1.

INTRODUCTION TO OPTIONS

WHAT IS A FINANCIAL OPTION?

Financial contract that gives the right (but not the obligation) to buy (call option)
or to sell (put option) some amount (contract size) of some financial asset
(underlying asset), at a predetermined price (strike price), and at (European-
style option) or until (American-style option) a future date (expiration date).

Note: the right to buy/sell is the distinction between an option and a future/forward.

The holder of the option does not have to exercise this right.

The underlying asset can be a real asset (may be not only financial asset)

Strike price = Exercise price  the price in the contract

SELL – PUT OPTION

OPTION

BUY – CALL OPTION

American options  Can be exercised at any time up to the expiration date;

European options  Can be exercised only on the expiration date itself.

There is:

 European Call
 European Put
 American Call
 American Put

There are four types of participants in options markets:

 Buyers of calls;
 Sellers of calls;
 Buyers of puts;
 Sellers of puts.

In the exchange-traded equity option market, one contract is usually an agreement

to buy or to sell 100 shares.

Would we prefer a European option or an American Option?

 European options are usually easier to analyze than American option;

 Some of the properties of an American option are frequently deduced form
those of its European counterpart.
 An American Option: the price of an American is lower;
 We never go wrong if we choose an American instead of an European.

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  But if we choose the European option, we might choose wrong.
 European and American options are the same, if the European option has an
expiration date of today.

EXAMPLES OF OPTIONS:

EXAMPLE 1: EXAMPLE 2: EXAMPLE 3:

Option to buy 100 shares of Option to sell 100 shares of Option to buy 100 shares of
Microsoft at $30 on 15/Dec/2021. Microsoft at $30 on 15/Dec/2021. Microsoft at $30 until 15/Dec/2021.

Option to buy = Call option Option to sell = Put option Option to sell = Call option

100 = contract size 100 = contract size 100 = contract size

Microsoft shares = underlying asset Microsoft shares = underlying asset Microsoft shares = underlying asset

15/Dec/2021 = Expiration date 15/Dec/2021 = Expiration date 15/Dec/2021 = Expiration date

on 15/Dec/2021 = European Option on 15/Dec/2021 = European Option on 15/Dec/2021 = American Option

EXAMPLE 4:

3-month American put option on 100 shares of Intel with strike price of $20.

What does this option give you?

Gives the right to sell 100 shares of Intel at $20 each and I have three months to do that (in/during three months/at any
date over the next 3 months)

OPTIONS vs FORWARDS/FUTURES

FORWARD/FUTURES OPTIONS CONTRACT:

 Only the seller/holder of short position has as an
obligation to trade the underlying asset.
In this contract both parties (buyer/holder of
 The buyer/holder of long position has the right,
long position and seller/holder of short
i.e he has the option to trade the asset or not.
position) have the obligation to trade the
 If the buyer decides to exercise his right to trade
underlying asset at the expiration date.
the asset, the seller is obligated to be
counterpart of that transaction.

EXAMPLE 1:

Bob negotiates with Deutsche Bank a forward contract to buy 100 shares of Microsoft on 15/Dec/2021, with a forward
price of $30.
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Bob has the long position and Deutsche Bank has the short position.

What will happen on 15/Dec/2021?

If you were Bob, would you want to have the long position in the forward or the call option? Why?

The call option, because the option to buy at $30 is better than the obligation to buy at $30.

If you were Deutsche Bank, would you want to have the short position in the forward or the call option? Why?
3
Even though in both situations Deutsche Bank is obliged to sell, the forward would be preferred, since Bob will only
exercise the option when it’s advantageous to him and, consequently, disadvantageous to Deutsche Bank.
POSITION, PAYOFFS AND PROFIT

OPTIONS POSITIONS:
There are two sides to every contract option contract:

 Investor who has taken the long position- has bought the option;
 Investor who has taken the short position – has sold the option;
o Receives cash up front;
o But has potential liabilities later;
o His profit or loss is the reverse of that for the purchaser on the option.

OPTIONS PAYOFF:
It is useful characterize a European option in terms of its payoff to the
purchaser of the option.
The initial cost of the option is then not included in the calculation.
The option payoff is the cash flow generated by the option contract at the
expiration date (European option) or at the exercise date (American option).

Notation:
K: strike price

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T: expiration date (measured in years from today), which makes today date
0)

St : price of the underlying on date t

Determine the payoff at expiration (T) for each of the 4 option

positions (as a function of the yet unknown ST )

t is a future date (i.e. t>0) then the exact

CALL PAYOFF value of St is unknown today (date 0)

The payoff of a call option depends on whether it is exercised or not:

The payoffs are symmetric between long and short positions (add up to
zero), since there are only two parties involved: one party’s profit, is the
other party’s loss.

As today (date 0) , the actual value of the payoff is unknown since S t will
only be known at date T>0.

In theory, the payoff for a long call position can be negative if the
option is exercised when ST < K;
 The asset can be bought in the market cheaper (ST) than through the
exercise of the call (K);
 But why would the holder of the long position choose to exercise the
option in those circumstances, when we can choose to not exercise?
He isn’t act rationally.

Because the holder of the long position chooses when to exercise the
option, he will choose whatever gives him the biggest payoff:
 exercise when ST > K, yielding a payoff of ST-K >0
 do not exercise when ST ≤ K yielding a payoff of 0 (instead of a
payoff ST – K < 0 if he exercised the option).

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The maximum between the amounts is 0;
The minimum between K and ST are 0;

(+) ST – K  before ST, there is a positive

sign, so the slope is positive

If the S0 is to the left to the strike point 

the option is in the money;

If the S0 is to the right of the strike point

 the option is out of the money

PUT PAYOFF
The payoff of a put option, as function of the exercise decision is:

6
For the same exercise decision, this is the symmetric of the call option
payoff.

However, the optimal exercise decision of a put option will be different:

 exercise when ST < K (can sell for K via option exercise instead of
selling for ST on the market) , yielding a payoff of K-ST > 0;
 do not exercise when ST
 do not exercise when ST ≥ K, yielding a payoff of 0.

After factoring in the optimal exercise decision, the payoff the long put is
not the symmetric of the payoff of the long call.

Long PUT
Max (K – ST)  there is a negative slope.
There is a negative exercise.

7
 Short put:
Anyone’s volunteer to have a
position where they have to
put money;

This isn’t making a long call equal to a short put:

- If we have a long call, we decide;
- If we have a short put, we don’t decide.

OPTIONS PREMIUM
The options contract is asymmetric:
 the payoff of long position is never negative;
 the payoff of a short position is never positive;

Therefore, the buyer of an option (long position) has to pay the seller
(short position) a premium, i.e. a price:
 this gives the opportunity to someone with a short position obtaining a
profit if the option is not exercised;

Since the payoff and the option premium

occur at different points in time, this
definition of the option profit does not take
For a short position: into account the time value of the money;
Options profit = Payoff + premium
For a long position:
Options profit = Payoff – Premium

Options profits:

8
We need to have a payoff big enough to cover however we pay (the
premium)

premium

MONEYNESS, INTRINSIC AND TIME VALUE

MONEYNESS
At time t an option is said to be:
IN-THE-MONEY (ITM)  if its (hypothetical) exercise at date t generated
a positive payoff;

OUT-OF-THE-MONEY(OTM)  if its exercise at date t generated a

negative payoff;

When the time comes to take the exercise decision for real, an option
should only be exercised if it is ITM:

In the absence INTRINSIC AND TIME VALUE

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 ct = the price of a call option at date t
pt = the price of a put option at date t

The price of an option at date t can be decomposed in two components:

Intrinsic value: Time value:

The option payoff if the expiration date The difference between the option price at date t
was at date t (and so the exercise and its intrinsic value at the same date;
decision had to be taken at date t); if
Comes from the possible future evolution of the
there is no time to maturity;
underlying asset’s price (ST) until the expiration
The exercise decision had to be made date T>t.
immediately.

Call Option OTM

With IV=0, if I had to take the decision now I won’t exercise
With:
C0 > 0  Correct
C0 < 0  Doesn’t make sense
C0 = 0  Because there is a value, doesn’t make sense
 The intrinsic value is never negative.

