Week 2 - Introduction to Options

Part 1: Design of Option Contracts

Participations in the Option Markets
● Option holder (also called long position or option buyer):
○ Holds the option to buy an asset at a predetermined exercise (strike) price
○ Pays option premium when establishing the option contract
○ At the settlement date, receives either positive cash flows or no cash flows
● Option writer (also called short position or option seller):
○ Has the obligation to trade for a predetermined strike price if the other party
executes the option
○ Receives the option premium when establishing the option contract as a
compensation for bearing risk
○ At the settlement date, faces either negative cash flows or no cash flows
● The option premium should be sufficient compensation for the risk of the short position

Option Types: Puts and Calls

● Call option – the right to buy the underlying asset at the strike price:
○ The holder (long position, buyer) has the right to purchase an asset for a
predefined price
○ The writer (short position, seller) has the obligation to sell an asset for a
predefined price
○ Execution of option right only when the price of the underlying asset increases
above the strike price
● Put option – the right to sell the underlying asset
at the strike price
○ The holder (long position, buyer) has the
right to sell an asset for a predefined price
○ The writer (short position, seller) has the
obligation to purchase an asset for a
predefined price
○ Execution of option right only when the
price of the underlying asset decreases
below the strike price
● Example: Apple options chain

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Call Option: Payoff and Profit
● Payoff is the value of option at expiration: compare asset price (𝑆t) and strike price (𝑋)
● Profit: option payoff at expiration adjusted for the original purchase price

Put Option: Payoff and Profit

● Payoff is the value of option at expiration: compare asset price (𝑆t) and strike price (𝑋)
● Profit: option payoff at expiration adjusted for the original purchase price

Moneyness
● The option value depends on the diff between the stock price and exercise price:
○ Relevant when the option expires
○ But also at all other moments, as the current price will be the best estimate of the
price at expiration
○ Moneyness measures the ratio of the asset price (𝑆t) and strike price (𝑋)
● 3 possible states of the relation between the stock price (𝑆t) and strike price (𝑋):
○ Option is in-the-money: the exercise would produce a positive cash flow
■ Call option is in-the-money when 𝑆t > 𝑋
■ Put option is in-the-money when 𝑆t < 𝑋

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 ○ Option is at-the-money: the exercise price and asset price are equal
○ Option is out-of-the-money: the holder would not exercise as it does not deliver a
positive cash flow
■ Call option is out-of-the-money when 𝑆t < 𝑋
■ Put option is out-of-the-money when 𝑆t > 𝑋

Option Types: European and American Options

● European options:
○ Exercise right to buy or sell only on the expiration date
● American options:
○ Exercise right to buy or sell at any time prior to the expiration date
○ The additional flexibility is valuable, but why would you exercise before the
settlement date?
○ For puts, early exercise is only sensible if the underlying asset (company) is close
to bankruptcy
○ For calls, early exercise is only sensible if the underlying asset (company) is
paying suddenly a big dividend
● Notes:
○ Names have nothing to do with the continent where the options are traded
○ For example, you can have a European put option traded in New York
○ The payoffs figures from the previous slides apply strictly speaking only to
European-style options, but they are relevant also for most American style options
as well)

Option Markets and Underlying Assets

● Options are popular on a wide range of underlying assets:
○ Stocks (individual stocks have had options traded on them longer than futures)
○ Index options
○ Foreign currency options
○ Interest rate options
○ Options on commodities
○ Future Options

Example: Call Option on Apple, S0=164.66 on April 6, 2023

● Characteristics of call option:
○ Price of $5.55 on 6 April 2023 and exercise price of $170
○ The option expires on 16 June 2023 (Note: by convention, stock option expiration
dates are always Fridays, usually the 3rd or 4th Friday in a month)
● If Apple trades below $170, the call will expire worthless
● But what if Apple trades for $175 on the 16th?

