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Basics of Stock Options

Introduction

n Options are very old instruments, going back, perhaps, to the time of
Thales the Milesian (c. 624 BC to c. 547 BC).
n Thales, according to Aristotle, purchased call options on the entire
autumn olive harvest (or the use of the olive presses) and made a
fortune.
n Joseph de la Vega (in “Confusión de Confusiones,” 1688, 104 years
before the NYSE was founded under the buttonwood tree) also
wrote about how options were dominating trading on the
Amsterdam stock exchange.
n Dubofsky reports that options existed in ancient Greece and Rome,
and that options were used during the tulipmania in Holland from
1624-1636.
n In the U.S., options were traded as early as the 1800’s and were
available only as customized OTC products until the CBOE opened
on April 26, 1973.
What is an Option?

n A call option is a financial instrument that gives the buyer the right,
but not the obligation, to purchase the underlying asset at a pre-
specified price on or before a specified date
n A put option is a financial instrument that gives the buyer the right,
but not the obligation, to sell the underlying asset at a pre-specified
price on or before a specified date
n A call option is like a rain check. Suppose you spot an ad in the
newspaper for an item you really want. By the time you get to the
store, the item is sold out. However, the manager offers you a rain
check to buy the product at the sale price when it is back in stock.
You now hold a call option on the product with the strike price
equal to the sale price and an intrinsic value equal to the difference
between the regular and sale prices. Note that you do not have to
use the rain check. You do so only at your own option. In fact, if
the price of the product is lowered further before you return, you
would let the rain check expire and buy the item at the lower price.
Options are Contracts

n The option contract specifies:


¡ The underlying instrument
¡ The quantity to be delivered
¡ The price at which delivery occurs
¡ The date that the contract expires
n Three parties to each contract
¡ The Buyer
¡ The Writer (seller)
¡ The Clearinghouse
The Option Buyer

n The purchaser of an option contract is buying the right to


exercise the option against the seller. The timing of the
exercise privilege depends on the type of option:
¡ American-style options can be exercised any time before
expiration
¡ European-style options may only be exercised during a short
window before expiration
n Purchasing this right conveys no obligations, the buyer
can let the option expire if they so desire.
n The price paid for this right is the option premium. Note
that the worst that can happen to an option buyer is that
she loses 100% of the premium.
The Option Writer

n The writer of an option contract is accepting the obligation to have


the option exercised against her, and receiving the premium in
return.
n If the option is exercised, the writer must:
¡ If it is a call, sell the stock to the option buyer at the exercise price
(which will be lower than the market price of the stock).
¡ If it is a put, buy the stock from the put buyer at the exercise price
(which will be higher than the market price of the stock).
n Note that the option writer can potentially lose far more than the
option premium received. In some cases the potential loss is
(theoretically) unlimited.
n Writing and option contract is not the same thing as selling an
option. Selling implies the liquidation of a long position, whereas
the writer is a party to the contract.
The Role of the Clearinghouse

n The clearinghouse (the Options Clearing Corporation)


exists to minimize counter-party risk.
n The clearinghouse is a buyer to each seller, and a seller
to each buyer.
n Because the clearinghouse is well diversified and
capitalized, the other parties to the contract do not have
to worry about default. Additionally, since it takes the
opposite side of every transaction, it has no net risk
(other than the small risk of default on a trade).
n Also handles assignment of exercise notices.
Examples of Options

n Direct options are traded on:


¡ Stocks, bonds, futures, currencies, etc.
n There are options embedded in:
¡ Convertible bonds
¡ Mortgages
¡ Insurance contracts
¡ Most corporate capital budgeting projects
¡ etc.
n Even stocks are options!
Option Terminology
n Strike (Exercise) Price - this is the price at which the underlying security can be
bought or sold.
n Premium- the price which is paid for the option. For equity options this is the price
per share. The total cost is the premium times the number of shares (usually 100).
n Expiration Date– This is the date by which the option must be exercised. For stock
options, this is usually the Saturday following the third Friday of the month. In
practice, this means the third Friday.
n Moneyness – This describes whether the option currently has an intrinsic value above
0 or not:
¡ In-the-Money –
n for a call this is when the stock price exceeds the strike price,
n for a put this is when the stock price is below the strike price.
¡ Out-of-the-Money –
n for a call this is when the stock price is below the strike price,
n for a put this is when the stock price exceeds the strike price.
n American-style - options which can be exercised before expiration.
n European-style - options which cannot be exercised before expiration.
The Intrinsic Value of Options

