III.

Option Trading Strategies And Properties of Stock Options

- Basics - Trading Strategies
       

- Factors Affecting Option Prices - Bounds for Option Prices - Early Exercise of American Options
 

single option holdings straddle strip strap strangle bull spread bear spread butterfly spread

without dividends with dividends

J. Wei, Department of Management, UTSC

MGTC71

Basics
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Options:

right but not obligation to buy or sell an asset at a fixed price. Time period within which the right is in effect. the fixed price at which the asset can be sold or bought.

Time to Maturity:

Exercise price / Strike price:

European options: American options: Call option: Put option:

the right can be exercised only at maturity. the right can be exercised any time before maturity. right to buy. right to sell.

At-the-money, In-the-money, out-of-the-money. Intrinsic value (For example call: max[0, S - X])

J. Wei, Department of Management, UTSC

MGTC71

Trading Strategies
- Single Option Holdings.
Payoff
Long call (bullish)

X 0 ST

Payoff
Long put (bearish)

X 0 ST

J. Wei, Department of Management, UTSC

MGTC71

Trading Strategies
- Single Option Holdings.
Payoff
Short call (bearish)

0 X

ST

Short put (bullish)

Payoff

0 X

ST

J. Wei, Department of Management, UTSC

MGTC71

Trading Strategies
- Discussions:


Comparing long call with short put, gain in shorting put is limited, and that in long call is not. But long call involves upfront cash outflow, while short put involves upfront cash inflow; Comparing long put and short call, we see that shorting a call leads to unlimited loss but upfront cash inflows; long put leads to limited loss, but requires upfront cash outflow. Unlike stocks, options cannot be bought on margin. Must be paid in full. Margin for naked call: max [mc1, mc2], where mc1 : a total of 100% of the option proceeds plus 20% of the underlying share price less the amount if any by which the option is out of the money mc2: a total of 100% of the option proceeds plus 10% of the underlying share price

 

J. Wei, Department of Management, UTSC

MGTC71

Trading Strategies
- Discussions: (contd)


Margin for naked put: max [mp1, mp2], where mp1 : a total of 100% of the option proceeds plus 20% of the underlying share price less the amount if any by which the option is out of the money a total of 100% of the option proceeds plus 10% of the exercise price

mp2:

Example: Peter writes 5 naked call contracts for $3 per call. Stock price is $45 and exercise price is $47. Then mc1 = 500*[3 + 0.2*45 - (47 - 45)] = $5,000 mc2 = 500*[3 + 0.1*45] = $3,750 Therefore the initial margin is $5,000.

J. Wei, Department of Management, UTSC

MGTC71

Trading Strategies
- Straddle: one call and one put
Payoff

ST

    

Upfront cost of 2 options, p + c (next page) Use when you expect market to move a lot either way (Bre-X, 1997) When market doesnt move, you lose the premium. If you expect market to be stable, sell straddle. Nick Leeson (1995). Straddle on Nikkei 225 betting on no movements, but market went down. Bought in to shore up Nikkei, then Kobe earthquake did him in.
MGTC71 7

J. Wei, Department of Management, UTSC

Trading Strategies
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Straddle: (contd)


Payoff payoff from call 0 ST - X payoff from put X - ST 0 total payoff X - ST ST - X Net profit X - ST - c - p ST - X - c p

Range of stock price ST X ST X



Example: c = $4, p = $1.5, X = $40. If ST = 45, then net profit is, 45 - 40 - 4 - 1.5 = - $0.5. If ST = 55, then net profit is, 55 - 40 - 4 - 1.5 = $9.5

J. Wei, Department of Management, UTSC

MGTC71

Trading Strategies
- Strip: 1 call and 2 puts
Payoff

ST

 

Upfront cost of 3 options, c + 2p Use when you expect market to move, and more likely to go down (Good for those who think Guzmans death was fishy). If market does not move, then lose a bundle.

J. Wei, Department of Management, UTSC

MGTC71

Trading Strategies
-

Strip: (contd)


payoff payoff from payoff from call put 0 2(X - ST) ST - X 0 total payoff 2(X - ST) ST - X Net profit 2(X - ST) - c - 2p ST - X - c - 2p

Range of stock price ST X ST X



Example: c = $4, p = $1.5, X = $40. If ST = 45, then net profit is, 45 - 40 - 4 - 2(1.5) = - $2. If ST = 35, then net profit is, 2(40 - 35) - 4 - 2(1.5) = $3.

