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Principles of

Options and Option Pricing

2

We sent the first draft of our paper to the Journal of Political

Economy and promptly got back a rejection letter. We then

sent it to the Review of Economics and Statistics, where it

was also rejected.

Merton Miller and Eugene Fama…then took an interest in the

paper and gave us extensive comments on it. They

suggested to the JPE that perhaps the paper was worth

more serious consideration. The journal then accepted the

paper.

- Fischer Black

3

Outline

Introduction

Option principles

Option pricing

4

Introduction

Innovations in stock options have been

among the most important developments in

finance in the last 20 years

The cornerstone of option pricing is the

Black-Scholes Option Pricing Model

(OPM)

• Delta is the most important OPM progeny to

the portfolio manager

5

Option Principles

Why options are a good idea

What options are

Standardized option characteristics

Where options come from

Where and how options trade

The option premium

Sources of profits and losses with options

6

Why Options Are A Good Idea

Options:

• Give the marketplace opportunities to adjust

risk or alter income streams that would

otherwise not be available

• Provide financial leverage

• Can be used to generate additional income from

investment portfolios

7

Why Options Are

A Good Idea (cont’d)

The investment process is dynamic:

• The portfolio managers needs to constantly

reassess and adjust portfolios with the arrival of

new information

Options are more convenient and less

expensive than wholesale purchases or sales

of stock

8

What Options Are

Call options

Put options

9

Call Options

A call option gives you the right to buy

within a specified time period at a specified

price

The owner of the option pays a cash

premium to the option seller in exchange

for the right to buy

10

Practical Example

of A Call Option

11

Put Options

A put option gives you the right to sell

within a specified time period at a specified

price

It is not necessary to own the asset before

acquiring the right to sell it

12

Standardized

Option Characteristics

All exchange-traded options have

standardized expiration dates

• The Saturday following the third Friday of

designated months for most options

• Investors typically view the third Friday of the

month as the expiration date

13

Standardized

Option Characteristics (cont’d)

The striking price of an option is the

predetermined transaction price

• In multiples of $2.50 (for stocks priced $25.00

or below) or $5.00 (for stocks priced higher

than $25.00)

• There is usually at least one striking price

above and one below the current stock price

14

Standardized

Option Characteristics (cont’d)

Puts and calls are based on 100 shares of the

underlying security

• The underlying security is the security that the

option gives you the right to buy or sell

• It is not possible to buy or sell odd lots of

options

15

Where Options Come From

Introduction

Opening and closing transactions

Role of the Options Clearing Corporation

16

Introduction

If you buy an option, someone has to sell it

to you

No set number of put or call options exists

• The number of options in existence changes

every day

• Option can be created and destroyed

17

Opening and

Closing Transactions

The first trade someone makes in a

particular option is an opening transaction

• An opening transaction that is the sale of an

option is called writing an option

18

Opening and

Closing Transactions (cont’d)

The trade that terminates a position by

closing it out is a closing transaction

• Options have fungibility

– Market participants can reverse their positions by

making offsetting trades

– E.g., the writer of an option can close out the

position by buying a similar one

19

Opening and

Closing Transactions (cont’d)

The owner of an option will ultimately:

• Sell it to someone else

• Let it expire or

• Exercise it

20

Role of the

Options Clearing Corporation

The Options Clearing Corporation (OCC):

• Positions itself between every buyer and seller

• Acts as a guarantor of all option trades

• Regulates the trading activity of members of

the various options exchanges

• Sets minimum capital requirements

• Provides for the efficient transfer of funds

among members as gains or losses occur

21

OCC-Related

Information on the Web

22

Where and How Options Trade

Options trade on four principal exchanges:

• Chicago Board Options Exchange (CBOE)

• American Stock Exchange (AMEX)

• Philadelphia Stock Exchange

• Pacific Stock Exchange

23

Where and How

Options Trade (cont’d)

