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Option Trading
Euan Sinclair

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Overview
• Session One: Introduction to options, pricing and
greeks.
• Session Two: General trading principles. Volatility
measurement and forecasting.
• Session Three: The variance premium. Hedging.
Expiration trading.
• Session Four: Risk management. Some examples of
trades. Trade evaluation.

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Option Trading
Lesson One: Introduction to Options

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Session One Overview

• History of derivatives.
• General option trading philosophy.
• Payoff diagrams.
• Model independent features of options: arbitrage
relationships between various options, and options
and underlying.
• Option pricing variables and parameters.
• Deriving the Black-Scholes-Merton PDE.
• Properties of BSM solution.
• Early exercise.

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Derivatives
• A derivative is a product that derives its value
from something else.
• Somewhat poor definition as, for examples, a
stock can be said to derive its value from the
companies earnings and bonds derive value
from credit and rates.
• But the standard definition includes futures,
forwards, swaps and options.

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Fallacies of “New” and “Complex”

• Options are much, much older than stocks.
• First joint stock company was formed in 1602, the
Dutch East India Company.
• Stocks are based on an incredibly complex set of legal
contracts.
• For example, the LinkedIn form S-1 document alone
is 179 pages.

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Brief History of Derivatives

• Genesis 29: Jacob enters a forward contract for
Rachel.
• C. 600 BC: Thales buys a call option on olive presses.
• Medieval Europe: the principles of put call parity are
used to avoid money lending bans.
• 1570: The Royal Exchange begins trading forwards in
london.
• 1690: Options trade in London.

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Brief History of Derivatives

• 1720: the South Sea’s bubble leads to options being
made illegal in UK (until 1825).
• Options have also been illegal at various times in
Japan and the USA.
• By the 19th century there was an OTC option market
in the USA.
• 1973: Black-Scholes-Merton model is published.
• 1973: CBOE starts trading stock options.

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Philosophy
"Before I learned the art, a punch was just a punch, and a
kick, just a kick.
After I learned the art, a punch was no longer a punch, a
kick, no longer a kick.
Now that I understand the art, a punch is just a punch and
a kick is just a kick."
-- Bruce Lee

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Philosophy
"Before I learned options, a call was just a call, and a
put, just a put.
After I learned the art, a call was no longer a call, a put,
no longer a put.
Now that I understand the art, a call is just a call and a
put is just a put."
-- Me

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Philosophy
• Math doesn’t matter intrinsically, it is just a means to an end.
• All good solutions should be (somewhat) intuitive and robust
with respect to the math used to formulate the problem.
• Our ideas will be expressed first through arbitrage
relationships, then “dirty math” and (maybe) then through
real math.

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Options
• An option gives the holder the right but not the
obligation to do something.
• A call confers the right to buy the underlying at a
certain price, the strike price.
• A put confers the right to sell the underlying at a
certain price, the strike price.

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Options
• European options can only be exercised at a single
time, the expiration date.
• American options can be exercised at a time prior to
the expiration date.
• Almost all exchange listed options are American.
• European options were basically invented by BSM
because they had an analytic solution, and weren’t
really like the ones that traded in America so they
needed a new name.

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Options
• There are also Asians, which settle to an average.
• Russians, which are eternal lookback options.
• Bermudans, which can be exercised at a set of specific
dates.
• Parisians, which are barriers that kick in when underlying
has spent a certain time beyond the barrier.
• Hawaiians, an Asian option with an American exercise
feature.

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Options
• Many other exotic options “exist”.
• But most rarely trade or have never even been traded at all.
• Mainly an example of the worst kind of financial mathematics.
• Even when they exist, their “trading” generally consists of one-
time selling to a customer (at an enormous markup).
• General rule: simplest products trade is the most complicated
ways.
• Futures: market makers use many “tricks” such as book
stacking, spoofing, flipping and stop hunting.
• Vanilla options: capturing edge is easy and traders are
differentiated by risk management.
• Exotic Options: edge comes from structuring, legal and sales.

