What are options?

A financial derivative contract that

provides a party the right to buy or sell but
not the obligation an underlying at a fixed
price by a certain time in the future
Types of Options
Call Option
An option granting the
right to buy the
underlying

Put Option
An option granting the
right to sell the
underlying
Characteristics of Options
Option price, option premium, or
premium
the amount of money a buyer pays and
seller receives to engage in an option
transaction
Characteristics of Options
Exercise price, strike price, striking price,
or strike
the fixed price at which the option holder
can buy or sell the underlying
Characteristics of Options
Expiration date

the date on which a

derivative contract
expires
Characteristics of Options
Time to expiration

the time remaining in

the life of a
derivative, typically
expressed in years
Option Pricing Dates

Trading Date
Day when option is traded
Option Pricing Dates

Premium Payment Date

Day when option
premium has to be
paid
Usually two banking
days after the trading
date
Option Pricing Dates

Exercise Date
Last day when option
writer accepts exercise
of option
Option Pricing Dates

Expiration Date
Last day when option
writer accepts exercise
of option
Option Pricing Dates

Settlement Date (European Options)

Two banking days after expiry
date
Option Pricing Dates

Settlement Date (American Options)

Two banking days after exercise
date
Principles in Pricing Options
Call options have a
lower premium, the
higher the exercise
price
Principles in Pricing Options
Put options have a
higher premium, the
lower the exercise
price
Principles in Pricing Options
Both call and put
options are cheaper
the shorter the time
to expiration
Concept of Moneyness of an Option

In-the-money (ITM)

At-the-money (ATM)

Out-of-the money (OTM)

 Concept of Moneyness of an Option
In-the-money

Option that, if
exercised, would
result in the value
received being
worth more than the
payment required to
exercise
Concept of Moneyness of an Option
At-the-money

Option in which the underlying

value equals the exercise price
Concept of Moneyness of an Option
Out-of-the money

Option that, if
exercised would
require the payment of
more money than the
value received and
therefore would not be
currently exercised
Characteristics of Options

European option
An option that can
be exercised only at
expiration
Also referred to as
European style
exercise
Characteristics of Options

American option
An option that can be
exercised on any day
through the expiration day
Also referred to as
American style exercise
Types of Financial Options
Equity Options
Options on individual
stocks
Also known as stock
options
 Types of Financial Options
Bond Options
Options in which the
underlying is a bond
Primarily traded in
over-the-counter
markets
 Types of Financial Options
Interest Rate Options

Options in which the

underlying is an
interest rate
 Types of Financial Options
Currency Options
Options that allow the
holder to buy (if a call) or
sell (if a put) an
underlying currency at a
fixed exercise rate,
expressed as an
exchange rate
 Types of Financial Options
Options on futures
Options that give the
holder the right to
enter into a long
futures contract at a
fixed futures price
 Types of Financial Options
Options on Forwards

Option on a forward
contract
Currency Option P/L Profile
Buyer of a Call
Profit (Loss) = spot rate (strike price + premium)
Write (seller) of a Call
Profit (Loss) = premium (spot rate strike price)
Buyer of a Put
Profit (Loss) = strike price (spot price + premium)
Writer (Seller) of a Put
Profit (Loss) = premium (strike price spot rate)
 Option Pricing Sensitivities (The Greek Chorus)
Delta Spot Rate Sensitivity
Delta () = premium
spot rate
As the option moves further ITM, delta rises
towards 1.0.
As the option moves further OTM, delta falls
towards zero.
The higher the delta (around 0.7, 0.8 or higher),
the greater the probability of the option expiring
in the money.
 Option Pricing Sensitivities (The Greek Chorus)
Theta Sensitivity to Time to Maturity
Theta () = premium
time

Option values increase the longer it is to maturity.

Longer maturity options have better values because it gives the

trader the ability to change his option position without losing
significant time value deterioration.

Option premiums deteriorate at an increasing rate as they

approach expiration.

