Introduction

European options
American options
Trading strategies

Derivatives and Risk Management

Lecture 4: Options

Charlotte Sun Clausen-Jørgensen and Søren Hesel

Department of Business and Management

Fall 2022

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 Introduction
European options
American options
Trading strategies

Outline

1 Introduction

2 European options

3 American options

4 Trading strategies

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 Introduction Definitions
European options Use of options
American options Factors affecting the option price
Trading strategies Assumptions and notation

Definitions
Definition (Option)
An option gives the holder the right to buy (or sell) the underlying asset
S at or before maturity T for the exercise price K

• American option can be exercised at any time up to maturity

• European option can be exercised only at the expiration date

Note: When you buy an option (take a long position), you have to pay
something upfront

Questions:
• What can be said about the price of an option in general?
• Can we determine the price of an option? (next topic)

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 Introduction Definitions
European options Use of options
American options Factors affecting the option price
Trading strategies Assumptions and notation

European call options

payoff
long, max(0, ST − K )
• Gives the holder the right to buy the
underlying asset
• Payoff from a European option:
I long position: ST
max (0, ST − K ) K

I short position:
−max (0, ST − K ) = min (0, K − ST )
short, − max(0, ST − K )

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 Introduction Definitions
European options Use of options
American options Factors affecting the option price
Trading strategies Assumptions and notation

European put options

payoff

• Gives the holder the right to sell the long, max(0, K − ST )

underlying asset
• Payoff from a European option:
I long position: ST
max (0, K − ST ) K

I short position:
−max (0, K − ST ) = min (0, ST − K )
short, − max(0, K − ST )

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 Introduction Definitions
European options Use of options
American options Factors affecting the option price
Trading strategies Assumptions and notation

Use of options
Hedging:
• You expect to buy an asset at a future date: buy call option, gives
an upper bound on the effective purchase price
• You expect to sell an asset at a future date: buy put option, gives
a lower bound on the effective selling price
• Note: if you afterwards find out that you will not need to buy/sell
the asset anyway, you have only lost the option price

Speculation:
• You expect an increase in the price of an asset: buy call (or sell
put)
• You expect a decrease in the price of an asset: buy put (or sell
call)

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 Introduction Definitions
European options Use of options
American options Factors affecting the option price
Trading strategies Assumptions and notation

Factors affecting the option price

Source: Hull’s Table 11.1 (p. 248)

European American
call put call put
Current stock price + − + −
Exercise price − + − +
Time to maturity ? ? + +
Volatility + + + +
Risk-free rate + − + −
Amount of future dividends − + − +

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 Introduction Definitions
European options Use of options
American options Factors affecting the option price
Trading strategies Assumptions and notation

Assumptions and notation

Notation:
St : Stock price at time t
K : Exercise price of option
T : Maturity date
r: Risk-free interest rate
Ct : American call option’s price at time t
ct : European call option’s price at time t
Pt : American put option’s price at time t
pt : European put option’s price at time t
Dt : Time t value of dividends in the interval [t, T ] (= It from Lec. 3)

Usual assumptions:
• No arbitrage
• No transaction costs
• No asymmetric taxes
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 Introduction Definitions
European options Use of options
American options Factors affecting the option price
Trading strategies Assumptions and notation

Discrete vs. continuous dividends

Discrete: With known dividends of D1 , . . . , DN at times

t1 , . . . , tN ∈ [t, T ] we have

X
N
Dt = Dj e−r (tj −t) .
j=1

Continuous: Divide [t, T ] into N intervals of length ∆t = TN−t . If the

asset pays dividends continuously at the rate q, the total dividends
Rt+∆t
over the interval [t, t + ∆t] is t qSu du ≈ qSt+∆t ∆t.

Consider a strategy in which h stocks are bought at date t and all

dividends collected are reinvested (in the same stock).

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 Introduction Definitions
European options Use of options
American options Factors affecting the option price
Trading strategies Assumptions and notation

Discrete vs. continuous dividends, cont’d

The strategy evolves as follows:
Date dividend # stocks
end of date
t h
t + ∆t hqSt+∆t ∆t h(1 + q∆t)
t + 2∆t h(1 + q∆t)qSt+2∆t ∆t h(1 + q∆t)2
.. .. ..
. . .
t + N∆t h(1 + q∆t)N−1 qSt+N∆t ∆t h(1 + q∆t)N
 N
Since limN→∞ 1 + q TN−t = eq(T −t) buying h = e−q(T −t) stocks
will result in one stock at the terminal date.