n The intrinsic value of an option is the profit (not net profit!) that
would be received if the option were exercised immediately:
¡ For call options: IV = max(0, S - X)
¡ For put options: IV = max(0, X - S)
n At expiration, the value of an option is its intrinsic value.
n Before expiration, the market value of an option is the sum of the
intrinsic value and the time value.
n Since options can always be sold (not necessarily exercised) before
expiration, it is almost never optimal to exercise them early. If you
did so, you would lose the time value. You’d be better off to sell the
option, collect the premium, and then take your position in the
underlying security.
Profits from Buying a Call
Selling a Call
Profits from Buying a Put
Selling a Put
Combination Strategies

n We can construct strategies consisting of


multiple options to achieve results that aren’t
otherwise possible, and to create cash flows that
mimic other securities
n Some examples:
¡ Buy Write
¡ Straddle
¡ Synthetic Securities
The Buy-Write Strategy

n This strategy is more


conservative than
simply owning the
stock
n It can be used to
generate extra
income from stock
investments
n In this strategy we
buy the stock and
write a call
The Straddle

n If we buy a straddle, we
profit if the stock moves
a lot in either direction
n If we sell a straddle, we
profit if the stock
doesn’t move much in
either direction
n This straddle consists of
buying (or selling) both
a put and call at the
money
Synthetic Securities

n With appropriate combinations of the stock and options,


we can create a set of cash flows that are identical to
puts, calls, or the stock
n We can create synthetic:
¡ Long Stock — Buy Call, Sell Put
¡ Long Call — Buy Put, Buy Stock
¡ Long Put — Buy Call, Sell Stock
¡ Short Stock — Sell Call, Buy Put
¡ Short Call — Sell Put, Sell Stock
¡ Short Put — Sell Call, Buy Stock
n The reasons that this works requires knowledge of Put-
Call Parity
Put-Call Parity

n Put-Call parity defines the relationship between put


prices and call prices that must exist to avoid possible
arbitrage profits:

n In other words, a put must sell for the same price as a


long call, short stock and lending the present value of the
strike price (why?).
n By manipulating this equation, we can see how to create
synthetic securities (in the above form it shows how to
create a synthetic put option).
Put-Call Parity Example

n Assume that we find the following conditions:


¡ S = 100 X = 100
¡ r = 10% t = 1 year
¡ C = 16.73 P=?
Put-Call Parity Example
n Q: What is the value of the put?
n A: 7.21
n To see that the put must be priced at 7.21, first note that the portfolio that we have
created results in exactly the same payoffs, under all conditions, as a put option with a
strike price of 100. By the law of one price, all assets which provide the same cash
flows must be priced the same or arbitrage will force them to be the same. The net
cash outlay for our portfolio is 7.21, so the put price must be 7.21.
n Suppose that the put was priced at 8.00. In this case we could purchase our portfolio
(for 7.21) and sell the put (for 8). At expiration, if the stock is below 100 the stock
would be put to us at 100 (a cash outflow), we would sell the bond for 100 (a cash
Synthetic Long Stock Position

n We can create a
synthetic long
position in the
stock by buying a
call, selling a put,
and lending the
strike price at the
risk-free rate until
expiration
Synthetic Long Call Position

n We can create a
synthetic long
position in a call
by buying a put,
buying the
stock, and
borrowing the
strike price at
the risk-free rate
until expiration
Synthetic Long Put Position

n We can create a
synthetic long
position in a put
by buying a call,
selling the stock,
and lending the
strike price at the
risk-free rate
until expiration
Synthetic Short Stock Position

n We can create
a synthetic
short position
in the stock
by selling a
call, buying a
put, and
borrowing the
strike price at
the risk-free
rate until
expiration
Synthetic Short Call Position

n We can create a
synthetic short
position in a call
by selling a put,
selling the stock,
and lending the
strike price at the
risk-free rate
until expiration
Synthetic Short Put Position

n We can create a
synthetic short
position in a put
by selling a
call, buying the
stock, and
borrowing the
strike price at
the risk-free
rate until
expiration
Option Valuation

n The value of an option is the present value of its


intrinsic value at expiration. Unfortunately,
there is no way to know this intrinsic value in
advance.
n The most famous (and first successful) option
pricing model, the Black-Scholes OPM, was
derived by eliminating all possibilities of
arbitrage.
n Note that the Black-Scholes models work only
for European-style options.
Option Valuation Variables

n There are five variables in the Black-Scholes


OPM (in order of importance):
¡ Price of underlying security
¡ Strike price
¡ Annual volatility (standard deviation)
¡ Time to expiration
¡ Risk-free interest rate
Variables’ Affect on Option Prices

