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Introduction

n

Options are very old instruments, going back, perhaps, to the time of

Thales the Milesian (c. 624 BC to c. 547 BC).

n

Thales, according to Aristotle, purchased call options on the entire

autumn olive harvest (or the use of the olive presses) and made a

fortune.

n

Joseph de la Vega (in “Confusión de Confusiones,” 1688, 104 years

before the NYSE was founded under the buttonwood tree) also

wrote about how options were dominating trading on the

Amsterdam stock exchange.

n

Dubofsky reports that options existed in ancient Greece and Rome,

and that options were used during the tulipmania in Holland from

1624-1636.

n

In the U.S., options were traded as early as the 1800’s and were

available only as customized OTC products until the CBOE opened

on April 26, 1973.

What is an Option?

n

A call option is a financial instrument that gives the buyer the right,

but not the obligation, to purchase the underlying asset at a pre-

specified price on or before a specified date

n

A put option is a financial instrument that gives the buyer the right,

but not the obligation, to sell the underlying asset at a pre-specified

price on or before a specified date

n

A call option is like a rain check. Suppose you spot an ad in the

newspaper for an item you really want. By the time you get to the

store, the item is sold out. However, the manager offers you a rain

check to buy the product at the sale price when it is back in stock.

You now hold a call option on the product with the strike price

equal to the sale price and an intrinsic value equal to the difference

between the regular and sale prices. Note that you do not have to

use the rain check. You do so only at your own option. In fact, if

the price of the product is lowered further before you return, you

would let the rain check expire and buy the item at the lower price.

Options are Contracts

n

The option contract specifies:

¡

The underlying instrument

¡

The quantity to be delivered

¡

The price at which delivery occurs

¡

The date that the contract expires

n

Three parties to each contract

¡

The Buyer

¡

The Writer (seller)

¡

The Clearinghouse

The Option Buyer

n

The purchaser of an option contract is buying the right to

exercise the option against the seller. The timing of the

exercise privilege depends on the type of option:

¡

American-style options can be exercised any time before

expiration

¡

European-style options may only be exercised during a short

window before expiration

n

Purchasing this right conveys no obligations, the buyer

can let the option expire if they so desire.

n

The price paid for this right is the option premium. Note

that the worst that can happen to an option buyer is that

she loses 100% of the premium.

The Option Writer

n

The writer of an option contract is accepting the obligation to have

the option exercised against her, and receiving the premium in

return.

n

If the option is exercised, the writer must:

¡

If it is a call, sell the stock to the option buyer at the exercise price

(which will be lower than the market price of the stock).

¡

If it is a put, buy the stock from the put buyer at the exercise price

(which will be higher than the market price of the stock).

n

Note that the option writer can potentially lose far more than the

option premium received. In some cases the potential loss is

(theoretically) unlimited.

n

Writing and option contract is not the same thing as selling an

option. Selling implies the liquidation of a long position, whereas

the writer is a party to the contract.

The Role of the Clearinghouse

n

The clearinghouse (the Options Clearing Corporation)

exists to minimize counter-party risk.

n

The clearinghouse is a buyer to each seller, and a seller

to each buyer.

n

Because the clearinghouse is well diversified and

capitalized, the other parties to the contract do not have

to worry about default. Additionally, since it takes the

opposite side of every transaction, it has no net risk

(other than the small risk of default on a trade).

n

Also handles assignment of exercise notices.

Examples of Options

n

Direct options are traded on:

¡

Stocks, bonds, futures, currencies, etc.

n

There are options embedded in:

¡

Convertible bonds

¡

Mortgages

¡

Insurance contracts

¡

Most corporate capital budgeting projects

¡

etc.

n

Even stocks are options!

Option Terminology

n

Strike (Exercise) Price - this is the price at which the underlying security can be

bought or sold.

n

Premium- the price which is paid for the option. For equity options this is the price

per share. The total cost is the premium times the number of shares (usually 100).

n

Expiration Date– This is the date by which the option must be exercised. For stock

options, this is usually the Saturday following the third Friday of the month. In

practice, this means the third Friday.

n

Moneyness – This describes whether the option currently has an intrinsic value above

0 or not:

¡

In-the-Money –

n

for a call this is when the stock price exceeds the strike price,

n

for a put this is when the stock price is below the strike price.

¡

Out-of-the-Money –

n

for a call this is when the stock price is below the strike price,

n

for a put this is when the stock price exceeds the strike price.

n

American-style - options which can be exercised before expiration.

n

European-style - options which cannot be exercised before expiration.