Investment needed to own one stock at the terminal date:

St − Dt = e−q(T −t) St ⇔ Dt = (1 − e−q(T −t) )St
If we can find Dt for an index, q in above equation is its implied
dividend yield Option Chains Case
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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

Bounds on European option prices:

Proposition 1
For a European call option
 
St − Dt > ct > max 0, St − Dt − Ke−r (T −t) .

Do you recognize an old friend?

Proof on the board!

Proposition 2
For a European put option
 
Ke−r (T −t) > pt > max 0, Ke−r (T −t) − (St − Dt ) .

Proof is similar!
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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

Bounds on European option prices (graphically)

payoff
underlying asset, ST

call, max(0, ST − K )
forward, ST − K

ST
K

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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

Example
Assume that St = 820, no dividends, r = 4% p.a., K = 810,
T − t = 0.25.

Proposition 1 implies that the bounds for the call option is given by
 
St > ct > max 0, St − Ke−r (T −t) ⇒
 
820 > ct > max 0, 820 − 810e−0.04×0.25 = 18.06

Proposition 2 implies that the bounds for the put option is given by
 
Ke−r (T −t) > pt > max 0, Ke−r (T −t) − St ⇒
 
801.94 = 810e−0.04×0.25 > pt > max 0, 810e−0.04×0.25 − 820 = 0

The bounds are wide!

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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

The put-call parity

Proposition 3
For European options

ct + Ke−r (T −t) = pt + St − Dt .

Proof on the board!

Feel free to rearrange the put-call parity – for example:

ct − pt = St − Dt − Ke−r (T −t) = ftT

where ftT is the value of a forward contract with delivery price K .

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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

The put-call parity, cont’d

(Tutorial: Hull’s Question 17.10)

Consider a stock index currently standing at 250. The dividend yield

on the index is 4% per annum, and the risk-free rate is 6% per
annum. A three-month European call option on the index with a strike
price of 245 is currently worth $10. What is the value of a
three-month put option on the index with a strike price of 245?

Hints:
• Use that St − Dt = e−q(T −t) St cf. slide 10
• Isolate pt in the put-call parity

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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

The put-call parity, cont’d

(Tutorial: Hull’s Question 17.11)

Show that a European call option on a currency has the same price
as the corresponding European put option on the currency when the
forward price equals the strike price.

You can do either of the following:

1 Insert St − Dt = e−rf (T −t) St along with K = FtT where FtT is the
forward price of the underlying currency cf. (5.9) and rf is the
foreign risk-free rate.
2 Use the alternative version of the put-call parity on slide 14 and
recall from Lec. 3 that the value of a forward contract is zero
when the current forward price equals the initial forward price.

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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

Risk-free profits in option markets?

(Tutorial: Hull’s Question 11.10)

A 4-month European call option on a dividend-paying stock is

currently selling for $5. The stock price is $64, the strike price is $60,
and a dividend of $0.80 is expected in 1 month. The risk-free interest
rate is 12% per annum for all maturities. What opportunities are there
for an arbitrageur?

Hints:
• Compute both sides of the call-option bounds
• If both inequalities are satisfied there is no arbitrage opportunity
– otherwise you should buy the “cheap” side and sell the call; or
sell the “expensive” side and buy the call

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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

European options and the exercise price

Assume K1 < K2 < K3 , same underlying, same expiration date T .

Proposition 4
The prices of European call options satisfy

ct (K1 ) − ct (K2 ) 6 e−r (T −t) (K2 − K1 ),

K3 − K2 K − K1
ct (K2 ) 6 ct (K1 ) + 2 ct (K3 ).
K3 − K1 K3 − K1

Proposition 5
The prices of European put options satisfy

pt (K2 ) − pt (K1 ) 6 e−r (T −t) (K2 − K1 ),

K3 − K2 K − K1
pt (K2 ) 6 pt (K1 ) + 2 pt (K3 ).
K3 − K1 K3 − K1

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 Introduction
Bounds
European options
The put-call parity
American options
Option prices and the exercise price
Trading strategies

