Chapter 11

Properties of Stock Options

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 1
Notation
c: European call option C: American call option
price price
p: European put option P: American put option
price price
S0 : Stock price today ST: Stock (settlement)
price at option
X: Strike price
maturity
T: Life of option D: PV of dividends paid
: Volatility of stock during life of option
price returns
r Risk-free rate for
maturity T with cont.
comp.

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 2
c  St –D – Xe –rT

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 3
Lower Bound (intrinsic value) for European Put
Prices; No Dividends

p  Xe -rT–S0

Options, Futures, and Other Derivatives, 8th Edition, Copyright ©

John C. Hull 2012 4
Effect of Variables on Option
Pricing (defer to Ch 19)
Variable c p C P
S0 + − + −
c  St – Xe –rT

X − + − +
T ? ? + +
 + + + +
r + − + −
D − + − +

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John C. Hull 2012 5
European and American options
Call: an option (or choice) to buy the underlying asset S at X

Payoff > 0 if S > X; 0 if S < X

Long call Payoff = Max [ST – X, 0] the non-negativity constraint

Put: an option (or choice) to sell the underlying asset at X

Payoff > 0 if S < X; 0 if S > X

Long put Payoff = Max [X-ST, 0] the non-negativity constraint

European options c(S,X,T) & p(S,X,T) : can only be exercised on its

expiration day T (e.g.: Hang Seng Index option)

American options C(S,X,T) & P(S,X,T) can be exercised at any time on

or before the expiration day (e.g., CBOE and HKEx stock options)

9.6
Long Call Expiration-day Payoff
Payoff at expiration = Max [ST – X, 0]

Payoff ($)
30

20
Terminal
10 stock price ($)
70 80 90 X=100
0
110 120 130
-5

9.7
Long Put Expiration-day Payoff
Payoff at expiration = Max [X – ST, 0]

Payoff ($)
30

20
Terminal
10
80 90 100 stock price ($)
0
40 50 60 X=70
-7

9.8
Non-negativity constraint on option payoff / price
at expiration/expiry date T:

Call payoff = Max[ST -X, 0] > 0

Put payoff = Max[X- ST, 0] > 0

Since the future payoff of long put/call position is

non-negative; therefore option prices are non-
negative

C  c 

P  p 

10.9
Long Call Expiration-day P/L
Profit at expiration = Max [ST – X, 0] – C0
Maximum profit = ??, Maximum loss = ??
Breakeven when ST =??

Profit ($)
30
20
Terminal
10 70 80 90 X=100 stock price ($)
0
110 120 130
-5

9.10
Short Call Expiration-day P/L
Profit at expiration = C0 - Max [ST – X, 0]
Maximum profit = ??, Maximum loss = ??
Breakeven when ST =??

Profit ($)
30
20
Terminal
10 70 80 90 X=100 stock price ($)
0
110 120 130
-5

9.11
Long Put Expiration-day P/L
Profit at expiration = Max [X – ST, 0] – P0
Maximum profit = ??, Maximum loss = ??
Breakeven when ST =??

Profit ($)
30
20
Terminal
10 X=70 stock price ($)
0
40 50 60 80 90 100
-7

9.12
Short Put Expiration-day P/L
Profit at expiration = P0 -Max [X – ST, 0]
Maximum profit = ??, Maximum loss = ??
Breakeven when ST =??

Profit ($)
30
20
Terminal
10 X=70 stock price ($)
0
40 50 60 80 90 100
-7

9.13
American vs European Options
An American option is worth at least as much
as the corresponding European option
Cc
Pp

Options, Futures, and Other Derivatives, 8th Edition, Copyright ©

John C. Hull 2012 14
American vs European Options
An American option is worth at least as much as
(i.e., no-less valuable than) corresponding
European option
c(S,X,T) < C(S,X,T) and p(S,X,T) < P(S,X,T)
American option is an European option plus an
option to exercise before time T (early exercise
option) C  c ; C = c + early exercise option
P  p ; P = p + early exercise option
Corollary: if the early exercise option value = 0, then
an American option can be priced as if it is an
European option
Options, Futures, and Other
Derivatives, 8th Edition, Copyright ©
15 John C. Hull 2012
Expectation Driven Strategies
Expect underlying asset return is positive (bullish)
Long call
Short put
Short overpriced call (large mispricing)
Long underpriced put (large mispricing)
Expect underlying asset return is negative (bearish)
Long put
Short call
Long underpriced call (large mispricing)
Short overpriced put (large mispricing)
10.16
Upper Bound for Call Option Price (cU)
Call options give the holders the right of buying a
stock at the exercise price X > 0