Variable Call Options Put Options


– Stock Price ¡ Direct ¡ Inverse
– Strike Price ¡ Inverse ¡ Direct
– Volatility
¡ Direct ¡ Direct
¡ Direct ¡ Inverse
– Interest Rate
¡ Direct ¡ Direct
– Time
Option Valuation Variables: Underlying Price

n The current price of the underlying security is


the most important variable.
n For a call option, the higher the price of the
underlying security, the higher the value of the
call.
n For a put option, the lower the price of the
underlying security, the higher the value of the
put.
Option Valuation Variables: Strike Price

n The strike (exercise) price is fixed for the life of


the option, but every underlying security has
several strikes for each expiration month
n For a call, the higher the strike price, the lower
the value of the call.
n For a put, the higher the strike price, the higher
the value of the put.
Option Valuation Variables: Volatility

n Volatility is measured as the annualized standard


deviation of the returns on the underlying
security.
n All options increase in value as volatility
increases.
n This is due to the fact that options with higher
volatility have a greater chance of expiring in-
the-money.
Option Valuation Variables: Time to Expiration

n The time to expiration is measured as the


fraction of a year.
n As with volatility, longer times to expiration
increase the value of all options.
n This is because there is a greater chance that the
option will expire in-the-money with a longer
time to expiration.
Option Valuation Variables: Risk-free Rate

n The risk-free rate of interest is the least important of the


variables.
n It is used to discount the strike price, but because the
time to expiration is usually not more than 3 months, and
interest rates are usually fairly low, the discount is small
and has only a tiny effect on the value of the option.
n The risk-free rate, when it increases, effectively
decreases the strike price. Therefore, when interest rates
rise, call options increase in value and put options
decrease in value.
The Black-Scholes Call Valuation Model

n At the top (right) is the


Black-Scholes valuation
model for calls. Below
are the definitions of d1
and d2.
n Note that S is the stock
price, X is the strike
price,  is the standard
deviation, t is the time to
expiration, and r is the
risk-free rate.
The Black-Scholes Call Valuation Model

The Black-Scholes-Merton option pricing


model says the value of a stock option is
determined by six factors:

S, the current price of the underlying


stock
y, the dividend yield of the underlying
stock
K, the strike price specified in the
option contract
r, the risk-free interest rate over the life
of the option contract
T, the time remaining until the option
contract expires

The Black-Scholes Call Valuation Model

The price of a call option on a single share


of common stock is: C = Se–yTN(d1) –
Ke–rTN(d2)

The price of a put option on a single share


of common stock is: P = Ke–rTN(–d2) –
Se–yTN(–d1)
The Black-Scholes Call Valuation Model

In the Black-Scholes-Merton formula, three common


fuctions are used to price call and put option prices:

e-rt, or exp(-rt), is the natural exponent of the


value of –rt (in common terms, it is a discount
factor)

ln(S/K) is the natural log of the "moneyness"


term, S/K.

N(d1) and N(d2) denotes the standard normal


probability for the values of d1 and d2.

In addition, the formula makes use of the fact that:

N(-d1) = 1 - N(d1)
B-S Call Valuation Example

n Assume a call with the following variables:


¡ S = 100 X = 100
¡ r = 0.05  = 0.10
¡ t = 90 days = 0.25 years
The Black-Scholes Put Valuation Model

n At right is the Black-


Scholes put valuation
model.
n The variables are all the
same as with the call
valuation model.
n Note: N(-d1) = 1 - N(d1)
B-S Put Valuation Example

n Assume a put with the following variables:


¡ S = 100 X = 100
¡ r = 0.05  = 0.10
¡ t = 90 days = 0.25 years
Naked Options - Margin

Method I
a.Calculate the option premium for No. of shares
b.Compute 0.20 (MP per share) x (No. of shares)
c.Compute the amount by which the contract is out of money

A+B -C

Method II
No.of shares x Option Premium per share + 0.10 (MP per share)x100

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