Table of contents

1. Terminology
2. Payoff diagrams
3. Option portfolios
4. Put-call parity
5. Option pricing

Terminology …
Call gives its holder the right to purchase an
asset for a specified price (exercise or
strike price) on or before some specified
date (expiration or maturity date)

Put gives its holder the right to sell an asset

for a specified price on or before some
specified date

Terminology 2
Terminology …
In the Money: exercise of the option would
be profitable
Call: market price > exercise price
Put: exercise price > market price

Out of the Money: exercise of the option

would not be profitable
Call: market price < exercise price
Put: exercise price < market price

At the Money: exercise price and asset price

are equal
Terminology 3

Terminology …
American option can be exercised at any
time before expiration or maturity

European option can only be exercised on

the expiration or maturity date

 American options are more valuable

 Most options in the U.S. are American

Terminology 4
Terminology …
Value of an option is never negative

Who is on the other side of these contracts?

(i.e., who writes (sells) option contracts?)
• Payoff to seller is either zero or negative

Therefore, option contracts require initial

cash outlay called option premium

Terminology 5

Types of options
 Stock Options
 Index Options
 Futures Options
 Foreign Currency Options
 Interest Rate Options

Terminology 6
Notation
Expiration Date

Price of underlying asset 0

Exercise Price (or )

Price of a Call 0

Price of a Put 0

Payoff diagrams 7

Option payoffs at expiration

Payoff diagrams 8
Option payoff diagrams

Payoff to Payoff to
Call at T Put at T

K ST K ST

Payoff diagrams 9

Payoffs to option writers

Payoff to Payoff to
Call writer at T Put writer at T

K ST K ST

Payoff diagrams 10
Option profit diagrams

Profit to Profit to
Call at T Put at T

K ST K ST
Call premium Put premium

Payoff diagrams 11

Call option returns

The maximum loss on a purchased call option
is 100% (when the option expires worthless)

Out-of-the money call options are more likely

to expire worthless, but if the stock goes up
sufficiently it will also have a much higher
return than an in-the-money call option

Call options have more extreme returns than

the stock itself

Payoff diagrams 12
Put option returns
The maximum loss on a purchased put option
is 100% (when the option expires worthless)

Put options will have higher returns in states

with low stock prices

Put options are generally not held as an

investment, but rather as insurance to hedge
other risk in a portfolio

Payoff diagrams 13

Straddles
A portfolio that is long a call option and a put
option on the same stock with the same
exercise date and strike price

This strategy may be used if investors expect

the stock to be very volatile and move up or
down a large amount, but do not necessarily
have a view on which direction the stock will
move

Option portfolios 14
Straddles …

Option portfolios 15

Bull spreads
Buy call with strike 1, sell call with strike 2

Profit equation:

Maximum profit 2 1 1 2
Minimum 1 2
Breakeven: ∗ 1 1 2
Option portfolios 16
Bull spreads …

Option portfolios 17

Bear spreads
Buy put with strike 2, sell put with strike 1

Profit equation:

Maximum profit 2 1 1 2
Minimum 1 2
Breakeven: ∗ 2 1 2
Option portfolios 18
Bear spreads …

Option portfolios 19

Butterfly spread
A portfolio that is long two call options with
differing strike prices, and short two call
options with a strike price equal to the
average strike price of the first two calls

While a straddle strategy makes money when

the stock and strike prices are far apart, a
butterfly spread makes money when the
stock and strike prices are close

Option portfolios 20
Butterfly spread …

Option portfolios 21

Protection with options

Protective put
• A long position in a put held on a stock you
already own

Portfolio insurance
• A protective put written on a portfolio rather than
a single stock. When the put does not itself trade,
it is synthetically created by constructing a
replicating portfolio
• Portfolio insurance can also be achieved by
purchasing a bond and a call option

Option portfolios 22
 Portfolio insurance

The plots show two different ways to insure against the possibility of the price of Amazon
stock falling below $45. The orange line in (a) indicates the value on the expiration date of
a position that is long one share of Amazon stock and one European put option with a
strike of $45 (the blue dashed line is the payoff of the stock itself). The orange line in (b)
shows the value on the expiration date of a position that is long a zero-coupon riskfree
bond with a face value of $45 and a European call option on Amazon with a strike price of
$45 (the green dashed line is the bond payoff).
Option portfolios 23