If S < C(X), then simply buy S

Therefore S is the upper bound of call option price

c ≤ S0 and C ≤ S0

cU = S0 and CU = S0

10.17
Arbitrage when c > c U

When c > cU = S0

Transactions CF0 CFT

Short Call +c – Max [ST – X, 0]

Buy Stock – S0 + ST
c – S0 > 0 ST – Max [ST – X, 0]

= Min [ST ,X] 

S, X 

10.18
 Proof: payoff from a covered-call (“buy-write”)
strategy (Che & Fung, 2012)
CFT = ST – Max [ST – X, 0] = Min [ST , X] >
0
CFT
Transactions CFT
ST > X ST < X

Short Call – Max [ST – X, 0] – (ST – X) 0

Buy Stock +ST + ST + ST

Min [ST ,X] > 0 +X + ST

10.19
Upper Bound for Call Option Price (cU)

Example: suppose that

S0 = $20, X = $20

cU = S0 = $20

What if c = $25 > cU = $20

10.20
Arbitrage with an Overpriced Call (c > c U)

If c (X=20) = $25 > cU =S = $20

CFT
Transactions CF0
ST > X (ST = $30) ST < X (ST = $10)

Short Call +$25 -$10 $0

Buy Stock -$20 +$30 +$10

$5 $20 (X) $10 (ST)

10.21
Call “exercise value” Max[St-X,0) at time t
before expiration date T
(moneyness of an option S/X)

An European call cannot be exercised before

expiry date T; hence exercise value is an
oxymoron for in-the-money call

However, when St > X the call is in the money

St /X is a measure of the “moneyness” of the call

10.22
Lower Bound or Intrinsic value (i.e., a sure
thing) cL for European Call Option

c  St – Xe –rT

0< ct = St – Xe
L –rT

10.23
Lower Bound or Intrinsic value (i.e., a sure
thing) cL for American Call Option

c  St – X

0< ct = St – Xe
L –rT

10.24
 Intrinsic and speculative (layman say
“time”) values

Option value = Intrinsic value (sure thing) +

speculative value

10.25
Proof: by way of contradiction: if c < c L
If c < cL = S0 – Xe–rT  ct + Xe–rT cheaper than S0

Transactions CF0 CFT

Buy Call –c Max [ST – X, 0]
Lend Xe-rT – Xe-rT Xe-rTerT=X

– (c + Xe-rT) Max [ST , X]

Short Stock + S0 – ST

(S0 –Xe-rT) -c> 0 Max [X – ST,0]  0

10.26
Arbitrage with an Underpriced Call
relative to cL (c < cL); No Dividends

10.27
Call + Bond = C+Xe–rT = Max[ST,X]
dominates Stock (ST) ; GIC (X, S)
S

0 ST
X=S0

10.28
Remark: the operation has produced a synthetic
put option with exercise price X

CFT
Transactions CFT
ST > X ST < X

Buy Call Max [ST – X, 0] ST – X 0

Lend Xe-rt X X X
Max [ST, , X ] ST X

Short Stock – ST – ST – ST

Max [X – ST,0] 0 X – ST > 0

10.29
Parity condition for European call
and put options = put-call parity

Call + Bond – Stock = Put

Ct (X) + Xe–rT – St = Pt (X)

10.30
Call + Bond = CT+Xe–rT = Max[ST,X]
dominates Stock (ST)

0 ST
X

10.31
Guaranteed investment
trust/certificate (GIT/GIC)
Call + Bond = CT+Xe–rT = Max[ST,X]

A guaranteed investment certificate with

gurantee set at X plus a potential participation
in S a particular asset

Options, Futures, and Other Derivatives, 8th Edition, Copyright ©

John C. Hull 2012 32
Upper Bound for Put Option Price (pU)

Put options give holders the right to sell the stock at

exercise price (X)

The maximum payoff of put is X at expiration

For European put, only PV(X) is needed today to meet

maximum payoff at expiration; hence PV(X) is upper
bound for P; for American put, upper bound = X

The present value of X = the upper bound p U = Xe-rT

p ≤ Xe-rT
pU
= Xe-rT

10.33
Prove by way of contradiction: if p > p U
If p > pU = Xe-rT
Short put long bond strategy: riskfree investment X deal with exercise

Transactions CF0 CFT

Short Put +p – Max [X – ST, 0]

Lend the PV of X (=Xe-
– Xe-rT +X
rT
)
p – Xe-rT > 0 X – Max [X – ST, 0]
= Min [ST ,X] > 0

