OPTIONS

OPTIONS PRICING
PRICING

WHAT ARE OPTIONS?

Options are derivative financial instruments dependent on the value of underlying

securities, for example, stocks. The owner of the option has the right but not the obligation
to use the option.

CALL VS. PUT

- A call option is a contract giving its owner the right to buy shares of a stock at a fixed price.

- A put option is a contract giving its owner the right to sell shares of a stock at a fixed price.

AMERICAN VS. EUROPEAN OPTIONS

- If the option can be exercised any time before the maturity date it is called an American
option.

- If it is only possible to exercise it at the date of expiration, it is termed a European option.

PAYOFF VS. PROFIT

Option payoff implies the gross value of an option at the maturity date, excluding the initial
transfer of the premium.

Option profit means showing the net gain or loss of a position in options by also accounting for
the costs and gains of establishing the position.

USEFUL TERMS AND ABBREVIATIONS IN OPTIONS PRICING

S = The current price of the underlying stock

C = The current value of the associated call
P = The current value of the associated put
K = The exercise price of the option (aka E or X) - the price at which the underlying security can
be bought or sold when trading options.
rf = The risk-free interest rate
T = time to maturity
σ = Standard deviation of the price of the underlying stock (not used in this stage case for
simplicity)

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 PAYOFF DIAGRAMS

payoff LONG CALL payoff LONG PUT

K S K S

buying a right to buy buying a right to sell

SHORT CALL SHORT PUT

payoff payoff

K K

S S

selling a right to buy selling a right to sell

USEFUL FORMULAS IN OPTIONS PRICING: r = annual (nominal) interest rate e = mathematical constant ~ 2.71828

growth rate 1 - rf
u = e d = Annual Discount Factor = e
u

r Option value = (payoff from upstep * probability of

e f- d
Pu= Pd = 1-Pu upstep + payoff from downstep * probability of
u-d
downstep) * annual discount factor
u = upstep d= downstep rf= annual risk-free interest rate
Pu = probability of upstep Pd = probability of downstep

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 EXAMPLE - EUROPEAN CALL OPTION
Calculations
Assumptions growth rate 18%
Annual up factor (u) = e =e = 1.20x
Stock Price today = 650$
Annual down factor (d) = 1/u = 1/1.20 = 0.84x
Annual risk-free rate = 3% - rf - 3%
Continuously compounded annualized up Annual discount factor = e = e = 0.97
and down return = 18% Up probability = (e r - d) / (u-d) = (e 3% - 1.20) /
f

Annual risk-free rate = 3% (1.20 - 0.84) = 53.93%

Strike Price = 600 $ Down probability = 1- up probability = 46.07%

t=0 t=1 t=2

S2 = S 1* u
S2= 778.19 * 1.20 = 931.66

S 1= S 0 * u
Payoff based on
S1= 650 * 1.20 = 778.19
S T ++
Expected value of
two values from t=2
S0= 650 S - K = 931.66 - 600 = 331.6
discounted by one
Expected value of period
S2= 778.19 * 0.84 = 650
two values from t=1 ( * Pu + * P d ) * discount factor
discounted by one (331.6* 53.93% + 50 * 46.07%) * 0.97 =
195.92
Payoff based on
period
S 1= S 0 * d
S T +-
Call value = S1= 650 * 0.84 = 542.93
( *P + * P ) * discount factor
u d Expected value of
(195.92 * 53.93% + 26.17 * 46.07%) * 0.97 =
S - K = 650 - 600 = 50
114.23
two values from t=2
discounted by one
period S2= 542.93 * 0.84 = 453.49

( *P +
u
* P ) * discount factor
d
(50 * 53.93% + 0 * 46.07%) * 0.97 =
26.17
Payoff based on
1. Calculate the binomial tree for the underlying stock’s S T --
share price from today (t = 0) until expiration (t = T) using -
the up factor U and the down factor D.
S - K = 453.49 - 600 = - ... -> -
NB! Given the nature of the assumptions (i.e., D=¹⁄U), you
(<0)
should only have T+1 (not 2^T) possible stock prices at
time t=T.
2. At t=T, compute all the possible payoffs of the option
for all potential share prices at expiration based on the NB! These risk-neutral up and down probabilities are NOT the
strike price and the nature of the option (i.e., call, put, market consensus probabilities that the stock will go up or
etc.). down.
3. Calculate the expected option payoff at t=T using the
f
risk-neutral up and down probabilities. Then, discount 4. Repeat step 3 for times t=T-2,T-3,… until you find the value
f
these expected payoffs using the risk-free rate (r_f) to find of the option at t=0. This should be the fair price of the option
the option value at t=T-1 (i.e., one period prior to according to the binomial tree model.
expiration). This value is called the continuation value of
the option at time t=T-1.

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 EXAMPLE - AMERICAN PUT OPTION (same assumptions)

t=0 t=1 t=2

S2 = S 1* u
S = 778.19 * 1.20 = 931.66
2

S 1= S 0 * u
Payoff based on
S1= 650 * 1.20 = 778.19
S T ++
The expected value is the
highest of the two: discounted
S0= 650 future payoffs from t=2 or if K - S = 600 - 931.66 = - ... -> -
(<0)
you were to exercise the
The expected value is the option right now. S2= 778.19 * 0.84 = 650
highest of the two:
( * Pu + * P ) * discount factor
discounted future payoffs d
(0 * 53.93% + 0 * 46.07%) * 0.97 =
from t=1 or if you were to 0 Payoff based on
exercise the option right now. -
S 1= S 0 * d S T +-
Call value = S1= 650 * 0.84 = 542.93
( *P + * P ) * discount factor
u d The expected value is the K - S = 600 - 650= - ... -> -
(0 * 53.93% + 65.51* 46.07%) * 0.97 = highest of the two: discounted (<0)
29.29
future payoffs from t=2 or if S2= 542.93 * 0.84 = 453.49
Compare with K-S (600-650=-50) -> you were to exercise the
29.29>-50
option right now.
Payoff based on
( * Pu + * P d ) * discount factor
(0 * 53.93% + 146.51 * 46.07%) * 0.97 = S T --
65.51
Compare with K-S (600-542.93=57.07) ->
65.51>57.07
K - S = 600 - 453.49 = 146.51

1. Calculate the binomial tree for the underlying

stock’s share price from today (t = 0) until
expiration (t = T) using the up factor U and the NB! These risk-neutral up and down probabilities are
down factor D. NOT the market consensus probabilities that the
NB! Given the nature of the assumptions (i.e., stock will go up or down.
D=¹⁄U), you should only have T+1 (not 2^T) possible 4. For American options, as they can be exercised at
stock prices at time t=T. any time, first calculate the expected value at t=T by
2. At t=T, compute all the possible payoffs of the discounting future payoffs (step 3) and compare this
option for all potential share prices at expiration value with stock minus exercise price (as if you were
based on the strike price and the nature of the to exercise the option at this time). Continue further
option (i.e., call, put, etc.). calculations with the highest number from these
3. Calculate the expected option payoff at t=T two.
using the risk-neutral up and down probabilities. 5. Repeat step 3 and 4 for times t=T-2, T-3,… until
Then, discount these expected payoffs using the you find the value of the option at t=0. This should be
risk-free rate (r_f) to find the option value at t=T-1 the fair price of the option according to the binomial
(i.e., one period prior to expiration). This value is tree model.
called the continuation value of the option at time
t=T-1.

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