J. Wei, Department of Management, UTSC

MGTC71

10

Trading Strategies
- Strap: 2 calls and 1 put
Payoff

ST

 

Upfront cost of 3 options, 2c + p Similar to Strip, except that you think market will more likely move up (good for those who think there really is gold). For both Strip and Strap you can make your position more aggressive by choosing proper exercise prices. For example, if you really believe there is gold, then you can choose the options with very low exercise prices, X. This way you are guaranteed to make money even if the stock moves up only a little. But nothing is free. The two in-the-money calls will cost you more.
MGTC71 11

J. Wei, Department of Management, UTSC

Trading Strategies
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Strap: (contd)


Payoff payoff from call 0 2(ST - X) payoff from put X - ST 0 total payoff X - ST 2(ST - X) Net profit X - ST - 2c - p 2(ST - X) - 2c - p

Range of stock price ST X ST X



Example: c = $4, p = $1.5, X = $40. If ST = 45, then Net profit is, 2(45 - 40) - 2(4) - (1.5) = 40.5. If ST = 35, then net profit is, 40 - 35 - 2(4) - 1.5 = -$4.5

J. Wei, Department of Management, UTSC

MGTC71

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Trading Strategies
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Strangle: 1 call and 1 put with call exercise price higher than puts
Payoff

X1

X2 ST

 

  

Upfront cost of 2 options, c + p (next page) Similar to Straddle, but you think that the market will move a lot either way. Less expensive than a Straddle. Sell Strangle if you dont expect market to move a lot. Reason for being less expensive: If at X1, then call with X2 is less expensive; if at X2, then put with X1 is less expensive.
MGTC71 13

J. Wei, Department of Management, UTSC

Trading Strategies
-

Strangle: (contd)


payoff payoff from call 0 0 ST - X2 payoff from put X1 - ST 0 0 total payoff X1 - ST 0 ST - X2 Net profit X1 - ST - c - p -c - p ST - X2 - c - p

Range of stock price ST X1 X1STX2 ST X2



Example: c = $3, p = $1.2, X1 = $25, X2 = 30. If ST = 34, then net profit is, 34 - 30 - 3 - 1.2 = -$0.2. If ST = 27, then net profit is, - 3 - 1.2 = -$4.2. If ST = 20, then net profit is, 25- 20 - 3 - 1.2 = $0.8.

J. Wei, Department of Management, UTSC

MGTC71

14

Trading Strategies
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Bull Spread: (long call with X1) + (short call with X2), with X2 > X1
Payoff

X1

X2 ST

  

c(X2) < c(X1), upfront cash outflow, - c1 + c2 Use when you expect market to go up. Different from single call, because it is less expensive; different from selling put, because loss is limited to a small amount.

J. Wei, Department of Management, UTSC

MGTC71

15

Trading Strategies
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Bull Spread: (contd)

payoff Range of stock price ST X1 X1STX2 ST X2
 

payoff from call one 0 ST - X1 ST - X1

payoff from call two 0 0 -(ST - X2)

total payoff 0 ST - X1 X2 - X1

Net profit -c1 + c2 ST - X1 - c1 + c2 X2 - X1 - c1 + c2

Example: c1 = $5, c2 = $1.5, X1 = $26, X2 = 30. If ST = 34, then net profit is, 30 - 26 - 5 + 1.5 = $0.5. If ST = 27, then net profit is, 27 - 26 - 5 + 1.5 = -$2.5. If ST = 20, then net profit is, - 5 + 1.5 = - $3.5.

J. Wei, Department of Management, UTSC

MGTC71

16

Trading Strategies
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Bear Spread: (short call with X1) + (long call with X2), with X2 > X1
Payoff

X1

X2

ST

  

Since c(X1) > c(X2), upfront cash inflow, c1 - c2 Use when you expect market to go down. Both gain and loss are limited, just like bull spread.

J. Wei, Department of Management, UTSC

MGTC71

17

Trading Strategies
-

Bear Spread: (contd)



payoff (exactly the opposite of bull spread) payoff from call one 0 -(ST - X1) -(ST - X1) payoff from call two 0 0 (ST - X2) total payoff 0 -(ST - X1) -(X2 - X1) Net profit c1 - c2 -(ST - X1) + c1 - c2 -(X2 - X1) + c1 - c2

Range of stock price ST X1 X1STX2 ST X2



Example: c1 = $5, c2 = $1.5, X1 = $26, X2 = 30. If ST = 34, then net profit is, -(30 - 26) + 5 - 1.5 = -$0.5. If ST = 27, then net profit is, -(27 - 26) + 5 - 1.5 = $2.5. If ST = 20, then net profit is, 5 - 1.5 = $3.5.

