Lecture 8
The Fundamentals of Options
Primary Text
Edwards and Ma: Chapter 18
Options
An option is a contract that gives its holder a right but not an
obligation to purchase or sell a specific asset (e.g., commodity futures
or security) at a specific price on or before a specified date in the
future.
To acquire this right, the buyer of the right (i.e., the option buyer or
holder) pays a premium to the seller of the right (i.e., the option seller
or writer).
If the option holder chooses to exercise her right to buy or sell the asset
at the specified price, the option writer has an obligation to deliver or
take delivery of the underlying asset. The potential loss to an option
writer is unlimited (?).
In contrast, if the option holder chooses not to exercise her right, but to
allow the option to expire, her loss is limited to the premium paid.
Options
Terminology
Option Holder (Buyer) An individual (or firm) who pays the
premium to acquire the right.
Option Writer (Seller) An individual (or firm) who sells the
right in exchange for a premium.
Premium the market value of the option, in effect the price of
the insurance.
Strike Price The fixed price specified in an option contract is
called the options strike price or exercise price.
Expiration Date The date after which an option can no longer
be exercised is called its expiration date or maturity date.
Options
Terminology
Call Option An option (a right but not an obligation) to buy a
specified asset at a set price on or before a specified date in the
future.
Put Option An option (a right but not an obligation) to sell a
specified asset at a set price on or before a specified date in the
future.
American-type Option An American-type option can be
exercised at any time prior to the contracts expiration date, at the
holders discretion.
European-type Option A European-type option can only be
exercised on the contracts expiration date.
Options
Exchange-Traded Options
Exchange-traded options contracts are standardized and traded on
organized (and government designated) exchanges.
An exchange-traded option specifies a uniform underlying asset, one
of a limited number of strike prices, and one of a limited number of
expiration dates.
Strike price intervals and expiration dates are determined by the
exchange.
Performance on options contracts is guaranteed by a clearing
corporation that interposes itself as a third party to all option
contracts.
Thus, contract standardization and a clearing corporation
guarantee provide the fundamental structure for exchange-traded
options.
Options
Exchange-Traded Options
Once an exchange-traded option contract is purchased, contract
obligation may be fulfilled in one of these three ways:
The option holder exercises her right on or before the
expiration date the option writer must then adhere to the terms
of the option contract, and accept the other side of the position.
The option writer keeps the premium.
The option holder allows the option to expire unexercised the
premium is retained by the option writer, and the writers
obligation is discharged.
Either or both the option holder and/or writer executes an
offsetting transaction in the option market, eliminating all
future obligations. In this case, the rights or obligations under the
original contract are transferred to a new option holder or writer.
Options
How Options Work
In addition to its type (call or put) and the name of the
underlying asset/security, an option is identified by its strike
price and expiration date.
For exchange traded options, the strike price and expiration date
are determined by the rules of the exchange.
On the Chicago Board Options Exchange (CBOE), a single call
option contract gives its holder the right to buy 100 shares of
the underlying stock and is of the American-type.
Original maturities of CBOE options vary from three months to
three years, and they all expire on the third Friday of the
month in which they mature.
Call Put
Strike Exp. Last sale Change Open Int. Last Sale Change Open Int.
20.00 April 3.60 0.20 9,055 0.35 0.03 16,036
22.50 1.49 -0.11 15,003 1.00 0.11 5,970
25.00 0.41 -0.05 13,125 2.14 -0.31 1,714
27.50 0.06 0.01 444 4.60 0.00 259
20.00 May 3.90 0.00 9971 0.72 0.04 16,614
22.50 1.95 -0.10 23,199 1.50 0.00 21,346
25.00 0.87 -0.05 35,601 2.62 -0.10 9,322
27.50 0.31 0.03 20,317 5.50 0.00 3495
Options
Listing of Home Depot Option Prices: CBOE, 24 March 2009
The HD April 09 call option with a strike price of $20.00 per share
was last traded at a price (premium) of $3.60 per share.
A buyer of this option, therefore, would have to make an immediate
payment of $3.60 per share (or $360 per contract) to the writer of the
option.
The buyer of the call option would have the right (but not the
obligation) to purchase 100 shares of HD at $20 until April 17 (the
third Friday in April).
If exercised, the holders net cost per share of the HD stock would be
$23.60 per share.