 Because the option payoff is non-linear (there is a kink at the

strike price) a potential favorable evolution in the asset’s price
(increase for calls, decrease for puts) will have a bigger impact on the
payoff than a potential unfavorable evolution in the asset’s price.

Therefore, in general the time value is positive.

 But there are exceptions:

o A put option on a nearly bankrupt firm (deep ITM put);
o A call option when the underlying asset distributes a dividend;

(in the money can be negative)

 The time value of American options is never negative:

10
An in-the-money American option must be worth at least as much as
its intrinsic value because the holder has the right to exercise
immediately.
Often it is optimal for the holder of an in-the-money American option
to wait rather than exercise immediately.

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EXAMPLES OF TIME VALUES AND INTRINSIC VALUE (1):

Consider the call option, on 100 shares of Microsoft with a strike price of $30 and expiration on 15/Dec/2021.

Suppose that Microsoft trades today at: (i) $30; (ii)$25; (iii) $35

CASE (i) $30 CASE (ii) $25

Exercising the call today would generate a Exercising the option today would generate a payoff of ($20-$30) * 100
payoff of ($30-$30) * 100 = $0 and so is = - $500 and so is OTM:
ATM:
Intrinsic Value is max ($25-$30,0)*100 =$0
Intrinsic Value is max ($30-$30,0)*100 =$0
Should the time value be positive? YES!(although smaller) ) (same
Therefore, the option price comes only from argument case (i)
the time value;

Should the time value be positive? YES! CASE (iii) $35

If the price increases above $30 by the Exercising the option today would generate a payoff of ($35-$30) * 100
expiration date, the option will be exercised = $500 and so is ITM:
and generate a positive payoff; Intrinsic Value is max ($35-$30,0)*100 =$500
But if the price decreases below $30 by the Should the time value be positive? YES!
expiration date, the option will not be
exercised and will generate a 0 payoff. Because this time the call is ITM, if the price drops form $35, we lose
money;
So, the expected payoff is positive: we have
a safety net because we are not forced to However, the loss potential is limited to the intrinsic value of $500, if the
exercise the option; price drops below $30 and the option is not exercised;

by the contrary, the gain potential is unlimited, which outweighs the loss
potential

EXAMPLE 1.1

Suppose that Microsoft will pay a dividend of $10 per share tomorrow.

Once the dividend is distributed, the price will drop by$10.

If the option is OTM or ATM, the time value should still be positive:

 it’s less likely, but still possible, that the option will be exercised at the expiration date;
 And there is nothing to lose (the intrinsic value is 0)

However, of the option is ITM, the time value may be negative:

 Now, there is something to lose (the intrinsic value is $500);

 Even though the loss potential is limited, and the gain potential is unlimited, it might be difficult to recover from a
$10 drop until expiration (i.e. the likelihood of an unfavorable evolution in the underlying asset’s price is too big)

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 STOCKS SPLITS
Options are protected against:
 Stock splits:
o Occurs when the existing shares are “split” into more shares;
o E.g. each old share is replaced by 5 new shares;
o If nothing happens, a stock split will be better to the stock put;

 Reverse stock splits -e.g. each 3 old shares are replaced by 1 new
share;
Because a stock split does not change the assets or the earning ability of a
company, we should not expect it to have any effect on the wealth of the
company’s shareholders.
A 5-to-1 stock split causes the price to drop by 80% (to 20% of the old
price), which would be extremely unfavorable to call holders and extremely
favorable to put holders;
 to cancel out the effect of the stock split on option prices, the strike
price is adjusted by the same factor, and the contract size is adjusted
by its inverse;
 In this example, the new strike price would be 20% of the original
strike price, and the new contract size would be 5 times the original
contract size;

SETTLEMENT
The payoff of an option can be materialized in one of two ways, depending
on the settlement:

Physical settlement: Financial settlement:

One party pays the strike price to the other; The long position holder receives the cash
equivalent of the payoff form the short position
And receives the underlying asset in return.
holder;
Physical settlement is the common practice, except when the underlying
asset has no physical existence (e.g. stock indices)

EXAMPLES OF SETTLEMENT

Consider a put option with K=$30 and a contract size of 100 and that ST = $35.

Under physical settlement the long position holder delivers 100 units of the underlying asset and receives $3,000 from
the short position holder.

Under financial settlement the long position holder receives (30-25)*100 = $500 from the short position holder and
doesn’t deliver the underlying asset.

UNDERLYING ASSETS
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In theory, anything can be used as an underlying asset.
But the most common underlying assets are:
 Stocks;
 Stock indices;
 Currencies;
 Futures;
 Interest rates;
 Commodities;
Included foreign currencies and future contracts as well as stock and stock
indices.

OTC vs. EXCHANGED-TRADED MARKETS

EXCHANGE-TRADED MARKET:
 A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange.
 Standardized contracts are traded, bosting liquidity at the expense of
contract flexibility;
 Arranged in order to minimize counterpart risk (margin system)

OVER-THE COUNTER MARKET (OTC):

 Banks, other large financial institutions, fund managers, and
corporations are the main participants in OTC derivatives markets.
 Traditionally, participants in the OTC derivatives markets have
contacted each other directly or have fund counterparties for their
trades using an interdealer broker.
 Non-standardized contracts are traded, improving contract flexibility
at the expense of liquidity.
 Over-the-counter options on foreign exchange and interest rates are
particularly popular.
 The chief potential disadvantage of the over-the counter market is
that the option writer may default – the purchaser is subject to some
credit risk.
 In an attempt to overcome this disadvantage, market participants
(and regulators) often require counterparties to post collateral.

PROPERTIES OF STOCK OPTIONS

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 INTRODUCTION

DISCRETE COMPOUNDING

The future value of $1 invested at the interest R for n years and

annual interest compounding is
n
1∗(1+ R)

If interest is compounded m times a year, the future value becomes:

m∗n
R
1∗(1+ )
m
(If m=2, R/m is the monthly interest rate)

EXAMPLE:

The future value of $100 compounded annually at the rate R=4% for n=2.5 years is:
2.5
100∗(1+0.04 ) =$ 110.30

If it’s compounded quarterly (m=4) it is:

4∗2.5
0.04
100∗(1+ ) =$ 110.46
4

CONTINUOUS COMPOUNDING
In the limit, when m →∞  interest is compounded continuously

(Compounding interest every fraction of a second)

Assuming continuous compounding, the future value of $1 becomes:

m∗n
R R∗n
lim (1+ ) =e
m→∞ m

If, instead of the future value, we are interest on the present value, then
we discount $1 instead of compounding it.

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 Since discounting is inverse operation of compounding, the present value
of $1 n years from now is:

1 −R∗n
R∗n
=e
e
So, if the $100 are compounded continuously, it’s future value is:
0.04∗2.5
100 e =$ 110.52

CONVERTING DISCRETE TO CONTINUOUSLY COMPOUNDED

RATES

To convert the discrete compounding interest rate Rm (interest

compounded m times a year) into a continuously compounded interest rate
RC we equate:

m∗n RC
R RC n R
(1+ m ) =e ⟺ RC =m∗ln (1+ m )⟺ R m=m∗(e m −1)
m m

EXAMPLE (cont):

The continuous compounding interest rate that is equivalent to a 4% annually compounded interest rate
is:

0.04
RC =1∗ln (1+ )=3.9221%
1

0.039221∗2.5 2.5
To confirm: 100∗e =$ 110.30=100∗(1+0.04 )

FACTORS AFFECTING OPTION PRICES

We assume that:
 There are some market participants, such as large investment banks;

16
  The market participants are prepared to take advantage or arbitrage
opportunities disappear very quickly (there is no arbitrage
opportunities).

ct = price of European call option on date t (years from today)

Ct = price of American call option on date t
pt = price of European put option on date t
Pt = price of American put option on date t
K = strike price
T = time to expiration date (in years from today)
St = price of the underlying asset on date t

σ = volatility of the underlying asset’s continuously compounded rate of return

D = dividend payed
r = continuously compounded risk-free interest rate

OPTION PRICE AT EXPIRATION

The price of the option at the expiration date is trivial: it’s equal to the
payoff

c T =CT =max (S T −K , 0)≡ IV T ⇒ TV T =0

pT =PT =max(K −S T , 0)≡ IV T ⇒ TV T =0

 At the expiration, there is only intrinsic value (which

corresponds to the option payoff);
 There is no time value because we reached the expiration date

(and so there is no more time left for the price of the underlying asset
to change before the exercise decision has to be taken)

There are six factors affecting the price of a stock option:

1. The current stock price, S0
2. The strike price, K
3. The time to expiration, T

4. The volatility of the stock price, σ

5. The risk-free interest rate, r

17
 6. The dividends that are expected to be paid

What happens to option prices when there is a change to one of the

factors, with all the other factors remaining fixed?