J. Wei, Department of Management, UTSC

MGTC71

18

Trading Strategies
-

Butterfly Spread: (long call with X1) + (long call with X3) +
(short 2 calls with X2 = (X1 + X3) / 2)

Payoff

X1

X2

X3 ST

  

Requires a small initial investment, c1 + c3 - 2c2 (next page) Use when you expect market to be stable. Different from selling Straddle, because the loss is limited to a small amount in both directions of market movements. Exercise: what if (long put with X1) + (long put with X3) + (short 2 puts with X2 = (X1 + X3) / 2)?
MGTC71 19

J. Wei, Department of Management, UTSC

Trading Strategies
-

Butterfly Spread: (contd)



Payoff
payoff from call one 0 ST - X1 ST - X1 ST - X1 payoff from call two 0 0 -2(ST - X2) -2(ST - X2) payoff from call three 0 0 0 ST - X3 Net profit - c1 - c3 + 2c2 ST - X1 - c1 - c3 + 2c2 X3 -ST - c1 - c3 + 2c2 - c1 - c3 + 2c2

Range of stock price ST X1 X1STX2 X2STX3 ST X3

(Note: 2X2 - X1 = X3, and 2X2 - X1 - X3 = 0)



Example:
X1 = $26, X3 = 32, X2 = (26+32)/2 = 29, c1 = $5, c2 = $2.5, c3 = $1.5, If ST = 36, then net profit is, - 5 - 1.5 + 2(2.5) = -$1.5. If ST = 27, then net profit is, 27-26 - 5 - 1.5 + 2(2.5)= -$0.5. If ST = 20, then net profit is, - 5 - 1.5 + 2(2.5) = - $1.5.

J. Wei, Department of Management, UTSC

MGTC71

20

Factors Affecting Option Prices

-

Stock price and exercise price:

Call: Put: S increases ==> C increases, X increases ==> C decreases S increases ==> P decreases, X increases ==> P increases

Time to Maturity


Both American calls and puts become more valuable as time to maturity increases. This is because owners of longer maturity options enjoy all the rights available to a shorter maturity option owner, plus more. For European call and put options, longer time to maturity may not be beneficial because sometimes it is better to exercise early. For example, when the stock price is close to zero, it is better to exercise a put early so that interests can be earned on the exercise price. (For calls, when dividends are high, longer maturities may hurt too.)
MGTC71 21

J. Wei, Department of Management, UTSC

Factors Affecting Option Prices

-

Interest Rate


For both American and European, r increases ==> c increases r increases ==> p decreases Interest rate affects option price in two ways. When interest rate is high, the overall growth in the stock price is high. But the discount rate also becomes higher. For put options, both effects work against the put price, hence, unambiguously, put price goes down as interest rate goes up. For call options, it can be shown that the growth effect dominates the discount effect, hence r increases ==> c increases.

Volatility
For both call and put options, higher volatility benefits prices. This is because of the non-symmetric nature of the payoff.

J. Wei, Department of Management, UTSC

MGTC71

22

Factors Affecting Option Prices

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Dividends
Since stock values go down after dividend payments, dividends will reduce call option value and increase put option value. Variable stock price strike price time to maturity volatility interest rate dividends European call + ? + + European put + ? + + American call + + + + American put + + + +

J. Wei, Department of Management, UTSC

MGTC71

23

Bounds for Option Prices

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Notation
S: X: T: C: c: P: p: current stock price exercise price time to maturity value of America call value of European call value of America put value of European put

Call options
 

S C c max [ 0, S - Xe-rT ] Proof : S C c is obvious what about c max [ 0, S - Xe-rT ] ?

J. Wei, Department of Management, UTSC

MGTC71

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Bounds for Option Prices

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Call options


Proof : (contd) Portfolio A: call and T-bill with face value X, and maturity T Portfolio B: stock VA = c + Xe-rT VB = S At Maturity: VAT VBT

ST u X
ST ST VAT VBT

ST e X
X ST

Therefore, VA VB, or c + Xe-rT S, c S - Xe-rT Since c > 0, therefore c max [ 0, S - Xe-rT ].