10.34
 Prove that:
CFT = X – Max [X – ST, 0] = Min [ST ,X] >
0
CFT
Transactions CFT
ST > X ST < X
– (X –
Short Put – Max [X – ST, 0] 0
ST)
Lend the PV of X (Xe-
+X +X +X
rT
)
X – Max [X – ST, 0]
+X + ST
= Min [ST ,X] > 0

10.35
Upper Bound for Put Option Price (pU)
Example: suppose that

S0 = $20, X = $20, r = 10%, T = 1

pU = Xe-rT

= $20e-10%

= $18.0968

What if p = $25 > pU = $18.0968

10.36
Arbitrage with an Overpriced Put relative
to pU (p>pU)
If p = $25 > pU = $18.0968

CFT
Transactions CF0 ST > X ST < X
(ST = $30) (ST = $10)

Short Put +$25 $0 -$10

Lend the PV of X (Xe-rT) -$18.0968 +$20 +$20

+$6.9033 +$20 (X) +$10 (ST)

10.37
Lower Bound (intrinsic value) for European Put
Prices; No Dividends

p  Xe -rT–S0

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John C. Hull 2012 38
Proof: by way of contradiction
If p < pL = Xe–rT – S0  pt + S0 cheaper than Xe–rT

Transactions CF0 CFT

Buy Put –p Max [X – ST, 0]
Buy Stock – S0 + ST
– (p + S0) Max [ST , X]

Borrow Xe-rT + Xe-rT –X

Xe-rT –(p + S0) > 0 Max [ST – X, 0]  0

10.39
Proof:
CFT = Max [ST – X, 0]  0

CFT
Transactions CFT
ST > X ST < X

Long Put Max [X – ST, 0] 0 X – ST

Buy Stock + ST + ST + ST
Borrow Xe-rt
–X –X –X

Max [ST – X, 0] ST – X > 0 0

10.40
Put-call parity condition again

Call + Bond = Stock + Put

Ct (X) + Xe–rT = St + Pt (X)
= GIC(X,S)

Put + Stock - Bond = Call

Pt (X) + St - Xe = Ct (X)
–rT

10.41
Put-call parity condition again

Call + Bond – Stock = Put

Ct (X) + Xe – St = Pt (X)
–rT

Put + Stock - Bond = Call

Pt (X) + St - Xe–rT = Ct (X)

10.42
Lower Bound for European Put
Option Prices (pL); No Dividends
Example: suppose that

S0 = $37; T = 0.5; r = 5%; X = $40; D = 0

pL = Xe–rT – S0

= $40e-5%(1/2) – $37

= $2.0124

What if p = $1 < pL = $2.0124

10.43
Arbitrage with an Underpriced Put
relative to pL (p<pL); No Dividends
If p = $1 < pL = $2.0124
$10 = Max[S-X,0]

CFT
Transactions CF0 ST > X ST < X
(ST = $50) (ST = $20)
Borrow Xe-rT at 5% for 0.5 yr +$39.0124 -$40 -$40
Long Put -$1 $0 +$20
Buy Stock -$37 +$50 +$20
+$1.0124 +$10 $0

10.44
Put-Call Parity: No Dividends

Consider the following 2 portfolios:

Portfolio A: European call on a stock + zero-
coupon bond that pays K at time T
Portfolio C: European put on the stock + the stock

Options, Futures, and Other Derivatives, 8th Edition, Copyright ©

John C. Hull 2012 45
Put-Call Parity: a proof
GIC(X,S) = Max[S,X] = c + Xe-rT = p + S0
CFT
Transactions
ST > X ST < X
Portfolio A Buy Call ST – X 0
Lend Xe-rt +X +X
ST X

Portfolio B Buy Put 0 X – ST

Buy Stock +ST +ST
ST X

10.46
The Put-Call Parity Result (Equation
10.6, page 222)
Both are worth max(ST , X) at the maturity of
the options
They must therefore be worth the same
today. This means that

c + Xe -rT = p + S0

Options, Futures, and Other Derivatives, 8th Edition, Copyright ©

John C. Hull 2012 47
Put-Call Parity; No Dividends

At time T, both portfolio A and B are worth Max [ST,X]

Therefore,

c + Xe-rT = p + S0
Bond + Call strategy Protective put strategy

Put-call parity is valid for European put and call having same
expiration date and strike price
10.48
Arbitrage Opportunities
Suppose that
c= 3 S0= 31
T = 0.25 r = 10%
K =30 D=0