Factors affecting the option price: St

∂ ct ∂C t ∂ pt ∂ Pt
>0 >0 <0 <0
∂ St ∂ St ∂ St ∂ St

If a call option is exercised at some future time, the payoff will be the
amount by which the stock price exceeds the strike price.

The higher St is  the more likely it is that ST will be high as well

And the higher ST (stock price increase) is:
 the more valuable is the option to buy the asset at a fixed price K
(call option);
 The less valuable is the option to sell the asset at a fixed price K (put
option);

Factors
affecting the
option price: K

∂ ct ∂ Ct ∂ pt ∂ Pt
<0 <0 >0 >0
∂K ∂K ∂K ∂ St

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The higher the strike price:
 the higher the price at which we can buy the asset in a call option –
the call option becomes less valuable (which is bad);
 The higher the price at which we can sell the asset in a put option –
the put option becomes more valuable (which is good)

Factors affecting the option price: T (expiration date)

∂ ct ∂ Ct ∂ pt ∂ Pt
=? >0 =? >0
∂T ∂T ∂T ∂ St

The value of American options increase with the time to expiration:

 an American option with expiration in 2 months has all the exercise
opportunities of an option expiring in 1 month, and more;
 the extra exercise opportunities cannot hurt the option value;

But the effect of the time to expiration on the price of European options
is uncertain:
 on the one hand, a longer time to expiration makes bug changes in
the price of the underlying asset more likely
 because losses are limited but gains are unlimited, the expected
result from those big changes is positive for both types of options,
 but, on the other hand, a longer time to expiration:
o may be the difference between a dividend being paid during
the life of the option (which hurts call options) or not,
o decreases the present value of the strike (which hurts put
options)
 in general the time value of European options is positive, but if this
second set of factors is strong enough, the time value can end up
being negative

ATM/OTM  more time is good

ITM  more time isn’t good

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Factors affecting the option price: r (risk free interest rate)

∂ ct ∂ Ct ∂ pt ∂ Pt
>0 >0 <0 <0
∂r ∂r ∂r ∂ St

As interest rates in the economy increase, the expected return

required by investors from the stock tends to increase.
The higher the interest rate, the smaller the present value of the
strike price:
 this is good for a call holder, which may have to pay the strike price in
the future (if the option is exercised) – increase the value f call
options;
 but it is bad for a put holder, which may receive the strike price in the
future – decrease the value of put options

We are assuming that interest rates change while all other variables stay
the same.
In practice, when interest rates rise (fall), stock prices tend to fall
(rise)

Combining the effects of the interest rate increase and a stock price
decrease:
 Decrease the value of a call option;
 Increase the value of a put option;

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Factors affecting the option price: σ (volatility)
The volatility of a stock price is a measure of how uncertain we are about
future stock price movements,

∂ ct ∂ Ct ∂ pt ∂ Pt
>0 >0 >0 >0
∂σ ∂σ ∂σ ∂σ

A higher volatility makes big changes in the price of the underlying

asset more likely (increases);
Because losses are limited but gains are unlimited, this has a
positive impact on the price of all types of options;
 The owner of a call benefits from price increases but has limited
downside risk in the event of price decreases because the most the
owner can lose is the price of the option.
 The owner of a put benefits from price decreases but has limited
downside risk in the event of price increases.

Factors affecting the option price: D (dividend paid)

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 ∂ ct ∂ Ct ∂ pt ∂ Pt
<0 <0 >0 >0
∂D ∂D ∂D ∂D

Only the dividends paid during the life of the option matter.
The distribution of dividends decreases the value of the underlying
asset.
This is unfavorable for a call option and favorable for a put option.

UPPER AND LOWER BOUNDS FOR OPTION PRICES

If an option price is above the upper bound or below the lower bound, then
there are profitable opportunities for arbitrageurs.

Any reasonable option pricing model has to generate prices that remain
within these bounds.

Currently is not the case for

It is assumed that the risk-free rate is positive (r>0)
the EUR.

ARBITRAGE OPPORTUNITY
DEFINTION:
An arbitrage opportunity:
 Is the possibility of obtaining a risk-free profit with a zero
investment;
 Can be seen as a free lunch, since you can get something (at least in
probability) for nothing;

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  Is a consequence of mispricing which cannot subsist for long in the
market;
o Why? Because people are going to “eat” the lunch;
o Since the strategy to take advantage of the arbitrage opportunity
does not require any money to set up, it can be infinitely scaled;
o This means we could become a billionaire in a second;
o Unfortunately that doesn’t happen because when you try to exploit
it, you correct the mispricing that originated it.

UPPER BOUND
An American or European call option gives the holder the right to buy one
share of a stock for a certain price.
No matter what happens, the option can never be worth more than the
stock.

Upper bound on American call price

The stock price is an upper bond to the option price:

C 0 ≤ S0

Intuition: The right to buy the asset (call option) cannot be worth more
than the asset itself.
Because in some cases, there isn’t certain that we gone get the assets;

Arbitrage opportunity exists if: C 0> S 0

(Whenever the bound is violated)

There is a strategy  that we gone make money for sure

HOW DO WE FIND THE STRATEGY?

Arbitrage strategy = short call + long asset
(Based on the principle “buy the cheap, sell the expensive)

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For an option that is greater than 0:
 If the K= 0  the scenario St < K is impossible;

The price of the asset upwards – because we are buying the asset
The overall cashflow is greater than 0

τ is the exercise date of the American Option

What we have to do:

Expensive  sell  short cheap  buy  long
Buy however is too cheap;
Sell what is more expensive that was supposed to be.

Upper bound on European call price

c 0 ≤C 0
Intuition:
The additional exercise opportunities of an American option cannot have a
negative value;

Corollary:

c 0 ≤C 0 ≤ S 0
The price of the European is the lower boundary of the price of an American.

LOWER BOUND

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Lower bound on European call price
Because the worst that can happen to a call option is that it expires
worthless, its value cannot be negative.

−rT
c 0 ≥ max(S0 −K e )

−rT
S0 −K e = lower bound for the price of a European call option

Intuition:
 The call cannot have a negative value, since its payoff is
nonnegative (c 0 ≥ 0¿ ;

 And the call cannot be worth less than a forward with forward price K
−rT
(S0 −K e ) because of its added flexibility (it gives the right to buy
and not the obligation to buy);

The value of a (long) forward contract (position) that has a forward price:
If we enter in a forward contract now, we should pay 0, because the price is
set in a balance way;
The price is set on the contract;

Next week, we have the forward contract, but if we have the forward
contract, we have a forward price different;

The right to buy is more valuable;

−rT
Arbitrage opportunity if c 0 < S0 −K e

If c0 is cheap --> long call

−rT
And if S0 −K e  we short

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 −rT
Ke = the amount of money

Because there is a minus, someone is going to borrowed money from me –

this is a boundary – so this is a risk free rate deposit;

If ST > K  the call option is exercised at maturity, and it is worth ST

If ST < K  the call option expires worthless and is worth K

In absence of arbitrage opportunities, the zero-coupon bond is worth K e−rT

today.

Lower bound on American call price

The price obtained for the option (c0) will be greater than its
intrinsic value.
Because the owner of an American call has all the exercise
opportunities open to the owner of the corresponding European
call, C0 ≥ c

−rT
C 0 ≥ c 0 ≥ max(S0 −K e , 0) INTRINSIC VALUE

If it were optimal to exercise at a particular time prior to maturity C would

equal the option’s intrinsic value at the time.
It follows that it can never be optimal exercise early.

This is a corollary from the previous two results.

We can find a value that is greater than the intrinsic value.

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Lower bound on American put price
P0 ≥ max(K −S 0 ,0)
This condition must apply because the option can be exercised at any time.