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Disclaimer
• The types of market making techniques that are legal differ
enormously from country to country and market to market.
• What is “smart market making” in one place might be market
manipulation in another.
• Always check with your compliance officer before doing
anything that could be interpreted as manipulation.

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Payoff Diagram: A Call

45

40

35

30
Option Payoff

25

20

15

10

0
60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140
Underlying Price

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Payoff Diagram: A Put

45

40

35

30
Option Payoff

25

20

15

10

0
60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140
Underlying Price

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Combinations
• The piecewise linearity of options means it is easy to
construct combinations of puts and calls to express
any view.
• Aside: Be very careful about overusing this feature.
• Being right on a single view is hard enough.

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Example: A Straddle
45

40

35

30

25
Payoff

20

15

10

0
60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140
Underlying Price

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Model Independent Relationships

American>European

• American options are worth more than Europeans.

• If you don’t choose to exercise an American option IS a
European option.
• So it is European plus some extra value.

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Call<Underlying
• If you exercise, you get the underlying.
• So if C>S just sell the call and buy the underlying.
• At expiration our profit is C-expiration value of
call + profit on stock.
• Above the strike this is C –(Sf-X)+(Sf-S0)=C+(X-S0)
• Below the strike this is C-0+(Sf-S0).

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American Put<Strike
• If you exercise, you get the strike minus the current price.
• So the highest value the option can ever have is the strike
(if S=0).

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C(X1)>Call(X2)
(if X1<X2)
There will be times when a lower strike call can be
exercised and the higher strike call cannot.

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Put/Call Parity

• Puts and calls are “the same thing”

• Specifically
C-P=S-X exp(-rT)
• Proof: Form a portfolio of long put, short call and one
share.
Instrument Initial Value Value at Expiration
If S<X If S> X

Long P(X) P(X) (X-S) 0

Short C(X) -C(X) 0 -(S- X)

Long Stock S S S

Total Portfolio S+ P(X) -C(X) X X

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Put/Call Parity: Proof by Example

• This concept was used to avoid usury laws in Europe in
the middle ages.
• Impressive, as exponentiation was discovered in 1683
and algebra didn’t reach Europe until 1500’s.
• So let’s buy a castle…
We need a loan of X that will be repaid at T with interest of r.
Rearranging we get
X=exp(rT)(S-C+P)
At T, this has to be worth S exp(rT) (value of castle plus accrued
interest).

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Put Call Parity Implications

• A call is like borrowing money to buy stock and a put. I.E it is
a limited downside leveraged position in the underlying.
• The payoff from any instrument can be replicated with the
other three.
• For call and put to have equal value the strike price must be
the forward price.
• The relationship does not hold for American options.
Because we can’t be sure of the duration of a short option
position.

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Put Call Parity Implications

• If we can make a bullish option position into a bearish
option position by adding stock, then we should also be
able to directionally neutralize an option.
• So P/C parity is an important precursor to volatility
trading.

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Option Pricing: Inputs

• Underlying price.
• Strike: distance between strike and price define the option.
• Rates : rates are the discount factor for cash flows.
• Dividends: income from the stock which affects its future
value.
• Time.
• Volatility.

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Option Pricing: Inputs

• Why not return?
• Surely if m>0 calls will be worth more and puts less?
• Refer back to put/call parity.
C-P=S-X exp(-rT)
• If you believe a positive drift leads C to increase, it also
means P must increase.
• So positive drift leads puts and calls to increase?
• Contradiction.