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 ● Payoff or value of call option:
○ Stock price at expiration – exercise price = 𝑆t − 𝑋 = $175 − $170 = $5
○ Profit of call option:
■ Option value at expiration – option price = 𝑆t − 𝑋 − 𝑃 = $5 − $5.55 =
−$0.55
○ The option will be exercised to offset part of the loss caused by the premium
■ The option is still in-the-money!
■ For the option holder, this call will not be strictly profitable unless Apple’s
price exceeds $175.55 (strike + premium) by expiration

Example: Put Option on Apple

● Characteristics of put option:
○ Premium (price) of $4.10 on 6 April 2023
○ Exercise price of $155
○ The option expires on 16 June 2023
● If Apple trades above $155, the put will expire worthless
● But what if Apple trades for $130 on the 16th?
● Payoff or value of put option:
○ Exercise price – Stock price at expiration = X − 𝑆t = $155 − $130 = $25
● Profit of put option:
○ Option value at expiration – option price = X − 𝑆t − 𝑃 = $25 − $4.10 = $20.90
● The option will be exercised as it is profitable for the holder

Returns on Options
● The return on our call option example:
○ 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑃𝑟𝑜𝑓𝑖𝑡/Premium = −0.55/5.55 = −9.91%
● The return on our put option example:
○ 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑃𝑟𝑜𝑓𝑖𝑡/Premium = 20.90/4.10 = 509.76%
● The returns on options:
○ If there are big swings in the underlying asset, at or near the money options can
offer enormous returns
○ Options provide leverage: The only money invested is the option premium, while
the exposure is the underlying asset itself. The premium is always less than the
value of the underlying asset
● Margin requirements:
○ The holder does not need to post any margin. The long position can only gain
from the option after the premium has been paid
○ The writer (short position) does have to post margin. Option markets also use
clearinghouses or similar structures; the margin calls apply in the same way as
with futures

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Why Options? Option vs. Stock Investments
● Reasons why investors use options: hedging (insurance) and speculation
○ The general reasons are similar to those of futures
○ However, with options, you can do both with more ease, flexibility and precision
– but at cost
○ Same like futures, using options also implies using leverage
● Example of three potential strategies to invest $10,000 in a stock. Suppose you think a
stock, currently selling for $100, will appreciate
○ Strategy A: Invest entirely in stock. Buy 100 shares, each selling for $100
○ Strategy B: Invest entirely in at-the-money call options. A 6-month call costs $10
(contract size is 100 shares). Buy 1,000 calls, each selling for $10. (This would
require 10 contracts, each for 100 shares)
○ Strategy C: Purchase 100 call options for $1,000. Invest your remaining $9,000 in
6-month T-bills, to earn 3% interest. The bills will be worth $9,270 at expiration

Three Strategies: Cash Flows and Returns

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Characteristics of Returns Delivered by Options
● Embedded leverage, which can be used to:
○ Enlarge your exposure, so one can profit more from expected price movements
○ Compare Strategy B with Strategy A – the slope of the all-option portfolio is
steeper
● Insurance: Secure the majority of your investment by putting money in safer assets
○ Compare Strategy C with Strategy A – limited downside of the portfolio with
T-Bills
● In general, options can create a payoff pattern that is tailor-made:
○ Making profits at the price-levels of the underlying we deem more likely (or
which offset existing risks)
○ Selling risk we consider unlikely to materialize or which are mispriced in the
market
○ Financial engineering (later slides) will take this to a more advanced level
● None of this is free: long positions require option premiums to be paid, short positions are
very risky: little upside, lots of downside

Part 2: Option Strategies

Option Strategies Using Standard Options
● Protective put (invest in a stock and buy a put option)
● Covered call (invest in a stock and sell a call option)
● Straddle (buy a put and call option on a stock with the same exercise price and maturity)
○ Strips and straps
● Money Spread (buy a call and sell another call with the same maturity but a higher strike
price)
● Collar (buy a put and sell a call option – brackets the value between two bounds)

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Option Strategies: Protective Put
● Protective put: own the underlying stock, buy a
put to insure against drops in price
○ Value from stock: 𝑆t
○ Value from put option: 𝑋– 𝑆t
○ The protection requires paying premium
𝑃
○ If 𝑆t ≤𝑋, down side limited to 𝑋−𝑃
○ If 𝑆t > 𝑋, upside not limited, but smaller:
𝑆t − 𝑃
● Applications: Risk management and portfolio
insurance

