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