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Black-Scholes-Merton
• As S (the underlying) increases, C (the call) does as well.
• So we can create a hedged portfolio by selling h shares
short. P  C  hS

• For a small move in the underlying we want

dP dC
 h 0
dS dS

(literally what we mean by hedged)

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Black-Scholes-Merton
• Next, assume the underlying changes by a small
amount, so the portfolio changes by
C (St 1 )  C (St )  h(St 1  St )

• Applying Taylor expansion to the first term we get

𝜕𝐶 𝜕2𝐶 2
𝜕𝐶
𝐶 𝑆 + 𝑆𝑡+1 − 𝑆𝑡 + 2 𝑆𝑡+1 − 𝑆𝑡 +
𝜕𝑆 𝜕𝑆 𝜕𝑡
− 𝐶 𝑆 − h 𝑆𝑡+1 − 𝑆𝑡
𝜕2 𝐶 2 𝜕𝐶
• Or, after cancelling terms, 𝑆𝑡+1 − 𝑆𝑡 +
𝜕𝑆 2 𝜕𝑡

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Black-Scholes-Merton
• Even by my low standards, how can we justify second order
price expansion and only first order in time?
• First, price changes are much more impactful.
• For example, for a one month option at 30 vol, a 1% underlying
move changes the price by 16%. This is the same as the time
change over 9 days.
• Also, time is not a random variable.

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Black-Scholes-Merton
𝜕2 𝐶 2 𝜕𝐶
𝑆𝑡+1 − 𝑆𝑡 +
𝜕𝑆 2 𝜕𝑡
• In the usual notation, the change in the portfolio value
is 1 ( S  S )   
t 1 t
2

• Volatility is defined as the standard deviation of the

(log) returns
2
1
𝜎 = 𝑟𝑡 − 𝑟 2
𝑁
• On average, and approximating logs by differences
St 1  St 2   2S

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Black-Scholes-Merton
• And assuming a hedged position makes no money
(why would it?) we get

1 2 2
 S    0
2

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Black-Scholes-Merton
• So far we have made no assumptions about
normality of returns (or any other distribution).
• By using only a second order Taylor expansion we
implicitly ignore distribution moments above 2nd,
but we do need a finite 2nd moment.
• But we don’t have to do this. This is just to simplify
things.
• Now solve this equation using the final boundary
condition of the payoff.

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Aside: Risk Neutrality

• Generally people are risk averse.
• This means they will accept a smaller certain amount over a
risky bet with a higher average payout.
• For example, they will take $4 over a 50/50 bet where they
win $10 or win nothing.
• A risk neutral person would be indifferent. All they want to
do is to maximize expected value.
• In our case, we have shown that the option is valued as if
there was no difference between the hedge and the
uncertain payoff of the option.

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Risk Neutrality: An Alternative Approach

• We know drift/returns are irrelevant to option

pricing.
• All we need is that S is assumed to grow at only the
risk free rate.
• This isn’t true in the real world and doesn’t mean
anyone has a neutral attitude to risk.
• But if you assume otherwise you can be arbed.

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Risk Neutrality: Simple Example

• A forward contract: an agreement to buy or sell
something at a set time in the future.
• This is priced to avoid arbitrage NOW and only
involves interest and carry rates.
• Ideas about asset appreciation are irrelevant but
clearly both parties will have a view on this.

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Risk Neutrality: General Approach

• In general we can value any financial contract as the
discounted value of its expected value.
𝑉𝑎𝑙𝑢𝑒 = exp −𝑟𝑇 × 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑎𝑦𝑜𝑓𝑓
• For a call

𝐶 = exp −𝑟𝑇 × 𝑝 𝑧 max 𝑆 − 𝑋, 0 𝑑𝑧

• Where p() is the risk neutral distribution of prices.

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Solution for European Options

• The option price is essentially an interpolation between the
stock price and the bond price.

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Option Value
• I.T.O the equations…

𝐶 = 𝑆𝑁 𝑑1 − 𝑋𝑒𝑥𝑝 −𝑟𝑇 𝑁 𝑑2

N() is cumulative normal distribution.

