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Options the Basics

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Content

• What is option?

• Terminology

• No arbitrage

• Pricing Options

– The Binomial Option Pricing Model

– The Black-Scholes Model

Why do we study options?

The underlying concern:

Happiness = U(Cnow,Cfuture)

We are happier with more Cfuture, but we are worried about the fluctuation of

Cfuture.

In other words:

Our happiness is derived not only from current consumption but also from

future consumptions which inherently involves uncertainty. This ultimately

constitutes our risk concern over the future payoffs of assets that we own.

Because of the special payoff structure of options, holding options enables us

to adjust our risk exposure, and ultimately change our happiness level.

Who trade options?

A quote from Chicago Board Options Exchange (CBOE):

“The single greatest population of CBOE users are not huge financial

institutions, but public investors, just like you. Over 65% of the

Exchange's business comes from them. However, other participants in the

financial marketplace also use options to enhance their performance,

including:

1. Mutual Funds

2. Pension Plans

3. Hedge Funds

4. Endowments

5. Corporate Treasurers”

How big is option trading?

Figure 6.1: Total number of option contracts traded in a year in all

exchange 1973 – 1999 (Source: CBOE)

How big is option trading?

Figure 6.1: CBOE average daily trading volume 1973 – 1999 (Source: CBOE)

How big is option trading?

Figure 6.2: CBOE year-end options open-interest dollar amount (in

thousands)1973 – 1999 (Source: CBOE)

Where do we trade options?

Trading of standardized options contracts on a national exchange started

in 1973 when the Chicago Board Options Exchange (CBOE), the world's

first listed options exchange, began listing call options.

Options also trade now on several smaller exchanges, including

• New York - the American Stock Exchange (AMEX)

- the International Securities Exchange (ISE)

• Philadelphia - the Philadelphia Stock Exchange (PHLX)

• San Francisco - the Pacific Stock Exchange (PCX)

Where do we trade options?

Trading of non-standardized (tailor-made) options contracts occurs on the

Over-the-counter (OTC) market. And it is in fact bigger than the

exchange-traded market for option trading.

options or other financial assets) which are not traded on an exchange

due to various reasons (e.g., an inability to meet listing requirements).

• For such securities, broker/dealers negotiate directly with one another

over computer networks and by phone, and their activities are monitored

by the National Association of Securities Dealers.

• One advantage of options traded in OTC is that they can be tailored to

meet particular needs of a corporate treasurer or fund manager.

Standardized VS Non-Standardized

Standardized Options

• The terms of the option contract is standardized.

• Terms include:

1. The exercise price (also called the strike price)

2. The maturity date (also called the expiration date)

• For stock options, this is the third Saturday of the month in which

the contract expires, or the third Thursday of the month if the

third Friday is a holiday.

3. Number of shares committed on the underlying stocks

• In US, usually 1 contract – 100 shares of stock

Non-standardized options also involves these terms, but they can be

anything. For example, 1 contract underlies 95 shares instead of 100

shares of stock. Terms being more flexible for non-standardized options

and are traded in OTC market are the two distinct features.

Options? Terminology Arbitrage Binomial Black-Scholes

Option Quotation (standardized)

• You will see how standardized options trading would be with a quick look

of option quotation system.

• Option quotes follow a pattern that enables you to easily construct and

interpret symbols once that formula is understood.

• The basic parts of an option symbol are:

Root symbol + Month code + Strike price code

• A root symbol is not the same as the ticker symbol. Please refer to the

option chain for that ticker to find the corresponding root.

• In conjunction with the option root symbol, you can utilize the tables below

to assist you in creating or deciphering options symbols.

Option Quotation (standardized)

• Expiration Month codes:

expiring December 2006. (MSQ LY)

Options? Terminology Arbitrage Binomial Black-Scholes

What is an option contract?

• There are 2 basic types of options: CALLs & PUTs

• A CALL option gives the holder the right, but not the obligation

• To buy an asset

• By a certain date

• For a certain price

• A PUT option gives the holder the right, but not the obligation

• To sell an asset

• By a certain date

• For a certain price

• Certain date – Maturity date/Expiration date

• Certain price – strike price/exercise price

Options? Terminology Arbitrage Binomial Black-Scholes

What is an option contract?

• For example, as of Nov 1, 2005 at around 5pm, Intel was selling at $22.65

per share.

• A call option that allows the holder to buy a share of Intel at the third

Saturday of November 2005 for a price of $20 has a market price of $2.80

• ONE stock option contract is a contract to buy or sell 100 shares. Thus,

you need $280 to buy ONE such call option contract in the market.

Call Option’s payoff

• Assuming you hold ONE contract of that Calls, i.e., the call contract

allows you to buy 100 shares of Intel on the third Saturday of December

at an exercise price of $20/share.

