OPTIONS

THE TWO BASIC OPTIONS - PUT AND CALL

• Other options are just combinations of these.

• Options are “derivatives” and other derivatives may

include options

• The price of an option is called a “premium”

because options are equivalent to insurance and the
price of insurance is called a premium.
 CALL OPTION CONTRACT
Definition: The right to purchase 100 shares of a security at
a specified exercise price (Strike) during a specific
period.

EXAMPLE: A January 60 call on Microsoft (at 7 1/2)

This means the call is good until the third Friday of January
and gives the holder the right to purchase the stock from the
writer at $60 / share for 100 shares.

cost is $7.50 / share x 100 shares = $750 premium or

option contract price.
 PUT OPTION CONTRACT
Definition: The right to sell 100 shares of a security at a
specified exercise price during a specific
period.

EXAMPLE: A January 60 put on Microsoft (at 14 1/4)

This means the put is good until the third Friday of January
and gives the holder the right to sell the stock to the writer
for $60 / share for 100 shares.

cost $14.25 / share x 100 shares = $1425 premium.

 INTRINSIC AND TIME VALUE
•An option's INTRINSIC value is its value if it were
exercised immediately.

•An option's TIME value is its price minus its intrinsic

value.

Microsoft Stock Price = 53 1/4 at the time - October 1987

QUESTION: Which Microsoft option has greater intrinsic

value? - put

QUESTION: Which Microsoft option has greater time

value? - call
 BREAK EVEN
•CALL BREAKEVEN

The stock must rise $14.25 = (60 - 53.25) + 7.50

(premium) for the Call buyer to break even.

•PUT BREAKEVEN

The stock must fall $7.50 = (53.25 - 60) + 14.25 (premium)

for the Put buyer to break even.

QUESTION: Which Microsoft option is a better deal? -

depends your expectation

Look at Options Quotes: www.bigcharts.com

HOW TO CALCULATE PROFIT OR LOSS ON OPTIONS

TWO PARTS

•Cash flows from premiums

•Cash flows when you close out positions

If you close out before expiration, then option value is its

market value.

If you close out at expiration then:

Call value = Max[0, (Stock price - Exercise price)]

Put value = Max[0, (Exercise price - Stock price)]
EXAMPLE: Both Options on the same stock

Sell a put for $4 - strike = $45

Buy a call for $2 - strike = $55

Assume that the stock price ends at $58

premiums put 400

call -200

option values put 0

at expiration call 300
Net 500
 Assume that the stock price ends at $40

premiums put 400

same as above call -200

option value put -500

at expiration call 0
Net -300

Note: The value of the put is actually $500 but because you
sold the put, it costs you $500 to buy it back.
WHAT ARE YOUR PERCENT RETURNS ON THE CALL?
Net investment = premium = 200

Stock goes to $58

300  200
Re turn  .5 50%
200

Stock goes to $40

 200
Re turn   1  100%
200

The holder of opposite positions earns opposite results -

zero sum. This is because options are derivative securities
created by one individual (the writer (seller)) and bought
by another. Original issue of stocks does not have this.
HOW TO CLOSE OUT A POSITION IN AN OPTION.

• sell (or buyback) option

• exercise option
• let option expire - worthless

OPTIONS ALLOW

• large leverage but limited downside

• hedge a profit
 CALL STRATEGIES
•Buy option alone

not sure when stock will move =>use long maturity

most leveraged - high strike price

•Hedge

if you own stock - sell stock - buy option

if you don't own stock - short stock - buy option with
high strike price

•Sell option

naked - bearish on stock - receive premium

 PUT STRATEGIES

•Buy option

not sure when stock moves => use long maturity

most leverage - low strike price

•Hedge - own stock - buy put - protect profit

•Sell put naked - if bullish on stock

 COMBINED STRATEGIES

• straddle - 1 call and 1 put

• strip - 1 call, 2 puts

• strap - 2 calls, 1 put

• money spread

• time spread
Illustrate complex options using

www.wolframalpha.com (click “Examples”, then Money

and Finance” then under “Derivatives Valuation” click
“Option” then click “more” and select a complex option)

Explain the payoff profiles.

USE OPTIONS TO CUT UP PRICE DISTRIBUTIONS -
NOW CALLED "FINANCIAL ENGINEERING"
Stock Price Distribution

Present
Stock Price
Financial engineering involves combining purchases and sales of
stocks, options or futures to capture only the parts of a stock price
distribution that you want. The possibilities are endless. If you buy
only the stock you own the whole price distribution.

Put Present Call

Exercise Stock Price Exercise
Price Price

If you believe the stock will soon rise (fall) sharply, buy the right (left)
tail by purchasing a call (put). If you believe that the stock will either
rise or fall sharply, but don’t know which, buy both tails by purchasing
a call and a put. This combination is called a straddle. Selling both
tails is called a strangle.