What are the arbitrage possibilities

when
p = 2.25 ?
p=1?
Options, Futures, and Other Derivatives, 8th Edition, Copyright ©
John C. Hull 2012 49
An illustration of
Put-call parity condition
Option value = intrinsic value (sure thing) +
speculative value
Speculative value of an ITM call with exercise
price X = corresponding OTM put with the
same exercise price X
Speculative value of an ITM put with exercise
price X = corresponding OTM call with the
same exercise price X
Options, Futures, and Other Derivatives, 8th Edition, Copyright ©
John C. Hull 2012 50
The Black-Scholes Formulas
(D=0)
c  S 0 N (d1 )  X e  rT N (d 2 )
p  X e  rT N ( d 2 )  S 0 N ( d1 )
ln( S 0 / X )  (r   2 / 2)T
where d1 
 T
2
ln( S 0 / X )  (r   / 2)T
d2   d1   T
 T

13.51
Example:
Suppose that:
S0 = $42
X = $40
r = 10%
 = 20%
T = 0.5
Put OTM and Call ITM
13.52
The Black-Scholes Formulas –
Example
c  S 0 N d1   Xe  rT N d 2 
 42 N 0.7693  38.049 N 0.6278
 420.7791  38.0490.7349
 4.76

p  Xe  rT N  d 2   S 0 N  d1 
 38.049 N  0.6278  40 N  0.7693
 38.0490.2651  400.2209
 0.81

13.53
Example:
Suppose that:
S0 = 15000
X = 12000
C = 3000 + time value
time value = P(X=12000)
Put OTM and Call ITM

13.54
Option value = Intrinsic value + speculative value

Xe-rt = 40e-0.1x0.5 = 38.049

c  Intrinsic _ value  Time _( speculativ e) _ value

 rT
 ( S 0  Xe )  P( X )
 (42  38.049)  0.809
 3.951  0.809
 4.76

13.55
Put-call parity condition (a verification)
S0 = $42, c = $4.76, p = $0.81, Xe-rt = $40e-0.1x0.5 = $38.049

Put-call parity:

c + Xe-rt = p + S

$4.76 + $38.049 = $42 + $0.81??

Yes!

$42.809 = $42.81

13.56
X = 10, S = 100, c(X=10) =100 = Intrinsic value
(90) + speculative value

c  Intrinsic _ value  Time _( speculativ e) _ value

 rT
 ( S 0  Xe )  P( X )
 (42  38.049)  0.809
 3.951  0.809
 4.76

13.57
10.58
Early Exercise
Usually there is some chance that an
American option will be exercised early
An exception is an American call on a non-
dividend paying stock = European call
A call on a stock that does not pay any
dividend before the option expire should never
be exercised early

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John C. Hull 2012 59
An Extreme Situation
For an American call option:
S0 = 100; T = 0.25; X = 60; D = 0
Should you exercise immediately?
What should you do if
You want to hold the stock for the next 3 months?
You do not feel that the stock is worth holding for the
next 3 months?
Exercise value = 100-60 = 40
Intrinsic value = 100-58.518 =$42.48=100 - 60e-10%(1/4)

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John C. Hull 2012 60
Reasons For Not Exercising a Call
Early (No Dividends)
No income is sacrificed (zero dividend)
You delay paying the strike price
Holding the call provides insurance against
stock price falling below strike price – put
If you afraid the share price may drop, you
may copy the strategy to lock-in the intrinsic
value of the call
Or you simply sell the call if the market is
efficient
Options, Futures, and Other Derivatives, 8th Edition, Copyright ©
John C. Hull 2012 61
Bounds for European or American Call
Options (No Dividends)

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John C. Hull 2012 62
Should Puts Be Exercised
Early ?
Are there any advantages to exercising
an American put when
S0 = 0 (the company is bankrupt)
can it go lower;
T = 0.25; r=10%
K = 100; D = 0

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John C. Hull 2012 63
Bounds for European and American
Put Options (No Dividends)

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John C. Hull 2012 64
The Impact of Dividends on Lower
Bounds to Option Prices for European
Options
 rT
c  S 0  D  Ke
 rT
p  D  Ke  S0

Options, Futures, and Other Derivatives, 8th Edition, Copyright ©

John C. Hull 2012 65
Extensions of Put-Call Parity
American options; D = 0
S0 − K < C − P < S0 − Ke−rT
Equation 10.7 p. 224

European options; D > 0

c + D + Ke −rT = p + S0
Equation 10.10 p. 230

American options; D > 0

S0 − D − K < C − P < S0 − Ke −rT
Equation 10.11 p. 230

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John C. Hull 2012 66
Put-Call Parity (American
Option)
Example: suppose that

S0 = $31; T = 0.25; r = 8%; X = $30; C = $4

S0 – X  C – P  S0 – Xe-rT
$31 – $30  4 – P  31 – 30e-0.08(0.25)
$1  4 – P  $1.59
– $3  –P  – $2.41
$3  P  $2.41
PU = $3, PL = $2.41

10.67