Intuition:
 the put cannot have a negative value, since its payoff is
nonnegative;
 And the American put cannot be worth less than its intrinsic
value, otherwise we can buy the put option for P 0 and exercise it
immediately, obtaining its intrinsic value K-S 0;

Upper bound on American put price

For a call there isn’t a maximum payoff

The payoff of a put equals to the maximum: (K-S T,0)

The maximum of a put is when ST=0  P0 ≤ K

Intuition:
The American put option cannot be worth more than its maximum payoff K,
which is obtained when S0 =0.

Arbitrage Opportunity when P0 > K

Upper bound on European put price

P0 ≥ p 0

27
Intuition:
The additional exercise opportunities of an American option cannot have a
negative value.

At maturity the option cannot be worth more than K.

It cannot be worth more than the present value of K today:
−rT
p≤K e
If this were not true, an arbitrageur could make a riskless profit by
writing the option and investing the proceeds of the sale at the risk-free
interest rate.

Lower bound on European put price

−rT
A lower bound for the price is: ( K e −S 0 ¿

−rT
p0 ≥ max(K e −S 0 ,0)

A right to sell is more value than the expiration to sell.

Intuition:

 The put cannot have a negative value, since its payoff is nonnegative;
 And the put cannot be worth less than a short position in a forward
with forward price K because of its added flexibility (it gives the right
to sell and not the obligation to sell).

Arbitrage opportunity

If p0 < K e−rT −S 0

28
Upper and lower bound on call option prices

The expressions in blue are the bounds when information about the option
price that constitute the tighter bounds are not available.
Upper and lower bounds on call option prices

It is never optimal to exercise an American call option on a non-

dividend-paying stock before the expiration date.

REASONS
1. Insurance that it provides:
A call option, when held instead of the stock itself, in effect insures
the holder against the stock price falling below the strike price.
Once the option has been exercised and the K has been exchanged
for the stock price, this insurance vanishes.

2. Time value of money:

From the perspective of the option holder, the later the strike price is
paid out the better.

Because American call option are never exercised early when there are no
dividends, they are equivalent to European call options, so that C=c:

−rT
LOWER BOUND: max ( K e −S0 , 0)

UPPER BOUND: S0

29
 The IV line is always below the lower
bound:
 This forces the price of a
option always be higher than
the intrinsic value;
 So the time value is never
below.

Variation of price of an American or European call option on a non-

dividend-paying stock with the stock price (S0):
The curve moves in the direction to up and left, when there is an increase in
the interest rate, time to maturity or stock price volatility.

The Time value is the maximum distance.

Upper and lower bound on put option prices

It can be optimal to exercise an American put option on a non-dividend-
paying stock early.
Indeed, at any given time during its life, the put option should always
be exercised early if it is sufficiently deep in the money.

A put option, when held in conjunction with the stock, insures the holder
against the stock price falling below a certain level.

30
 A put option is different from a call option
It may be optimal for an investor to forgo this insurance and exercise early
in order to realize the strike price immediately.

In general, the early exercise of a put option becomes more

attractive as:
 S0 decreases;
 r increases;
 The volatility decreases;

Bounds for European and American put options when there

are no dividends:

Variation of price of an American put option with stock price:

Curve moves up and right when the time to maturity or stock price
volatility increases or when the interest rate decreases:

31
 American put price

S0
 Provided that r>0, it is always optimal to exercise an American put
immediately when the stock price is sufficiently low.
 When early exercise is optimal, the value of the option is K-S 0.
 The curve representing the value of the put therefore merges into the
put’s intrinsic value, K-S0.
 Because there are some circumstances when it is desirable to exercise
an American put option early, it follows that an American put option is
always worth more than the corresponding European put option;
 And because an American put is sometimes worth its intrinsic value, a
European put option must sometimes be worth less than its intrinsic
value.

The curve representing the relationship between the put price and the stock
price for a European option must be below the corresponding curve for an
American option.

32
Point B – at which the price of the option is equal to its intrinsic value, must
represent a higher value of the stock price than point A, because the curve
B is below curve A.

Point E is where S0=0 and the European put price is K e−rT .

PUT – CALL PARITY

 Relationship between the price of a European call option, the
price of a European put option and the underlying stock price.

The price of European calls and puts with the same characteristics (same
underlying asset, strike price and expiration date) obeys the following
relationship:
−rT
c0+ K e = p 0+ S 0

PUT-CALL PARITY
Long call + deposit = long put + long asset

Considering 2 portfolios:

 Long call and risk-free deposit of K e−rT

o Portfolio value = c 0 + K e−rT
 Long put and long asset:
o Portfolio value = p0 + S0

Show that these portfolios generate the same payoff in all possible
scenarios:

33
Since the payoff of the two portfolio is the same in every scenario, they
have to be worth the same:
−rT
c0+ K e = p 0+ S 0

otherwise there is an arbitrage opportunity.

CALL, PUT AND ASSET REPLICATION

From the put-call parity it’s easy to see how we can replicate the following
positions:
−rT
Long call=long put+ longasset + risk−free borrowing of K e
−rT −rT
c0+ K e = p 0+ S 0 ⟺ p0 + S 0−K e

−rT
Long put=long call+ short asset +risk −free deposit of K e
−rT −rT
c0+ K e = p 0+ S 0 ⟺ p0 =c 0−S0 + K e

−rT
Long asset =long call +short put+risk −free deposit of K e
−rT −rT
c0+ K e = p 0+ S 0 ⟺ S 0=c 0−S0 + K e

EFFECT OF (DISCRETE) DIVIDENDS

Supposing that we know that the underlying asset will pay dividends with a
present value of PV(D) during the life of the option (the dividends that will
pay are known) …

34
 If we remove those dividends from today’s price, the dividend-adjusted
price is:
'
S0 =S 0−PV (D)
'
Everything that we saw until now stands with S0 =S 0−PV (D) instead of S0.

Now, a long position in the asset also involves a risk-free borrowing

of an amount PV(D), to be repaid with the dividends receive:
Way to “kill” the effect of the dividends.

Assuming that the dividend is paid at only one date τ , in which case
−rT
PV ( D )=D e …
…the put-call parity becomes:
−rT −rT
c0+ K e = p 0+ S 0−D e

EARLY EXERCISE
If an American option isOTM at expiration , anyone whoexercised
it before expiration would regret having done so

EXAMPLE:

Consider:

 An American call with a strike ok K=$25 and expiration in T=1 year;

 That the spot price of the underlying asset during is currently S0=$40, meaning the call is deep ITM;
 That you want to buy the underlying asset during the next year and hold it for the long run;
 Two scenarios for ther underlying asset’s price in 1 year:
i. $60 (the option expires ITM);
ii. $20 (the option expires OTM)

If the option expires ITM, exercising early or at expiration is always equivalent: you end up owning the asset, and
paying $25 for it (the strike);
35
The payoff may be different, but it only represents how much you saved by buying the asset through option
exercise instead of at the market price of the moment; it does not represent a cash amount you receive (for that
we have to sell the asset immediately after exercise, but that isn’t the goal here);
 EARLY EXERCISE OF AMERICAN CALLS

If the underlying asset does not pay If the underlying asset pays dividends
dividends until expiration, the early exercise until expiration, then it may be
of an American call is never optimal: optimal to exercise the American call
immediately before an ex-dividend
C 0=c 0 date.
Intuition: Intuition:
 delaying the exercise decreases the present 36
 Delaying the exercise past an ex-
value of the (strike) price paid by the asset dividend date will make the call
(delaying is good); holder miss the opportunity to
 there is always possibility of the call being collect the dividend, which may not
EARLY EXERCISE OF AMERICAN PUTS
If an American put is deep ITM, early exercise is optimal.
Intuition:
 Delaying the exercise decreases the present value of the price
received by the asset (delaying is bad);
 but there is always the possibility of the put being OTM at expiration,
in which case the put holder would regret his decision to exercise
early (delaying is good);
 when the option is deeply ITM, there is little chance that it will end
OTM and so the first effect dominates (and the option should be
exercised early).

It is never optimal to exercise an American put right before an ex-

dividend rate.
 if the put holder waits a little longer, he will collect the dividend.

