positively related to volatility - the increased probability that an
option will be exercised for high volatility than low volatility.
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Option Price (Cont)
X = Strike / Exercise price
S = Underlying asset price
Call Put Remarks

In-the-money X<S X>S Intrinsic Value

>0
At-the-money X=S X=S Strike price =
Underlying
security price
Out-of-the-money X>S X<S Intrinsic Value
=0
Intrinsic Value Max (0, S – X) Max (0, X – S)

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Example – Call Option
The Hang Seng Index level is 19000, the Call Option price for
respective Strike per below.
** For stock index option, the option premium is quoted in index points.
** For stock option, the option premium is quoted in $.

Strike Call price

18800 543
19000 415
19200 308

What is the Intrinsic Value of each Strike?

What is the time value of each Strike?
What is the Moneyness of each Strike?
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Example – Put Option
The Hang Seng Index level is 19000, the Put Option price for
respective Strike per below.

Strike Put price

18800 165
19000 239
19200 333

What is the Intrinsic Value of each Strike?

What is the time value of each Strike?
What is the Moneyness of each Strike?
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Example – Call & Put Option
Call Option
Stirke / Intrinsic
Exerice Call Price S-X Value Time Value Moneyness
Price (X) Max(0,S-X)
18800 543 200 200 343 In-the-money
19000 415 0 0 415 At-the-money
19200 308 -200 0 308 Out-of-money

Put Option
Stirke / Intrinsic
Exerice Put Price X-S Value Time Value Moneyness
Price (X) Max(0,X-S)
18800 165 -200 0 165 Out-of-money
19000 239 0 0 239 At-the-money
19200 333 200 200 133 In-the-money

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Factor affecting Option Pricing

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Example – Buy/Sell Call Option
The Hang Seng Index level is 19000, the Call/Put Option price for respective
Strike per below.

Strike Call price Put price

18800 543 165
19000 415 239
19200 308 333
If you buy Call Option @ strike 18800, you expect?
What is the premium? pay / receive? Pay 543

If you sell Call Option @ strike 18800, you expect?

What is the premium? pay / receive? Receive 543

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Example – Buy/Sell Put Option
The Hang Seng Index level is 19000, the Call/Put Option price for respective
Strike per below.

Strike Call price Put price

18800 543 165
19000 415 239
19200 308 333
If you buy Put Option @ strike 18800, you expect?
What is the premium? pay / receive? Pay 165
If you sell Put Option @ strike 18800, you expect?
What is the premium? pay / receive? Receive 165

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Basic Vanilla Option Strategy
Below are the Profit/Loss Profile diagram to show the profit/loss outcome at Option expiry for
each stock price outcome (taken into account the option premium paid/received)

◼ Market Outlook: Bearish ◼ Market Outlook: Bullish

Long Put ◼ Investor long put to

protect the downside risk
Long Call ◼ Investor long call to enjoy
the upside potential profit

◼ Market Outlook: Bullish ◼ Market Outlook: Bearish

Sell Put ◼ Investor short put to
realize the premium in
Sell Call ◼ Investor short call to
realize the premium in
bullish market, but could bearish market, but could
suffer huge loss in case of suffer unlimited loss in
bearish market. case of bullish market.

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Complex Strategy : Straddles
◼ Long Straddles: long call + long put at the
same strike
◼ Market Outlook: Uncertain
◼ Volatility Outlook: Rising
◼ Expectation: Investor expects a sharp
movement in the share price, but is unsure of
the direction it will take. Long straddle to
exploit potential profit.
Long Straddle
◼ Short Straddles: short call + short put at the
same strike
◼ Market Outlook: Range Bound
◼ Volatility Outlook: Declining
◼ Expectation: Investor expects the market is
going to trade in a tight range or volatility will
fall. Short straddle to earn double premium if
volatility is low.
Short Straddle
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Complex Strategy - Strangles
◼ Long Strangles: buying a call and put at
different strike (call strike > = put strike),
usually both strike are out-of-money
◼ Market Outlook: Uncertain
◼ Volatility: Rising
◼ Expectation: Investor expects the stock price
to make a big jump or drop to generate the
profit.
Long Strangles
◼ Short Strangles: selling a call and put at
different strike (call strike > = put strike), usually
both strike are out-of-money
◼ Market Outlook: Uncertain
◼ Volatility: Declining
◼ Expectation: When option premium are
overpriced, an investor expects to earn the
double premium if the underlying share will stay
with a fairly narrow price range or low volatility
Short Strangles
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 Example – Call/Put Option
Current Stock Price = $105 What you expect for each of below strategy?
Long Stock / Short Stock
Option Strike Price = $100 Long Call / Short Call
Long Put / Short Put
Call Option Premium = $15
Put Option Premium = $6 What is the maximum loss?
What is the maximum gain?
The breakeven point? (i.e. breakeven point taken into account
the option premium paid/received)
++=+ -+=- +-=- --=+
Long Stock Short Stock Long Call Short Call Long Put Short Put
Current Stock Price (So) 105 105 105 105 105 105
Strike (X) 100 100 100 100
Premium (P) -15 15 -6 6
Max Loss -105 unlimited -15 unlimited -6 -94
Max Gain unlimited 105 unlimited 15 94 6
Breakeven Point 105 105 115 115 94 94
S S X+|P| X+|P| X-|P| X-|P|
Assumed Stock Price (St)
105 105 105 105 105 105
at option expiry
Potential P&L at expiry 0 0 -10 10 -6 6
@ St St-So -{St-So} MAX[(S-X),0]-|P| -{MAX[(S-X),0]-|P|} MAX[(X-S),0]-|P| -{MAX[(X-S),0]-|P|}
** Long Put max gain = X - |P| (limited)
** Short Put max gain = - (X - |P|) significant compare to premium