What is your payoff if Intel at that date is:

(a) Selling @ $25

• You will be very happy. To cash in, you do two things simultaneously:

• [1] exercise your right, and buy 100 Intel at $20. Total amount

you use is $2,000.

• [2] sell 100 shares of Intel at the market price (i.e., $25/share).

Total amount you get is $2,500.

• Your payoff is $2,500 - $2,000 = $500.

(b) Selling @ $19

• You will be very sad. You would not exercise the rights. The contract

is thus expired without exercising.

• Your payoff is $0.

Options? Terminology Arbitrage Binomial Black-Scholes

Call Option’s payoff

• Exercise Price = $20/share.

• If at maturity, market Price = $25 > $20

(You exercise and get profit, the option you hold is said to be

“in-the-money” because exercising it would produce profit)

• If at maturity, market price = $19 < $20

(You do not exercise, the option you hold is said to be

“out-of-the-money” because exercising would be unprofitable)

• In general, if you hold a call option contract, you want Intel’s stock price to

skyrocket. If Intel is selling at $100, you will be really happier.

• That means, the value of a call option is higher if the underlying asset’s

price is higher than the exercise price.

• That also means, the value of a call option is zero if the underlying asset’s

price is lower than the exercise price. Whether it is $18, $19 or $2.50, it

does not matter, the call option will still worth zero.

Put Option’s payoff

• Assuming you hold ONE contract of that Puts, i.e., the put contract allows

you to sell 100 shares of Intel on the third Saturday of December at an

exercise price of $22.50/share. (current price of this option = 0.65)

What is your payoff if Intel at that date is:

(a) Selling @ $25

• You will be very sad. You would not exercise the rights. The contract

is thus expired without exercising.

• Your payoff is $0

(b) Selling @ $19

• You will be very happy. To cash in, you do two things simultaneously:

• [1] you buy 100 shares of Intel at $19, total purchase = $1,900

• [2] exercise your right, and sell 100 Intel at $22.5. Total amount

you get is $2,250.

• Your payoff is $2,250 - $1,900 = $350.

Put Option’s payoff

• Exercise Price = $22.50/share.

• If at maturity, market Price = $25 > $22.50

(You do not exercise, and the option you hold is said to be “out-of-the-

money” because exercising would be unproductive)

• If at maturity, market price = $19 < $22.50

(You exercise, and the option you hold is said to be “in-the-money”

because exercising would be profitable)

• In general, if you hold a put option contract, you want Intel to go broke. If

Intel is selling at a penny, you will be even happier.

• That means, the value of a put option is higher if the underlying asset’s

price is lower than the exercise price.

• That also means, the value of a put option is zero if the underlying asset’s

price is higher than the exercise price. Whether it is $23, $24 or $1000, it

does not matter, the put option will still worth zero.

Bunch of Jargons

Option is a derivative – since the value of an option depends on the price of

its underlying asset, its value is derived.

Call: market price>exercise price

Put: exercise price>market price

Call: market price>exercise price

Put: exercise price>market price

• Long – buy

• Short – sell

Short a call on company y – sell a call contract of company y

Bunch of Jargons

American VS European Options

An American option – allows its holder to exercise the right to purchase (if a

call) or sell (if a put) the underlying asset on or before the expiration date.

A European option – allows its holder to exercise the option only on the

expiration date.

Bunch of Jargons

(b) An index – the option is an index option

(c) A future contract – the option is a futures option

(d) Foreign currency – the option is a foreign currency option

(e) Interest rate – the option is an interest rate option

• ECMC49F will only focus on stock option. But you should know that there

are other options trading in the market. You should definitely know them

when you do interview with a firm or an i-bank for financial position. You

will fail your CFA exam if you don’t know them.

Stock options VS stocks

Let’s say you hold a option contract for GE. How does that differ from

holding GE’s stock?

Similarities:

• GE’s options are securities, so does GE’s stocks.

• Trading GE’s options is just like trading stocks, with buyers making bids and

sellers making offers.

• Can easily trade them, say in an exchange.

Differences:

• GE’s options are derivatives, but GE’s stocks aren’t

• GE’s options will expire, while stocks do not.

• There is not a fixed number of options. But there is fixed number of stock shares

available at any point in time.

• Holding stocks of GE entitles voting rights, but holding GE’s option does not

• GE has control over its number of stocks. But it has no control over its number of

options.

Notations

Strike price = X

Stock price at present = S0

Stock price at expiration = ST

Price of a call option = C

Price of a put option = P

Risk-free interest rate = Rf

Expiration time = T

Present time = 0

Time to maturity = T – 0 = T

Payoff of Long Call

If you buy (long) a call option, what is your payoff at expiration?