3. TRADING STRATEGIES
OPTIONS STRATEGIES
What can be achieved when an option is traded in conjunction
with other assets?
We already analyzed the payoff and profit profiles form the 4 basic option
positions: long call, short call, long put and short put.
All of them exhibit a kink at the strike price:

37
  this is what allows us to obtain very interesting payoff profiles by
combining different option positions on the same underlying asset.

Strategies involving options can have one of two goals:

 to hedge the risk of one of the positions in the strategy;
 to speculate based on an expectation about the future evolution of
the price of the underlying asset;

We will only cover strategies where all options have the same expiration
date:
o but there are strategies where options have different expiration dates
(known as calendar spreads)

SKETCHING THE PROFIT PROFILE OPTION STRATEGIES

The building blocks for the option strategies will be long and short positions
on calls, puts and the underlying asset.

Each of the se basic positions has a distinct payoff/profit profile as a function

of ST:

Long asset:

A straight line with positive slope (+45º)

S0
ST
Short asset:
A straight line with a negative slope (-45º).

S0
Long call: ST

For ST < K an horizontal straight line (0º) and for S T ≥

K a straight line with positive slope (+45º).

38

K ST
Short call:
For ST < K an horizontal straight line (0º) and for S T ≥
K a straight line with negative slope (-45º).
K ST

Long put:
For ST < K a straight line with negative slope (-45º)
and for ST ≥ K an horizontal straight line (0º)

K ST
Short put:
For ST < K a straight line with positive slope (+45º)
and for ST ≥ K an horizontal straight line (0º).
K ST

So, basically, we always have straight lines with either

0º, +45º or -45º slope, to which we assign the values
0, +1 and -1 respectively.
SUMMARY OF THE PAYOFFS AND PAYOFF PROFILE SLOPES FOR
EACH BASIC POSITION:

The payoff profile corresponds to the number that is multiplying the variable
ST.

39
There are a number of different trading strategies involving a
single option on a stock and the stock itself:

When mixing the basic positions in an option strategy, we have to keep in

mind that we will have as many straight line segments as the number
of different strikes used in the strategy +1.

MAKING A STRATEGY:
1. If we make a strategy with a short asset position (1 unit) we don’t
have any strikes (there are no options) and there is only one straight
line segment.

2. If we add to the above a long position on 1 call with a strike of

$60, we will now have a strategy with 2 segments because we have
one option with one (different) strike;
a. the first segment os for ST < 60 and;
b. the second segment for ST ≥ 60.

3. If we further add to this strategy a short position on 2 puts with a

strike of $ 60 we still have two segments because, despite having
two different options in the strategy, there is only one different strike,
$60 (all options have the same strike).

4. Finally, adding a short position on 2 calls with a strike pf $50 will

give us a third segment because we now have 2 different strikes, $50
and $60:
a. the first segment is for ST < 50;
b. the second is for 50 ≤ ST < 60 and
c. the third is for ST≥60.

To know what is the slope the resulting option strategy, we have to

look at the slope (in terms of 0,1 and -1) of each of the strategy components
on that specific segment, and add them up.

Then we translate the 0,1 and -1 to straight lines with 0º, +45º and
-45º slopes, respectively, from which we can sketch the profit profile of
the strategy.

 We know find not just 0, and ± 1, but also ± 2 ,±3 and so on. The slope
90 n
of the straight line is ( )º where n is the 0, ± 1, ±2 ,±3 and so on.
|n|+1

40
Dashed line:
Shows the relations between profit and the
stock price for the individual securities
constituting the portfolio;

Solid line:
Shows the relationship between profit and
the stock price for the whole portfolio.
The profit have the same general shape
as the profit for short put, long put,
long call and short call.

The put-call parity provides a way of understanding why this so:

−rT
p+ S0 =c+ K e +D p = price of na European Put

S0 = stock price
A long position in a European put combined with a c = price of a European call
long position in the stock price is equivalent to a
K =strike price of both call and put
long European call position + a certain amount
r = risk-free interest rate
−rT
(K e + D) of cash. T= time to maturity of both call and put

D = present value of the dividends

Rearranged to become: anticipated during the life of the
options
−rT
S0 −c=c + K e + D− p

41
A long position in a stock combined with a short position in a European call
is equivalent to a short European put position + a certain amount ( K e−rT + D)
of cash.

HEDGING STRATEGIES

Protective put
(Long position in a put combined with long position in a stock):

Combines: long asset and long put

Goal: hedge a long asset position against price decreases
Payoff and profit (0/1)
(Assuming all positions taken at t=0)

Break-even point: ST −S0− p 0=0 ⟺ S T =S 0 + p0

Is when the profit on the segment is equal to 0.

When is enough to cover the cost of the put: ST – S0 = p0
Minimum profit: K−S 0− p0

The straight represents the minimum price guaranteed.

Maximum profit: unlimited

The investment strategy involves buying a European put option on a stock

and the stock itself.
 The long position guarantees the worst-case price at which we
can sell the asset, without limiting the upside potential of a long
asset position (unlike a short forward position would do)

42
  The cost of the protection is the price (premium) paid for the
put;
 When the protection is not used (put is not exercised) the profit is
lower than that of a naked (unprotected) long asset position because
of the protection cost;
 More protection requires a put with a higher strike (higher
worst-case selling price), which is more expensive;
 This means a smaller worst-case loss at the expense of lower profits if
things go well and the protection is not used.
Graph with
different straights:

The green is more

protective;

The profits are

lower, but the
We
protection is
higher.

can choose different levels of protection by choosing the straight.

More protection  increasing the straight

43
EXAMPLE:

An investor bought 100 shares of Microsoft some time ago( not today) at $25.

Meanwhile, the Microsoft stock price increased to $30 (= S0 ) so at the moment the investor has a potential profit of
$5 a shares.

The investor believes that the stock price will continue to increase in the next 3 months but wants to protect his
current potential profit of $5.

What can he do?

The investor can take (should buy) a long put position over 100 Microsoft shares with expiration in 3 months, and
strike K=$30:

 by doing that he guarantees a minimum selling price of $30 for his shares;
 but he has to pay the price of protection.

Assuming this option costs $3 (per unit of underlying asset), the profit profile in 3 months per unit of the
underlying asset is:

Note: the investor is able to guarantee a minimum profit of $2 per share:

 this is not an arbitrage opportunity because this is the result of the favorable price movement before the
long put was bought (the investor starts from a profit of $5 and not from $0);
 the price movement could just as easily have been negative!
 the investor can only guarantee a $2 profit instead of $5 because of the cost of protection ($3)

Protective call:
(Short position in a stock combined with long position in a call)

Combines: short asset and long call

Goal: hedge a short asset position against price increases

Payoff and profit (-1/0):

44
 Break-even point: −ST + S 0−c 0 =0 ⟺ S T =S 0+ c 0

Minimum profit: −K + S0 −c 0

Maximum profit: S0 −c 0 (“unlimited”)

 The long call position locks the worst-case price at which we can
buy back the asset, without limiting the upside potential of a short
asset position (unlike a long forward position would do);
 The cost of the protection is not used (call is not exercised) the
profit is lower than a naked (unprotected) short asset position
because of the protection cost.
 More protection requires a call with lower strike, which is
more expensive;
 This means a smaller worst-case loss at the expense of lower profits if
things go well and the protection is not used.

EXAMPLE:

An investor has an expectation that the Microsoft price will fall over the next year.

Therefore, he wants to open, today, a short position in Microsoft, currently trading for $30.

However, he is afraid of the consequences of being wrong in his expectations.

What can he do to limit his losses?

The investor can add to his short asset position a long call position over Microsoft shares with expiration in 1 year:

 the strike price should be chosen according to the level of protection desired;
 the smaller the strike, the higher the protection in case of things going wrong, but the higher its 45
cost.

Assuming the investor chooses a call with K=35 costing $2.5, the profit profile in 1 year (per unit of the
Writing a covered put:
(Short position in a put combined with short position in a stock)
Combines: short put short asset (symmetric of protective put)
Goal: hedge a short put position against decreases in the price of the
underlying asset or hedge a short asset position against small increases in
the price of the underlying asset.

