Chapter 15

Options Markets
Outline

15.1 Options Contracts

15.2 Value of Options at Expiration OR Option payouts
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Call Option
The option to BUY a fixed quantity of an
underlying asset for a fixed price (X) by a
fixed date .
● The underlying asset can be an individual stock (i.e.
Apple, Goldman Sachs) or an index (i.e. Strait Times,
Nikkei 225, SP500, etc.).

Investors purchase call options when they

believe the underlying asset value will
increase.
BF2201 Option Markets Nanyang Business School
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Put Option
The option to SELL a fixed quantity of an
underlying asset for a fixed price (X) by a
fixed date.

Investors purchase put options when they

believe the underlying asset value will
decrease.

BF2201 Option Markets Nanyang Business School

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Each option has key contract terms:

Strike price (X) (or exercise price)

Set price to buy/sell the underlying asset
Expiration date
Last day to exercise the option.
Lot Size (i.e. number of shares)
European options can be exercised only on the
expiration date. American options can be exercised at
any time before or on the expiration date.

BF2201 Option Markets Nanyang Business School

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Option Definitions
Be familiar with these terms
Premium
Purchase price of the option
In the Money
Exercise would generate positive cash flow
Out of the Money
Exercise would generate negative cash flow
At the Money
Strike price equals underlying asset price

BF2201 Option Markets Nanyang Business School

 Example: Call Option on Nikkei 225 6
Strike X=15,000 Expires on Dec 15.
Current price for the underlying: Nikkei 225

Call option is currently “out of the money” on Oct 11 because

the closing price of Nikkei 225: 14,400 < 15,000 (strike)

BF2201 Option Markets Nanyang Business School

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Nikkei 225 Index Options
Quotes based on Oct 11th.
Dec 15th
Calls Puts
Strike
Close Vol OI IV Delta Close Vol OI IV Delta

- - 0 - - 12,625 90.00 2 0 0.26 -0.10

- - 18,595 - - 13,000 127.00 2605 37,345 0.25 -0.15

- - 32,755 - - 14,000 350.00 1 11,745 0.21 -0.36

255.00 2662 35,355 0.20 0.34 15,000 - - 3,600 - -

194.00 2002 6,313 0.20 0.27 15,250 - - 0 - -
58.00 1 0 0.20 0.11 16,125 - - 0 - -

Premium (close) for call option (X=15,000) is currently $255.

BF2201 Option Markets Nanyang Business School

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15.2 Value of Options at

Expiration.

Important distinction between:

Payoff and Profit at expiration.

BF2201 Option Markets Nanyang Business School

 Call Option: Payoff 9
Buy (long) 1 call of XYZ Corp. with expiration
March 28:
TODAY St X Cash Flow

18 FEB t=0 80 80

28 MAR t=T (expiration) 87 Payoff: + $7

Max(ST-X, 0)

Option to buy 1 XYZ share at t=T for $80.

Because XYZ closing price on 28 MAR (ST) is greater than
Strike X ($87 > $80), we exercise our right to buy XYZ.

PAYOFF for buyer of call option : Max(ST-X, 0)

BF2201 Option Markets Nanyang Business School
 Call Option: Profit 10
Buy (long) 1 call of XYZ Corp. with expiration
March 28:
TODAY St X Cash Flow

18 FEB t=0 80 80 - Premium: - $14

28 MAR t=T (expiration) 87 Payoff: + $7

Max(ST-X, 0)
Profit: -$14+$7: -$7

PROFIT for buyer of call option :

Max(ST-X, 0) – Premium

BF2201 Option Markets Nanyang Business School

 11
European call option on XYZ
Premium = $14, strike (X)= $80
BUYER

Breakeven price ST* is the

stock price at expiration
where the profit from
buying the call option
Premium equals zero.

BF2201 Option Markets Nanyang Business School

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Q1. The maximum LOSS for the buyer of a call
option is the ____________.
1. call premium Solution:
2. stock price The maximum loss to
3. stock price minus the a buyer of call is the
value of the call call premium.

4. stock price minus the This is why options are

exercise price valuable – downside is
5. exercise price limited.
6. $0 Sellers accordingly
charge a premium.

BF2201 Option Markets Nanyang Business School

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Q2. If an option is “in the money,” the owner will
always exercise - even if the final profit is
negative after exercise.
1. True
2. False
3. Not necessarily

BF2201 Option Markets Nanyang Business School

 Call Option: Payoff 14
Sell (short) 1 call of XYZ Corp. with expiration
March 28:
TODAY St X Cash Flow

18 FEB t=0 80 80

28 MAR t=T (expiration) 87 Payoff: -$7

– Max(ST – X, 0)

We write an option to buy 1 share of XYZ at t=T for $80.

We must sell one share of XYZ to our counterparty at $80 to fulfill
our obligation in the options contract. To obtain that share, we buy
XYZ stock at $87 in the spot market.

PAYOFF for seller of call option : – Max(ST – X, 0)

BF2201 Option Markets Nanyang Business School
 Call Option: Profit 15
Sell (short) 1 call of XYZ Corp. with expiration
March 28:
TODAY St X Cash Flow

18 FEB t=0 80 80 Premium: +$14

28 MAR t=T (expiration) 87 Payoff: -$7

– Max(ST – X, 0)
Profit: +$7

PROFIT for writer of a call option :

– Max(ST – X, 0) + Premium

BF2201 Option Markets Nanyang Business School

 European CALL option on XYZ 16
Premium = $14, strike (X)= $80
SELLER
Premium Breakeven price
ST* = Strike price
+ option price

Notice: This is the mirror image of the call buyer payoff and
profit diagram.
BF2201 Option Markets Nanyang Business School
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Q3. The maximum PAYOFF for the writer of a call
option is the ____________.
1. call premium
2. stock price Solution:
For the writer, ideally
3. stock price minus the the option finishes out
value of the call of the money.
4. stock price minus the
exercise price In this scenario, the
payoff = $0.
5. exercise price
6. $0 See previous figure.