Put Present
Exercise Stock Price
Price

If you are longterm bullish on a stock but wish to avoid any near-term
sharp decline, buy the stock and a put. This is called a protective put.
Of course, the put costs money so your net gains will be smaller.

Put Present Call

Exercise Stock Price Exercise
Price Price

One way to pay the additional costs of the put in a protective put is to
also sell a call of similar value. This is called a collar. Of course, by
selling the call you give up some gains if the stock price rises above
the call’s exercise price.
 BLACK - SCHOLES MODEL

CRUCIAL INSIGHT - it is possible to replicate the payoff

to an option by some investment strategy involving the
underlying asset and lending or borrowing.

We can do this because the option value and the stock value
are perfectly correlated – we need to know the hedge ratio
(how much the option price increase when the stock price
increases).

Therefore, we should be able to derive the value of an

option from the asset price and the interest rate.
THERE IS A HEDGE RATIO BETWEEN THE CALL AND STOCK
THAT ALLOWS ONE TO EXACTLY REPLICATE AN OPTION

For a simplified approach to replication one can use the

Binomial Model.

1. Assume that

S = Stock price today

C = Call option price today
r = risk-free rate
q = the probability the stock price will increase
(1-q) = probability the stock price will decrease
u = the multiplicative stock price increase
(u > 1 + r > 1)
d = multiplicative decrease (0 < d < 1 < 1 + r )
Cu = call price if stock price increases
Cd = call price if stock decreases
The hedge ratio specifies how one asset’s price
moves for a given change in another’s.
Each period the stock can take on only two values; the
stock can move up to uS or down to dS.

2. Construct a risk-free hedge portfolio composed of

one share of stock and m call options written against
the stock. This means the payoffs in the up or down
moves will be the same so that

uS – mCu = dS – mCd

Solve for m, the hedge ratio of calls to be written on

stock

m = S(u – d)/(Cu - Cd )
3. Because we constructed the portfolio to be risk-free,
then
(1 + r)(S – mC) = uS – mCu
Or
S [(1  r )  u ]  mCu
C
m(1  r )

4. Substituting for the hedge ratio m,

  (1  r )  d   u  (1  r )  
 Cu  u  d   Cd  u  d  
   
C 
1 r
Or to simplify let

(1  r )  d u  (1  r )
p and 1 p 
u d u d

So C = [pCu + (1 - p)Cd] / (1 + r)

Here, p is called the hedging probability, also called the risk-neutral

probability. The potential option payoffs Cu and Cd are multiplied by the
risk neutral probabilities and the sum is discounted at the risk-free rate.
(Note: the risk-neutral probability for the up (down) move is less (more)
than the objective probability that would be used if we discounted the
payoffs with a risk-adjusted rate (say a CAPM rate based on option beta)
because the value in the numerator must be smaller if we are discounting
at the smaller risk-free rate r.
Example: Suppose that a stock’s price is S=100 and it
can increase by 100% or decrease by 50%. If the risk-
free rate is 8% and the exercise price for the call is
$125, find the price of the call and the hedge ratio.
u = 2, d = 0.5, r = .08

Cu = Max [0, 200 – 125] = 75

Cd = Max [0, 50 – 125] = 0
  (1  .08)  .5   2  (1  .08)  
 75   0 
  2  .5   2  .5  
C 26.85
1  .08

m = S(u – d)/(Cu - Cd ) = 100(2 – .5)/(75 - 0) = 2

Here, the option price moves half as much as the
stock’s. Therefore, if you own one share of the stock in
this example, you can hedge, that is, eliminate your
risk, by selling two calls.

To see how hedging works, form a hedged portfolio by

buying one share and selling 2 options and find its risk-
free end-of-period value. (Why is this risk-free?)

Stock goes:
Down Up
Own the stock 50 200
Sold 2 options 0 -150
50 50
Find the present value of the portfolio’s end value by
discounting at the risk-free rate.

In this case, 50/(1+.08)=46.30.

You borrow this amount of money and add (S – 46.30)

= (100 – 46.30) = $53.70 of your own money to buy
one share. This leveraged position in the stock should
give the same return as owning two calls.

To see this note that in one year you pay off the loan
and you will have

150 [= 200 - 46.30(1+.08)] if stock goes to 200

or 0 [= 50 - 46.30(1+.08)] if the stock goes to
50.
Set the present value of the hedged portfolio equal to
its discounted risk-free value and solve for C.

Here, S - 2 C = 100 - 2C = 46.30 => C=26.85.

GET THE PUT VALUE - PUT/CALL PARITY FORMULA

Put Price = C - S + E/(1 + risk-free rate)t

For this case:

Put = 26.85 - 100 + 125/(1 + .08)1 = 42.6.