Payoff and profit (0/-1):

Break-even point: −ST + S 0 + p 0=0 ⟺ ST =S0 + p0

Minimum profit: unlimited

Maximum profit: −K + S0 −c 0

From the perspective of protecting the short put position:

 with a short position we are exposed to losses if the price of
the underlying asset stays below the option’s strike price at
the expiration date;
o in that case we will be forced to purchase the asset for a price
above its market price;
o and getting rid of the asset at its market price will generate a
loss;
 in this context, shorting the asset today guarantees the price at
which we sell the asset, we expect to receive from the exercise
of the put (we already sold it);

From the perspective of protecting the short asset position:

 this strategy can also be used to protect a short asset position
against small increases in the price of the asset;
 what we receive from selling the put increases the profit when the
option is not exercised (which is the case when the price of the
underlying asset increases above the option’s strike price);
 this can compensate a small loss in the short asset position;

46
  the advantage (compared to the protective call) is that this
protection does not cost extra money (you actually get paid to
set up the protection);
 the disadvantage is that it does not limit losses (only attenuates
them) while limiting the upside potential;

Writing a covered call:

(Long position in a stock combined with short position in a call)
Combines: short call and long asset (symmetric of protective call)
Goal: hedge a short call position against increases in the price of the
underlying asset or hedge a long asset position against small decreases
in the price of the underlying asset.

Payoff and profit (0/-1):

Break-even point: ST −S0 +c 0=0 ⟺ S T =S 0+ c 0

Minimum profit: −S0 + c0 (unlimited )

Maximum profit: K−S 0+ c 0

47
From the perspective of protecting the short call position:
 with a short call position we are exposed to losses if the price of the
underlying asset stays above the option’s strike price at the
expiration date:
o in that case we will be forced to sell the asset for a price below
its market price;
o when we buy the asset at its market price to sell it when the
short call is exercised, we will suffer a loss;
 in this context, buying the asset today guarantees the price at which
we buy the asset, and we expect to have to sell due to the exercise
of the call (because we already bought it);

From the perspective of protecting the long asset position:

 this strategy can also be used to protect a long asset position against
small decreases in the price of the asset;
 what we receive from selling the call increases the profit when the
option is not exercised (which is the case when the price of the
underlying asset decreases below the option’s strike price);
 this can compensate a small loss in the long asset position;
 Advantage:(compared to the protective put) is that this protection
does not cost extra money (because we actually get paid the call
price when setting up this protection)
 Disadvantage: this does not limit losses (only attenuates them) while
limiting the upside potential;

Long
range forward(bull spread):
Combines: long asset, long put K1 and short call K2, with K2>K1
(Same as protective put + short call with a higher strike or writing a covered
call + long put with a lower strike)

48
Goal: hedge a long asset position against price decreases
Payoff and profit: (0/1/0):

If the stock price does well and its greater than the higher strike
price, the payoff is the difference between the two strike prices: K 2−K 1

If the stock price on the expiration date lies between the two strike
prices, the payoff is ST −K 1

If the stock price on the expiration date is below the lower strike
price the payoff is 0.

Break-even point: ST −S0− p 0+ c 0=0 ⟺ S T =S 0 + p0−c 0

Minimum profit: K 1−S 0− p0 +c 0

Maximum profit: K 2−S 0− p0 +c 0

This strategy is a hybrid of a protective put and a writing covered

call:
 Both can be used to hedge a long asset position;
 the protective put costs money, limiting losses without limiting
the upside potential;
 the writing a covered call doesn’t cost money (we actually
receive a cash-flow initially) but limits the upside potential while
not limiting losses;
 Requires an initial investment;

49
 By “combining” the two strategies, we can lower the cost of
protection of a protective put, although at the expense of limiting the
upside potential;

Higher strike of the put  more protection we get  more

expensive the strategy is
Lower strike of the call  more we limit the upside potential 
less expensive the strategy is

Dashed lines = profits from the two options positions taken

separately;
Solid line: profit from the whole strategy = sum of the profits given by
the dashed lines

The profit is calculated by subtracting the initial investment from the payoff.

EXAMPLE (cont example1):

Even though the investor believes the Microsoft stock price will increase, he does not believe that it can go above
$40 over the next 3 months.

What can the investor do to reduce the cost of protection considered?

The investor can, in addition to his strategy take a shor call position over 100 Microsoft shares with expiration in 3
months, and strike K=$40; 50

By selling the call he reduces the costs of hedging strategy, at trading off the ability to benefit from a stock price
increase over $40 (which he does not think is possible anyway);
Short range forward:
Combines: short asset, long call K2 and short put K1, with K2 > K1
(same as protective call + short put with lower strike or writing a covered
put + long call with a higher strike)
Goal: hedge a short asset position against price increases

Break-even point: −ST + S 0−c 0 + p0 =0 ⟺ S T =S 0+ p 0−c 0

Minimum profit: −K 2 + S0 −c 0+ p 0

Maximum profit: −K 1 + S0−c 0+ p 0

This strategy is a hybrid of a protective call and writing a covered put:

 both can be used to hedge a short asset position;

51
  the protective call costs money, limiting losses without limiting
the upside potential;
 the writing a covered put does costs money (we actually receive
a cash-flow initially) but limits the upside potential while not
limiting losses.

By combining the two strategies, we can lower the cost of protection

of a protective call, but at the expense of limiting the upside
potential:
Lower the strike of the call  more protection we get  more expensive
the strategy is;
Higher the strike of the put  more we limit the upside potential  less
expensive the strategy is;

EXAMPLE: HEDGING A LONG ASSET POSITION

Suppose an investor takes a long position in the asset today, when its spot price is 50€, and wants to maintain it
over the next 3 months.

Fearing a sharp decline in the asset’s price, the investors wants to limit his losses to 10% of his investment (without
taking into account the cost of protection).

The investor also thinks that os is unlikely that the asset’s price will increase by more than 20% over the next 3
months.

(i) identify the 2 strategies adequate to protect his long asset position, and their costs

(ii) Compute the minimum and maximum profit of these strategies, identifying the circumstances where they
occur;

(iii) Compute the break-even point for each strategy; 52

(iv) Identify in what circumstances one strategy is more profitable than the other.
Let’s consider the following options and their prices:

EXAMPLE: HEDGING A LONG ASSET POSITION (cont)

This investor can hedge his risk using one of the following strategies:

(the option positions are over the same number of units of the underlying asset as the long asset position)

(Costs are per unit of the underlying asset. )

Protective put:
o Take a long put position with a strike of 50 * (1 – 10%) = 45;
o Strategy costs: $1.632
o Losses are limited while the unlimited upside potential is maintained.

Long range forward:

o Take a long put position with a strike or 45 and a short call position with a strik of 50*(1+20%)=60
o Strategy cost: 1.632-1.522 = $0.110
o Both losses and profit are limited, but since the investor doesn’t think it is likely that the asset price
increases by more than 20%, he can give up of the potential to profit from the price increase aboce
20% to reduce the cost of protection.

53
EXAMPLE: HEDGING A LONG ASSET POSITION (cont)

Minimum profit is: -6.632 when ST ≤ 45

(Corresponding to (-6.632/50) = -13.26% of the amount invested in the asset

Maximum profit is: unlimited

Break-even point: ST =51.632 (the profit on the long asset position exactly offsets the cost of protection which is $1.632)

(This is wrong because we can’t have a strategy with profits “sobreposta” with other.

Minimum profit is: -5.110 when ST ≤ 45

−5.110
(Corresponding to =−10.22 % of the amount invested in the asset
50
Maximum profit is: 9.89 when ST ≥ 60

9.89
(Corresponding to =19.78 % of the amount invested in the asset
50
Break-even point: ST =50.11 (the profit on the long asset position exactly offsets the cost of protection which is $1+0.110)

Since the long range forward has a smaller cost than the protective put, the former will always be preferred to the latter
unless the price of the underlying asset is high (somewhere in the third segment, S T ≥ 60

Comparing the profit of both strategies in the third segment:

ST =51.632 > 9.89  ST > 61.522

54

Therefore, the investor is better off with a protective put only if the price of the underlying
SPECULATIVE STRATEGIES

Speculative strategies can be of two types:

 Speculative strategies betting on the direction of the underlying

asset’s price (i.e. will the price increase or decrease?)

