FMT – IPM

Lecture 9: Options (20)

Lecture outline

• Purposes of derivatives assets

• Options basic
• Futures basic
• Examples of options and futures
• New development of derivatives
products
1 Derivatives – what
are they?
4
 Derivatives

• What are they?

– Forward contracts
– Futures contracts
– Options
– Swaps
6
 Derivatives

• Derivatives are used by firms to achieve one of more

of the following individual benefits:
– Permit firms to achieve payoffs that they would not be
able to achieve without derivatives, or could achieve
only at greater cost
– Hedge risks
– Make underlying markets more efficient
– Reduce volatility of stock returns
– Motivate management (agency theory effect)
2 CHAPTER 20
OPTIONS
 Options

• An option is a contract giving the option purchaser

(the buyer) the right, but not the obligation, to buy
or sell a given amount of an underlying asset at a
fixed price per unit for a specified time period (until
the maturity date).
• There are two basic types of options, puts and calls.
– A call is an option to buy the underlying asset.
– A put is an option to sell the underlying asset.
 Option Terminology
• Buy - Long
• Sell - Short
• Key Elements
– Exercise or Strike Price
– Premium or Price
– Maturity or Expiration
 Options
• The buyer (long) of an option is termed the holder,
while the seller (short) of the option is referred to as
the writer or grantor.
• Every option has three different price elements:
– The exercise or strike price – the price at which the
underlying asset can be purchased (call) or sold (put)
– The premium – the cost, price, or value of the option itself
– The underlying or actual spot price of the underlying asset
in the market
 Position Right Obligation

Long - holder
Call option
Short - writer

Long - holder
Put option
Short - writer
 Options

• An American option gives the buyer the right to exercise

the option at any time between the date of writing and
the expiration or maturity date.
• A European option can be exercised only on its
expiration date, not before.
Example
 Market and Exercise Price
Relationships

• In the Money - exercise of the option would be

profitable.
– Call: market price > exercise price
– Put: exercise price > market price
• Out of the Money - exercise of the option would not be
profitable.
– Call: market price < exercise price
– Put: exercise price < market price
• At the Money - exercise price and asset price are equal.
Example: IBM Call options

These call
options expire
on 3/11/2017.

These
calls are
in the
money.

These
calls are
out of the
money.
 Example: IBM PUT options

These put options expire on 3/11/2017.

These
puts are
out of
the
money.

These
puts are
in the
money.
IBM Call options
How is premium
related to exercise
prices of the call
options?
IBM Call option: Zoom-in
IBM1703K150
Premium of this option?
• $4.10/share in the call option

Intrinsic value of this option

• $153.68 – $150 = $3.68

Why should investors pay $4.10 to buy

something that has an intrinsic value of
only $3.68?
• As the option has not expired yet, there
is still chance that the stock price will
move in favour of the option, creating
larger possible gain for the option.
Therefore, investors are paying for the
time value of the option.

Time value = $4.10 – $3.68 = $0.42

 Comparing two options

IBM1703K150 IBM1701L150
 Different Types of Options

• Stock Options
• Index Options
• Futures Options
• Foreign Currency Options
• Interest Rate Options
 Payoffs and Profits at
Expiration - Calls
Notation
Stock Price = ST
Exercise Price = X
Payoff to Call Holder Payoff to Call Writer
(ST - X) if ST >X - (ST - X) if ST >X
0 if ST < X 0 if ST < X

Profit to Call Holder Profit to Call Writer

Payoff – Premium (Purchase Payoff + Premium
Price)
 Call Option

ST < X ST > X

• Payoff = 0 • Payoff = ST - X
• Holder Loss = – Call Premium • Holder Gain = Payoff – Call Premium
• Writer Gain = + Call Premium • Writer Loss = – (Payoff – Call Premium)
Call option profit - Holder
Exercise Price: X = $20

Call Premium: C = $2

1. What is the break even price?

2. What is the max possible gain for short call?

3. What is the max possible loss for short call?

4. What is the max possible loss for long call?

5. What is the max possible gain for long call?

6. What is the profit/loss for long/short call if S = $10?

 Payoffs and Profits at
Expiration - Put

Payoffs to Put Holder Payoffs to Put Writer

0 if ST > X 0 if ST > X
(X - ST) if ST < X -(X - ST) if ST < X

Profit to Put Holder Profits to Put Writer

Payoff - Premium Payoff + Premium
 Put Option

ST < X ST > X

• Payoff = X – ST • Payoff = 0
• Holder Gain = Payoff – Put Premium • Holder Loss = – Put Premium
• Writer Loss = – (Payoff – Put Premium) • Writer Gain = + Put Premium
Call option profit - Writer
 Option strategies

• Protective put (long stock and long put)

• Covered call (long stock and short call)
• Straddle (Long Call and Long Put with Same Exercise Price)
• Spreads - two or more call or put options on the same asset
with differing exercise prices or times to expiration.
• Vertical or money spread: Same maturity, different
exercise price
• Horizontal or time spread: different maturity dates
 Option strategies:
Protective Put
Position - long the stock and long the put
• Puts can be used as insurance against stock price declines.
• Protective puts lock in a minimum portfolio value.
• The cost of the insurance is the put premium.
• Options can be used for risk management, not just for
speculation.
ST < X ST ≥ X
Stock (long) ST ST
Put (long) X-ST 0
Total Payoff X ST
Profit X-S0-P ST-S0-P
Protective Put
 Option strategies:
Covered call
Position - Own the stock and write a call.
Use - Some downside protection at the expense of giving up
gain potential.
• Call writer gives up any stock value above X in return for
the initial premium.
• If you planned to sell the stock when the price rises
above X anyway, the call imposes “sell discipline.”
ST < X ST ≥ X
Stock (long) ST ST
Call (short) 0 -(ST-X)
Total Payoff ST X
Profit ST-S0+C X-S0+C
 Option strategies: Straddle

• Long straddle: Buy call and put with same exercise price and
maturity.
• The straddle is a bet on volatility.
– To make a profit, the change in stock price must exceed the
cost of both options.
– You need a strong change in stock price in either direction.
• The writer of a straddle is betting the stock price will not change
much.
ST < X ST ≥ X
Call (long) 0 ST - X
Put (long) X - ST 0
Total Payoff X-ST ST - X
Profit X-ST-C-P ST-X-C-P
Option strategies: Straddle
 Put – call parity

The call-plus-bond portfolio (on left) must

cost the same as the stock-plus-put
portfolio (on right):
X
C+ = S0 + P
(1 + r f ) T
 Payoff ST < X ST > X

Buy Call

Buy Bond

Total payoff

Payoff ST < X ST > X

Buy Stock

Buy Put

Total payoff
0 0
X X
Long call Long Bond

0
X
Long Call + Long Bond