European options and the exercise price, cont’d

(Tutorial: Hull’s Questions 11.25)
Assume that K1 < K2 < K3 and show that
1 1
ct (K2 ) 6
ct (K1 ) + ct (K3 )
2 2
(corresponds to the case K2 − K1 = K3 − K2 in Prop. 4 above)

Hints:
• Make a payoff diagram to get the intuition
• Then show that “>” leads to arbitrage:
I Sell two calls with strike K2
I Buy one option with strike K1
I Buy one option with strike K3
• What does the strategy cost today?
• What is the payoff from the strategy when
I ST < K1
I K1 6 ST < K2
I K2 6 ST < K3
I K3 6 ST
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 Introduction
Bounds
European options
Early exercise
American options
Put-call inequality
Trading strategies

Bounds on American options

You can exercise an American option at any time before maturity

more rights with an American option than a European option, hence

Ct > ct and Pt > pt

Furthermore T2 > T1 implies that (why?)

Ct (T2 ) > Ct (T1 ) and Pt (T2 ) > Pt (T1 )

Different from European options where time to maturity can affect

both directions! Option factors

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 Introduction
Bounds
European options
Early exercise
American options
Put-call inequality
Trading strategies

Bounds on American options, cont’d

Proposition 6
For an American call option
 
St > Ct > max 0, St − K , St − Dt − Ke−r (T −t) .

Recall that for a European call (Prop. 1):

 
St − Dt > ct > max 0, St − Dt − Ke−r (T −t) .

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 Introduction
Bounds
European options
Early exercise
American options
Put-call inequality
Trading strategies

Bounds on American options, cont’d

Proposition 7
For an American put option
 
K > Pt > max 0, K − St , Ke−r (T −t) − (St − Dt ) .

Recall that for a European put (Prop. 2):

 
Ke−r (T −t) > pt > max 0, Ke−r (T −t) − (St − Dt ) .

For both calls and puts the bounds get even bigger!

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 Introduction
Bounds
European options
Early exercise
American options
Put-call inequality
Trading strategies

American options and the exercise price

Assume K1 < K2 < K3 , same underlying, same expiration date T .
Proposition 8
The prices of American call options satisfy

Ct (K1 ) − Ct (K2 ) 6 K2 − K1 ,
K − K2 K − K1
Ct (K2 ) 6 3 Ct (K1 ) + 2 Ct (K3 ).
K3 − K1 K3 − K1

Proposition 9
The prices of American put options satisfy

Pt (K2 ) − Pt (K1 ) 6 K2 − K1 ,
K − K2 K − K1
Pt (K2 ) 6 3 Pt (K1 ) + 2 Pt (K3 ).
K3 − K1 K3 − K1

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 Introduction
Bounds
European options
Early exercise
American options
Put-call inequality
Trading strategies

Early exercise of call options

Proposition 10
It is never optimal to exercise an American call option on a non-
dividend-paying stock before maturity, i.e. Ct = ct .

For an American call option on a dividend-paying stock, early exercise

may be optimal immediately before a dividend payment.

Without dividends we know that

Ct > ct > St − Ke−r (T −t) > St − K = exercise payoff

hence the value of the option is higher than the value you will get if
you exercised the option!

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 Introduction
Bounds
European options
Early exercise
American options
Put-call inequality
Trading strategies

Early exercise of put options

Proposition 11
It can be optimal to exercise an American put option on a non-
dividend-paying stock.

Never exercise an American put option on a dividend-paying stock im-

mediately before a dividend payment.
The idea in the no-dividends case:
• The maximum gain on a put is the exercise price K .
• Assume that the option is deep-in-the-money, i.e. St ≈ 0
I If you exercise you almost get the maximum gain
I If you wait:
∗ There is a chance that the stock price will increase
∗ If the stock price stays at the same level at time t + 1 you would have
earned interest on K if you had exercised at time t.
i.e. for deep-in-the-money option it is optimal to exercise before
maturity.
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 Introduction
Bounds
European options
Early exercise
American options
Put-call inequality
Trading strategies

Put-call inequality for American options

Proposition 12
For American options

St − Dt − K 6 Ct − Pt 6 St − Ke−r (T −t)
Proof in the no-dividend case:

(i) We have that Ct − Pt = ct − Pt 6 ct − pt = St − Ke−r (T −t) .