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Example – Call/Put Option

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Example - Straddle
What you expect for each of below strategy?
Current Stock Price = $105 Long Call + Long Put
Option Strike Price = 100 Short Call + Short Put

Call Premium = $15 What is the maximum loss?

What is the maximum gain?
Put Premium = $6
The breakeven point?
Long Call Long Put Long Straddle Short Call Short Put Short Straddle
Current Stock Price (So) 105 105 105 105 105 105
Strike (X) 100 100 100 100 100 100
Premium (P) -15 -6 -21 15 6 21
Max Loss -15 -6 -21 unlimited -94 unlimited
Max Gain unlimited 94 unlimited 15 6 21
Breakeven 115 94 115 94
X+|P| X-|P| X+|P| X-|P|
Breakeven Point on 121 79
upside
X+|P| X-|P|
Breakeven Point on 79 121
downside
X-|P| X+|P|
Assumed Stock Price (St)
105 105 105 105 105 105
at option expiry
Potential P&L at expiry -10 -6 -16 10 6 16
@ St MAX[(S-X),0]-|P| MAX[(X-S),0]-|P| -{MAX[(S-X),0]-|P|} -{MAX[(X-S),0]-|P|}

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Example - Straddle

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 Example - Strangle
Current Stock Price = $105 What you expect for each of below strategy?
Long Call + Long Put
Short Call + Short Put
Call Strike = $110, Call Premium = $6 The Strike price the same?
Can it be the same?
Put Strike = $100, Put Premium = $10 What is the maximum loss?
What is the maximum gain?
The breakeven point?

Long Call Long Put Long Strangle Short Call Short Put Short Strangle
Current Stock Price (So) 105 105 105 105 105 105
Strike (X) 110 100 C110/P100 110 100 C110/P100
Premium (P) -6 -10 -16 6 10 16
Max Loss -6 -10 -16 unlimited -90 unlimited
Max Gain unlimited 90 unlimited 6 10 16
Breakeven 116 90 116 90
X+|P| X-|P| X+|P| X-|P|
Breakeven Point on 126 84
upside
Xc+|P| Xp-|P|
Breakeven Point on 84 126
downside
Xp-|P| Xc+|P|
Assumed Stock Price (St)
105 105 105 105 105 105
at option expiry
Potential P&L at expiry -6 -10 -16 6 10 16
@ St MAX[(S-X),0]-|P| MAX[(X-S),0]-|P| -{MAX[(S-X),0]-|P|} -{MAX[(X-S),0]-|P|}

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Example - Strangle

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Example – Protective Put
Long Stock + Long Put
Current Stock Price = $105
Put Strike = $100, Put Premium = $10
What you expect for this strategy?
◼ Put Strike <= Current Stock Price, to protect the potential
downside risks
◼ investor desires upside exposure (unlimited gain)
◼ enjoy downside protection

What is the maximum loss?

What is the maximum gain? Long Stock Long Put Protective Put
Current Stock Price (So) 105 105 105
Strike (X) 100 100
The breakeven point? Premium (P)
Max Loss -105
-10
-10
-10
-15 (X-S)-|P|
Max Gain unlimited unlimited unlimited
Breakeven Point 105 90 115 X + |(X-S) - |P||
S X-|P| X+|Max Loss|
Assumed Stock Price (St)
105 105 105
at option expiry
Potential P&L at expiry 0 -10 -10
@ St St-So MAX[(X-S),0]-|P|

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Example – Covered Call
Long Stock + Short Call
Current Stock Price = $105
Call Strike = $120, Call Premium = $6
What you expect for this strategy?
◼ Call Strike >= Current Stock Price, to lock up the potential
profit before stock price rising to Call Strike $120.
◼ investor is bullish for the market who wants to enhance the
stock holding returns by receiving premium (when implied
volatility is too high or option is overpriced).
◼ limited upside potential gain at Call Strike $120
◼ stock holding returns will decrease with falling stock price
and will suffer loss when price below $99 (Entry Stock
Price – Premium)
Long Stock Short Call Covered Call Long Call
Current Stock Price (So) 105 105 105 105
What is the maximum loss? Strike (X) 120 120 120
Premium (P) 6 6 -6
What is the maximum gain? Max Loss -105 unlimited -99 |P|-S -6
Max Gain unlimited 6 21 (X-S)+|P| unlimited
Breakeven Point 105 126 99 126
The breakeven point? S X+|P| S-|P| X+|P|
Assumed Stock Price (St)
105 105 105 105
at option expiry
Potential P&L at expiry 0 6 6 -6
@ St St-So -{MAX[(S-X),0]-|P|} MAX[(S-X),0]-|P|
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