Session 9 :

Derivatives : Options

Theory of Finance (MSc Finance, MSc Corporate

Finance)

Dr Dirk Nitzsche (E-mail : d.nitzsche@city.ac.uk)

Overview
• Introduction to options market : Jargon, different types of options
• Usage of options : Speculators, Arbitrageurs, Hedgers
• Standard options : Call and Put
• Payoff profiles at expiry
• Introduction to option trading strategies :
• Basic concepts
• More on Option Trading Strategies
• Guaranteed bond and put call parity
• Pricing Options
• Determinants of option value
• Black-Scholes model
• Binomial Option Pricing Model – Intuition ONLY
• Implied volatilities
Organisation of Option Markets
Options are traded
• on organised exchanges (i.e. CBOE, PHLX)
• Over the counter (OTC)
(The CBOE was established in 1973, but options have been traded
much longer.)

On organised exchanges standardised contract are being traded with a

deep secondary market
Types of Options
Options are being traded on the following underlying :

• Individual Stocks
• Stock indices (Index Options)
• Foreign Currencies Options
• Options on Futures Contracts
Standardisation
• Exchange traded options are standardised with respect to
• Availability
• Contract size
• Delivery dates

• Some options, in particular stock indices are cash settled.

US Stock Options
• CBOE (in Chicago) is one of the most important derivative exchanges
• Contract size : individual stocks are usually for delivery of 100 stocks
• Expiration dates : determined by the exchange. Stock options are traded up
to 4.30pm (Central) on the third Friday of the expiry month. Expiration dates
for options on individual stocks usually extends to about nine months.
• Strike/Exercise Price : might be set at $2.50 (if stock price is less than $25), at
$5 (if stock price is between $5 and $200) and $10 (if stock price is more than
$200).
• Trading : takes place on floor (but there is also an electronic trading system).
• Option clearing corporation
Call Option
A European call option gives the holder the right (but not the
obligation)
• Topurchase the underlying asset at a
• Specific future date
• For a certain price
• And in an amount which is fixed in advanced

For this privilege you pay today, the call premium/price.

Put Option
A European put option gives the holder the right (but not the
obligation)
• Tosell the underlying asset at a
• Specific future date
• For a certain price
• And in an amount which is fixed in advanced

For this privilege you pay today, the put premium/price.

Option Premia
• Option premia = intrinsic value + Time value
Intrinsic value : for Call max(0, St-K), for Put max(0, K-St)

• Suppose St = 26.80
• If K = 25, then intrinsic value (IV) and time value (TV)
• For call : IV = St-K (1.80 here) and TV = Call Premium - IV
• For put : IV = 0 and TV = Put Premium
• If K = 27.50, then intrinsic value (IV) and time value (TV)
• For call : IV = 0 and TV = Call Premium
• For put : IV = K-St (0.70 here) and TV = Put Premium - IV
Intrinsic and Time Value – Call Premia on
st
Company A, 1 July
Current stock price, S0 = 376p

Expiry Month
Strike price October January April
360p 36.5 50 57.5
(16 \ 20.5) (16 \ 34) (16 \ 41.5)

390p 21.5 38.5 44

(0 \ 21.5) (0 \ 35.5) (0 \ 44)
Intrinsic and Time Value – Put Premia on
st
Company A, 1 July
Current stock price, S0 = 376p

Expiry Month
Strike price October January April
360p 16 25 27.5
(0 \ 16) (0 \ 25) (0 \ 27.5)

390p 31 40 43.5
(14 \ 17) (14 \ 26) (14 \ 29.5)
Option Payoff Profiles
Long Call
• Suppose you purchase in July a (European) call option on
stock XYZ.
• If the quoted call premium is C = $3.-
• Suppose the strike price is K = $80 and the expiry date is
October.

