Lecture 5 Options

Options, Futures, and Other Derivatives
Tenth Edition
Chapter 10
Mechanics of
Options Markets
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Review of Option Types
• A call is an option to buy
• A put is an option to sell
• A European option can be exercised only at the end of its life
• An American option can be exercised at any time
Option Positions
• Long call
• Short call
• Long put
• Short put
Long Call (Figure 10.1, Page 210) Long Call Profit graph
Profit from buying one European call option: option price = $5, strike
price = $100, option life = 2 months Payoff does not consider premium paid at the beginning
Profit = considers premium
Call Pay off = 0 St < K = Not excercise

this is a payoff graph St - K St > K = Exercise it
30 Profit ($)
Call profit 0 -C
St - K -c
20
10 Terminal Market price

70 80 90 100 stock price ($)
0
-5 110 120 130
Short Call (Figure 10.3, page 212) Short call profit graph
Profit from writing one European call option:

option price = $5, strike price = $100
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)
Short call payoff graph
-20
-30
Long Put (Figure 10.2, page 211) Long put profit graph
Looking from Long perspective
Profit from buying a European put option: PUt Pay off = K - ST ST< K
0 ST > K
Put Profit = K- ST -P ST < K
0-P ST > K
30 Profit ($)
20
10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7
Short Put (Figure 10.4, page 212) Short put profit graph
Profit from writing a European put option:

Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10
-20
-30
Payoffs from Options
K = Strike price, ST = Price of asset at maturity
Payoff Long Call Payoff Short Call
K
K ST ST
Payoff Long Put
Payoff Short Put
K
K ST ST
Assets Underlying Exchange-Traded
Options
• Stocks
• ETFs (and other ETPs)
• Foreign Currency
• Stock Indices chapter 17
• Futures chapter 18
Called secondary derivatives coz they are build on derivative
Terminology
Moneyness:
– At-the-money option stock price = K (strike price)
– In-the-money option for call =ST > K , for Put ST < K
– Out-of-the-money option for call ST < K for Put ST > k
ETPs Exchange traded products: They are designed to replicate the performance of a particular market, often by tracking an underlying benchmark
index. The most common ETP is an exchange-traded fund (ETF)
1 contract =100 options
Other CBOE Products

• Flex options – nonstandard terms – strike price/expiration date
• Weeklys – created Thursday and expire Friday of next week like betting
• Binary options – Fixed payoff $100 if strike price is reached, 0 otherwise

• Credit event binary options (CEBOs) – fixed payoff for a “credit event”
eg: deafults in interest payment,
• Doom options – Deep out of Money Put Options bankrupcy
ST >>>>>> K
100 10
Dividends and Stock Splits
• Suppose you own N options with a strike Stock split say 2 :1 = It means two shares for existing 1
share. 5:1 means 5 shares for existing 1 share
price of K:
– No adjustments are made to the option terms for cash dividends
– When there is an n-for-m stock split,
▪ the strike price is reduced to Km/n
▪ the no. of options is increased to Nn/m
– Stock dividends are handled similarly to stock splits
After stock split
1 stock = 2
1 option contract = 100 option
2 option contract = 200 options
so if before stock split price was 100 after split price = 50
so K will also be 50 i.e K/2
Why does the share price drops after dividends are paid = Equity value drops . Equity value ( No. of shares * ST)+
earning . Dividend paid from earnings
Cash dividends have no effect on option contracts . Stock dividends has an effect on option contract
Market Makers
• Most exchanges use market makers to facilitate options trading
• A market maker quotes both bid and ask prices when requested
• The market maker does not know whether the individual requesting
the quotes wants to buy or sell
Margin
Buying an option = No margin required ( cz u have right not obligation to buy)
selling an option = Margin money is requried.
When the seller of the call option does not have the underlying asset it is called naked call. If
the seller is selling a naked call you have to put up a margin.
Covered call = seller of the call option has the asset with him
• Margin is required when options are sold
• When a naked option is written the margin is the
greater of: call premium
– A total of 100% of the proceeds of the sale plus 20% of the
No need to memorize underlying share price less the amount (if any) by which the
option is out of the money S0 < K
– A total of 100% of the proceeds of the sale plus 10% of the
underlying share price (call) or exercise price (put)
• For other trading strategies there are special rules
In case of Index options 20 % in the 1st calculation is replaced by 15%
Explain why the market maker’s bid-offer spread represents a real cost to options investors ?
A “fair” price for the option can reasonably be assumed to be half way between the bid and
the offer price quoted by a market maker
Warrants HW = TARP ( Troubled assets relieved program
• Warrants are options that are issued by a corporation or a financial