Option Strategies: Covered Call

● Covered call: own the underlying stock, write a call to profit now (for sure) from possible
future price rises
○ The call is usually written out-of-money
○ No margin requirements as you already own the stock and can deliver it if
necessary
○ If 𝑆t ≤ 𝑋, downside not limited, but some premium as silver lining: 𝑆t + 𝑃
○ If 𝑆t > 𝑋, upside limited, but premium compensation: 𝑋 + 𝑃
● Applications:
○ Advantages: Some investors implement it as a search for incremental alpha or
limit downside risk (by collecting a small premium compensation)
■ Retail investors find it as an attractive solution to introduce “sell
discipline” in their trading decisions
■ Institutional investors, like pension funds, also look at this strategy: "Buy
Writing Makes Comeback"
○ Disadvantages: Covered call writing went out of style, when the stock market
increased quickly and some investors got caught with positions that lost a lot of
money (missed the market rally)

Option Strategies: Straddle (1)

● Long straddle: buying both a call and a put with the same exercise price and maturity
○ Not need to own the underlying asset
○ The position benefits from both a large decrease and a large increase in price.
Useful if a major event is coming (like ECB or Fed announcement), but no
prediction how the market will react

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 ○ To make a profit, one of the options has to become valuable enough to
compensate both premiums

● Pay-offs:
● Short straddle is a bet on the price remaining roughly the same: sell a call and a put
option with the same exercise price and maturity
● Strips and straps are extensions that incorporate some view on the direction of expected
market movement (or asymmetric volatility) by buying either more calls or more puts

Option Strategies: Straddle (2)

● Or, in a graph (and drawing these graphs is warmly recommended, at first it may be the
only way to keep track of a position that combines multiple options):

Option Strategies: Spread (1)

● Money spread: Buy a call and sell a call with the same maturity but a higher strike price
○ Again, the underlying asset is not included in the position
○ The idea is to profit from price increases, but limit the amount of capital needed,
by writing a call on extreme profits. A spread can substantially reduce the cost of
a position
○ However, as options are one-sided contracts, the extremes are quite valuable, even
if the probabilities aren’t that high

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 ● Payoffs of this bullish spread:

● Bearish spread: buy and sell puts to speculate on a price decrease

Option Strategies: Spread (2)

● This is the payoff and profit of the bullish spread option strategy. Why 𝑪𝟐 − 𝑪𝟏 < 𝟎?

Option Strategies: Collar

● Collar: buy a put and sell a call, which are both (far) out-of-the-money, and own the
underlying stock as well
○ In effect, this combines the protective put and writing of a covered call
○ The position limits the gains and the losses, so the portfolio value remains
between two bounds
○ The costs of insurance are mitigated: the protective put costs money, but writing
the covered call delivers a premium to compensate the put costs
○ Risk managers can thereby get insurance for a relatively low amount, or perhaps
at a small profit, depending on what value the market assigns to the outcomes
beyond the bounds (which is what you’re buying/selling)
● Try drawing the payoff and profit figure at home

Option Strategies: Additional Webcasts on Canvas

● To better demonstrate how versatile options can be if combined → (webcasts). Webcasts
and lectures will reinforce each other, as neither covers exactly the same option strategies

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Option Strategies Using Exotic Options
● Exotic options are a prime example of financial engineering
● Option strategies using exotic options:
○ Asian options: payoffs depend on the average price (difference) over time
○ Barrier options: payoffs that depend not only on some asset price at expiration,
but also on whether the underlying asset price has crossed through some barrier
(cheaper hedge against big moves)
○ Lookback options: payoffs depend on the maximum or minimum price in a period
○ Currency-translated options (like quanto – provides a random number of options
as the amount of foreign currency that will be translated in domestic currency
depends on the returns on the underlying)
○ Rainbow options: have two or more assets as underlying, designed to hedge risk if
correlations move strongly against you
○ Digital (binary) options: offer a fixed payoff that depends on whether a condition
is satisfied by the price of the underlying asset
○ Chooser options (can become puts or calls, you choose), etc. etc.
● Many of these exotic products are only traded OTC, so conditions can be negotiated