Theta is not based on a linear relationship with time, but rather

the square of time.
 Option Pricing Sensitivities (The Greek Chorus)

Vega Sensitivity to Volatility

Vega = premium
volatility

If volatilities will fall sharply in the near term,

traders will write (sell) options now, hoping to
buy them back for a profit right after volatilities
fall.

This action causes option prices to fall.

 Option Pricing Sensitivities (The Greek Chorus)

Rho Sensitivity to Change in Domestic

Interest Rates

Rho () = premium
Domestic Interest Rate

A call option on foreign currency should

be bought before a rise in domestic
interest rates before the option price will
increase.
 Option Pricing Sensitivities (The Greek Chorus)

Phi Sensitivity to Change in Foreign

Interest Rates

Phi () = premium
Foreign Interest Rate
Option Payoff
Payoff of Options
Call Option
At expiration, a call option is worth either
zero or the difference between the underlying
price S and the exercise price X, whichever
is greater
Payoff has to be positive to be exercised

Payoff = max [0, S - X]

Payoff of Options
Put Option
At expiration, a put option is worth either
zero or the difference between the exercise
price X and the underlying price S,
whichever is greater
Payoff has to be positive to be exercised

Payoff = max [0, X - S]

 Minimum and Maximum Values of Options

The maximum value of a European put is

the present value of the exercise price.
The maximum value of an American put is
the exercise price.
Option Pricing and Valuation Determinants

Time Value
Time Value = Option Premium less Intrinsic Value

Intrinsic Value

Call Option = Spot Price less Strike Price

Put Option = Strike Price less Spot Price

Intrinsic Value financial gain if the option is exercised

immediately.
Time Value value of an option arising from the time left to
maturity.
Factors Affecting Option Price
Strike
Price
Time Value

Outright
Forward
Rates Option
Premium

Term

Intrinsic Value

Volatility
Three Types of Volatility

Historic Volatility

Forward-Looking Volatility

Implied Volatility
 Three Types of Volatility

Historic Volatility

Standard deviation of
the continuously
compounded return
on an asset estimated
from historical data
 Three Types of Volatility

Forward-Looking
Volatility

Recent historic
volatility adjusted for
expected market
outlook
 Three Types of Volatility

Implied Volatility

Volatility implied from

an option price using
Black-Scholes that will
equal the observed
market price of the
option
 Black-Scholes-Merton Model
A model for pricing European options on stocks,
developed by Fischer Black, Myron Scholes, and Robert
Merton in 1973.

c = S0 N(d1) X e-rT N(d2)

p = X e-rT [1 - (d2)] S[1 - N(d1)]

where
d1= ln(S/X) + [rc + (/2)]T / T
d2 = d1 - T
= annualized standard deviation of the continuously
compounded return on the stock
rc = continuously compounded risk-free rate of return
T = time
N( ) = Cumulative Normal DistributionFunction
Put-Call Parity
c0 + X / ( 1 + r )t = p0 + S0

Where:
c0 = European call option
p0 = European put option
X = risk free bond
S0 = the underlying asset
r = annual interest rate
t = time in years
Put-Call Parity
An equation expressing
the equivalence (parity)
of a portfolio of a call and
a bond with a portfolio of
a put and the underlying,
which leads to the
relationship between put
and call prices
Pricing Options
Binomial Model a model for pricing
options in which the underlying price can
move to only one of two possible new
prices
Its used for discrete time option pricing
Binomial tree a diagram representing
price movements of the underlying in a
binomial model
Kinds of Binomial Models
One Period Binomial Model
Two Period Binomial Model
N period Binomial Model
 Assumptions of Binomial Option Pricing
Model
Market is frictionless
Investors are price takers
Short selling is allowed, with full use of
proceeds
Borrowing and lending at the risk free rate
is permitted
Future stock prices will have one or two
possible values
 Hedge Ratio

H = cu - cd
S0(u d)
Synthetic Forward Contract

A contract consisting of a long call, a short

put, and a long risk free bond with a face
value equal to the exercise price minus the
forward price.
 Black Model
Model for pricing European options on
futures.
Used frequently to price interest rate
options.
 Black Model
c0 = e-r T [f0 ( T ) N(d1 ) X N(d2 )]

p0 = e-r T (X[1-N(d2)] f0 (T)[1- N(d1)]