𝑆 𝜎2
𝑙𝑛 𝑋 + 𝑟 + 2 T
𝑑1 =
𝜎 𝑇
𝑑2 =𝑑1 -𝜎 𝑇

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Option Value
• The interpolation interpretation also tell us what the
terms “mean”.
• A call is a part (𝑁 𝑑1 ) of the stock and a part
(−𝑒𝑥𝑝 −𝑟𝑇 𝑁 𝑑2 ) of the cash/bond.
• 𝑁 𝑑1 is the amount of stock we are exposed to.
• 𝑁 𝑑2 is the amount of cash we are exposed to. i.e.
what we need to deliver at expiration.

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Option Value
• 𝑁 𝑑2 is the amount of cash we are exposed to. i.e. what we
need to deliver.
• Alternatively, 𝑁 𝑑2 is the probability we need to pay out on
the option.
• 𝑁 𝑑2 is the probability of finishing in the money.
• NO!!!!!!!!!!!!!!!

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Option Value
• This interpretation is only true in a risk-neutral world; a
world that doesn’t exist.
• In the real world, the probabilities are mainly driven by
drift, something we have no interest in (as a pricing
variable) or significant ability to predict.
• Never use options to make probabilistic statements about
the real prices.

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“Greeks”
• “Greeks” is the collective term for partial derivatives (in the
mathematical sense) of the option price.
• Can be calculated either analytically or numerically.
• Volatility traders generally quantify their positions i.t.o. Greek
exposure.

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Delta
• Delta is the partial derivative of the option price w.r.t.
underlying.
Δ𝑐𝑎𝑙𝑙 = 𝑒𝑥𝑝 −𝑟𝑡 𝑁 𝑑1

Δ𝑝𝑢𝑡 = −𝑒𝑥𝑝 −𝑟𝑡 𝑁 −𝑑1

P/C parity implies
Δ𝑐𝑎𝑙𝑙 − Δ𝑝𝑢𝑡 = 𝑒𝑥𝑝 −𝑟𝑡

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Delta
• Delta is the tangent of the option price Vs Underlying graph.

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Delta Vs Time/Vol

• At infinite time (or volatility) call delta goes to one

and put delta to zero.
• At high volatility, the stock can go much higher but
is bounded below.

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Delta Misconceptions
• Delta IS the partial derivative of the option price w.r.t. the
underlying.
• Delta IS the hedge ratio.
• Delta IS NOT probability of finishing in the money. First, in risk
neutral world this is N(d2). Second, risk neutral world isn’t the
real world.
• ATM delta is close to 0.5 but calls will be slightly higher.

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Gamma
• Gamma is the partial derivative of the delta w.r.t.
the underlying.
• To manage delta, must know gamma.
𝑒𝑥𝑝 −𝑟𝑡 𝑛 𝑑1
Γ𝑐𝑎𝑙𝑙 = = Γ𝑝𝑢𝑡
𝑆𝜎 𝑡
• Gamma is highest for ATM short-dated options
(actually slightly below the actual ATM strike).
• Indeed, traders usually refer to short dated options
just as “gamma”.

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Gamma Vs Spot

• Unsurprisingly, delta looks a lot like a cumulative

normal distribution and gamma looks a lot like a
normal distribution.

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Gamma Vs Time/Vol Out of the Money Option

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Gamma Vs Time/Vol At the Money Option

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Theta
• Theta is the partial derivative of the option price w.r.t.
time.
• Normally expressed so short option premium has
negative theta, and in daily units.
𝑆𝜎𝑛 𝑑1
𝜃𝑐𝑎𝑙𝑙 = − − 𝑟𝑋𝑒𝑥𝑝 −𝑟𝑇 𝑁 𝑑2
2 𝑡
𝑆𝜎𝑛 𝑑1
𝜃𝑝𝑢𝑡 = − + 𝑟𝑋𝑒𝑥𝑝 −𝑟𝑇 𝑁 −𝑑2
2 𝑡

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Theta
• First term (same for puts and calls) is the time decay, the
amount the option declines because volatility has less time
to act.
• Second term is often misunderstood (or just ignored).
𝜃𝑐𝑎𝑙𝑙 − 𝜃𝑝𝑢𝑡 = 𝑟𝑋𝑒𝑥𝑝 −𝑟𝑇
(From P/C parity discussion)