institution e.g. put gold warrants
• The number of warrants outstanding is determined by the size of the
original issue and changes only when they are exercised or when
they expire
• The issuer settles up with the holder when a warrant is exercised
Firm = Sells gold warrants
Employee Stock Options
• Employee stock options are a form of remuneration issued by a
company to its executives
• They are usually at the money when issued
• When options are exercised the company issues more stock and
sells it to the option holder for the strike price
Agency problem = Incentives of SH and Management not aligned

To tackle these issues call options are issued to the management. Now the management are focused to increase
ST cz they can exercise when ST > K
Convertible Bonds
• Convertible bonds are regular bonds that can be exchanged for
equity at certain times in the future according to a predetermined
exchange ratio
• Usually a convertible is callable callable bond is like a right to the firm to call back the options
• The call provision is a way in which the issuer can force conversion
at a time earlier than the holder might otherwise choose
callable bonds == when the interest rate drops firm can call back the bonds and issue new bonds at lower interest rate.
When firm issues you a callable bond it buys the right like a option to call the bond. It will usually do so when the interest rate increases.
Tenth Edition
Chapter 11
Properties of Stock
Options
Notation
c: European call option C: American call option
price = call premium price
p: European put option P: American put option
price price
S0 : Stock price today ST: Stock price at option

maturity
K: Strike price
D: PV of dividends paid
T: Life of option during life of option
s: Volatility of stock
price r: Risk-free rate for
Standard deviation of the returns
maturity T with cont.
Volatility is high the stock is moving up and down comp.
5 questions in exam
how option will move keeping all the other things constant
When a call price increases the call premium goes up
Effect of Variables on Option Pricing

Euro options Euro options
ST > K ST < K American American
Variable c p C P
S0 + - + -
K - + - +
T ? ? + +
s + + + +
r + - + -
D - + - +
C?c
P?p
? = we will have to see whether there is a dividend or not... coz it changes depends on that
Read the book for each logic
Lower Bound for European Call Option
Prices; No Dividends Lower
this
bond is the premium cannot fall below
Payoff =c = 0 St < K
St - K ST >= K
Pv of ST - K or MAX (0, ST - K)
Calls: An Arbitrage Opportunity?

• Suppose that
c=3 S0 = 20 Price of an asset = Pv fo all
future cashflow
T=1 r = 10% PV of ST -K
K = 18 D =0 = (ST - K) e ^-r*t
• Is there an arbitrage opportunity?

C >= MAx 3.71 , 0)
As C = 3 means trading below the lower bond so arbitrage opportunity
Puts: An Arbitrage Opportunity?
p >= Max ( k*e ^ -rt - s0,0) This is the lower bound
• Suppose that for put option
p P=1 S0 = 37
T = 0.5 r = 5%
K = 40 D =0
Lower Bound for European Put Prices;
No Dividends
p ≥ max(Ke –rT – S0, 0)
Puts: An Arbitrage Opportunity?

• Suppose that
P=1 S0 = 37
T = 0.5 r = 5%
K = 40 D =0
Values of Portfolios at maturity
Looking at payoff
Blank Blank ST > K ST < K
Portfolio A Call option Long call ST − K 0 Bond has
nothing to do
Zero-coupon bond long bondK K Face value
with the option
Total ST-K +K = ST K
Portfolio C Put Option long put No Exercise 0 K− ST Pay off
Share long stock ST ST

Total ST K Portfolio A and Portfolio C has the
same payoff at maturity, means u
should have paid the same
amount. or else there would be an
The Put-Call Parity Result

arbitrage
• Both are worth max(ST, K ) at the maturity of the options

• They must therefore be worth the same today. This means that
c = call premium
p = put premium
c + Ke -rT = p + S0 This is called the put call parity
Arbitrage Opportunities
• Suppose that
c=3 S0 = 31
T = 0.25 r = 10%
K = 30 D=0
• What are the arbitrage possibilities when
p = 2.25 ?
HW
p=1?
Tenth Edition
Chapter 12
Trading Strategies
Involving Options
Strategies to be Considered
• Stock plus option
• Two or more options of the same type (a spread) all call or all put
• Two or more options of different types (a combination) a call and a put together
Writing a covered call
Long stock + Short call
Positions in an Option & the Underlying