J. Wei, Department of Management, UTSC MGTC71

i.e.

Q.E.D.
25

Bounds for Option Prices

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Call options


What if c < S - Xe-rT ? E.g., S = 100, X = 100, r = 0.1, T = 1 yr, c = 8.50 Then, S - Xe-rT = 100 - 100e - 0.1 = 9.516 > c Arbitrage: Short a stock, purchase a T-bill and a call. Proceeds from the transaction is: V0 = S - Xe-rT - c = $1.016 At maturity: ST X = 100 ST X = 100 T-bill 100 100 stock short -ST -ST call ST - 100 0 . Total 0 100 - ST > 0 End result: pocket $1.016 today, and possibly 100 - ST > 0 at maturity. Can not last long: c and S , until c max [ 0, S - Xe-rT ]

J. Wei, Department of Management, UTSC

MGTC71

26

Bounds for Option Prices

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Put Options
American: European:


X P max [0, X - S] Xe-rT p max [0, Xe-rT - S]

proof : X P max [0, X - S] is obvious Xe -rT p The best scenario for a European put is when the current stock price is zero, and remains at zero. In this case, the put will be for sure worth X at maturity, which is Xe -rT in todays terms. This is the maximum value of the put. Hence, p Xe -rT.

J. Wei, Department of Management, UTSC

MGTC71

27

Put Options


Bounds for Option Prices

proof : (contd) p max [0, Xe -rT - S] Portfolio A: long put and stock Portfolio B: T-bill with face value X VA = p + S VB = Xe -rT ST u X At maturity: ST VAT X VBT Since VAT VBT, we have VA VB, that is, p + S Xe -rT , or p Xe -rT - S Since p > 0 , therefore p max[0, Xe -rT - S]
MGTC71

ST e X
X X

Q.E.D.
28

J. Wei, Department of Management, UTSC

Bounds for Option Prices

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Put Options
Example: p = $2.5, X = $50, S = 45, r = 5%, t = 0.5 Then, p = 2.5 < Xe -rT - S = 3.765 Arbitrage strategy: buy stock and put, short T-bill (i.e. borrow PV of X) Current position: V0 = Xe-rT - p - S = $1.265 At maturity: T-bill (loan) stock put Total End result: ST X = 50 -50 ST 0 ST - 50 > 0 ST X = 50 -50 ST 50 ST 0

pocket $1.265 today, and possibly ST - 50 > 0 at maturity. Can not last long: p and S , until p max[0, Xe -rT - S]
MGTC71 29

J. Wei, Department of Management, UTSC

Bounds for Option Prices

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A call options price is convex in its exercise price, i.e.

If Then X3 = X1 + (1 - )X2 c(X3) c(X1) + (1 - )c(X2), and C(X3) C(X1) + (1 - )C(X2) (0 < < 1)

A put options price is convex in its exercise price, i.e.

If Then X3 = X1 + (1 - )X2 p(X3) p(X1) + (1 - )p(X2), and P(X3) P(X1) + (1 - )P(X2) (0 < < 1)

J. Wei, Department of Management, UTSC

MGTC71

30

Bounds for Option Prices

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Example of convexity
three options with the same time to maturity. S = 40, X1 = 40, X2 = 50 c1 = 4, c2 = 3. X3 = (0.2)(40) + (0.8)(50) = 48, then the value of the option with exercise price of 48 cannot be more than (0.2)(4) + (0.8)(3) = 3.2 Otherwise, there is arbitrage opportunity. Suppose c3 = $3.6. Since c(X3) = 3.6 > c(X1) + (1 - )c(X2) = 3.2, Short c3, buy 0.2 units of c1 and 0.8 units of c2 Current position: V0 = 3.6 - (0.2)(4) - (0.8)(3)=$0.4

J. Wei, Department of Management, UTSC

MGTC71

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Bounds for Option Prices

-

Example of convexity (Contd)

At maturity: ST 50 c3 0.2c1 0.8c2 Total -(ST - 48) 0.2(ST - 40) 0.8(ST - 50) 0 40 ST 48 0 0.2(ST - 40) 0 0.2(ST - 40) > 0 48 ST 50 -(ST - 48) 0.2(ST - 40) 0 0.8(50 - ST) > 0 ST 40 0 0 0 0

c3 0.2c1 0.8c2 Total End result:

J. Wei, Department of Management, UTSC

pocket $0.4 today, and possibly more at maturity. Cannot last long.
MGTC71 32

Bounds for Option Prices

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Relative pricing
If X2 > X1, then for European calls, c(X1) - c(X2) (X2 - X1)e -rT for European puts, Example: p(X2) - p(X1) (X2 - X1)e -rT r = 0.1, X1 = 40, X2 = 42, c1 = 4, T = 1.0 yr, then, 4 - c2 e -(0.1)(1.0) (42 - 40) = 1.81 ===> c2 2.19. Therefore, the value of the second call cannot be smaller than 2.19. Exercise: show how to take advantage of arbitrage if c2 = $2.