If the holder let the option expire without exercising the right, her net
loss would be $360.
Options
Listing of Home Depot Option Prices: CBOE, 24 March 2009
The HD April 09 put option with a strike price of $20.00 per
share was last traded at a price (premium) of $0.35 per share.
A holder of this option, therefore, would have to make an immediate
payment of $0.35 per share (or $35 per contract) to the writer of the
option.
The holder of the put option would have the right (but not the
obligation) to sell 100 shares of HD at $20 until April 17 (the third
Friday in April).
The holders net revenue per share of the HD stock would be $19.65
per share.
If the holder let the option expire without exercising the right, her
net loss would be $35.
Options
Listing of Home Depot Option Prices: CBOE, 24 March 2009
The level of the strike price and the value of option: Call
options with lower strike prices are more valuable and the put
options with higher strike prices are more valuable to the
holders.
Call: Strike Price => Premium
Put: Strike Price => Premium
Intrinsic value versus time value: Option premiums have two
components
Intrinsic value
Time value
Options
Properties of Option Pricing
Intrinsic value:
If the current stock price is above the strike price of a call (or
below the strike price of a put), the option has intrinsic value.
An option with intrinsic value is said to be in-the-money.
If the current stock price is equal to or below the strike price of a
call (or equal to or above the strike price of a put), the option has
no intrinsic value.
An option with no intrinsic value is said to be at-the-money if
current market price of the stock is equal to the strike price
An option with no intrinsic value is said to be out-of-the-money if
current market price of the stock is below the strike price of a call
and above the strike price of a put
Options
Properties of Option Pricing
Market Scenario Call Put
Market price > Strike Price I n-the-Money Out-of-the-Money
Market price = Strike Price At-the-Money At-the-Money
Market price < Strike Price Out-of-the-Money I n-the-Money
Options
Properties of Option Pricing
Time value: Why, then, the options that are out-of-the-money
have positive premiums?
Because, it still has a time value. The difference between an
options price (premium) and its intrinsic value is called the
options time value.
Time Value = Premium Intrinsic Value
Intrinsic value and Time Value:
Call: Intrinsic Value = Market Price Strike Price
Time Value = Premium Intrinsic Value
Premium = Intrinsic Value + Time Value
Put: Intrinsic Value = Strike Price Market Price
Time Value = Premium Intrinsic Value
Premium = Intrinsic Value + Time Value
Options
Properties of Option Pricing
Call Put
Strike Exp. Premium Int. Val. Time Val. Premium Int. Val. Time Val.
20.00 April 3.60 2.95 0.65 0.35 0.00 0.35
22.50 1.49 0.45 1.04 1.00 0.00 1.00
25.00 0.41 0.00 0.41 2.14 2.05 0.09
27.50 0.06 0.00 0.06 4.60 4.55 0.05
20.00 May 3.90 2.95 0.95 0.72 0.00 0.72
22.50 1.95 0.45 1.50 1.50 0.00 1.50
25.00 0.87 0.00 0.87 2.62 2.05 0.57
27.50 0.31 0.00 0.31 5.50 4.55 0.95
Options
Components of Option Premiums
HD Stock Closing price on 24 March 2009: $22.95 per share
The relationship between time value and time to expiration: the
longer the time remaining until an options expiration, the higher the
premium tends to be, everything else being equal.
The difference between the premiums of two options with the same strike
price but different expiration date is the same as the difference between the
time values of the two options.
For example, the premium for the HD May 2009 call option with the
strike price of 20.00 is ($3.90) higher than the premium for the HD
April 2009 call option ($3.60) with the same strike price. The
difference between the time value of these two options is also $0.30
per share.
This is because a longer time provides more opportunity for the price of
the underlying asset to move to a level where the option is in-the-money,
and where the purchase and sale of the asset at the specified strike price
will be profitable.
Options
Properties of Option Pricing
The relationship between time value and strike price:
The magnitude of an options time value reflects the potential of the
option to gain intrinsic value during its life.
A deep out-of-the-money option has little potential to gain intrinsic
value because to do so asset prices will have to change substantially.
Therefore, it will have little time value.
Similarly, a deep in-the-money option is as likely to lose intrinsic
value as to gain it, as a consequence also has little time value.