AMEX and Philadelphia Stock Exchange

options trade via the specialist system

• All orders to buy or sell a particular security

pass through a single individual (the specialist)

• The specialist:

– Keeps an order book with standing orders from

investors and maintains the market in a fair and

orderly fashion

– Executes trades close to the current market price if

no buyer or seller is available

24

Where and How

Options Trade (cont’d)

CBOE and Pacific Stock Exchange options

trade via the marketmaker system

• Competing marketmakers trade in a specific

location on the exchange floor near the order

book official

• Marketmakers compete against one another for

the public’s business

25

Where and How

Options Trade (cont’d)

Any given option has two prices at any

given time:

• The bid price is the highest price anyone is

willing to pay for a particular option

• The asked price is the lowest price at which

anyone is willing to sell a particular option

26

The Option Premium

Intrinsic value and time value

The financial page listing

27

Intrinsic Value and Time Value

The price of an option has two components:

• I ntrinsic value:

– For a call option equals the stock price minus the

striking price

– For a put option equals the striking price minus the

stock price

• Time value equals the option premium minus

the intrinsic value

28

Intrinsic Value and

Time Value (cont’d)

An option with no intrinsic value is out of

the money

An option with intrinsic value is in the

money

If an option’s striking price equals the stock

price, the option is at the money

29

The Financial Page Listing

The following slide shows an example from

the online edition of the Wall Street

Journal:

• The current price for a share of Disney stock is

$21.95

• Striking prices from $20 to $25 are available

• The expiration month is in the second column

• The option premiums are provided in the “Last”

column

30

The Financial Page Listing

31

The Financial

Page Listing (cont’d)

Investors identify an option by company,

expiration, striking price, and type of

option:

Disney JUN 22.50 Call

Company

Expiration Striking

Price

Type

32

The Financial

Page Listing (cont’d)

The Disney JUN 22.50 Call is out of the money

• The striking price is greater than the stock price

• The time value is $0.25

The Disney JUN 22.50 Put is in the money

• The striking price is greater than the stock price

• The intrinsic value is $22.50 - $21.95 = $0.55

• The time value is $1.05 - $0.55 = $0.50

33

The Financial

Page Listing (cont’d)

As an option moves closer to expiration, its

time value decreases

• Time value decay

An option is a wasting asset

• Everything else being equal, the value of an

option declines over time

34

Sources of Profits and

Losses With Options

Option exercise

Exercise procedures

35

Option Exercise

An American option can be exercised at

any time prior to option expiration

• It is typically not advantageous to exercise

prior to expiration since this amount to

foregoing time value

European options can be exercised only at

expiration

36

Exercise Procedures

The owner of an option who decides to

exercise the option:

• Calls her broker

• Must put up the full contract amount for the

option

– The premium is not a downpayment on the option

terms

37

Exercise Procedures (cont’d)

The option writer:

• Must be prepared to sell the necessary shares to

the call option owner

• Must be prepared to buy shares of stock from

the put option owner

38

Exercise Procedures (cont’d)

In general, you should not buy an option

with the intent of exercising it:

• Requires two commissions

• Selling the option captures the full value

contained in an option

39

Profit and Loss Diagrams

For the Disney JUN 22.50 Call buyer:

-$0.25

$22.50

$0

Maximum loss

Breakeven Point = $22.75

Maximum profit

is unlimited

40

Profit and Loss Diagrams

For the Disney JUN 22.50 Call writer:

$0.25

$22.50

$0

Maximum profit

Breakeven Point = $22.75

Maximum loss

is unlimited

41

Profit and Loss Diagrams

For the Disney JUN 22.50 Put buyer:

-$1.05

$22.50

$0

Maximum loss

Breakeven Point = $21.45

Maximum profit = $21.45

42

Profit and Loss Diagrams

For the Disney JUN 22.50 Put writer:

$1.05

$22.50

$0

Maximum profit

Breakeven Point = $21.45

Maximum loss = $21.45

43

Option Pricing

Determinants of the option premium

Black-Scholes Option Pricing Model

Development and Assumptions of the model

Insights into the Black-Scholes Model

Delta

Theory of put/call parity

Stock index options

44

Determinants of the

Option Premium

Market factors

Accounting factors

45

Market Factors

Striking price

• For a call option, the lower the striking price,

the higher the option premium

Time to expiration

• For both calls and puts, the longer the time to

expiration, the higher the option premium

46

Market Factors (cont’d)

Current stock price

• The higher the stock price, the higher the call

option premium and the lower the put option

premium

Volatility of the underlying stock

• The great the volatility, the higher the call and

put option premium

47

Market Factors (cont’d)

Dividend yield on the underlying stock

• Companies with high dividend yields have a

smaller call option premium than companies

with low dividend yields

Risk-free interest rate

• The higher the risk-free rate, the higher the call

option premium

48

Accounting Factors

Stock splits:

• The OCC will make the following adjustments:

– The striking price is reduced by the split ratio

– The number of options is increased by the split ratio

• For odd-lot generating splits:

– The striking price is reduced by the split ratio

– The number of shares covered by your options is

increased by the split ratio

49

Black-Scholes

Option Pricing Model

The Black-Scholes OPM:

| | | |

1 2

2

1

2 1

( ) ( )

ln( / ) ( / 2)

rt

C S N d Ke N d

S K R t

d

t

d d t

o

o

o

÷

= ÷

(

+ +

¸ ¸

=

= ÷

50

Black-Scholes

Option Pricing Model (cont’d)

Variable definitions:

• C = theoretical call premium

• S = current stock price

• t = time in years until option expiration

• K = option striking price

• R = risk-free interest rate

51

Black-Scholes

Option Pricing Model (cont’d)

Variable definitions (cont’d):

• = standard deviation of stock returns

• N(x) = probability that a value less than “x” will

occur in a standard normal distribution

• ln = natural logarithm

• e = base of natural logarithm (2.7183)

o

52

Black-Scholes

Option Pricing Model (cont’d)

Example

Stock ABC currently trades for $30. A call option on ABC

stock has a striking price of $25 and expires in three

months. The current risk-free rate is 5%, and ABC stock

has a standard deviation of 0.45.

According to the Black-Scholes OPM, but should be the

call option premium for this option?

53

Black-Scholes

Option Pricing Model (cont’d)

Example (cont’d)

Solution: We must first determine d

1

and d

2

:

2

1

2

ln( / ) ( / 2)

ln(30/ 25) 0.05 (0.45 / 2) 0.25

0.45 0.25

0.1823 0.0378

0.978

0.225

S K R t

d

t

o

o

( + +

¸ ¸

=

( + +

¸ ¸

=

+

= =

54

Black-Scholes

Option Pricing Model (cont’d)

Example (cont’d)

Solution (cont’d):

2 1

0.978 (0.45) 0.25

0.978 0.225

0.753

d d t o = ÷

= ÷

= ÷

=

55

Black-Scholes

Option Pricing Model (cont’d)

Example (cont’d)

Solution (cont’d): The next step is to find the normal

probability values for d

1

and d

2

. Using Excel’s

NORMSDIST function yields:

1

2

( ) 0.836

( ) 0.774

N d

N d

=

=

56

Black-Scholes

Option Pricing Model (cont’d)

Example (cont’d)

Solution (cont’d): The final step is to calculate the option

premium:

| | | |

| | | |

1 2

(0.05)(0.25)

( ) ( )

$30 0.836 $25 0.774

$25.08 $19.11

$5.97

rt

C S N d Ke N d

e

÷

÷

= ÷

= ÷

= ÷

=

57

Using Excel’s

NORMSDIST Function

The Excel portion below shows the input

and the result of the function:

58

Development and

Assumptions of the Model

Introduction

The stock pays no dividends during the option’s

life

European exercise terms

Markets are efficient

No commissions

Constant interest rates

Lognormal returns

59

Introduction

Many of the steps used in building the

Black-Scholes OPM come from:

• Physics

• Mathematical shortcuts

• Arbitrage arguments

The actual development of the OPM is

complicated

60

The Stock Pays no Dividends

During the Option’s Life

The OPM assumes that the underlying

security pays no dividends

Valuing securities with different dividend

yields using the OPM will result in the same

price

61

The Stock Pays no Dividends

During the Option’s Life

The OPM can be adjusted for dividends:

• Discount the future dividend assuming

continuous compounding

• Subtract the present value of the dividend from

the stock price in the OPM

• Compute the premium using the OPM with the

adjusted stock price

62

European Exercise Terms

The OPM assumes that the option is

European

Not a major consideration since very few

calls are ever exercised prior to expiration

63

Markets Are Efficient

The OPM assumes markets are

informationally efficient

• People cannot predict the direction of the

market or of an individual stock

64

No Commissions

The OPM assumes market participants do

not have to pay any commissions to buy or

sell

Commissions paid by individual can

significantly affect the true cost of an option

• Trading fee differentials cause slightly different

effective option prices for different market

participants

65

Constant Interest Rates

The OPM assumes that the interest rate R in

the model is known and constant

It is common use to use the discount rate on

a U.S. Treasury bill that has a maturity

approximately equal to the remaining life of

the option

• This interest rate can change

66

Lognormal Returns

The OPM assumes that the logarithms of

returns of the underlying security are

normally distributed

A reasonable assumption for most assets on

which options are available

67

Insights Into the

Black-Scholes Model

Divide the OPM into two parts:

| | | |

1 2

( ) ( )

rt

C S N d Ke N d

÷

= ÷

Part A Part B

68

Insights Into the

Black-Scholes Model (cont’d)

Part A is the expected benefit from

acquiring the stock:

• S is the current stock price and the discounted

value of the expected stock price at any future

point

• N(d

1

) is a pseudo-probability

– It is the probability of the option being in the money

at expiration, adjusted for the depth the option is in

the money

69

Insights Into the

Black-Scholes Model (cont’d)

Part B is the present value of the exercise

price on the expiration day:

• N(d

2

) is the actual probability the option will be

in the money on expiration day

70

Insights Into the

Black-Scholes Model (cont’d)

The value of a call option is the difference

between the expected benefit from

acquiring the stock and paying the exercise

price on expiration day

71

Delta

Delta is the change in option premium

expected from a small change in the stock

price, all other things being equal:

where the first partial derivative of the call premium

with respect to the stock price

C

S

C

S

c

A =

c

c

=

c

72

Delta (cont’d)

Delta allows us to determine how many

options are needed to mimic the returns of

the underlying stock

Delta is exactly equal to N(d

1

)

• E.g., if N(d

1

) is 0.836, a $1 change in the price

of the underlying stock price leads to a change

in the option premium of 84 cents

73

Theory of Put/Call Parity

The following variables form an interrelated

securities complex:

• Price of a put

• Price of a call

• The value of the underlying stock

• The riskless rate of interest

If put/call parity does not hold, arbitrage is

possible

74

Theory of

Put/Call Parity (cont’d)

The put/call parity relationship:

(1 )

where price of a call

price of a put

option striking price

risk-free interest rate

time until expiration in years

T

K

C P S

R

C

P

K

R

T

÷ = ÷

+

=

=

=

=

=

75

Stock Index Options

A stock index option is the option

exchanges most successful innovation

• E.g., the S&P 100 index option

Index options have no delivery mechanism

• All settlements are in cash

76

Stock Index Options (cont’d)

The owner of an in-the-money index call

receives the difference between the closing

index level and the striking price

The owner of an in-the-money index put

receives the difference between the striking

price and the index level

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