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Theta
𝜃𝑐𝑎𝑙𝑙 − 𝜃𝑝𝑢𝑡 = 𝑟𝑋𝑒𝑥𝑝 −𝑟𝑇

• From P/C parity discussion we know a long call and short put has
no volatility exposure.
• But it does have carry, the cost of holding the strike value in cash.
• Theta just allocates this carry across calls and puts according to
the chance of each finishing in the money.

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Theta Vs Spot

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Vega
• Vega is the partial derivative of the option price w.r.t. volatility.
• Inconsistent with the assumption of constant volatility, but very
important to traders.

𝑉𝑒𝑔𝑎𝑐𝑎𝑙𝑙 = 𝑆𝑛 𝑑1 𝑡 = 𝑉𝑒𝑔𝑎𝑝𝑢𝑡

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Vega Vs Spot

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Vega Vs Time

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Minor Greeks: Rho

• Rho is the partial derivative of the option price w.r.t. interest rates.
• Inconsistent with the assumption of constant rates.
• Usually ignored by traders, as it is managed at the firm level by
treasury.
• Generally scaled to be dollar change for a 1% move in rates.
𝜌𝑐 = 𝑇𝑋𝑒𝑥𝑝 −𝑟𝑇 𝑁 𝑑2
𝜌𝑝 = −𝑇𝑋𝑒𝑥𝑝 −𝑟𝑇 𝑁 −𝑑2

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Secondary Greeks
• From just looking at equations or graphs it is clear that the
greeks also have derivatives.
• E.g. the derivative of delta w.r.t. volatility, the derivative of Vega
with respect to time etc.
• Many books and authors want you to think it is vital to know the
exact form of all of these.
• Not really true.
• You need to know they exist.
• But no trading or risk management ideas are dependent on
these actual equations.

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Secondary Greeks
• Any professional level trading or risk system will
show these greeks, but detailed understanding
of their characteristics isn’t really essential.
(We will return to this when we look at risk
management).
• B.T.W. There is no standard nomenclature for
these derivatives.
• E.G. The derivative of delta with respect to
volatility is variously called “vanna”,
“DdeltaDvol”, “DdelV” or even “alpha”,
depending on who the trader learned from.

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Early Exercise
• Failing to exercise correctly is just a way to leave money on the
table.
• You exercise early if what you will receive is worth more than
what you forego.
• For example, when exercising a call you get the stock but you
miss out on any remaining optionality.
• Compare the alternatives and choose the better one.

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Exercising a Put on a Stock

• Exercised to avoid the interest costs of holding the shares until
expiration.
• Underlying is $100,we own the 120 put. T=30 days r= 5%.
• If we don’t want to change our short delta position in the
market we can either
• Hold the option
• Sell the option and sell the underlying
• Exercise the option

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Exercising a Put on a Stock

• Exercise and invest the cash. This earns interest=$120 x
0.05 x 30/365 = $0.49
• By not exercising we forgo this money so we should
exercise if the option is trading less than 49c above
intrinsic.
• Note: Sometimes we need to consider the call price as
well if we would need to buy it to cover risk.

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Early Exercise of Equity Calls

• Turning a call into a share is a way to get dividend.
• Exercise as close as possible to the record date.
• Exercise-> get intrinsic and div but lose time value.
• Hold-> value the option against ex div price and a day later.

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Early Exercise of Calls on Futures

• Turning a call into a long future is a way to avoid paying
interest.
• Exercise-> can buy futures and not have to pay interest on
the option premium.
• So exercise if interest income is more than time value.
• Need to check every day.

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Session Two Preview

• General principles of trading: edge, variance, breadth,
selection methods.
• Volatility measurement.
• Volatility forecasting and why not to bother too much with
it.
• Implied volatility.

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