In general, time value is at the maximum when an option is at-the-
money.
Options
Properties of Option Pricing
Options make it possible for investors to modify their risk exposure to
the underlying asset
Denote the exercise (strike) price of an option on date t by SP
t
and
the market price of the underlying stock by MP
t
At expiration the strike price of the call option and the market price
of the underlying stock can be denoted by SP
T
, and MP
T
,
respectively.
At expiration the payoff from a call option is the larger number
between its intrinsic value (time value is zero at expiration) and zero.
Max (MP
T
SP
T
, 0)
At expiration the payoff from a put option is the larger number
between its intrinsic value (time value is zero at expiration) and zero.
Max (SP
T
MP
T
, 0)
Investing with Options
0
20
40
60
80
100
0 20 40 60 80 100 120 140 160 180 200
C
a
l
l
O
p
t
i
o
n
P
a
y
o
f
f
Stock Price at Expiration Date
Call Option Payoff Diagram
0
20
40
60
80
100
120
0 20 40 60 80 100 120 140 160 180 200
P
u
t
O
p
t
i
o
n
P
a
y
o
f
f
Stock Price at Expiration
Put Option Payoff Diagram
Stock Price Strike Price Call Put
at Expiration of the Option Option Value Option Value
0 100 0 100
20 100 0 80
40 100 0 60
60 100 0 40
80 100 0 20
100 100 0 0
120 100 20 0
140 100 40 0
160 100 60 0
180 100 80 0
200 100 100 0
Investing with Options
Denote call and put premiums by C and P respectively.
Profit/Loss of the Call Holder = Max (MP
T
SP
T
, 0) C
Profit/Loss of the Call Writer = C Max (MP
T
SP
T
, 0)
Profit/Loss of the Put Holder = Max (SP
T
MP
T
, 0) P
Profit/Loss of the Put Writer = P Max (SP
T
MP
T
, 0)
Profit/Loss Long and short Call Options.
Stock Price Strike Price Options Long Call Short Call
at Expiration of the Option Premium profits/losses profits/losses
0 100 10 -10 10
20 100 10 -10 10
40 100 10 -10 10
60 100 10 -10 10
80 100 10 -10 10
100 100 10 -10 10
120 100 10 10 -10
140 100 10 30 -30
160 100 10 50 -50
180 100 10 70 -70
200 100 10 90 -90
-100
-80
-60
-40
-20
0
20
40
60
80
100
0 20 40 60 80 100 120 140 160 180 200
P
r
o
f
i
t
s
o
r
L
o
s
s
e
s
Stock Price at Expiration
Long Call
Short Call
Profit/Loss Long and Short Put Options.
Stock Price Strike Price Options Long Put Short Put
at Expiration of the Option Premium Profits/losses Profits/losses
0 100 10 90 -90
20 100 10 70 -70
40 100 10 50 -50
60 100 10 30 -30
80 100 10 10 -10
100 100 10 -10 10
120 100 10 -10 10
140 100 10 -10 10
160 100 10 -10 10
180 100 10 -10 10
200 100 10 -10 10
-100
-80
-60
-40
-20
0
20
40
60
80
100
0 20 40 60 80 100 120 140 160 180 200
P
r
o
f
i
t
s
o
r
L
o
s
s
e
s
Stock Price at Expiration
Long Put
Short Put
In addition to using options to modify risk exposure, buying or selling
options is an alternative way to take a position in the market for a
trader who does not own the underlying asset.
For example, suppose that you have $100,000 to invest and you expect
that the price of a stock is going to increase (bullish).
Assume that the riskless interest rate is 5% per year and the stock pays
no dividends.
Compare your portfolios rate of return for three alternative
investment strategies over a one-year holding period:
Invest the entire $100,000 in the stock.
Invest the entire $100,000 in call options of the stock.
Invest 10% ($10,000) in call options of the stock and the rest ($90,000) in
the risk-free asset.
Investing with Options
Assume that the current price of the stock is $100 per share, and the
premium for the call option with $100 strike price is $10 per share.
Under the three alternative strategies, the investment scenarios and
corresponding rate of returns are
Strategy 1: Buy 1,000 share of the stock
Strategy 2: Buy calls (with strike price $100) on 10,000 share of the stock
Strategy 3: Buy calls (with strike price $100) on 1,000 share of the stock
and invest $90,000 in risk free asset (with 5% interest rate).