Financial Engineering
● Constructing exactly the right pattern of pay-offs and timings that supports a particular
hedge strategy, speculation strategy, or perhaps a kind of ‘legal arbitrage’
● Combining various derivatives, there’s hardly any limit to what is possible, but each risk
has its price. One can use derivatives to...
○ Realize profits earlier or later, with possible tax consequences, or
○ Create exposures without stringent capital requirements – i.e. for banks
● Derivatives used to be pretty much “off-balance”, so not included in the balance sheet
○ The last decade has seen substantial debate about this, as well as rule changes
○ However, many over-the-counter instruments are quite illiquid, and therefore hard
to rein in, as the value prior to expiration/settlement is often unclear

Option-Like Features Embedded in Many Other Instruments

● Callable bonds (bonds that may be redeemed early)
○ Issuing firm holds the option, so callable bond will sell cheaper than a comparable
straight bond
● Convertible securities (bonds that can be turned into stocks)
○ Investor holds the option, so the convertible bond should sell for a higher price
than a comparable straight bond
● Warrants (call options written by the firm, placing new stock if exercised)
● Collateralized loans (quiz question: if you invest in a mortgage-backed security in the
US, how many derivatives are contained in that asset?)

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 ○ Borrowers hold an implicit call option and can walk away if the collateral value
declines
● Levered equity and risky debt:
○ JC Penny: FT: JCPenney misses bond payment, considers options
○ Probabilities of defaults among department stores: CNBC: US Department Stores
Most Likely to Default
● Performance fee paid to hedge funds managers resemble call options (next lectures)

Put-call parity
● One of the basic strategies has an impact on pricing as well:
○ If we buy a call and an investment the present value of the strike price in the
risk-free rate, we get a pattern that does not decline below 𝑋, and increases with
the share value afterwards to 𝑆t − 𝑋
○ If we buy the stock, and then also buy a put option with the same exercise price,
we get an identical pattern (draw the diagram!)
● This results in the following formula:

● In this formula:
○ 𝐶 is the premium paid for the call
○ 𝑃 is the premium paid for the put
○ 𝑆0 is the current stock price
○ 𝑋 is the strike price of both options

Example of Put-Call Parity (1)

● Suppose we have the following:

● A cash position of 100 (the Net Present value of X), together with the call, has a value of
117. But the Stock, together with a (protective) put, is worth only 115
○ An arbitrage profit is possible, as the payoffs a year from now for both strategies
are identical!
○ As always: buy the cheap side, sell the expensive side

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Example of Put-Call Parity (2)
● Execution of the Arbitrage Strategy:
○ Buy the stock and buy the put
○ Sell the call and borrow the present value of the strike price
○ Lock in the difference of $2 regardless of the ultimate stock price

● Practical challenges with such arbitrage strategies:

○ Transaction costs higher than the price difference
○ Stale prices (out-of-date quotes)

Preview of Next Lecture: Determinants of Option Values

● The risk profile of an option is not constant:
○ CAPM does not help with options
○ What are the determinants of the price of an option?
● We get paid when the option ends up in the money at the expiration date, otherwise not
(assume European options for now, see next week)
○ The probability of that happening is relevant
● The probability depends on the moneyness (𝑋 compared to 𝑆) and the volatility of the
underlying asset
○ The more it moves, the higher the chance the option will end up in the money!
● Also, due to the put-call parity, there has to be a relation with the risk-free rate
● Option valuation tries to answer how those elements need to be combined

Conclusion
● Two main types of option contracts: call and put options
● Options can deliver insurance and are attractive instrument for hedging
● Options incorporate leverage and are also attractive instrument for speculation
● Option strategies: Combine many calls and puts as if they were lego bricks, and you can
get whatever pattern you want!
● Many other financial assets and contracts embody option characteristics
● The put-call parity theorem relates the prices of put and call options

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