This model shows that, to get an option value, ones needs to

know the

• current stock price

• option’s exercise price
• risk-free rate
• option maturity
• stock price volatility.
BLACK-SCHOLES MODEL - A NEARLY EXACT
OPTION PRICING MODEL

C0 = P0N(d1) - E e-rt N(d2)

where Price of Stock = P0

Exercise price = E
Risk free rate = r
Time until expiration in years = t
Normal distribution function = N( )
Exponential function (base of natural log) = e
Note: Here the hedge ratio is represented by N(d1) and
N(d2) where:

ln( P0 / E )  (r .5 2 )t
d1 
 t

ln( P0 / E )  (r  .5 2 )t
d2  d 1   t
 t

where Standard deviation of stocks return = 

Natural log function = ln
NOTE: the call price is a weighted average of the stock
price and the present value of the exercise price
(replicating strategy – buy N(d1) shares and sell N(d2)
bonds).
The weights are cumulative probabilities of a
normal distribution. These probabilities are sometimes
described as “risk-adjusted” probabilities. For each (d), we
have the term ln(P0/E) which is the percent by which the
stock price exceeds the exercise price (i.e. is in the money).
Clearly, if the stock price exceeds the exercise price by a
large percentage, the more likely the option will be
valuable (i.e. exercised) at expiration. But note that
ln(P0/E) is divided by  so that the probability is adjusted
for the stock’s risk and the time to expiration. A call on a
risky stock (relatively large ) in the money by a given
 TO GET THE VALUE OF THE CALL, C0

EXAMPLE: ASSUME

Price of Stock P0 = 36
Exercise price E = 40
Risk free rate r = .05
time period 3 mo. t = .25
Std Dev of stock return  = .50

•Substitute into d1 and d2.

ln(36 / 40)  [.05.5(.50) 2 ].25

d1   .25
.50 .25

d  .25  .50 .25  .50

2
•Substitute d1, d2 and other variables in the main equation

C0 = 36N(-.25) - 40e-.05(.25)N(-.50)

•Look up in the normal table for d to get N(d).

here N(d1) = N(-.25) = .4013

and N(d2) = N(-.50) =.3085

•Substitute in the main equation

C0 36(.4013)  40e  .05(.25) (.3085) 2.26

USE PUT CALL PARITY FORMULA TO GET PUT PRICE
T0 = PUT PRICE

T0 C0  P0  Ee  rt
To see why this holds, look at the stock price distribution
and how the put gives you the left tail of the distribution.
Then see that shorting the stock and buying the call leaves
you with the same left tail. Or see that payoff at time t=0 is
equal on both sides no matter what price is.

EXAMPLE - use info above - you need the call price

T0 2.26  36  40e  .05(.25)

= 2.26 - 36 + 39.5 = 5.76
•BUYING A CALL OPTION IS LIKE BUYING STOCK
USING MARGIN MONEY

•BUYING A PUT IS LIKE SELLING A STOCK SHORT

AND INVESTING (LENDING) PROCEEDS.

One difference is that with an option, the most you

can lose is 100%.With margin you can lose more.

The attraction of an option is this limited loss

feature - this is why a premium is paid.

The more volatile the stock the more valuable this

feature is. (see futuresource.com –S&P volatility
term structure).
 HOW MARGIN WORKS
EXAMPLES: USING MARGIN MONEY - ignore interest

Assume: Required margin = 60%

Stock Price = 75
Investment = 30,000

Buy without margin borrowing

How many shares can you buy? - 30,000/75 = 400

Suppose price goes to 100

(400 x 100) - 30,000

% return = .333 33.3%
30,000
 Suppose price goes to 40

(400 x 40) - 30,000

% return =  .466  46.6%
30,000

Buy with margin borrowing - M = investable funds

= your funds/margin rate

How much do you have to invest counting margin

borrowing?

M = 30,000/.60 = 50,000

=> you borrow 20,000 and buy 50,000/75 = 667 shares

 Suppose price goes to 100
(667 x 100) - 30,000 - 20,000
% return = .556 55.6%
30,000

Note: Remember your investment at risk is still just 30,000

- must pay back 20,000 margin

Suppose price goes to 40

(667 x 40) - 30,000 - 20,000
% return =  .777  77.7%
30,000

Selling short and having to put up 60% margin gives the

same returns but opposite signs.
A stock is an option on the value of the firm if there is
debt in the capital structure. the value of the debt is the
strike price. shareholders exercise their option to own the
firm if the firm's value exceeds to value of debt, otherwise,
they default and give the firm to the debtholders.

Initial Values Firm Value Falls

Firm value 10mm 3mm
Debt value 5mm 3mm
EQUITY value 5mm 0mm