The Intrinsic Value of Options

n

The intrinsic value of an option is the profit (not net profit!) that

would be received if the option were exercised immediately:

¡

For call options: IV = max(0, S - X)

¡

For put options: IV = max(0, X - S)

n

At expiration, the value of an option is its intrinsic value.

n

Before expiration, the market value of an option is the sum of the

intrinsic value and the time value.

n

Since options can always be sold (not necessarily exercised) before

expiration, it is almost never optimal to exercise them early. If you

did so, you would lose the time value. You’d be better off to sell the

option, collect the premium, and then take your position in the

underlying security.

Profits from Buying a Call

Selling a Call

Profits from Buying a Put

Selling a Put

Combination Strategies

n

We can construct strategies consisting of

multiple options to achieve results that aren’t

otherwise possible, and to create cash flows that

mimic other securities

n

Some examples:

¡

Buy Write

¡

Straddle

¡

Synthetic Securities

The Buy-Write Strategy

n

This strategy is more

conservative than

simply owning the

stock

n

It can be used to

generate extra

income from stock

investments

n

In this strategy we

buy the stock and

write a call

The Straddle

n

If we buy a straddle, we

profit if the stock moves

a lot in either direction

n

If we sell a straddle, we

profit if the stock

doesn’t move much in

either direction

n

This straddle consists of

buying (or selling) both

a put and call at the

money

Synthetic Securities

n

With appropriate combinations of the stock and options,

we can create a set of cash flows that are identical to

puts, calls, or the stock

n

We can create synthetic:

¡

Long Stock — Buy Call, Sell Put

¡

Long Call — Buy Put, Buy Stock

¡

Long Put — Buy Call, Sell Stock

¡

Short Stock — Sell Call, Buy Put

¡

Short Call — Sell Put, Sell Stock

¡

Short Put — Sell Call, Buy Stock

n

The reasons that this works requires knowledge of Put-

Call Parity

Put-Call Parity

n

Put-Call parity defines the relationship between put

prices and call prices that must exist to avoid possible

arbitrage profits:

n

In other words, a put must sell for the same price as a

long call, short stock and lending the present value of the

strike price (why?).

n

By manipulating this equation, we can see how to create

synthetic securities (in the above form it shows how to

create a synthetic put option).

Put-Call Parity Example

n

Assume that we find the following conditions:

¡

S = 100 X = 100

¡

r = 10% t = 1 year

¡

C = 16.73 P = ?

Put-Call Parity Example

n

Q: What is the value of the put?

n

A: 7.21

n

To see that the put must be priced at 7.21, first note that the portfolio that we have

created results in exactly the same payoffs, under all conditions, as a put option with a

strike price of 100. By the law of one price, all assets which provide the same cash

flows must be priced the same or arbitrage will force them to be the same. The net

cash outlay for our portfolio is 7.21, so the put price must be 7.21.

n

Suppose that the put was priced at 8.00. In this case we could purchase our portfolio

(for 7.21) and sell the put (for 8). At expiration, if the stock is below 100 the stock

would be put to us at 100 (a cash outflow), we would sell the bond for 100 (a cash

Synthetic Long Stock Position

n

We can create a

synthetic long

position in the

stock by buying a

call, selling a put,

and lending the

strike price at the

risk-free rate until

expiration

Synthetic Long Call Position

n

We can create a

synthetic long

position in a call

by buying a put,

buying the

stock, and

borrowing the

strike price at

the risk-free rate

until expiration

Synthetic Long Put Position

n

We can create a

synthetic long

position in a put

by buying a call,

selling the stock,

and lending the

strike price at the

risk-free rate

until expiration

Synthetic Short Stock Position

n

We can create

a synthetic

short position

in the stock

by selling a

call, buying a

put, and

borrowing the

strike price at

the risk-free

rate until

expiration

Synthetic Short Call Position

n

We can create a

synthetic short

position in a call

by selling a put,

selling the stock,

and lending the

strike price at the

risk-free rate

until expiration

Synthetic Short Put Position

n

We can create a

synthetic short

position in a put

by selling a

call, buying the

stock, and

borrowing the

strike price at

the risk-free

rate until

expiration

Option Valuation

n

The value of an option is the present value of its

intrinsic value at expiration. Unfortunately,

there is no way to know this intrinsic value in

advance.

n

The most famous (and first successful) option

pricing model, the Black-Scholes OPM, was

derived by eliminating all possibilities of

arbitrage.

n

Note that the Black-Scholes models work only

for European-style options.