 Speculative strategies betting on the volatility of the underlying

asset’s price (i.e. will the price be far away from, or close to, the
current price?)

STRATEGIES FOR DIRECTIONAL SPECULATION

SPECULATING ON A PRICE INCREASE
To speculate on the increase of the underlying asset’s price we can use:

1. Long call:
 unlimited upside potential, with losses limited to the call price;
 adequate in situations where high volatility is also expected (we want
to benefit from large price increases, but safeguard against sharp
price decreases);

2. Short put:
 Profit limited to the put price, and unlimited downside potential;
 Adequate in scenarios of low volatility ( we expect only a small price
increase, and both large price increases and decreases are unlikely);

3. A vertical bullish spread with calls or puts

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LONG CALL STRATEGIES:

The higher the strike of the call:

 the smaller the maximum is (the option is cheaper);
 the smaller the profit in case our expectations is confirmed
 the lower the probability of obtaining a profit (the break-even point is
higher)

OPTION FOR OPTION:

1 long call with a lower strike is a stronger bet on the increase of the price
of the underlying asset than 1 long call with a higher striker;

However, long calls with higher strikes are cheaper, and so for the same
investment we can buy more calls if they have higher strikes;

More long calls with higher strikes makes the bet more aggressive
compared to fewer calls with lower strikes since the probability of turning a
profit is smaller while the upside potential is considerably

The more we invest in a long call strategy, the stronger the bet we
are placing.

SHORT PUT STRATEGIES:

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The higher the strike of the short put:
 the larger the maximum profit (the option os more expensive);
 the largest the losses in case our expectation is wrong;
 the lower the probability of obtaining a profit (the break-even point is
higher)

OPTION FOR OPTION:

1 short put with a higher strike is a stronger bet on the increase of the price
of the underlying asset than 1 short put with a lower strike;

But since puts with lower strikes are cheaper, to achieve the same
maximum profit (value of premiums collected) we have to short more puts;

More short puts with lower strikes makes the bet more aggressive than
fewer short puts with higher strikes because the downside potential is
considerably larger while the probability of obtaining a profit (and also the
maximum profit) is larger.

Naturally, the more we receive in premiums from shorting the options, the
stronger the bet.

VERTICAL BULLISH SPREAD:

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Combines: long call K1 and short call K2, with K2 > K1 (can also be done by
substituting both calls with puts);
Goal: speculate on an increase in the price of the underlying asset.

Strategy:
The investor has a call option with a strike price equal to K 1 and has chosen
to give up some upside potential by selling a call option with strike price K 2
(K2 > K1).
In return, for giving up the upside potential, the investor gets the price of
the option with strike price K2.

3 types of vertical bullish spread:

1. Both calls are initially OTM;

2. One call is initially ITM; the other call is initially OTM;
3. Both calls are initially ITM.

The most aggressive are those of type 1.

They cost very little to set up and have a small probability of giving a
relatively high payoff (=K2 – K1).
As we move from type 1 to type 2 and from type 2 to type 3, the spreads
become more conservative.

Payoff and profit (0/1/0):

 If the stock price does well and is greater than the higher strike price,
the payoff is the difference between the two strike prices ( K2 – K1).
 If the stock price on the expiration date lies between the two strike
prices, the payoff is ST – K1.

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  If the stock price on the expiration date is below the lower price, the
payoff is zero.

Break-even point: ST −K 1−c10 + c20 =0 ⟺ S T =K 1+ c10−c 20

Minimum profit: −c 10 +c 20

1 2
Maximum profit: K 2−K 1 −c 0+ c 0

The vertical bullish is similar to:

 Long call:
The extra short call with higher strike we have in the vertical bullish
spread with calls reduces the strategy cost while limiting the upside
potential;

 Short put:
The extra long put with a lower strike we have in the vertical bullish
spread with puts increases the strategy cost but limits its downside
potential;

The vertical bullish spread is adequate when we want to limit the

downside potential and we do not expect a large increase in the
asset’s price (therefore we don’t mind giving up some of the upside
potential)

Because a call price always decreases as the strike price increases, the
value of the option sold is always less than the value of the option bought.

Profit from bullish spread created using call options:

Profit = initial investment - payoff

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 When creates from a call requires an initial investment.

Bull spreads can also be created by buying a European put with a low
strike price and selling a European put with a high strike price.

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 Comparison between long call, short put and vertical bullish
spread:

SPECULATING ON A PRICE DECREASE

To speculate on the decrease of the underlying asset’s price we use

the symmetric strategies of those we considered to speculate on the
increase of the underlying asset’s price:
 Short call:
o Limited upside potential with unlimited downside
potential;

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 o Adequate in scenarios of low volatility;
o Similar to speculating on the price increase with a short
put;

 Long put:
o “Unlimited” upside potential with limited downside
potential;
o Adequate in scenarios of high volatility;
o Similar to speculating on the price increase with a long
call.
o
 Vertical bearish spread with calls or puts

VERTICAL BEARISH SPREAD

Combines: short call K1 and long call K2, with K2 > K1 (can also be
done by substituting both calls with puts;
It’s the symmetric of the vertical bullish spread;

Goal: speculate on a decrease in the price of the underlying asset

Payoff and profit: (0/-1/0)

Break-even point: K 1−ST +c 10−c20 =0 ⟺ S T =K 1+ c10−c 20

Minimum profit: K 1−K 2 + c10 −c 20

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Maximum profit: c 10−c 20

STRATEGIES FOR VOLATILITY SPECULATION

To speculate on high volatility in the price of the underlying asset,
we can use:
 Long straddle, long strangle, long strip or long strap
o Limited downside potential with unlimited upside
potential

 Short butterfly spread with calls or puts

o Limited downside and upside potentials;

COMBINATIONS:
Is an option trading strategy that involves taking a position in both calls and
puts on the same stock.

LONG STRADDLE
Combines: long put and long call with the same strike K
(Usually the closest to the spot price S 0);

Goal: speculate on high volatility

(ST far away from the chosen K)

A straddle is appropriate when an investor is expecting a large move in a

stock price but does not know in which direction the move will be.

Payoff and profit (-1/1):

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Break-even points:
{
S T −K− p0−c 0=0 {
K−ST − p0−c 0=0 ⇔ ST =K −p 0−c 0
S T =K + p 0+ c 0

Minimum profit: − p0−c 0 when ST =K

Maximum profit: unlimited

Top straddle - reverse position.

Is created by selling a call and a put with
the same exercise price and expiration
date.
It is a highly risky strategy.

If the stock price is close to this strike price at expiration of the options, the
straddle leads to a loss.
However, if there is a sufficiently large move in either direction. a significant
profit will result.

LONG STRANGLE:
Combines: long put K1 and long call K2 with K2 > K1
(Usually K2 > S0 > K1);

Goal: speculate on high volatility

(price outside of [ K1, K2]

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Payoff and profit (-1/0/1):

Break-even points:
{K 1−ST − p0−c 0=0
S T −K 2− p0−c 0=0 {S =K 1− p0 −c 0=0
⇔ T
ST =K 2 + p0 +c 0

Minimum profit: − p0−c 0 when K 1 ≤ ST < K 2

Maximum profit: unlimited

 Similar to a long straddle;

 The lower K1 is, the cheaper the put, and the larger K2 is, the
cheaper the call;
 Therefore, the higher the minimum profit (the strategy is
cheaper);
 But the farther away the break-even points are and the lower the
profit when it occurs;

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LONG STRIP AND LONG STRAP
Strip = long position in one European call and two European puts with the
same strike price and expiration date.
 The investor is betting that there will be a big stock price move;
 And considers a decrease in the stock price to be more likely than an
increase.

Strap = long position in two European calls and one European put with the
same strike price and expiration date.
 The investor betting that there will be a big stock price move.
 An increase in the stock price is considered to be more likely than a
decrease.