Investing with Options
100 100
000 , 100
000 , 100 000 , 1
%
T
T
MP
MP
RR
100 ) 0 , 100 ( 10 100
000 , 100
000 , 100 ) 0 , 100 ( 000 , 10
%
T
T
MP Max
MP Max
RR
) 0 , 100 ( 5 . 5 100
100000
100000 ) 0 , 100 ( 1000 05 . 1 90000
%
T
T
MP Max
MP Max
RR
Investing with Options
Portfolio rate of returns from alternative investment strategies
Stock Price Strike Price Call
at Expiration of the Option Option Value Strategy 1: Stock Strategy 2: Call Strategy 3: Mix
0 100 0 -100 -100 -5.5
20 100 0 -80 -100 -5.5
40 100 0 -60 -100 -5.5
60 100 0 -40 -100 -5.5
80 100 0 -20 -100 -5.5
100 100 0 0 -100 -5.5
120 100 20 20 100 14.5
140 100 40 40 300 34.5
160 100 60 60 500 54.5
180 100 80 80 700 74.5
200 100 100 100 900 94.5
Rate of Return on Portfolio (%)
-100
-50
0
50
100
150
0 20 40 60 80 100 120 140
R
a
t
e
o
f
R
e
t
u
r
n
o
n
P
o
r
t
f
o
l
i
o
(
%
)
Stock Price at Expiration
Rate of Returns Diagrams for Alternative Bullish Stock Strategies
100% Stock 100% Options
10% Options 100% risk-Free
State of the Riskless Strategy 1: Strategy 2: Strategy 3:
Economy Probability Investment 100% Stock 100% Call 10% Call
Boom (+50%) 0.2 5% 50% 400% 44.50%
Normal (+10%) 0.6 5% 10% 0 4.50%
Recession (-30%) 0.2 5% -30% -100% -5.50%
Rate of Return on Portfolio
Which of the three strategies is the best for you?
It depends on your expectation about the stock price and your risk tolerance
Suppose that you have scenario forecasts for three possible states of the
economy. You believe that
there is a probability of 0.2 (20% chance) that there will be a boom and
stock price will rise by 50% during the year,
a probability of 0.6 (60% chance) that the economy will be normal and
market will rise by 10%, and
a probability of 0.2 (20% chance) that there will be a recession and the stock
will fall by 30%.
Which of the three strategies is the best for you?
Normal situation Strategy 1 performs the best
Boom Strategy 2 performs the best
Recession Strategy 3 performs the best
Thus, none of the strategies dominates the other.
Depending on an investors risk tolerance, he or she might
choose any one of them.
Indeed, a very highly risk-averse investor might prefer the
strategy of investing all 100,000 in the risk-free asset to earn
5% for sure.
The Put-Call Parity Pricing Relationship:
Common Stock
We have just seen that a strategy of investing some of your
money in the riskless asset and some in a call option can
provide a portfolio with a guaranteed minimum value and an
upside slope equal to that of investing in the underlying stock.
There are at least two other ways of creating that same pattern
of payoffs:
Buy a share of stock and a European put option and
buy a pure discount bond and a European call option.
Consider a share of a stock with market price $100, and
European call and put options with strike price $100 and
premium $10.
Payoff Structure for Stock plus Put Strategy
Payoff Structure for Stock plus Put Strategy
Position If MP
T
< SP=$100 If MP
T
> SP=$100
Stock MP
T
MP
T
Put $100 - MP
T
0
Stock plus Put $100 MP
T
Value of Position at Maturity
0
40
80
120
160
200
0 20 40 60 80 100 120 140 160 180 200
P
a
y
o
f
f
Stock Price at Expiration
Payoff Diagram for Stock plus Put Strategy
Stock Put Stock plus Put
Payoff Structure for Bond plus Call Strategy
Payoff Structure for Bond plus Call
Position If MP
T
< SP=$100 If MP
T
> SP=$100
Bond $100 $100
Call 0 MP
T
- $100
Bond plus Call $100
MP
T
Value of Position at Maturity
0
40
80
120
160
200
0 20 40 60 80 100 120 140 160 180 200
P
a
y
o
f
f
Stock Price at Expiration
Payoff Diagram for Bond plus Call.