Option value
Intrinsic value: Profit that could be made if
the option was immediately exercised
• The amount by which an option is in-the-money,
or zero if the option is out-of-the-money
▪ An American option cannot be worth less than its
intrinsic value

Time value: The difference between the

option price and the intrinsic value
▪ An American option cannot have a negative time value

Put-call parity 24
Arbitrage bounds on option prices
An American option cannot be worth less
than its European counterpart

A put option cannot be worth more than its

strike price

A call option cannot be worth more than the

stock itself

(Although an American option cannot be

worth less than its European counterpart,
they may have equal value)
Put-call parity 25

Put-call parity
European call and put premium are related
to each other by the equation

Put-call parity 26
Put-call parity diagram

CT − PT Value at time T ST − K

Long call Long stock


ST ST

K Short put K

Borrow

C0 − P0 Value at time 0 S0 − K/(1+rf )T

Put-call parity 27

Put-call parity proof

Compare these two portfolios:
• A: Buying a European call option with strike price
K and investing (lending) K/(1+rf)T in T-Bills
• B: Buying the underlying stock at its current
price S0 and buying a put option on the stock
with strike price K

Hold both portfolios until expiration

Put-call parity 28
Put-call parity proof …
The two strategies have identical payoffs at
expiration
Payoff
Portfolio Initial Cost ST >K ST =K ST <K
T
A C0 +K/(1+rf) ST - K + K K 0+K
B S 0 + P0 ST + 0 K ST + K - ST
A-B ?? 0 0 0

Their values today must be identical, else

arbitrage

0 0 0

Put-call parity 29

Put-call parity violation

Stock Price=110, Call Price=17, Put Price=5,
Risk Free=10.25%, Maturity=0.5yr, K=105

Buy cheap (stock plus put)

Sell high (call plus loan)

Put-call parity 30
Put-call parity violation …

Payoff
Portfolio Initial Cost ST >105 ST <105
Buy stock -110 ST ST
Buy put -5 0 105 - ST
0.5
Borrow 105/1.1025 =100 -105 -105
Sell call 17 -(ST -105) 0
Total 2 0 0

Put-call parity 31

Non-dividend-paying stocks
For a non-dividend paying stock, Put-Call
parity can be written as

where dis( ) is the amount of the discount from

face value of the zero-coupon bond

Put-call parity 32
Non-dividend-paying stocks …
Because dis(K) and P must be positive before
the expiration date, a European call always
has a positive time value

Since an American option is worth at least as

much as a European option, it must also have
a positive time value before expiration

Thus, the price of any call option on a non-

dividend-paying stock always exceeds its
intrinsic value prior to expiration

Put-call parity 33

Non-dividend-paying stocks …
This implies that it is never optimal to
exercise a call option on a non-dividend
paying stock early
• You are always better off just selling the option

Because it is never optimal to exercise an

American call on a non-dividend-paying stock
early, an American call on a non-dividend
paying stock has the same price as its
European counterpart

Put-call parity 34
Non-dividend-paying stocks …
However, it may be optimal to exercise a put
option on a non-dividend paying stock early

When a put option is sufficiently deep in-the-

money, dis(K) will be large relative to the
value of the call, and the time value of a
European put option will be negative. In that
case, the European put will sell for less than
its intrinsic value
Put-call parity 35

Non-dividend-paying stocks …
However, its American counterpart cannot
sell for less than its intrinsic value, which
implies that an American put option can be
worth more than an otherwise identical
European option

Put-call parity 36
Put-call parity with dividends
Without dividends

or

With dividends

Put-call parity 37

Option pricing
Want to find the price of a European call on
IBM stock, which currently trades at
$90/share. The option expires in one year
and has a strike price of $95. The risk-free
rate over the next period is 5%

Option pricing - Binomial 38

Binomial approach
We assume there are two possible outcomes
for IBM share prices next period
• It can go up by 10%
• Or it can drop by 20%

Note that this is more general than you may

think!

What are the probabilities of up and down

move?
• Not needed!