• Payoff profile at expiry : (+1) [Max(0, ST-K)]

• Profits : (+1) [Max(0, ST-K)] - C
• If ST > K : Profits = ST – K - C (exercise the option)
• If ST < K : Profits = -C (do not exercise the option)
Long Call – Payoff Profile at Expiry

Strike price K = $80 +1

0
Profit K

$5

K = $80
0
Call premium $83 $88 ST
-$3
Writing (Selling) a Call
• The gains of one party are the loses of the other party (and vice
versa)
• Zero sum game (ignoring commission)

• Payoff profile at expiry : (-1) [Max(0, ST-K)]

• Profits : (-1) [Max(0, ST-K)] + C

(same concept applies to put options.)

Short Call – Payoff Profile at Expiry

0 K
Strike price K = $80
-1
Profit

$3
Call premium
$83
0
K = $80 $88 ST
-$5
Long Put
• Suppose you hold ABC stocks (as part of a pension plan). The stock price in July is
$72. You are planning to sell them in 3 month time and you are worried that
stock price falls below $70.
• Purchase in July a (European) put option on stock ABC.
• If the quoted put premium is P = $2.-
• Suppose the strike price is K = $70 and the expiry date is October.

• Payoff profile at expiry : (+1) [Max(0, K-ST)]

• If ST > K : Profits = - P (do not exercise the option)
• If ST < K : Profits = K-ST-P (exercise the option)
Long Put – Payoff Profile at Expiry

-1
Strike price K = $70 0
Profit K

$3
$68 ST
0
$65 K = $70 Put premium
-$2
Writing (Selling) Put – Payoff Profile at Expiry

K 0
Strike price K = $70
+1
Profit

$2
Put premium
$65
0
$68 K = $70 ST
-$3
Positions in Options
• There are two sides of the market in calls and puts
Long call = buy a call option
Long put = buy a put option
Short call = sell (or write) a call option
Short put = sell (or write) a put option

• In, Out and At-the-Money :

if option has intrinsic value : ‘in the money’
if option has no intrinsic value : ‘out of the money’
if St = K, option is ‘at the money’
Types of Options
• European style options
• Can only be exercised on the day of expiry

• American style options

• Can be exercised up to the expiry date.
Uses of Options
Using Options
• Trading strategies – to construct particular payoff profile
• Put call parity can be used to structure guarantee bonds
• Hedging : i.e. stock index options can protect equity portfolio
• Speculation - leverage
Trading Strategies – Straddle
• Long Straddle
• Suppose you buy in July a call and a put with October expiry and the same
strike price, K = 102. The call premium is C = 5 and the put premium is P = 3.
• If the stock price at expiry (October) is ST = K = 102, you will not exercise the
call or the put and lose premium = 8
• If ST is slightly above or below K you would exercise one of the options. The
break even points are SBE = 94 and SBE = 110
• Short Straddle : sell call and put option with same strike price.
Long Straddles
+1 Long Call
0
plus
K
-1 Long Put

Profit 0
K
equals
K = 102
-1 +1
8 8
0
Long Straddle

-8 SBE = 110
SBE = 94
Stock Index Options
• Stock index options (SIO) can be used to hedge market risk of
a diversified portfolio of stocks
• Most popular US stock index options are on S&P500 (SPX),
S&P100 (OEX) and Nasdaq100 (NDX) indices
• One index point on the S&P500 is z = $100, so if S0 = 2000,
value of option is zS0 = 200,000 (i.e. 100 times the index)

• Dollar payoff on the S&P500 index option

• Long call : $100 max(ST-K,0)
• Long put : $100 max(K-ST,0)
• Call and put premia are quoted in “index points”
Example : Protective Put
• Suppose you hold a diversified stock portfolio, V$ = $4m (with a beta of 1). If you fear
that the general stock market is going to fall, protect downside risk by buying put.