BF2201 Option Markets Nanyang Business School

 Put Option: Payoff 18
Buy (long) 1 put of XYZ Corp with expiration
October 31:
TODAY St X Cash Flow

6 OCT t=0 81 80

31 OCT t=T (expiration) 75 Payoff: +$5

Max(X-ST,0)

The option to sell 1 share of XYZ at t=T for $80.

The price is lower in the spot market ($75 < $80) at t=T. Therefore,
we exercise our right to sell XYZ.

PAYOFF for a buyer of a put option : Max(X-ST,

0)
BF2201 Option Markets Nanyang Business School
 Put Option: Profit 19
Buy (long) 1 put of XYZ Corp with expiration
October 31:
TODAY St X Cash Flow

6 OCT t=0 81 80 -Premium:-$7

31 OCT t=T (expiration) 75 Payoff: +$5

Max(X-ST, 0)
Profit: -$2

PROFIT for buyer of put option :

Max(X-ST, 0) - Premium

BF2201 Option Markets Nanyang Business School

 European PUT option on XYZ 20
Premium = $7, strike (X)= $80
BUYER

Breakeven price
ST* = strike price
– options premium

BF2201 Option Markets Nanyang Business School

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Q4. The Y-intercept point of the PROFIT line for
the buyer of a put option is equal to
___________.
1. call premium
2. Strike price
3. Stock price minus the
premium
4. Strike price minus
the premium

BF2201 Option Markets Nanyang Business School

 Put Option: Payoff 22
Sell (short) 1 put of XYZ with expiration
October 31:
TODAY St X Cash Flow

6 OCT t=0 81 80

31 OCT t=T (expiration) 75 -Max(X-ST, 0)=-$5

We write an option to sell 1 share of XYZ at t=T for $80.

We must buy one share of XYZ from our counterparty at $80.
At the same time we sell the share of XYZ stock at only $75 in
the spot market.

PAYOFF for writer of put option : -Max(X-ST, 0)

BF2201 Option Markets Nanyang Business School
 Put Option: Profit 23
Sell (short) 1 put of XYZ with expiration
October 31:
TODAY St X Cash Flow

6 OCT t=0 81 80 Premium: +$7

31 OCT t=T (expiration) 75 -Max(X-ST, 0)=-$5

Profit = +$2

PROFIT for writer of put option :

Premium-Max(X-ST, 0)

BF2201 Option Markets Nanyang Business School

 European PUT option on XYZ 24
Premium = $7, strike (X)= $80
SELLER

Profit
7
60 70 80
0
90 100 110 120
-10 Payout

-20 Breakeven price

ST*= strike price –
-30 option premium

BF2201 Option Markets Nanyang Business School

 25
Q5. You write an IBM March 120 put
contract and receive a put premium of $10.
The maximum profit that you can gain from
this strategy is ___________.

Solution:
1. $120 The maximum value will
be $10.
2. $110
3. $10 See previous figure.
4. $0

BF2201 Option Markets Nanyang Business School

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Protective Put Strategy
Long stock + Long put option
1. Owner of a stock purchases a put option
2. Purpose: guarantee minimum floor on the
long stock position equal to strike price of
the put.

What are the costs/benefits of this

strategy?
Draw payoff/profit diagrams to understand

BF2201 Option Markets Nanyang Business School

 Protective Put Position at Expiration 27

(solid line) and profit (dotted line) Portfolio (C) = (A) Stock + (B) Put

ST

ST
ST – S0

The minimum
profit occurs
when ST = 0
-S0 ST - S0 - P
(solid line) and profit (dotted line)
ST – S0 + X – ST –P =
-S0 + X - P

X-ST
X-ST -P Min Profit: – S0 +X – P
0 Max Profit: Unlimited
X-P

-P

BF2201 Option Markets Nanyang Business School

 Q6. Use the previous diagrams to fill in the table 28
for protective put PAYOFF table AT EXPIRATION.

ST ≤ X ST > X
Stock ST ??? (c)
Put ??? (a) 0
Total ??? (b) ??? (d)

1. (a)=X-ST, (b)=X, (c)= ST, (d)=ST

2. (a)=0, (b)= ST, (c)=X, (d)=X
3. (a)=ST, (b)=0, (c)= ST, (d)=ST
4. (a)=X, (b)= ST-X, (c)= ST-X (d)= ST-X

BF2201 Option Markets Nanyang Business School

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Protective Put versus Stock Investment

If X = S0
Min Profit: -P
Max Profit: Unlimited

BF2201 Option Markets Nanyang Business School

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Covered Call Strategy
Long stock + Write call option

1. Owner of a stock writes a call option

2. Purpose: To collect a call premium

What are the costs/benefits of this

strategy?
Draw payoff/profit diagrams to understand

BF2201 Option Markets Nanyang Business School

 Value of Covered Call Position at 31
Expiration
(solid line) and profit (dotted line)
ST Portfolio (C) = (A) Stock + (B) Short Call

ST – S0

ST – (ST –X) = X
-S0
(solid line) and profit (dotted line) ST

C C – (ST –X)

0
ST - S0 + C X + C -S0
C - S0
= ST – S0 + C – (ST –X)
– (ST –X) Min Profit: C – S0
Max Profit: X +C - S0

BF2201 Option Markets Nanyang Business School