MBA Finance and Financial Management

Options
Options

• Why Study Options?

• Calls and Puts
• European & American Options
• Options Terminology (e.g., at the money, in the money, ...etc)
• Types of Options
• Factors/Variables Affecting Option Values(Premiums)
 Why study options?

1. Employees of large and small corporations regularly receive options as

part of their compensation. Thus, it is important to understand the value
of this component of pay package.

2. Firms often raise capital by issuing securities with embedded options. For
example, firms that issue debts that is convertible into shares of common
stock needs understanding of option values.

3. Many capital budgeting projects have option like characteristics. The best
way to develop intuition to recognise which real investment projects have
embedded options and which do not is to become an expert on ordinary
financial options.

4. Firms regularly use options to hedge risks they face, such as risk related
to movement of commodity price, interest rate, foreign exchange.
Understanding how to hedge using options requires fundamental
knowledge of how options work.
Options Market

Options provide the right (to the buyer) to purchase or

sell an asset at specified prices. They are classified as
calls or puts.

Customized options offered by brokerage firms and

commercial banks are traded in the over-the-counter
market.
Options Vocabulary

• Gives the holder the right to purchase an

Call option asset at a specified price on or before a
certain date.

• Gives the holder the right to sell an asset

Put option at a specified price on or before a certain
date.

Strike price or exercise price (X): The price specified for

purchase or sale in an option contract.

American or • American options allow holders to

exercise at any point prior to expiration.
European • European options allow holders to
option exercise only on the expiration date.
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Premium: the cost (Ct) of acquiring a call (Cc ) or a
put (Cp) – the amount paid for an option when it is
purchased.

Underlying Asset: the asset which the option

contract gives the holder the right to buy (call) or sell
(put) - it might take the form of shares or equities,
currencies, commodities…..

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Option Life: options on equities traded on Liffe
have life of 9 months when issued – there are
usually options with three different expiry dates
trading at any point in time.

Expiration Date: the expiration, expiry or

maturity date is the last date on which the
contract can be exercised (T) – following this
date the option contract ceases to exist.
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Equity Option Prices (Extract from
Financial Times Table)

Exercise Prices
(X)

Current Share Call Prices,

Price (St) given X and T

A RBS call option with an exercise price of 56 with a February expiry date is selling at 10.
Options Trading

• The buyer of an option has a long

Long position position, and has the ability to exercise
the option.

• The seller (or writer) of an option has a

short position, and must fulfill the
Short position contract if the buyer exercises.
• As compensation, the seller receives the
option premium from the buyer.

Options trade on an exchange (such as CBOE) or in the over-

the-counter market.

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Option Prices

S = Current stock price

X = Strike price

Call Put
S>X In the money Out of the money
S=X At the money At the money
S<X Out of the money In the money

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 Call Options

Suppose the strike is $1.50 to buy a share.

A call option is said to be:

in the money if spot price ($1.54) > strike price ($1.50)
(buy it from the seller @ 1.50 instead of buying in market @ 1.54)

at the money if spot price ($1.50)= strike price ($1.50)

out of the money if spot price ($1.46)< strike price ($1.50)

(buy it from the market @ 1.46 instead of buying from the seller @ 1.50)
 Put Options

Suppose the strike is £0.60 to sell each share.

A put option is
in the money if spot price (£0.57) < strike price (£0.60)
(sell to writer @ 0.60 instead of selling @ 0.57 in the market)

at the money if spot price (£0.60) = strike price (£0.60)

out of the money if spot price (£0.62)> strike price (£0.60)

(sell in the market @ 0.62 instead of selling @ 0.60 to eh writer)
Option Investors (Buyers) And Writers

Investors Writers

Pay for a call Receive payment for the call

Acquire a right to be exercised at Acquire obligations under the

this discretion contract

Maximum loss is equal to cost of Maximum loss is unlimited

call

Maximum gain unlimited Maximum gain is equal to selling

price of the call

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Types of Options

 Stock Options
 Index Options
 Currency Options
 Other Types of Options
 interest rate options
 currency options
 options attached to bonds
 exotic options
 warrants, callable bonds, convertible bonds
 non-traded executive options
 Real Options
Transaction Costs in Option Trading

 Floor Trading and Clearing Fees

 Commissions
 Bid-Ask Spread
 Other Transaction Costs
Intrinsic and Time Value of Options

• For in the money options: The difference

Intrinsic between the current price of the underlying
asset and the strike price
value • For out of the money options, the intrinsic
value is zero.
St  X if St  X, otherwise 0

• The difference between the option’s

Time value intrinsic value and its market price
(premium)

C t - (St  X) if St  X, otherwise Ct
Time Value reflects the possible advantageous
changes in the price of the underlying asset over the
remaining life of the option (in principle this should
always be positive but can be close to zero if the
likelihood of St>X occurring is very small)

Why is the time value always positive, even though

prices of the underlying asset can be expected to fall
as well as to rise?