• Today
• If S0 = 2000
• K = 2000, P = 50 and z = $100, need to buy Np index puts
• Np = [$4m/200000]1 = 20 contracts (= [($ value of portfolio)/zS0]bp = ($V/zS0)bp)
• Cost of puts : $100,000 (= 20 contracts x 50 x $100)

• Future
• Suppose ST = 1600 (20% fall in index)
• Cash profits : $800,000 (= 20 contracts x 400 x $100)
• (Remember : Put premium payments of $100,000).
Put-Call Parity : European Options
Arbitrage relationship between (European) call and put premia, the
stock price and some cash : S + P = C + Ke-rT

• Portfolio-A : One put option plus one stock at t=0

• Portfolio-B : One call option plus an amount of cash equal to Ke-rT at t=0
• Both portfolios have the same value at expiry
Put-Call-Parity : Value at Expiry

Portfolio ST > K ST < K

Portfolio A ST K

Portfolio B (ST – K) + K = ST K

Portfolio A : One put option plus one stock at t= 0

Portfolio B : One call option plus cash of Ke-rT at t = 0
Speculation - Leverage from Options (on 100
Shares)
OPTIONS MARKET (JULY) CASH MARKET (JULY)

Call premium, C = $3 Spot price, S = $78

Premium paid = $300 Cash paid = $7800
Strike price, K = $80

OPTIONS MARKET (OCT.) CASH MARKET (OCT.)

Profit = $8 = ($88 - $80) Profit = $10 = ($88 - $78)

Net profit = $800 - $300 Total profit = $1000
Return = $500/$300 = 167% Return = $1000/$7800 = 12.8%
Guaranteed Bond – A
Financial Product
Guaranteed Bond – Structured Finance
• Advert : “Invest in our US Fund, Benefit from increases in the stock
market with no risk”. (We guarantee you will gain most of any upside
in the S&P500, but even if the index should fall over the next 2 years
you get your money back. (Administration fee of 6.6% of capital invested.)

• Example : For total investment of $106.60, we guarantee you a

minimum amount of $100 after 2 years, but you can benefit of large
increases in the stock market.
Guaranteed Bond : Data - Stock, Options and
Bond Prices
Current stock price (i.e. S&P500), S0 = $100
Interest rate, r = 5% (0.05)
Investment horizon = 2 years
Price of 2 year zero coupon bond = $90.50 (pays out $100 in two years)

Option Prices (maturity in 2 years)

Call Premium Put Premium
K = 100 16.10 6.60
K = 90 22.00 3.50
Guaranteed Bond : What shall we do?
• Objectives : Need to structure so that if $106.60 invested today we
get $100 in two years.
• Work out what happens if in 2 years the stock price is 50 or 150.
Note S0 = 100

• Put-Call-Parity : C + Ke-rT = P + S
• In ‘numbers’ : 16.10 + 90.50 = 6.60 + 100
Structuring Guarantee Bond – Possibility 1
Possibility 1 : Using Stocks and a Put Option
• Today, buy $100 of the stock and buy put (K = 100) at cost 6.60. Total cost is
$106.60 (equals investment of investor.)
• 2 Years later :
• ST = 50, exercise put to get $100.
• ST = 150, %Return to investor : $50/$106.60 = 47%

Uses put call parity for structuring here. To make riskless profit charge
more than $106.60.
Structuring Guarantee Bond – Possibility 2
Possibility 2 : Using Bonds and a Call Option
• Today, use $106.60 to invest in bond ($90.50) and buy 2 year call (K = 100) at
cost $16.10. Total costs $106.60
• 2 Years later :
• ST = 50 : Bond has maturity value of $100 which is paid to investor. Do not exercise the
call.
• ST = 150, exercise the call. Value of call is St-K = $50 and bond has value of $100 which
gives a total payout of $150.

How to make money ?

• Take $107.60 (higher fees) would make $1 for the bank
• Delay the cash payout in 2 years time.
• Using possibility 1 : Keep any potential dividends
• Offer lower admin fees for some loses (say 10%).
Pricing Options
Determinants of Option Prices
• Speculators quite often buy and the sell options over a very short
period of time (rather than holding them to maturity)

• Option premia vary second-by-second as stock prices, interest rates

and volatility of the stock changes over time
Option Pricing Methods
• Options can be priced in a number of different ways. The most
common one is the Black-Scholes formula.
• Alternative option pricing methods : Binomial Option Pricing Model
(BOPM) and Monte Carlo Simulation (MCS).

