GROUP 7 FM 102

FM 3C

Lachica, Emilia
Batan, Jose Mari
Dimaculangan, Mitzi
Cofreros, Carl
Mejico, Daniel

Narrative Report
Using Options as Investments
CONTENTS
◦ 7.1. Essentials of options
◦ 7.2. Options pricing
◦ 7.3. Using options. Profit or loss on options
◦ 7.4. Portfolio protection with options. Hedging
7.1. Essentials of Options
 Option is a type of contract between 2 persons where one person grants the other person the
right to buy or to sell a specific asset at a specific price within a specific time period. The most
often options are used in the trading of securities.
 Option buyer is the person who has received the right, and thus has a decision to make.
Option buyer must pay for this right.
 Option writer is the person who has sold the right, and thus must respond to the buyer’s
decision.
Types of Option Contracts
Call Option
 It gives the buyer the right to buy (to call away) a specific number of shares of a specific
company from the option writer at a specific purchase price at any time up to including a
specific date.
Put Option
 It gives the buyer the right to sell (to put away) a specific number of shares of a specific
company to the option writer at a specific selling price at any time up to including a specific
date.
Option contract specifies four main items
1. The company whose shares can be bought or sold;
2. The number of shares that can be bought or sold;
3. The purchase or selling price for those shares, known as the exercise price (or strike price);
4. The date when the right to buy or to sell expires, known as expiration date.
Types of call and put options
◦ European options
◦ American options
The major advantages of investing in options
 ◦ Possibility of hedging: using options the investor can “lock in the box” his/ her return already
earned on the investment;
◦ The option also limits exposure to risk, because an investor can lose only a set amount of
money (the purchase price of option);
◦ Put and call options can be used profitably when the price of the underlying security goes up or
down.
The major disadvantages of investing in options
◦ The holder enjoys never interest or dividend income nor any other ownership benefit;
◦ Because put and call options have limited lives, an investor have a limited time frame in which to
capture desired price behavior;
◦ This investment vehicle is a bit complicated and many of its trading strategies are to complex for
the non-professional investor.

7.2 Option Pricing

Option Pricing
 Refers to the process of determining the value of a financial contract known as an "option." An
option is a derivative financial instrument that gives the holder the right, but not the obligation,
to buy or sell an underlying asset at a predetermined price.
There are two main types of options:
 Call Option: This gives the holder the right to buy the underlying asset at the strike price.
 Put Option: This gives the holder the right to sell the underlying asset at the strike price.
The intrinsic value of an option
 Is the difference between the current market price of the underlying asset and the option's
strike price. In other words, it is the value that an option would have if it were exercised
immediately.
For call options:
 Intrinsic Value of Call Option=Current Market Price of Underlying Asset−Strike Price For put
options:
 Intrinsic Value of Put Option=Strike Price−Current Market Price of Underlying Asset

The time value (TV) reflects the option’s potential appreciation and can be calculated as the
difference between the option price (or premium, Pop) and intrinsic value (IVop)
TV = Pop – IVop
Profits and losses on options depend on various factors, including the type of option (call or put), the
direction of the underlying asset's price movement, the option's strike price, the premium paid or
received, and the time remaining until expiration. Here's a brief overview of how profits and losses work
for different scenarios:
1. Call Options:
Profit for the Buyer (Long Call):
 Profit occurs when the market price of the underlying asset is higher than the sum of the
call option's strike price and the premium paid.

Profit=(Current Market Price−Strike Price−Premium Paid)×Number of

ContractsProfit=(Current Market Price−Strike Price−Premium Paid)×Number of Contracts Profit
for the Seller (Short Call):
 Profit occurs when the market price of the underlying asset is below the sum of the call
option's strike price and the premium received.
Profit=(Strike Price+Premium Received−Current Market Price)×Number of ContractsProfit=(Strike
Price+Premium Receive d−Current Market Price)×Number of Contracts

2. Put Options:
Profit for the Buyer (Long Put):
 Profit occurs when the market price of the underlying asset is lower than the sum of the
put option's strike price and the premium paid.

Profit=(Strike Price−Current Market Price−Premium Paid)×Number of ContractsProfit=(Strike

Price−Current Market Price−Premium Paid)×Number of Contracts Profit for the Seller (Short
Put):
 Profit occurs when the market price of the underlying asset is above the sum of the put
option's strike price and the premium received.

Profit=(Premium Received+Current Market Price−Strike Price)×Number of ContractsProfit=(Premium

Received Current Market Price−Strike Price)×Number of Contracts

7.3. Using options. Profit and loss on options.

 Fig.7.1 shows the intrinsic values of call and put options at expiration. However, for the investor
even more important is the question, what should be his/ her profit (or loss) from using the
option?

 In order to determine profit and loss from buying or writing these options, the premium involved
must be taken into consideration. Fig.7.2, 7.3, 7.4 demonstrates the profits or losses for the
investors who are engaged in some of the option strategies. Each strategy assumes that the
underlying stock is selling for the same price at the time an option is initially bought or written.
Each strategy assumes that the underlying stock is selling for the same price at the time an
option is initially bought or written.
Fig. 7.2 shows the profits and losses associated with buying and writing a call respectively.

Fig.7.3 shows the profits and losses associated with buying and writing a put, respectively.

The profit or loss of using options is defined as difference between the intrinsic value of the
option and option premium:

Fig. 7.4 illustrates a more complicated option strategy known as straddle. This strategy
involves buying (or writing) both a call and put options on the same stock, with the options
having the same exercise price and expiration date.
 For more precise valuation of options some fairly sophisticated options pricing models
have been developed. The most famous of them is Black-Scholes model for estimating the
fair value of the call options published by Black and Scholes in 1973.
5 main parameters used in Black-Scholes model:
1. Continuously compounded risk free rate of return expressed on the annual basis;
2. Current market price of the underlying stock;
3. Risk of the underlying common stock, measured by the standard deviation of the continuously
compounded annual rate of return on the stock;
4. Exercise price of the option;
5. Time remaining before expiration, expressed as a fraction of a year. Many active options traders
use the complex formulas of this model (see Annex 2) to identify and to trade over- and under
valuated options.

7.4. Portfolio Protection with Options. Hedging.

Hedger is an individual who is unwilling to risk a serious loss in his or her investing position and takes
the actions in order to avoid or lessen loss.
◦ Using options to reduce risk
◦ Using options to reduce losses
Hedging portfolios of shares using index options
Index option is based on stock index instead of an underlying stock.
Hedge ratio is a number of stocks to buy or sell with options such that the future portfolio
value is risk-free. The hedged portfolio consists of m purchased shares and n options
written (issued) on these shares.

Hedge ratio (HR) can be estimated using formula

Riskless (perfect) hedge is when for m and n are chosen such a values which allow in each moment
given to compensate the decrease in prices of the stocks by increase in value of options.
This meaning of hedge ratio is called as a perfect hedge ratio.