Professional Documents
Culture Documents
An Options Primer
An Options Primer
AN OPTIONS PRIMER
2. Options Pricing
Chapter 12 1
Options and Options Markets
Options
IBM Example:
Chapter 12 2
Options and Options Markets
Chapter 12 3
Options and Options Markets
Put Options
The buyer of a put option has the right but not the
obligation to sell a pre-specified amount of a pre-specified
asset at a pre-specified price during a pre-specified time
period.
Chapter 12 4
Options and Options Markets
Terminology
The Premium
Expiration
Exercise
Chapter 12 5
Options and Options Markets
Terminology
Option Writer
The seller of an option.
Writing an Option
The act of selling an option.
European Options
European options can be exercised only on the maturity
date.
American Options
American options can be exercised any time prior to
maturity.
Covered Call
Writing call options against stock that the writer owns.
Naked Option
Writing a call option on a stock that the writer does not
own.
Chapter 12 6
Options and Options Markets
Terminology
Intrinsic Value
Chapter 12 7
Call Option Example
0 1 2 3
-$2.50
Chapter 12 8
Call Option Example
After three months the stock price will have either gone up,
gone down, or stayed the same.
Chapter 12 9
Call Option Example
Chapter 12 10
Put Option Example
Suppose that at the time you enter into the contract, the
price of IBM stock is $50.50
The buyer pays the seller a $2.50 premium on the day they
enter into the agreement.
Timeline:
0 1 2 3
-$2.50
Chapter 12 11
Put Option Example
After three months the stock price will have either gone up,
gone down, or stayed the same.
– Thus, the buyer will purchase the stock for $45 in the
market and sell it using the put option for $50.
Chapter 12 12
Put Option Example
Chapter 12 13
Option Exchanges
Table12.1
Principal Options Exchanges and Option Traded
Exchange Option Traded
Panel 1: Options Exchanges in the United States
Chapter 12 14
Option Quotations
Chapter 12 15
Option Pricing
C(S, E, t)
Chapter 12 16
Pricing Call Options at Expiration
C(S, E, 0) = max(0, S - E)
SE
S>E
Where t = 0.
Chapter 12 17
Pricing Call Options at Expiration
First Possibility: S E
Example:
A call option with an exercise price of $80 on a
stock trading at $70. The option is about to expire.
Max(0, S-E)
Max(0, 70-80) = 0
Chapter 12 18
Pricing Call Options at Expiration
If the stock price is greater than the exercise price, the call
option must have a price equal to the difference between
the stock price and the exercise price.
Max(0, S-E) = S – E
Chapter 12 19
Pricing Call Options at Expiration
Example 2:
Chapter 12 20
Pricing Call Options at Expiration
Chapter 12 21
Graphical Analysis of Option Values and
Profits Expiration
Chapter 12 22
Option Values and Profits Expiration
Chapter 12 23
Option Values and Profits Expiration
Chapter 12 24
Pricing Prior to Maturity
C(S, 0, ) = S
Chapter 12 25
A Call Option with Zero Exercise Price
and an Infinite Time until Expiration
Chapter 12 26
Relationship Between Option Prices
If two call options are alike, except the exercise price of the
first is less than that of the second, then the option with the
lower exercise price must have a price that is equal to or
greater than the price of the option with the higher exercise
price.
Chapter 12 27
Relationship Between Option Prices
Example:
Chapter 12 28
Relationship Between Option Prices
Chapter 12 29
Relationship Between Option Prices
Chapter 12 30
Relationship Between Option Prices
Chapter 12 31
Relationship Between Option Prices
If there are two options that are otherwise alike, the option
with the longer time to expiration must sell for an amount
equal to or greater than the option that expires earlier.
Chapter 12 32
Relationship Between Option Prices
Example:
Chapter 12 33
Relationship Between Option Prices
Chapter 12 34
Call Option Prices and Interest Rates
Example:
Chapter 12 35
Call Option Prices and Interest Rates
Table 12.2
Portfolio Values in One Year
Stock Price Change
+10% B10%
Portfolio A
Stock $11,000 $9,000
Portfolio B
Maturing Bond $10,000 $10,000
Call Option $1,000 0
$10,000
C $10,000 - = $1,071
(1.12)
Chapter 12 36
Call Option Prices and Interest Rates
Chapter 12 37
Prices of Call Options and The
Riskiness of Stocks
Chapter 12 38
Prices of Call Options and The
Riskiness of Stocks
Table 12.3 shows the impact that stock price changes have
on option prices.
Table 12.3
Portfolio Values in One Year
Stock Price Change
+10% B10%
Portfolio B
Maturing Bond $10,000 $10,000
Call Option $1,000 0
In Portfolio B, the call option must be worth at
least $1,071.
Portfolio B
Maturing Bond $10,000 $10,000
Call Option $2,000 0
Chapter 12 39
Option Pricing Model
Chapter 12 40
Option Pricing Model (OPM)
Chapter 12 41
Option Pricing Model (OPM)
Chapter 12 42
Option Pricing Model (OPM)
d1
ln(S / E ) r .5 2 t
t
d 2 d1 t
N (d1 ), N (d 2 ) cumulative normal probability values of d1 and d 2
Where
+S = stock price
-E = exercise price
+t = time to expiration
+r = risk-free interest rate
+σ = variability of the stock
Chapter 12 43
Option Pricing Model (OPM)
S = $100
E = $100
t = 1 year
r = 12%
σ = 10%
d1
ln(S / E ) r .5 2 t
t
0 .1250
d1 1.25
.1
d 2 d1 t
Chapter 12 44
Option Pricing Model (OPM)
Chapter 12 45
The Value of Put Options and Put-Call
Parity
E
P S C
1 r t
$100
P= - $100 + $11.84 = $1.13
(1.12)
Chapter 12 46
Speculating with Options
Chapter 12 47
Speculating with Options
Table 12.5
Payoffs for Calls, Puts, and a Straddle at Expiration
Stock Price Call Put Straddle
at Expiration Profit/Loss Profit/Loss Profit/Loss
$50 B$10 +$43 +$33
$80 B$10 +$13 +$ 3
$83 B$10 +$10 0
$85 B$10 +$ 8 B$ 2
$90 B$10 +$ 3 B$ 7
$95 B$10 B$ 2 B$12
$100 B$10 B$ 7 B$17
$105 B$ 5 B$ 7 B$12
$110 0 B$ 7 B$ 7
$115 +$ 5 B$ 7 B$ 2
$117 +$ 7 B$ 7 0
$120 +$10 B$ 7 +$ 3
$150 +$40 B$ 7 +$33
Note: Profit/Loss figures reflect the amounts paid for the instruments:
Call = $10
Put = $7
Straddle = Call + Put = $17
Chapter 12 48
Speculating with Options
Chapter 12 49
Hedging with Options
Table 12.6
A Hedged Portfolio
Original Portfolio: S = $100 C = $11.84
8,944 shares of stock $894,400
A short position for options on 10,000 shares (100 contracts) B$118,400
Total Value $776,000
Stock Price Rises by 1%: S = $101 C = $12.73
8,944 shares of stock $903,344
A short position for options on 10,000 shares (100 contracts) B$127,300
Total Value $776,044
Stock Price Falls by 1%: S = $99 C = $10.95
8,944 shares of stock $885,456
A short position for options on 10,000 shares (100 contracts) B$109,500
Total Value $775,956
Chapter 12 50