• Black-Scholes is a closed form solution and can only be applied to

European options.
Factors Affecting Option Premia
Long (European) Long (European)
Call Option Put Option
Time to Expiration, T + +
Current Stock Price, + -
S0
Strike Price, K - +
Stock Return + +
Volatility, s
Risk free rate, r + -

Dividend payments are also a factor, but let’s assume the stock
does not make dividend payments.
Speculating with Calls

Payoff from call at expiry

Call premium

Value of call prior to expiry

Ct B
BC = time value
C
CD = intrinsic value
C1 = 3.3
C0 = 3.1 A D
0

S1 = 100.5
S0 = 100.0 K St Stock price
Potential Futures Spot Price, S1
Starting Position = S X

0 0 0 0 0 0 10 20 30 40 50 60

Win Nothing Win a Prize

Example : Pricing Call Option on BA Share
• Data
• r = 10%
• S0 = 100 (no dividends are paid)
• K = 110
• Forward price = 110 (same as strike price)
• Next years price S1 either 88 or 132 (i.e. volatility 20%)
132

100

88
Example : Pricing Call Option on BA Share (Cont.)

Call -22
132 BA share 0
Premium ?
Net -22

C ???

Call 0
BA share 0
88 Premium ?
Net 0
Example : Pricing Call Option on BA Share (Cont.)

• Buy BA shares ‘forward’ at 110

• Sell call option, receive call premium, have to ‘deliver’ if S1 > K
• S1 = 132 : BA%(132-110) + C(1+10%) + (110-132) = 0

• S1 = 88 : BA%(88-110) + C(1+10%) = 0

2 equations, 2 unknowns (BA%, C).

Hence : BA% = 50% and C = 10
Example : Pricing Call Option on BA Share (Cont.)
Profits and Loss

= C(1+10%) – Max(S1–110, 0) + 50%(S1-110)

If S1 = 88 → P&L = 0
If S1 = 132 → P&L = 0
Example : Pricing Call Option on BA Share (Cont.)

Profits and Loss 11

0
88 110 132 S1
Black-Scholes Model
C = SN(d1) – N(d2)Ke-rT
where d1 = (ln(S/K) + (r+s2/2)T)/(s sqrt(T))
d2 = d1 – s sqrt(T) = (ln(S/K) + (r-s2/2)T)/(s sqrt(T))
N = probability under normal distribution

T = (number of trading days to maturity of the option)/252

or
T = (number of calendar days to maturity of the option)/365
Black-Scholes Model - Symbols
• C = price of call option (call premium)
• r = risk free rate of interest for horizon T (continuously compounded)
• S = current stock price
• T = time to expiry/maturity (as proportion of a year)
• s = annual standard deviation of the (continuously compounded)
return on the stock
• ln = natural logarithm of a variable
Black Scholes Model - Assumptions
• All risk free arbitrage opportunities are eliminated
• No transaction costs or taxes
• Investors can borrow and lend unlimited amounts at risk free rate
(and remains constant over life of option)
• Stock prices are random (geometric Brownian motion). Stock prices
are continuous without jumps.
• Stock pays no dividends
• Volatility of stock returns is known (and stays constant over life of
option).
Standard Normal Distribution

-4 -3 -2 -1 0 1 2 3 4

Rem. : Area underneath this curve is 1.

Black Scholes Model - Example
Data :
S = $45
K = $43
r = 1% p.a. (0.01), continuously compounded
s = 20% p.a. (0.2)
T = 6 month (approximately 126 trading days, 0.5 years)

• Calculate the call premium ?

• Calculate the put premium ?
Excel Spreadsheet
Calculating the BS option price

Put-call parity concept is used here to calculate the Put premium.

only change the values in the yellow shaded area. Do not change anything else.