Option pricing - Binomial 39

Binomial approach – Step 1

Draw payoff diagrams

$99 $1.05

$90 Stock $1 Risk-free asset

$72 $1.05

$4

?? CALL

$0

Option pricing - Binomial 40

Binomial approach – Step 2
Form tracking portfolio for option and find its
price. Under no-arbitrage the option and its
tracking portfolio must have the same price

The tracking portfolio of an option is a

portfolio of the underlying stock and the risk-
free asset

The tracking portfolio is dynamic because you

will change your strategy depending on the
outcome (i.e., exercise the option or not)

Option pricing - Binomial 41

Binomial approach – Step 2 …

We know the payoffs of the option, but now
want to track them. So, we want to create a
portfolio that solves the following

where
 = # of shares of stock (underlying asset)
= dollars invested in risk-free asset

Option pricing - Binomial 42

Binomial approach – Step 2 …
Solving, we get and

Thus 0.148 shares of IBM and $10.16

borrowed at the risk-free rate for one period
perfectly tracks the option

Option pricing - Binomial 43

Binomial approach – Step 3

Price of option = Price of tracking portfolio
= 0.148($90) − $10.16
= $3.16

Option pricing - Binomial 44

Risk neutral valuation
So, where were the probabilities of the up
and down states?

Why wasn’t risk aversion taken into account?

Since no-arbitrage price is unaffected by risk

preferences, we can use the following trick:

Assume everyone is risk-neutral then

calculate what the probabilities will be; We
get risk-neutral probabilities
Option pricing - Risk-neutral 45

Risk neutral valuation – Step 1

Draw payoff diagrams

$99 $1.05

$90 Stock $1 Risk-free asset

$72 $1.05

$4

?? CALL

$0

Option pricing - Risk-neutral 46

Risk neutral valuation – Step 2
Compute risk-neutral probabilities (, 1−)

Solve
90 = [ (99) + (1−) (72)]/1.05
Price today = E[Payoff tomorrow]/(1+risk-free
rate)

We get
90×1.05 = [27 + 72]
 = 0.833 and 1− = 0.167

Option pricing - Risk-neutral 47

Risk neutral valuation – Step 3

Apply risk-neutral probabilities to derivative
asset

Call price
= [($4) + (1−)($0)]/1.05
= 0.833×$4/1.05
= $3.16

Option pricing - Risk-neutral 48

Risk neutral valuation …
Easy to program in a computer

Once get  for a stock, or underlying security,

can apply it to all of its options

Option pricing - Risk-neutral 49

Risk neutral valuation …

Let the stock price in the up and down state
be denoted by Su and Sd
In the example Su=$99 and Sd=$72

Let the call value in the up and down state be

denoted by Cu and Cd
In the example Cu=$4 and Cd=$0

Option pricing - Risk-neutral 50

Risk neutral valuation …
Then, the risk-neutral probability is given by

Call price is given by

Option pricing - Risk-neutral 51

Two period example

Suppose we evaluate IBM over two time
periods, each with an up or down state. Let’s
assume price of IBM shares can either
increase by 10% or decrease by 20%

What is the price of a European call on IBM

with a strike price of $75 that expires in two
periods? Assume risk-free rate is 5% in each
period

Option pricing - Risk-neutral 52

 Two period example – Step 1
Payoff diagram

$108.9 = 99×1.1

$99
=90×1.1
$79.2 = 99×0.8 = 72×1.1
$90

$72
=90×0.8
$57.6 = 72×0.8
Stock

Option pricing - Risk-neutral 53

Two period example – Step 2

Compute risk-neutral probabilities

$108.9
0.833
90=[(99)+(1−)(72)]/1.05 99=[(108.9)+(1−)(79.2)]/1.05
$99 0.167
0.833 $79.2
$90
0.167 0.833
72=[(79.2)+(1−)(57.6)]/1.05
$72
0.167
$57.6

Option pricing - Risk-neutral 54

 Two period example – Step 3
Compute call price
$33.9 = 108.9 − 75
27.56=(0.833×33.9+0.167×4.2)/1.05
$27.56

$4.2 = 79.2 − 75
$22.40

$3.33
3.33=(0.833×4.2+0.167×0)/1.05
$0

22.40=(0.833×27.56+0.167×3.33)/1.05

Go backwards recursively

Option pricing - Risk-neutral 55

American call
Assume that IBM distributes a $5 dividend in
first period. Still assume that price of IBM
shares can either increase by 10% or
decrease by 20%

What is the price of an American call on IBM

with a strike price of $75 that expires in two
periods? Assume risk-free rate is 5%in each
period

Option pricing - Risk-neutral 56

 American call – Step 1
Payoff diagram

$108.9

$99
+$5
$79.2
$90

$72
+$5
$57.6
Stock

Option pricing - Risk-neutral 57

American call – Step 2

In last year, risk-neutral probability as before
In first year, take dividends into account
Why?