Bond Call Bond plus Call
Thus, a portfolio consisting of a stock plus a European put
option (with strike price SP) is equivalent to a pure discount
default-free bond (with face value SP) plus a European call
option (with strike price SP).
So, by the Law of One Price, they must have the same price.
The following equation expresses the pricing relation:
The equation is known as the put-call parity relationship.
The relationship allows one to determine the price of any one
of the four securities from the values of the other three.
The Put-Call Parity Pricing Relationship:
Common Stock
C
r
SP
P MP
T
) 1 (
The put-call parity relationship can also be used as a recipe for synthesizing
any one of the four from the other three.
Use the sign of each variable to determine long or short
A plus sign indicates cash inflow thus, short
A minus sign indicates cash outflow thus, long
Rearranging the put-call parity relationship we have:
That is the characteristics of a short call option can be broken into three
components:
Short the put option with the same strike price
Short the underlying stock at the prevailing market price
Long the bond with the face value equal to the SP of the options
The Put-Call Parity Pricing Relationship:
Short Call Synthetic
T
r
SP
MP P C
) 1 (
Rearranging the put-call parity relationship we have:
That is the characteristics of a long call option can be broken
into three components:
Long a put option with the same strike price of the call
long the stock at the prevailing market price
Short the bond with face value equal to the SP of the
options
The Put-Call Parity Pricing Relationship:
Long Call Synthetic
T
r
SP
MP P C
) 1 (
The put-call parity relationship can also be rearranged as :
That is the characteristics of a short put option can be broken
into three components:
Short a call option with the same strike price
Long the underlying stock at the prevailing market price
Short the bond with the FV equal to the SP of the options
The Put-Call Parity Pricing Relationship:
Short Put Synthetic
T
r
SP
MP C P
) 1 (
The put-call parity relationship can also be rearranged as :
That is the characteristics of a long put option can be broken
into three components:
Long the call option with the same strike price
Short the underlying stock at the prevailing market price
Long the bond with the FV equal to the SP of the options
Similarly, long or short stock or bond can also be synthesized using the
put-call parity relationship following the same principle.
The Put-Call Parity Pricing Relationship:
Long Put Synthetic
T
r
SP
MP C P
) 1 (
Call-Put Arbitrage
The equations for call and put premiums can also be regarded as
formulas for converting a put into call and vice versa.
For example, suppose that MP = $100, SP = $100, P = $10, T = 1
year, and r = 0.08
Then the price of the call option, C, would have to be 17.41
C = 10 +100 100/1.08 = 17.41
If the price of the call is too high or too low relative to the price of the
put, and there are no barriers to arbitrage, arbitragers can make a
certain profit.
For example, if C is $18 and there are no barriers to arbitrage, an
arbitrager can lock in a riskless profit by selling a call with strike price
$100 and simultaneously buying a put with the same strike price and
expiration date, borrowing the capital at the risk-free interest rate, and
buying the underlying stock.
Call-Put Arbitrage (market premium for the call is higher than the calculated call premium)
Immediate
Transactions Cash Flow If MP
T
< $100 If MP
T
> $100
Sell (Write) a Call
Buy (Long) a Put
Sell the bond with FV of $100
Buy a share of the Stock
Net Cash Flows
Profit/Loss
Cash Flow at Maturity Date
Buy Replicating Portfolio (Synthetic Long Call)
Call-Put Arbitrage
Call-Put Arbitrage (market premium for the call is higher than the calculated call premium)
Immediate
Transactions Cash Flow If MP
T
< $100 If MP
T
> $100
Sell (Write) a Call $18 0 (MP
T
$100)
Buy (Long) a Put $10 $100 MP
T
0
Sell the bond with FV of $100 $92.59
$100 $100
Buy a share of the Stock $100 MP
T
MP
T
Net Cash Flows $0.59 0 0
Profit/Loss $0.59 $0.59
Cash Flow at Maturity Date
Buy Replicating Portfolio (Synthetic Long Call)
Call-Put Arbitrage
Put-Call Arbitrage
If the price of the put option is high relative to call prices, an arbitrager
can lock in a riskless profit by selling the overpriced put and buying a call,
selling the underlying stock, and lending the proceed at the risk-free
interest rate (8%).
Put-Call Arbitrage (Market premium for a put is higher than the calculated put premium).