Buy write = if you buy the stock and sell call option whose underlying asset is that stock simultaneously
Over write = if you sell the call on already bought stock
Profit
Long Stock you buy the stock at S0
K ST
(a) Short Call If the long position

exercises the option then
u need to have the asset
hence u entered into long
Pay off Short call Long stock Total stock
ST < K 0 ST ST
Copyright
ST©> 2018,
= K 2015,
- ( ST 2012
- K) Pearson
STEducation, Inc.
K All Rights Reserved
Short stock = Borrow and sell the assets I m bearish. I am convinced that price will fall but i am afraid what if prices rise hence enter into a long call to buy at
a determined price K
Profit
Long Call
ST
(b)
Short Stock
Call Payoff =
Long stock = buying at S0 selling at ST Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Short stock = Negative of long stock
This is buying a covered put. If u buy a put and stock simultaneously it is called married put.
Buy put on a previously held stock = protective put

Profit Long stock = u brought a stock
Long Stock Long stock profit = St- S0
Long Put Long put profit = K- St - P

0 -P
ST<= K
ST > K
Total Profit
ST <= K
K
ST
(c)
Profit
Short Stock
Short Put
K ST
(d)
Bull Spread Using Calls This is Vertical Spread. Where u have different strike price with
same Maturity i.e T.
You can have horizontal spread same K different T = calendrer
spread
Diagonal spread = Different K different T
Profit
Short Call, Strike K2
ST
K1 K2
Long Call, Strike K1
Bull Spread Using Puts - P + P > 0 = This is a credit spread
Short Put, Strike K2

Profit
K1 K2 ST
Long Put, Strike K1
Bear Spread Using Puts 2 put option with different strike price
Buy high Sell low
Profit
Short Put, Strike K1
K1 K2 ST
Long Put, Strike K2
Bear Spread Using Calls
Profit
Short Call, Strike K1
K1 K2 ST
Box Spread
• A combination of a bull call spread and a bear put spread
• If all options are European a box spread is worth the present value of
the difference between the strike prices
Butterfly Spread Using Calls
Profit
Short 2 Calls, Strike K2

K1 K2 K3 ST
A Straddle Combination Volatility Play. High volitality
Profit
K ST
Long Call, Strike K
Long Put, Strike K
Strip & Strap
Profit Profit
K ST K ST
Strip (1 call +2 puts) Strap (2 calls+ 1 put)

A Strangle Combination
Profit
K1 K2
ST
Long Call, Strike Long Put, Strike K1
K2
Other Payoff Patterns
• When the strike prices are close together a butterfly spread provides a
payoff consisting of a small “spike”.
• If options with all strike prices were available any payoff pattern could
(at least approximately) be created by combining the spikes obtained
from different butterfly spreads.

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Options, Futures, and Other Derivatives

Call Pay off = 0 St < K = Not excercise

10 Terminal Market price

Profit from writing one European call option:

Looking from Long perspective

Profit from writing a European put option:

K = Strike price, ST = Price of asset at maturity

Payoff Long Call Payoff Short Call

Other CBOE Products

• Binary options – Fixed payoff $100 if strike price is reached, 0 otherwise

In case of Index options 20 % in the 1st calculation is replaced by 15%

• Warrants are options that are issued by a corporation or a financial

Agency problem = Incentives of SH and Management not aligned

S0 : Stock price today ST: Stock price at option

Effect of Variables on Option Pricing

Calls: An Arbitrage Opportunity?

• Is there an arbitrage opportunity?

Puts: An Arbitrage Opportunity?

Share long stock ST ST

The Put-Call Parity Result

• Both are worth max(ST, K ) at the maturity of the options

• What are the arbitrage possibilities when

Positions in an Option & the Underlying

Over write = if you sell the call on already bought stock

(a) Short Call If the long position

Positions in an Option & the Underlying

Long Stock Long stock profit = St- S0

Long Put Long put profit = K- St - P

Long Call, Strike K1

Short Put, Strike K2

Long Put, Strike K1

Short Put, Strike K1

Long Put, Strike K2

Long Call, Strike K2

Short 2 Calls, Strike K2

Long Call, Strike K3

Long Call, Strike K1

Long Put, Strike K

Strip (1 call +2 puts) Strap (2 calls+ 1 put)

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