$108.9
90=[(99+5)+(1−)(72+5)]/1.05 0.833
99=[(108.9)+(1−)(79.2)]/1.05
$99 0.167
+$5
0.648 $79.2
$90
0.352 0.833
$72 72=[(79.2)+(1−)(57.6)]/1.05
0.167
+$5
$57.6

Option pricing - Risk-neutral 58

American call – Step 3
Compute American call price
27.56 ??
$33.9 = 108.9 − 75
29.0=max(27.56,99−75+5)
$29.0

19.02=max(19.02,90−75) $4.2 = 79.2 − 75

$19.02

$3.33
3.33=max(3.33,72−75+5)
$0
3.33 ??
19.02=(0.64829+0.3523.33)/1.05

Option pricing - Risk-neutral 59

American call …
Strategy:
• If in up state, exercise option right before
dividend is paid in order to receive it
• If in down state, wait and hold option until
expiration
• At time zero, wait

Option pricing - Risk-neutral 60

Real life option pricing
Monte Carlo Simulation
• A common technique for pricing derivative assets
in which the expected payoff of the derivative
security is estimated by calculating its average
payoff after simulating many random paths for
the underlying stock
• In the randomization, the risk-neutral
probabilities are used and so the average payoff
can be discounted at the risk-free rate to
estimate the derivative security’s value.

Option pricing - Risk-neutral 61

Making the model realistic

Although binary up or down movements are
not the way stock prices behave on an annual
or even daily basis, by decreasing the length
of each period, and increasing the number of
periods in the stock price tree, a realistic
model for the stock price can be constructed.

Option pricing - Black-Scholes 62

A binomial stock price path

Option pricing - Black-Scholes 63

Black-Scholes option pricing model

A technique for pricing European-style
options when the stock can be traded
continuously. It can be derived from the
Binomial option pricing model by allowing the
length of each period to shrink to zero and
letting the number of periods grow infinitely
large.
• Derived by Fischer Black, Myron Scholes and
Robert Merton in 1972
• Gives value of a European call option
• Based on no arbitrage

Option pricing - Black-Scholes 64

BS assumptions
 Stock returns
• are independent from period to period
• (continuously compounded) returns are normally
distributed
 Returns have constant variance
 No restrictions on the mean
• Remember we don’t need it...
 No dividends during the life of the option
 No transaction costs
 Constant interest rate

Option pricing - Black-Scholes 65

BS formula

Option pricing - Black-Scholes 66

BS formula …
= probability that a random draw from
a normal distribution will be less than

Option pricing - Black-Scholes 67

BS formula …
will always lie between 0 and 1

is the natural logarithm operator

You can replace by if you

prefer

and are just shorthand for the

fundamental parameters

Option pricing - Black-Scholes 68

BS formula …
Call price depends on
• Current price of stock
• Exercise price
• Time to maturity
• Volatility of stock
• Interest rate

Does not depend on

• Expected return on the stock

Option pricing - Black-Scholes 69

JetBlue option quotes

Option pricing - Black-Scholes 70

JetBlue option price

Option pricing - Black-Scholes 71

Implied volatility
BS formula shows that option price depends
on five parameters:
• The first four of these are directly observable

Can use the market price of the option to

back out the volatility that the market is
using to price the option
• Called implied volatility

Implied volatility is the value of σ that solves:

Market price = Black-Scholes price
Option pricing - Black-Scholes 72
JetBlue implied volatility

Option pricing - Black-Scholes 73

JetBlue implied volatility …

Option pricing - Black-Scholes 74

VIX – the fear index
Implied volatility of S&P500

Option pricing - Black-Scholes 75

VSTOXX (Euro Stoxx 50 “VIX”)

Option pricing - Black-Scholes 76