Option Valuation Variables

n

There are five variables in the Black-Scholes

OPM (in order of importance):

¡

Price of underlying security

¡

Strike price

¡

Annual volatility (standard deviation)

¡

Time to expiration

¡

Risk-free interest rate

Variables’ Affect on Option Prices

Call Options

¡

Direct

¡

Inverse

¡

Direct

¡

Direct

¡

Direct

Put Options

¡

Inverse

¡

Direct

¡

Direct

¡

Inverse

¡

Direct

Variable

– Stock Price

– Strike Price

– Volatility

– Interest Rate

– Time

Option Valuation Variables: Underlying Price

n

The current price of the underlying security is

the most important variable.

n

For a call option, the higher the price of the

underlying security, the higher the value of the

call.

n

For a put option, the lower the price of the

underlying security, the higher the value of the

put.

Option Valuation Variables: Strike Price

n

The strike (exercise) price is fixed for the life of

the option, but every underlying security has

several strikes for each expiration month

n

For a call, the higher the strike price, the lower

the value of the call.

n

For a put, the higher the strike price, the higher

the value of the put.

Option Valuation Variables: Volatility

n

Volatility is measured as the annualized standard

deviation of the returns on the underlying

security.

n

All options increase in value as volatility

increases.

n

This is due to the fact that options with higher

volatility have a greater chance of expiring in-

the-money.

Option Valuation Variables: Time to Expiration

n

The time to expiration is measured as the

fraction of a year.

n

As with volatility, longer times to expiration

increase the value of all options.

n

This is because there is a greater chance that the

option will expire in-the-money with a longer

time to expiration.

Option Valuation Variables: Risk-free Rate

n

The risk-free rate of interest is the least important of the

variables.

n

It is used to discount the strike price, but because the

time to expiration is usually not more than 3 months, and

interest rates are usually fairly low, the discount is small

and has only a tiny effect on the value of the option.

n

The risk-free rate, when it increases, effectively

decreases the strike price. Therefore, when interest rates

rise, call options increase in value and put options

decrease in value.

The Black-Scholes Call Valuation Model

n

At the top (right) is the

Black-Scholes valuation

model for calls. Below

are the definitions of d

1

and d

2

.

n

Note that S is the stock

price, X is the strike

price, o is the standard

deviation, t is the time to

expiration, and r is the

risk-free rate.

The Black-Scholes Call Valuation Model

The Black-Scholes-Merton option pricing

model says the value of a stock option is

determined by six factors:

S, the current price of the underlying

stock

y, the dividend yield of the underlying

stock

K, the strike price specified in the

option contract

r, the risk-free interest rate over the life

of the option contract

T, the time remaining until the option

contract expires

o, (oiyµo) uni)n io tnr rpi)r

The Black-Scholes Call Valuation Model

The price of a call option on a single share

of common stock is: C = Se–yTN(d1) –

Ke–rTN(d2)

The price of a put option on a single share

of common stock is: P = Ke–rTN(–d2) –

Se–yTN(–d1)

The Black-Scholes Call Valuation Model

In the Black-Scholes-Merton formula, three common

fuctions are used to price call and put option prices:

e-rt, or exp(-rt), is the natural exponent of the

value of –rt (in common terms, it is a discount

factor)

ln(S/K) is the natural log of the "moneyness"

term, S/K.

N(d1) and N(d2) denotes the standard normal

probability for the values of d1 and d2.

In addition, the formula makes use of the fact that:

N(-d1) = 1 - N(d1)

B-S Call Valuation Example

n

Assume a call with the following variables:

¡

S = 100 X = 100

¡

r = 0.05 o = 0.10

¡

t = 90 days = 0.25 years

The Black-Scholes Put Valuation Model

n

At right is the Black-

Scholes put valuation

model.

n

The variables are all the

same as with the call

valuation model.

n Note: N(-d

1

) = 1 - N(d

1

)

B-S Put Valuation Example

n

Assume a put with the following variables:

¡

S = 100 X = 100

¡

r = 0.05 o = 0.10

¡

t = 90 days = 0.25 years

Naked Options - Margin

Method I

a.Calculate the option premium for No. of shares

b.Compute 0.20 (MP per share) x (No. of shares)

c.Compute the amount by which the contract is out of money

A+B -C

Method II

No.of shares x Option Premium per share + 0.10 (MP per share)x100

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