(ii) Suppose St − K > Ct − Pt and look at the following investment strategy:

t ST < K ST > K Sτ < K
Buy call −Ct 0 ST − K Cτ
Sell put Pt −(K − ST ) 0 −(K − Sτ )
Sell St St −ST −ST −Sτ
Invest K −K Ker (T −t) Ker (T −t) Ker (τ−t)
     
St − K K er (T −t) − 1 K er (T −t) − 1 K er (τ−t) − 1
−Ct + Pt > 0 >0 >0 +Cτ > 0

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 Introduction
Introduction
European options
Spreads
American options
Combinations
Trading strategies

Introduction

• We are going to look at different profit patterns which are

obtainable using options:
I A spread strategy involves taking a position in two or more options
of the same type.
I A combination strategy involves taking a position in both calls and
puts on the same stock.
• Assume that the underlying asset is a stock
I Similar results can be obtained for other underlying assets
• Only going to look at strategies involving European options
I American options may lead to slightly different outcomes because
of the possibility of early exercise.

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 Introduction
Introduction
European options
Spreads
American options
Combinations
Trading strategies

Bull spread
• Buy a call option on a stock with exercise price K1
• Sell a call option on the same stock with a exercise price K2 > K1
• Both options have the same expiration date.
• Limits the investor’s upside profit potential and the downside risk
• The investor hopes/believes that the stock price will increase
• Why not just buy a call option with strike K1 ?

The payoff:

Payoff from Payoff from Total

long call short call Payoff
ST 6 K1 0 0 0
K1 < ST < K2 ST − K1 0 ST − K1
ST > K2 ST − K1 −(ST − K2 ) K2 − K1

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 Introduction
Introduction
European options
Spreads
American options
Combinations
Trading strategies

Bear spread
• Buy a put option on a stock with exercise price K2
• Sell a put option on the same stock with a exercise price K1 < K2
• Both options have the same expiration date.
• Limits the investor’s upside profit potential and the downside risk
• The investor hopes/believes that the stock price will decline
• Why not just buy a put option with strike K2 ?

The payoff:

Payoff from Payoff from Total

long put short put Payoff
ST 6 K1 K2 − ST −(K1 − ST ) K2 − K1
K1 < ST < K2 K2 − ST 0 K2 − ST
ST > K2 0 0 0

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 Introduction
Introduction
European options
Spreads
American options
Combinations
Trading strategies

Butterfly spread
• Buy a call with a relatively low exercise price K1
• Buy a call with a relatively high exercise price K3 > K1
• Sell two calls with exercise price, K2 = 12 (K3 + K1 )
• All options have the same expiration date.
• Leads to a profit if ST ≈ K2 , gives a small loss if there is a
significant move in S
• The investor hopes/believes that large stock movements are
unlikely.
The payoff:
Payoff from Payoff from Payoff from Total
long call(K1 ) long call(K3 ) short calls Payoff
ST 6 K1 0 0 0 0
K1 < ST 6 K2 ST − K1 0 0 ST − K1
K2 < ST < K3 ST − K1 0 −2(ST − K2 ) K3 − ST
ST > K3 ST − K1 ST − K3 −2(ST − K2 ) 0

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 Introduction
Introduction
European options
Spreads
American options
Combinations
Trading strategies

Straddle

• Buy a call and a put with the same exercise price, K , and
expiration date
• If ST ≈ K the strategy leads to a loss (≈ the initial outlay), if
there is a sufficiently large move in the stock price a significant
profit will be made

The payoff:

Payoff from Payoff from Total

call put Payoff
ST 6 K 0 K − ST K − ST
ST > K ST − K 0 ST − K

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 Introduction
Introduction
European options
Spreads
American options
Combinations
Trading strategies

Strangle
• Buy a put with exercise price K1
• Buy a call with exercise price K2 > K1 , and the same expiration
date as the call
• Similar strategy to a straddle - but the stock price has to move
farther in a strangle for the investor to make a profit
• On the other hand the downside risk if ST ends up at a central
value is less with a strangle (initial outlay is lower)

The payoff:

Payoff from Payoff from Total

call put Payoff
ST 6 K1 0 K1 − ST K1 − ST
K1 < ST < K2 0 0 0
ST > K2 ST − K2 0 ST − K2

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