Where
d1 = ln [f0 (T) / X] + ( 2 / 2 ) T
T
d2 = d1 - T
f0 (T) = the futures price
 Long Call (Buy a Call)
Option premium or price
Payoff
+
Profit
Payoff

0
Price of Stock at Expiration
- Strike or Exercise Price (X)

Long call or buy a call means buying a call option or the

option to buy a particular stock at a particular price in the
future called exercise price (X).
Maximum Loss: Limited to the premium paid up front for
the option
Maximum Gain: Unlimited as the market rallies
 When to Use Long Call
Bullish strategy
When the investor is bullish on the market
direction and also bullish on market
volatility
 Long Put (Buying a Put)
Price of Stock at Expiration

Payoff
+
Profit
Payoff

0
Option premium or price

-
Strike or Exercise Price (X)

Long put or buy a put means buying a put option or the

option to sell a particular stock at a particular price in the
future called exercise price (X).
Maximum Loss: Limited to the premium paid up front for
the option
Maximum Gain: Unlimited as the market sells off
 When to Use Long Put
Bearish strategy
When the investor is bearish on the
market direction and also bullish on
market volatility
 Short Call (Write a Call)
Option premium or price
Payoff
+
Profit
Payoff

0
Price of Stock at Expiration
- Strike or Exercise Price (X)

Short call or write a call means selling a call option at a

particular price in the future called exercise price (X).
Maximum Loss: Unlimited as the market goes up
Maximum Gain: Limited to the premium received for
selling the call option
 When to Use Short Call
Bearish strategy
Also known as a naked call
Very risky when the risk in risky position
for the investor is unlimited
When the investor is bearish on the
market direction and also bearish on
market volatility
 Short Put (Write a put)
Option premium or price
Payoff
+
Profit
Payoff

0
Price of Stock at Expiration
- Strike or Exercise Price (X)

Short put or write a put means selling a put option at a

particular price in the future called exercise price (X).
Maximum Loss: Unlimited as the market goes down
Maximum Gain: Limited to the premium received for
selling the put option
 When to Use Short Put
Bullish strategy
When the investor is bullish on the market
direction and also bearish on market
volatility
 Covered Call
Payoff
Option premium or price
Profit
Stock

Net with premium

Payoff

Price of Stock at Expiration

Short Call

Covered call means long on the underlying

asset and short call options
 When to Use Covered Call
Bullish strategy
When the investor owns the underlying
stock (or futures contract) and wish to lock
in the profits
Idea is to hold stock over a long period of
time and every month or so sell out of the
money call options to generate income
Example of covered call is warrant
 Example of a Covered Call
Investor bought JP Morgan stock last year at US$ 25
and its now trading at US$ 40.

Investor decides to write a call option with exercise price

US$ 45.

If the market sell off temporarily, itll still be a long way to

the original price of US$ 25 before the investor will lose
money on the underlying.

The call option will expire worthless and the investor

pocket the premium received from the spread.
 Example of a Covered Call
Investor bought Nike stock at US$ 50 per
share and wanted to generate additional
cash flow and did not believe that Exxons
stock price had much potential for a
substantial increase.

What could the investor do?

 Example of a Covered Call
Solution:

Investor can write an out of the money call option on

Nike stock at exercise price of US$ 55. The premium is
US$ 3 per share.

If the stock goes up to US$ 55 (strike price), the investor

has a US$ 5 gain (US$ 55 US$ 50) in the stock and a
US$ 3 gain (premium received) on the call option since it
expired at the money or a total gain of US$ 8.
 Covered Call
Option premium or price
Buy Stock
Payoff

$3
$0
$ 50 $ 55 Price of Stock at Expiration

Write Call
 Covered Call
Net Position of Covered Call Writing
$8
Payoff

$0
$ 50 $ 55 Price of Stock at Expiration
 Example of a Covered Call
Solution:

Scenario 2: If the stock goes down below

US$ 55 (strike price), the investor will lose
money. Loss is unlimited.