OPTIONS

Gives us an idea of volatility (risk, or standard deviation on risk). The price of each option is
fixed. Price above or below a certain threshold. In what directions price will go. Option price: I
can walk away from this if I am not in favor. It gives you the option to pay or sell – option price
or premium. We pay a price to be able to enter into this contract – that is an option. E.g.:
insurance.
o An option is a financial derivative contract that provides a party the right to buy or sell an
underlying at a fixed price by a certain time in the future.
o A call is an option granting the right to buy the underlying.
o A put is an option granting the right to sell the underlying.
o To obtain this right, the option buyer pays the seller a sum of money, commonly referred to
as the option price.

1. Uses of options:
a. To hedge risk:
The original reason for options. They act as a form of insurance policy for a particular
investment. I buy a stock at $25. If the price of the stock goes down, I lose money (value in my
investment), but my insurance policy goes up in value.
o Purchase a stock and a put option on that stock.
b. Speculative use:
One can increase leverage by trading options than the underlying.
o Buying out of the money options with large deltas.
c. Synthetics:
Options allow the creation of "synthetic instruments" that behave just like the real one.
o Reproduce a security using the Put-Call parity. I can combine these items to create
a call option + bond (US treasury) = owning a put option + stock. Create a
synthetic ownership simply by rearranging this: stock = call option + bond – put
option.
Risk neutral investment: I have a stock that goes up in price if stock price goes to the right, so
the profit goes up. So, the risk is that the stock price goes in the left direction, so what I need is
a type of instrument that moves in the other direction so I can create an optimal risk-free
investment.
Limited downside and unlimited upside. To do that, I buy the stock and I buy a put option on
that stock because stock price has a theoretical downside limit of 0, and theoretical upside of
infinity. The most I can lose on an investment is my entire investment, which is 0. If I include a
put option, my limit turns into put option value when stock price is 0, and infinity.
By doing that, we created a risk-free investment.
A bond on the other side is risk-free, meaning that Call + Bond = Put + Security stock. If price
of the stock goes up, the put option would be worthless, so we can use the proceeds of the bond
to buy the call option. If stock prices go down, the put option goes up in value, the call option
would be worthless, and bond stay at its nominal value, so we protect it.

d. Spreading:
Involves putting multiple options together to create investment strategies with limited risk
o Buying a put and a call to build a straddle and profit from volatility when price
movement is uncertain.
o Bonds: yield spreading. Option spreading allows u to create a portfolio with
different profit curves. With options, we can create financial instruments with any
type of profit curves.

2. Terminology:
 Underlying: The asset to which the option is linked. E.g.: google stock, by buying 1 option ,
I am controlling 100 shares of Google.
 Exercise price: the fixed price at which the option holder can buy or sell the underlying.
E.g.: 25$, buy (exercise price).
 Time to expiration: When the expiration date arrives, an option that is not exercised simply
expires. E.g.: 3 to 5 years.
 European option: The option can be exercised only on its expiration day
 American option: Such an option can be exercised on any day through the expiration day
 Multiplier: The amount of underlying controlled by one option contract

3. Contracts:
4. Pricing:
o An options market price is composed of two parts: the intrinsic value and the time value
o The intrinsic value is simply the delta between the exercise price of the option (X) and the
current price of the underlying (SO) so that:
o a call option is in the money if SO > X
o a call option is out of the money if SO < X
o a put option is in the money if SO < X
o a put option is out of the money if SO > X

Option intrinsic payoff call option

The second component of the option price is the residual between the market price and the
current intrinsic value.
The time value component is a function of the underlying expected volatility or risk, σ , the
current level of interest rates, r, and the options time to expiration, T.
The intrinsic value is a function of security price (S0) and exercise price (X).

Option price = Intrinsic value + Time value

e.g..: I want to buy the 141 option, the intrinsic value to buy it right now of the option would be
64 cents. If intrinsic value is 0.64, and the price is 1,66, the time value must be worth 1.02
because P = I (So – X)+ T.

5. Binomial pricing
The binomial model maps all the paths that the underlying can take from t=0 to a certain point
in time and accordingly constructs a second tree that maps the intrinsic price of the derivative.
Each point in time along the tree is called a node. At each node we value what the option would
be worth for a given price in the underlying. We then discount each node for the time value.
In order to build the binomial, we need to know:
a. by how much the price of the underlying will move
b. what is the probability of an upwards movement or downwards movement

Terminology of binomial pricing:

o S(t) = stock price at time t o D = the factor by which the stock
o σ = the standard deviation of returns moves downwards
o U = factor by which the stock moves o t = the time period

upward o r = risk free rate

o p = risk neutral probability

Step 1:
Find your volatility by calculating the standard deviation of returns (σ ).