J. Wei, Department of Management, UTSC

MGTC71

33

Bounds for Option Prices

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European options with dividends

Let D be the present value of dividends before option maturity  call options, c max [ 0, S - D - Xe -rT]  put options, p max [ 0, D + Xe -rT - S]


Proof (for call): Portfolio A: Portfolio B: At maturity: VAT VBT

One European call plus T-bill of face value De rT + X. One share.

ST u X
ST + De rT ST + De rT

ST e X
De rT + X ST + De rT

J. Wei, Department of Management, UTSC

MGTC71

34

Bounds for Option Prices

-

European options with dividends



Proof (for call): (contd) Since VAT VBT Therefore, c + D + Xe -rT S, c S - D - Xe rT

VA VB, i.e. or

Since c > 0, therefore c max [ 0, S - D - Xe -rT]



Proof (for put): Similar. Do it as an exercise.

J. Wei, Department of Management, UTSC

MGTC71

35

Bounds for Option Prices

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Put - Call Parity.



European options with no dividends: c + Xe -rT = p + S Proof : Portfolio A: Call + T-bill with face value of X Portfolio B: Put and stock At maturity:

ST u X
ST ST

ST e X
X X

VAT VBT Therefore:



VA = VB

European options with dividends c + D + Xe -rT = p + S D = PV of dividends. Proof : Similar. Do it as an exercise.

J. Wei, Department of Management, UTSC

MGTC71

36

Early Exercise of American Options

-

Without Dividends


Call Options Since C c, and c max[0, S - Xe -rT] early exercise is not desirable, because S - X < S - Xe -rT. To see it another way, call options provide insurance against the price going down. If exercise early and price goes down subsequently, then suffer the loss. Also, by postponing exercising, you save the interest earnings on the exercise price.

Put Options An American put may be exercised early. Therefore P p. Also, P X - S. Consider an extreme example, where the stock is worth zero now due to bankruptcy. If exercise now, you get X. But if wait until maturity, you still get X. And you lose the interest earnings on X.

J. Wei, Department of Management, UTSC

MGTC71

37

Early Exercise of American Options

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With Dividends


Call Options Early exercise of calls is likely because of the drop in stock price on ex-dividend date. If the price drop is much bigger than the interest earnings on the exercise price, then early exercise may be optimal. Ex-dividend date: Dividends: t1 D1 t2 D2 t3...........tn, with D3.........Dn.

J. Wei, Department of Management, UTSC

MGTC71

38

Early Exercise of American Options

(contd from previous slide) At time tn: If exercise: S(tn) - X. If wait, then option worth at least S(tn) - Dn - Xe -r(T - tn) condition for not early exercise is S(tn) - Dn - Xe -r(T - tn) > S(tn) - X or, Dn < X (1 - e -r(T - tn)) i.e. not early exercise if the size of dividend is not as big as the interest earnings on the exercise price. In general, at time ti, condition for not early exercise is:

Di
J. Wei, Department of Management, UTSC

X (1  e  r ( t i 1 ti ) )
MGTC71 39

Early Exercise of American Options

Example: American Call, T - t = 6 months. Two dividends before maturity: D1 = $1.2 to be paid one month from now, and D2 = $2.5 to be paid four months from now. X = $100, r = 0.1 At t2 = 4 months: X [1 - e -r(T - t2)] = 100[1 - e -0.1 * 2/12] = $1.65 Since D2 = 2.5 > 1.65 there is a possibility that call may be exercised at t2 = 4 months. At t1 = one month, X[1 - e -r(t2 - t1)] = 100 [1 - e -0.1 x 3/12] = $2.47 Since D1 = 1.2 < 2.47, There is no early exercise possibility at t = one month.

Put Options As in the case of no dividends, early exercise is still possible. But dividend payments make early exercise less likely.

J. Wei, Department of Management, UTSC

MGTC71

40