Combines:
 2 long puts and 1 long call with the same strike (long strip)
 1 long put and 2 long calls with the same strike (long strap)

Goal:
Speculate on high volatility tilted to price increase (strap) or to a price
decrease (strip)

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Payoff and profit (long strip) (-2/1):

{ {
2 K −2 p 0−c 0
2 K −2 S T −2 p0 −c 0=0 ST =
Break-even points: ⇔ 2
S T −K −2 p 0−c 0=0
ST =K +2 p 0 +c 0

Minimum profit: −2 p 0−c 0 when ST =K

Maximum profit: unlimited

 Similar to a long straddle but incorporates an element of directional

speculation;
 A long strip (strap) generates profits if the price is far away from K in
any direction, but more so if it is below (above) K than otherwise.

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SHORT BUTTERFLY SPREAD:
A butterfly spread involves positions in options with three different strike
prices.
Requires a small investment initially.

Combines: 1 short call with strike K1, 2 long calls with strike K2 and 1 short
call with strike K3, K3 > K2 > K1;
(Usually K2 is chosen to be close to S0; we can substitute all calls with puts)

Goal: speculate on high volatility

Payoff and profit (0/-1/1/0):

Break-even points:

Minimum profit:

Maximum profit:

 Similar to a long straddle, but with limited upside and downside

potentials;

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 The lower K1 and the larger K3, the larger the upside potential and the
larger the downside potential (because the strategy is more
expensive)

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 SPECULATING ON LOW VOLATILITY
To speculate on low volatility in the price of the underlying asset we use the
symmetric strategies:
 Short straddle, short strangle, short trip or short strap:
o Limited upside potential with unlimited downside potential

 Long butterfly spread with calls or puts:

o Limited downside and upside potentials;

Each of these strategies is the symmetric of those used to speculate on high

volatility;

EXAMPLE 1 – SPECULATING ON LOW VOLATILITY

Na investor has na expectation that the volatility of a given asset will be low in the next month.

The asset’s spot price is 55€.

To profit from this expectation, the investor is considering two speculative strategies:

(i) long butterfly spread with calls, using strikes of 50€, 55€ and 60€;

(ii) short straddle with strike of 55€.

Compare the profit profile of each of these strategies, considering the following prices for options with expiration in
1 month:

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EXAMPLE 1 – SPECULATING ON LOW VOLATILITY (cont):

The minimum profile is -0.6 when ST ≤ 50 or ST ≥ 60

The maximum profit is 55 – 50.6 = 59.4 – 55 =4.4 when ST =55

The strategy is profitable whenever 50.6 < ST < 59.4

The minimum profile is unlimited

The maximum profit is 55 – 45.7 = 64.3 – 55 = 9.3 when ST =55

The strategy is profitable whenever 45.7 < ST < 64.3

To know when the short straddle is more profitable than the long butterfly spread, we have to compare their profits
segment by segment:

In the second and third segments, the profit of the long butterfly spread is clearly less than that of the short straddle;

In the first segment, the long butterfly spread is more profitable if:

- ST + 45.1 > 0  ST < 45.1

In the fourth segment the long butterfly spread is more profitable if:

ST – 64.9 > 0  ST > 64.9

Therefore, the long butterfly spread is more profitable than the short straddle when S T < 45.1 and ST > 64.9
4. BINOMINAL OPTION PRICING MODEL
OPTION PRICING
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Binomial tree = diagram representing different possible paths that might
be followed by the stock price over the life of an option.

No arbitrage option pricing:

Like other derivatives, options are priced by a no-arbitrage argument:
 We find the portfolio that replicates the option
(the combination of the underlying asset and the risk free asset)

 Since we know the quantities and prices of the assets in the

replicating portfolio, we know the value of the replicating portfolio,
otherwise there is an arbitrage opportunity.

 The price of the option has to be the price of the replicating portfolio ,
otherwise there is an arbitrage opportunity.

What makes option valuation more challenging is that the replicating

portfolio is not static (i.e. it changes over time):
 if we are sure that the option will expire OTM, its payoff will not
depend on ST (it will be 0), and so the replicating portfolio cannot
include the underlying asset;

 but if we are sure that the option will expire ITM, its payoff will
depend on ST, and so the replicating portfolio has to include a
position in the underlying asset.

Problem:
Before expiration, we are not exactly sure of whether the option will expire
OTM or ITM:
 as expiration ITM becomes more likely, we have to increase the
size of the position in the underlying asset (either long or short)
 and reduce the size of that position as expiration OTM becomes
more likely.

The replicating portfolio is dynamic – it has to be continuously

adjusted

MODEL FOR THE FUTURE EVOLUTION OF THE UNDERLYING ASSET’S

PRICE

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 The likelihood of the option expiring ITM or OTM (and thus how much the
replicating portfolio should be exposed to the underlying asset) depends on
the underlying asset at that point in time and its future evolution from
the until the expiration date.

We need to come up with a model for the future evolution of the

underlying asset’s price:
 Start with a simple one-step binomial model;
 Add more steps (an arbitrary number of them) to obtain the multi-
step binomial model;
 Consider that the price of the underlying asset flows a Geometric
Brownian Motion.

ONE-STEP BINOMIAL MODEL

EXAMPLE:

Consider the following European call option:

 expiration: 3 months (T =0.25 years)

 Strike: K=$21
 Contract size: 1

The underlying asset has the following characteristics:

 it does not pay dividends (at least until the option expires);
 spot price S0 =$20
 price in 3 months’ time is either ST=$22 or ST =$18
 likelihood of each scenario: irrelevant!

Risk-free interest rate: 12%

Binomial tree representation of the possible future evolution of the underlying asset’s price:

EXAMPLE (cont):

We already know how to compute the price of the call at expiration:

 it’s equal to the payoff, c T =max(S T −K , 0)

Using that information, we just need to compute the price of the option at t=0:

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  If the stock price moves up to $22, the value of the portfolio is:
22 x 0,25 – 1 = 4.5

 If the stock price moves down to $18, the value of the portfolio is:
18 x 0.25 = 4.5
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The value of the portfolio is always the same.
GENERALIZATION:
(generalize the no-arbitrage argument)

Each period (tree model), the price of the underlying asset:

 increases by a factor u<1
22
( =1.1∈the previous example)
20

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  or decreases by a factor d<1
18
( =0.9∈the previous example)
20

Si,j = the price of the underlying asset;

ci,j = price of the call, in period i when j up moves have occurred until then;

∆=t = time interval between periods (tree nodes)

The option last for time T and that during the life of the option the stock
price can either:
 move up from S0  new level, S0u (u<1) or
o % increase = u-1
o Payoff: cu

 down from S0new level, S0d (d<1)

o % decrease = 1 – d
o Payoff: cd

The two portfolios are equal when:

S0 u ∆−c 1 ,1=S0 d ∆−c 1 ,0

So,

c i+1 , j+1−ci +1 , j +1
∆ i , j=
S i+1 , j+1−Si +1 , j+1

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Delta is the ratio of the change in the option price to the change in the stock
price as we move between the nodes at time T.

(Si +1 , j +1∗c i+ 1, j )−(S i+1 , j∗ci +1 , j )

Bi , j =
c r ∆ t∗(S i+1 , j+ 1)−(S i+1 , j )

The replicating portfolio is:

This can further simplified (using S 1,1 = S0u and S1,0 = S0d ):

The price of the option is then:

The only assumption needed for the equation is that there are no
arbitrage opportunities in the market.

RISK-NEUTRAL VALUATION

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When valuing a derivative, we can make the assumption that investors are
risk-neutral:
Do not increase the expected return they require from an investment
to compensate for increased risk.

(in reality, the world is not risk-neutral)

A risk-neutral world has two features that simplify the pricing of derivatives:
1. The expected return on a stock is the risk-free rate;
2. The discount rate used for the expected payoff on an option is the
risk-free rate.

The expression for the call price:

can be interpreted as and expected payoff discounted at the risk-

free rate:
r∆t

e −d : the probability of an up move;
q=
u−d
 the expected payoff is then discounted at the risk-free rate r;

However, the call is clearly not a risk-free asset.

Isn’t wrong to discount its expected payoff at the risk-free rate?

 Yes  It is wrong: if we compute the expected value using real world
probabilities;

 however, q is not the probability of an up move in the real world

What is q?
 it is the probability of an up move in a alternative fictious risk-neutral
world;
 in such a world, all investors are risk neutral and don’t care about
risk;

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 therefore, all assets should earn (and so their cash-flows should be
discounted at) the same rate of return, the risk-free interest rate r;

79