Step 2:
Calculate your (U) factor by using the formula:

u=e
σ×
√ t
N
∧d=
1
u
where:
t = days until expiration / 360 N = number of nodes

Step 3:
Calculate your risk neutral probability using the formula:
t
( r −q) ×
N
e −d
p=
u−d
Where:
p = the probability of an up-move r = risk free rate
(1-p) = the probability of a down q = dividend yield
move

Step 4:
Build the tree:

rt
e n −d
p=
u−d
σ √ t
n

u=e
−σ √ t
n

d=e

1st step binomial example:

Imagine a stock currently trading at 100 with a volatility of 25% and risk free rate of 5 p.a.%.
The stock pays no dividends. Calculate the value of a one year "at the money" call option : S0 =
X.

a. Calculate U and D:
U = e^0.25 = 1.28
D = 1/1.28 = 0.78
b. Calculate P:
0.05
е −0.78
=0.54
1.28−0.78

c. Calculate Nominal Expected Payoff:

Upswing = ((1.28 * 100) - 100) * 0.54 = 15.12
Downswing = ((0.78 * 100) - 100) * 0.46 = 0 - out of the money
Total Expected Payout = 15.12
d. Discount Expected Payoff (using continuous compounding):
15.14 / e^0.05 =
= 15.14 / 1.05 = 14.3

2nd step binomial example:

Now imagine the same stock and option but realize that modelling for just one period doesn't
accurately capture the path that prices could follow. You thus decide to add more nodes to
your original model.

6. Options - Black Scholes

The binomial model can become quite tedious to calculate as one adds more nodes to the model.
As we add more nodes to our calculation, we slowly start moving towards continuous time
option pricing. The more nodes, the sooner I get to infinity (pricing in options not at time 0, nor
1, but being able to calculate at any point in time in space).
The Black Scholes model provides an elegant and easy to use alternative to price European
options that includes both intrinsic value and a time/volatility component.
The major inputs are the same as the binomial:
o Price of underlying = S o Standard deviation of returns = σ
o Exercise Price = X o Time to expiry = T

7. Options - Black Scholes - Breakdown

Use the Black-Scholes-Merton model to calculate the prices of European call and put options on
an asset priced at 68.5. The exercise price is 65, the continuously compounded risk-free rate is 4
percent, the options expire in 110 days, and the volatility is 0.38. There are no cash flows on the
underlying
Step 1: Calculate T (time to expiration)
 110 / 365 = 0.3014

Step 2: Calculate D1

( )( )
2
68.5 ( 0.38 )
¿ + 0.04+ ( 0.3014 )
65 2
D 1= 1
=0.4135
0.3014
0.38

Step 3: Calculate D2
1
d 2=0.4135−0.38 /0.3014=0.2049

Step 4: Look up in the normal probability table:

N(0.41) = 0.6591
N(0.20) = 0.5793

Step 5: Plug into the option price formula:

call = 68.5*(0.65991) - 65e^-0.04(0.3014)*(0.5793) = 7.95
put = 65e^-0.04(0.3014)*(1 - 0.5793) - 68.5* (1 - 0.65991) = 3.67

8. Options - Black Scholes – Assumptions

o The underlying price follows a lognormal probability distribution as it evolves through time
o The risk free rate is known and constant
o The volatility of the underlying asset is known and constant
o There are no taxes or transaction costs
o There are no cash flows on the underlying
o The options are European.
The higher the volatility, the higher the price of the option.
The bigger the gap between S and X (delta), the bigger the price of the option
The higher T is, a higher price in the option.

9. Options – The Greeks

Both binomial and Black-Scholes pricing show us that an options price is influenced by
multiple factors. These are commonly referred to as "the Greeks":
 Delta: measures the sensitivity of the option price to a change in the price of the underlying.
The delta of an option is also known as the hedge ratio because it specifies the number of
shares in the underlying security needed to offset a change in option value resulting from
changes in the underlying security price.
 Theta: measures the "time decay" or the sensitivity of the option price to the passage of
time. Theta is higher for shorter term options, especially at-the-money options.
 Gamma: measures the rate of change of Delta given a change in the price of the underlying.
As the time to expiration draws nearer, the gamma of at-the-money options increases while
the gamma of in-the-money and out-of-the-money options decreases.
 Vega: measures the sensitivity of the option price to changes in volatility (time, price of the
underlying).. Options tend to be more expensive when volatility is higher.

10. Implied volatility

Because options are forward looking their pricing incorporates expectations of volatility rather
than actual historical volatility. Although this disrupts a basic premise of the Black-Scholes
model it gives us into market predictions of stock movement.
Just like the term structure of interest rates, option contracts with different expiration dates can
be used to forecast how the volatility of the underlying security is expected to evolve over time.
These advanced probability-distribution and term-structure-of-volatility perspectives both use
the concept of implied volatility, which is defined as the volatility parameter that justifies a
quoted option price.
VIX is the volatility implied by the price for options on the S&P 500 Index.
STOCKS (NOT OPTIONS): If risk-free rate goes up, stocks go down. Inverse relationship btw
volatility of bonds and the proportion of stock prices??? min 124. When volatility goes up, stock
market goes down.
If standard deviation of returns, there is higher risk, higher discount rates.

*VOLATILITY INCREASES OPTIONS PRICES, BUT HIGH VOLATILITY IS NOT GOOD

FOR STOCKS.
In options, risk goes up and price of options increase.

11. Open interest

Open Interest is the total number of outstanding contracts that are held by market participants at
the end of each day. Where volume measures the pressure or intensity behind a price trend,
open interest measures the flow of money into the futures market. For each seller of a futures
contract there must be a buyer of that contract.
o The relationship between the prevailing price trend, volume, and open interest can be
summarized by the following table:

Price Volume Open interest Interpretation

Rising Rising Rising Market is strong
Rising Falling Falling Market is weakening
Falling Rising Rising Market is weak
Falling Falling Falling Market is strengthening