S 45
K 43
r 0.01
T 0.5 182.5 days
d 0
Sigma 0.2

B-S Call Premium 3.737121

B-S Put Premium 1.522658

Auxillary inputs to calculate B-S premia

d1 d2 N -"dash"
(d1)
0.427534 0.2861122 0.364098
Implied Volatility
Implied Volatility
• “Market’s” average forecast for the volatility of the stock
• Solving the BS model for volatility if we have the call price C = f(S, K, r, T and s)
• Price = traded price for options
• Volatility is ‘forward looking’ measuring the risk of the underlying
(between now and when the option expires).
• Problem : extracting implied vol. using different strike prices (everything
else the same) gives us different results → violation of theory.
Excel Spreadsheet – Implied Volatility (Trial
and Error)
Calculating the Implied Volatility (using Trial and Error)

Data Inputs
S 164
K 165
r 0.0521
T 0.0959
d 0
Quoted C Premium 5.75

Trial and Error calculations

Choose different values for "sigma" and calculate the "theoretical"
call premium using B-S until the latter equals the actual quoted call premium

Trial d1 d2 N -"dash" Call

values for (d1) Premium
Sigma using B-S

0.281 0.031068 -0.05595 0.39875 5.606273

0.282 0.031267 -0.05606 0.398747 5.626524
0.283 0.031466 -0.05617 0.398745 5.646776
0.284 0.031664 -0.05628 0.398742 5.667027
0.285 0.031862 -0.0564 0.39874 5.687277
0.286 0.03206 -0.05651 0.398737 5.707528
0.287 0.032257 -0.05662 0.398735 5.727779
0.288 0.032454 -0.05673 0.398732 5.748029
0.289 0.032651 -0.05685 0.39873 5.76828

Sigma=0.288 gives quoted call premium

Excel Spreadsheet – Implied Volatility
(Optimisation)
Calculating the Implied Volatilities (Using "Solver")

Data Inputs
only change the values in the yellow shaded area. Do not change anything else.

S 164
K 165
r 0.0521
T 0.0959
d 0

Actual Call Premum 5.75

B-S Call Premium 3.965562

Cell to be minimised by SOLVER( Actual premium - B-S Premium)^2 = 3.184219

Start value (and final value) for Sigma for use in SOLVER = 0.2

Auxillary inputs to calculate B-S premia

d1 d2 N -"dash"
(d1)
0.013487 -0.04845 0.398906
CBOE SPX Volatility VIX – Price Index

100
80
60
40
20
0
Summary
• Option markets and types of options
• Call and put options
• European and American style options
• Stock index option
• Structured Products – Guaranteed Bond
• Combining different options gives us alternative payoff profiles : Only
Straddles covered here. (More advanced in pre-recording)
• Pricing options : The Black Scholes model and intuition of BOPM
• Implied volatility – Volatility of the underlying asset extracted from
options data (and options pricing model).
Readings
• Cuthbertson, K. and Nitzsche, D. (2008) ‘Investments’, J.Wiley (2nd
edition), Chapters 23, 24 and 25

• Cuthbertson, K, Nitzsche, D. and O’Sullivan, N. (2019) Derivatives –

Theory and Practice, J.Wiley, 1st edition
• Chapters 14, 15 and 16
Appendix : BOPM
Generalising the BOPM : Stock Price Tree

Data : S = 100, K = 100, r = 0.05, U = 1.1, D = 0.9

A. Long One Share

SU2 = 121
SU = 110

100 SD = 99
SD = 90
SD2 = 81
 Generalising the BOPM : Value of Call
B. Long One Call
(K = $ 100) Cuu = 21
Cu = 15
(hu = 0.9545)
C = 10.714 Cud = 0
(h = 0.75)
Cd = 0
(hd = 0)
Cu = (1/R) [qCuu + (1-q)Cud] Cdd = 0
Cd = (1/R) [qCud + (1-q)Cdd]

q = (R-D)/(U-D) and R = 1+r Intrinsic value

From BOPM to Black Scholes
• If the number of steps n (in the BOPM) increases (time intervals get
shorter) the BOPM converges to the Black-Scholes model

• dt = T/n
• As n → infinity, dt → 0, the lattice approximates the geometric
Brownian motion which is being used in the Black-Scholes model.
BOPM and Black-Scholes
6.4

6.2

5.8

5.6

5.4

5.2

5
1 6 11 16 21 n
Advantage and Disadvantages of BOPM
• Advantages
• Can easily be extended to other options
• European options with dividend payments
• American options
• Exotic options

• Disadvantage
• Computational burdensome
End of Lecture
D.Nitzsche@city.ac.uk
Theory of Finance