It is because the consequences of a potential fall in

price are always less significant than the
consequences of a potential increase in price. 17
INTRINSIC VALUE = St  X if St  X, otherwise 0

TIME VALUE = C t - (St  X) if St  X, otherwise Ct

Long (Buyer) Call Option Payoffs

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Short (Writer) Call Option Payoffs

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Usage of Call Options

Firms may purchase call options to hedge payables, project bidding, or

target bidding.

Speculators may purchase call options on a asset that they expect to

appreciate.

Profit = {selling (spot) price– buying (strike) price} – option premium

They may also sell (write) call options on a asset that they expect to
depreciate.

Profit = option premium + {selling (strike) price – buying (spot) price}

 Profit for Buyer of Call Option

Strike price = $1.50

Premium = $ .02

Net Profit per Unit

+$.04

+$.02

0
$1.46 $1.50 $1.54
– $.02 Future Spot Price

– $.04

What is the profit at the spot of $1.53

 For Seller of Call Option

Strike price = $1.50

Premium = $ .02

Net Profit per Unit

+$.04
Future Spot
+$.02 Price

0
$1.46 $1.50 $1.54
– $.02

– $.04

What is the profit to seller at the spot of $1.51

Long (Buyer) Put Option Payoffs

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Short(Writer) Put Option Payoffs

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Speculation

A RBS call option with an exercise price of 56 with

a February expiry date is selling at 10.

For a speculator to anticipate a profit the expected

price at the maturity date must exceed ?
Call Option: The motivation to
purchase for speculative purposes

A speculator in an option can be assumed to expect

that the share price at the expiration date (E(ST) will
exceed the exercise price (X) by more than the cost of
acquiring the option (C0).

(ST - X)  C0
As we have seen a RBS call option with an exercise price of 56 with
a February expiry date is selling at 10. For a speculator to
anticipate a profit the expected price at the maturity date must
exceed 66:
(E(S T ) - 56)  10
(E(S T )  ( 56  10)  66 27
Factors Affecting Option Values (premium)
Call Price: 𝐶𝑐 = 𝑓(𝑆 − 𝑋, 𝑇, 𝜎)
Put Price: 𝐶𝑝 = 𝑓(𝑋 − 𝑆, 𝑇, 𝜎)

Price of • Asset price (S) and call price (Cc) are

positively related.
underlying • Asset price (S) and put price (Cp) are
asset negatively related.

Time to • More time usually makes options more

expiration valuable.

• Higher X means higher put price; lower X

Strike price means higher call price.

• Options are more valuable when the

Volatility underlying asset’s price is more volatile. 28
Call Options - A Zero Sum Game

Profit
Investor’s (buyer’s) position

+C
X ST

-C

Writer’s (seller’s) position

Loss

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Naked Option Positions

Naked call option position – Occurs when an investor

buys or sells a call option on a stock without having a
position in the underlying stock.

Naked put option positions – Occurs when a trader

buys or sells a put option without having a position in
the underlying stock

These positions are purely speculative.

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Combinations strategy I - Straddle

A straddle – an investment in a call and a put at the same

exercise price.

The combination essentially represents a bet on volatility.

If the price of the security increases or decreases sufficiently the

strategy will be profitable.

A large price change is anticipated, but its direction cannot be

identified.

If this is a generally held view the demand for calls and puts will
increase and their cost will increase – thereby eliminating any
expected profit from an investment in a straddle.
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Straddle Positions

Long straddle A portfolio consisting of long

positions in calls and puts on the same stock
with the same strike price and expiration
date.
Short straddle  A portfolio consisting of short
positions in calls and puts on the same stock
with the same strike price and expiration
date.