Immediate
Transactions Cash Flow If MP
T
< $100 If MP
T
> $100
Sell (Write) a Put
Buy (Long) a Call
Short a share of the Stock
Buy the Bond with FV of $100
Net Cash Flows
Profit/Loss
Cash Flow at Maturity Date
Buy Replicating Portfolio (Synthetic Long Put)
Put-Call Arbitrage
If the price of the put option is high relative to call prices, an arbitrager
can lock in a riskless profit by selling the overpriced put and buying a call,
selling the underlying stock, and lending the proceed at the risk-free
interest rate (8%).
Put-Call Arbitrage (Market premium for a put is higher than the calculated put premium).
Immediate
Transactions Cash Flow If MP
T
< $100 If MP
T
> $100
Sell (Write) a Put $11 ($100 MP
T
) 0
Buy (Long) a Call $17.41 0 MP
T
$100
Short a share of the Stock $100 MP
T
MP
T
Buy the Bond with FV of $100 $92.59 $100 $100
Net Cash Flows $1 $0 $0
Profit/Loss $1.00 $1.00
Cash Flow at Maturity Date
Buy Replicating Portfolio (Synthetic Long Put)
The Put-Call Parity Pricing Relationship
We can gain some additional insight into the nature of the
relationship among puts, calls, stocks, and bonds by
rearranging the terms in the put-call parity relationship.
If MP = SP/(1+r)
T
=> C = P
If MP > SP/(1+r)
T
=> C > P
If MP < SP/(1+r)
T
=> C < P
P C
r
SP
MP
T
) 1 (
Option Pricing: The Black-Scholes Model
Black and Scholes derive the following equations for pricing European call
options on non-dividend-paying stocks:
C = price (premium) of the call
MP = current market price of the stock
SP = current strike price of the call
r = riskless interest rate
T = time to maturity of the option in years
= standard deviation of the annualized rate of return on the stock
N(d)= probability that a random draw from a standard normal distribution will be
less than d
rT
e SP d N MP d N C
) ( ) (
2 1
T
T r SP MP
d
) 2 / ( ) / ln(
2
1
T d d
1 2
The formulation of the model is the construction of a
hypothetical risk-free portfolio, consisting of long call options
and short positions in the underlying stock, on which an
investor earns the riskless rate of interest.
We can derive the formula from the price of a put option by
substituting C in the put-call parity condition:
Option Pricing: The Black-Scholes Model
rT
e SP d N MP d N P
)] ( 1 [ ] 1 ) ( [
2 1
Estimation of Price Volatility
Price volatility refers to the degree of volatility of price change the
percentage changes in prices.
A commonly used measure of this volatility is the standard deviation of
previous daily, weekly, or even monthly percentage changes in prices.
The percentage price change is often calculated as the difference between
the natural logarithms of the current and previous prices.
N = Number of observations
X
t
= ln(MP
t
/MP
t-1
), i.e., the percentage price change
MP
t
= stock price at the end of period t
X-bar = mean of X
t
1
) (
1
2
n
X X
sd
N
t
t
Estimation of Price Volatility
Depending on which data interval is used to calculate the
standard deviation of prices, annualized price volatility ()
is obtained by multiplying the calculated standard deviation
by the square root of the number of periods:
For monthly data: = monthly standard deviation
For weekly data: = weekly standard deviation
For daily data: = daily standard deviation
12
52
252
Fundamental Determinants of Option Prices
In general, prior to expiration the value of an option depends
upon six variables:
the current value of the underlying asset or stock (MP
t
)
the options strike price (SP
t
)
the time remaining until the option expires (T t)
the current level of the risk-free interest (r)
the anticipated volatility of the price of the underlying asset or
stock ()
Cash dividend yield (d)
Fundamental Determinants of Option Prices
Determinants of Options Premiums - effect of an increase in each factor.
Pricing Factors Call Premium (C) Put Premium (P)
Stock market price (MP
t
) () Increase () Decrease ()
Strike Price (SP
t
) () Decrease () Increase ()
Time to Expiration (T t ) () Increase () Increase ()
Interest Rate (r ) () Increase () Decrease ()
Volatility ( ) () Increase () Increase ()
holding other factors constant
Effect of an increase in each pricing factor on the option value,