Strike price = X (ST - X) if ST >X

Stock price at present = S0 0 if ST < X

Profit to Call Holder at expiration

Stock price at expiration = ST

Payoff – Purchase Price

Price of a call option = C $

Payoff

Price of a put option = P

Risk-free interest rate = Rf

Profit

Expiration time = T

Present time = 0 ST

Purchase price x

Time to maturity = T – 0 = T

Payoff of Short Call

If you sell (short) a call option, what is your payoff at expiration?

Strike price = X -(ST - X) if ST >X

Stock price at present = S0 0 if ST < X

Profit to Call seller at expiration

Stock price at expiration = ST

Payoff + Selling Price

Price of a call option = C $

Price of a put option = P

Risk-free interest rate = Rf

Selling price

Expiration time = T

Present time = 0 ST

x

Time to maturity = T – 0 = T

Profit

Payoff

Payoff of Long Put

If you buy (long) a put option, what is your payoff at expiration?

Strike price = X 0 if ST >X

Stock price at present = S0 (X – ST) if ST < X

Profit to Put Holder at expiration

Stock price at expiration = ST

Payoff - Purchasing Price

Price of a call option = C $

Price of a put option = P

Risk-free interest rate = Rf

Expiration time = T Payoff

Present time = 0 ST

x Purchasing price

Time to maturity = T – 0 = T

Profit

Payoff of Short Put

If you sell (short) a put option, what is your payoff at expiration?

Strike price = X 0 if ST >X

Stock price at present = S0 -(X – ST) if ST < X

Profit to Put seller at expiration

Stock price at expiration = ST

Payoff + Selling Price

Price of a call option = C $

Price of a put option = P

Risk-free interest rate = Rf Profit

Selling price

Expiration time = T Payoff

Present time = 0 ST

x

Time to maturity = T – 0 = T

Payoff of Long Put & Short Call

If you buy (long) a put option and sell (short) a call, assuming their exercise

prices are the same, what is your payoff at expiration?

Payoff to Call seller at expiration Payoff to Put Holder at expiration

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

+

0 if ST < X (X – ST) if ST < X

$ $

Payoff

ST ST

x x

Payoff

Payoff of Long Put & Short Call

If you buy (long) a put option and sell (short) a call, assuming their exercise

prices are the same, what is your payoff at expiration?

Payoff to Call seller at expiration Payoff to Put Holder at expiration

-(ST - X) if ST >X 0 if ST >X = -(ST – X)

+

0 if ST < X (X – ST) if ST < X = (X - ST)

ST

x

Payoff

Long Put & Short Call & Long stock

If you buy (long) a put option and sell (short) a call, as well as holding 1

stock. Assuming the options’ exercise prices are the same, what is your

payoff at expiration?

+ Stock price (ST) at time T =

(X - ST) if ST < X X if ST < X

Payoff (long the stock)

$

x

ST

x

Payoff (short call & long put)

Put-Call Parity

What we just do introduces a very important concept for pricing options.

Holding a portfolio with (a) 1 stock (which costs S0)

(b) selling one call (which earns C)

(c) buying one put (which costs P)

Total value of constructing portfolio = S0 + P - C

$ is always X !!!

x

ST

x

Payoff (short call & long put)

Put-Call Parity

Total value of constructing portfolio = S0 + P – C

Get back X at maturity for sure.

Thus X discounted at the risk-free rate should equal to the portfolio value now.

Thus, S0 + P – C = X/(1+Rf)T

In words: “Current stock price plus price of a corresponding put option at exercise

price X minus the price of a corresponding call option with exercise price X is equal

to the present value of X at maturity discounted at risk-free rate.

Payoff (long the stock)

$

x

ST

x

Payoff (short call & long put)

Put-Call Parity

S0 + P – C = X/(1+Rf)T

Let’s do an exercise. What is the risk-free interest rate?

From the data below, S0 = 22.65,

05 DEC 22.50 Call sells at 0.90, C = 0.90, X = 22.50

05 DEC 22.50 Put sells at 0.65, P = 0.65, X = 22.50

Time to maturity is roughly 6 weeks. Thus, T = 6/52

We have 22.65 + 0.65 – 0.90 = 22.50/(1+Rf)6/52

Readings for next class on pricing options

sources and the lecture notes.

• Many of the course materials are drawn from

CBOE learning center Online tutorials

Click on “Options Basics” and read:

[1] Options Overview

[2] Introduction to Options Strategies

[3] Expiration, Exercise and Assignment

[4] Options Pricing 1

• There are some other online sources you may

find useful. For example, optionscentral.com.

• Check out the websites for US exchanges.

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