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Straddle (Call)
Invest in a call and a put at
Profit\Loss the same exercise price

Call

X
Share price

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Straddle (Put)
Profit\Loss
Put

X Share price

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Straddle Profit Graph (1)
Profit\Loss

Put Call

+
Straddle
Share price

Cost = C0+P0
Exercise the put Exercise the call
_
A profitable straddle requires (ST – X) > (C0+P0) or
(X – ST) > (C0+P0)
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Straddle Profit Graph (2)
Profit\Loss

Put Call

Profitable Unprofitable Profitable

Cost = C0+P0
Exercise the put Exercise the call
_
A profitable straddle requires (ST – X) > (C0+P0) or
(X – ST) > (C0+P0)
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 Straddle Profit Graph (3)

Profit\Loss A long straddle on RBS’s shares, given X=52 and a

December call selling at 7 and a put at 6.
Put Call

+
Straddle
39 X=52 75 Share price

P0= -6
C0= -7
(P0 + C0)= -13
Cost = C0+P0
Exercise the put Exercise the call
_
A profitable straddle requires (ST – 52) > 13 or
(52 – ST) > 13
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Payoff of a Long Straddle
In this illustration, the strike price is $30, and the call and put
premiums combined are $8. By purchasing a call and put that have
same strike price, an investor can profit from a significant change in
the underlying stock price in either direction.

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Combinations strategy II - A Covered Call

• A covered call involves writing a call and

investing in the underlying asset.
• It is a strategy employed by the writers of calls to
control their risk exposure.
• The threat of large losses is eliminated by
foregoing the potential for large gains on the share
being held.
Covered call (1) Underlying asset
Profit / Loss Capital Gain/Loss
(long position)

Share Price

_
A covered call involves
writing a call and investing in
the underlying asset.
Covered call (2) Written Call
Profit / Loss

Share Price

_
Written Call
(short position)
Covered call (3) A Share and Written Call

Profit / Loss Capital Gain/Loss

(long position)

Share Price

_
Written Call
(short position)
Covered Call (4) A Share and Written Call, Net Effect
Capital Gain/Loss
Profit / Loss (long position)

Covered
+ Call

Share Price

_
Written Call
(short position)
Covered call – illustration
X = 52 Share Price = 53 Price of Call = 12
Expiry Date - February
Call Liability of a Profit/Loss
Share Exercise Price of Call at Net profit on Profit/Loss on Covered
Price Price Call Expiry Date Call on share Call
0 52 12 0 12 -53 -41
5 52 12 0 12 -48 -36
10 52 12 0 12 -43 -31
15 52 12 0 12 -38 -26
20 52 12 0 12 -33 -21
25 52 12 0 12 -28 -16
30 52 12 0 12 -23 -11
35 52 12 0 12 -18 -6
40 52 12 0 12 -13 -1
45 52 12 0 12 -8 4
50 52 12 0 12 -3 9
55 52 12 -3 9 2 11
60 52 12 -8 4 7 11
65 52 12 -13 -1 12 11
70 52 12 -18 -6 17 11
75 52 12 -23 -11 22 11
80 52 12 -28 -16 27 11
 Share (spot) price = 53
Covered Call
40

30

20

10

0
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
Pay off

-10

-20

-30
CALL LESS
-40
PROFITABLE
THAN
-50
CALL MORE PROFITABLE THAN HOLDING
HOLDING SHARE SHARE
-60

Share Price
Short Call Profit on Share Covered Call
 Profit/Loss on Covered Call

The profit on a covered call (holding a share and

writing a call) exceeds the profit on a simple
investment on a share for all share prices up to the
exercise price plus the value of a call.

There are no free lunches – the combination results

in a lower profit than would be generated by holding
the share on its own for those prices exceeding the
exercise price plus the value of a call.
Factors Affecting Option (Call) Prices

Current share Time to expiration

price (S) (T- t)

+ +

_ + Volatility of
Exercise or strike Cp returns
price (X)
SD(R)
+

Risk free interest

rate (r)
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 Current Share Price and Exercise Price

The higher the current share price and the lower the
exercise price the greater the value of a call option.

If ST > X the intrinsic value is positive and the immediate

exercise of the call will generate a gross profit – but the
gross profit will be lower than the value of a call.

The higher the share price in relation to the exercise

price the more likely a call will end up in the money at
maturity.
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Time to Expiry

The longer the time to expiry the greater the scope for both
price increases and price decreases.
The potential for price increases and decreases for the share
do not have an equal impact on the value of a call – the most
an investor can lose from a price fall is the current value of the
call but there is no limit to the gain from increases in the share
price (an uneven bet!).
Buying a call can be thought of as an alternative way of taking a
position in a share
• Buy now (S0)
• Buy a call now (C0) and exercise it if it is profitable to do so.
• The longer the time interval the greater the interest saving in
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delaying the purchase of the share.
 Volatility

The greater the potential price change of a share

the greater the value of a call option.

As we have noted potential losses and gains from

price changes are not equal – the uneven bet
argument.

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 Risk Free Rate of Interest

The higher the interest rate the greater the value of a

call.

The higher the interest rate the greater the saving from
postponing a share purchase and therefore the higher
the demand for the call alternative.

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