Lecture 10

Option strategies
 Introduction
At the end of this lecture, you should
understand:
option concepts and various terminologies
various option strategies and their payoffs
put-call parity, and based on the parity derive the
value of puts or calls based on other parameters
in the parity

2
 Derivatives
Derivatives are financial instruments whose value
depend on some observable variable
That observable value is most often the price of some
other financial asset, such as a stock price
If the derivative depends on a financial asset, that asset is
referred to as the underlying asset, denoted S
Most derivatives live for a predefined period of time
(just like bonds do)
When that period runs out, the derivative is said to mature
The time-of-maturity is typically denoted T
Many derivatives have all their cash flow consequences at
time T
We usually use t to denote the current time point
Option basics 3
 Options
Options are derivatives that give the holder the
right but not the obligation to trade the
underlying asset
Call options give the right to buy an asset
Put options give the right to sell an asset
The price at which the asset can be bought/sold under
the option is called the strike price or the exercise
price
If an option is used to trade the underlying, its said to
be exercised

Option basics 4
 Intrinsic value
The intrinsic value of an option is the value it would have if
exercised today
A call option gives the option holder the right to buy the
underlying asset for some exercise price X
If the current market price of the underlying asset, denoted St, is
higher than X, the option allows the holder to buy the
underlying asset at a discount
The size of the discount, St - X, is the options intrinsic value
If St is lower than or equal to X, the option holder would rather
buy the underlying asset at the market price and will ignore her
option
The options intrinsic value is zero
Hence the intrinsic value = max(0, St - X)

Option basics 5
 Intrinsic value
A put option gives the option holder the right to sell the
underlying asset for some exercise price X
If the current market price of the underlying asset, denoted St, is
lower than X, the option allows the holder to sell the underlying
asset at a higher price
The size of the price increase, X - St, is the options intrinsic
value
If St is higher than or equal to X, the option holder would rather
sell the underlying asset at the market price and will ignore her
option
The options intrinsic value is zero
Hence the intrinsic value = max(0, X - St)

Option basics 6
 Moneyness
If an option has a positive intrinsic value its said to be in the
money
For call options: X < St
For put options: X > St
If the strike price exactly equals the current market price of
the underlying asset, X = St, the option is said to be at the
money
Otherwise the option is said to be out of the money
For call options: X > St
For put options: X < St
To emphasize that the distance between the strike price and
the underlying price is large, options are sometimes said to be
deep in the money or deep out of the money
Option basics 7
 Intrinsic value and moneyness: example
Suppose that you hold a call option on a stock with a strike
price, X = $110, and the option expires in one year, so T t = 1
If you exercise the option today:
If St=$120, its intrinsic value = max(0, St - X) = $10. The option is in the
money.
If St=$110, its intrinsic value = max(0, St - X) = $0. The option is at the
money.
If St=$100, its intrinsic value = max(0, St - X) = $0. The option is out of
the money.
But even in the 2nd and 3rd case, should the option carry some
value even if its intrinsic value is zero?
The answer is YES.

Option basics 8
 Time value

The option nevertheless has some value, even if its intrinsic

value is zero.
Intrinsic value is the value added by the option if you exercise today.
But the beauty of the option is that it is an OPTION. And you can
choose to exercise it later.
In the previous example, there is some chance that the price of the
underlying asset will rise above $110 before time T
The value arising from that possibility (roughly) is called the
options time value
The name comes from the fact that: who knows what would happen in
the future, and maybe underlying assets price will move in some way
to make the option very valuable.
So time value is always positive until the expiration, because it is the
value of your option of not having to exercise your option today.

Option basics 9
 Time value
The time value comes mainly from the possibility that the
moneyness may increase in the future
The probability of that occurring increases with
the time to maturity, so the time value of an option
typically increases with the time to maturity
the volatility of the underlying assets price, so the time
value of an option always increases with the underlying
volatility

The total value of an option is the sum of its intrinsic value

and its time value.
Its value to you if you have to exercise it immediately + its
value from not having to be exercised immediately

Option basics 10
 European and American options
A distinction is typically made between two
different kinds of options
European options
Can only be exercised at time T
Are relatively easy to value using the Black-Scholes formula
Options written on indexes are generally European
American options
Can be exercised at any time before T
Are somewhat cumbersome to value
Options written on individual stocks are typically American
European and American have no geographical
meaning
Option basics 11
 More option terminology
The purchase price of an option is called the option
premium (to distinguish it from the exercise price)
Creating (and selling) an option is known as writing or
issuing the option
This is equivalent to short-selling the option
If an option is exercised some form of settlement
occurs
Physical settlement: The writer of call option (or put
option) must make (or take) physical delivery of the
underlying asset, i.e. there is an actual trade
Cash settlement: The option writer must pay out the
intrinsic value of the option at the time of exercise. This is
usually the case when the underlying is a financial asset

Option basics 12
 Contract size
Typically one option contract is written on
several units of the underlying asset
For instance, one call option contract may grant
the right to buy 100 units of the underlying stock
When doing valuation, we typically value the
right to buy one unit of the underlying and
multiply the result with the contract size

Option basics 13
 The use of options
Hedging
Options can be used to construct insurance for other positions
For instance, if you hold a stock and worry about its price dropping
below $100, you can create insurance by buying a put option written
on the stock with a strike price of $100
Such insurance is known as hedging
Speculation
If you have strong views on the future returns of an asset, options may
be an efficient way on betting on those views
If you think a stock is undervalued, you can buy a call option
If you think a stock is overvalued, you can buy a put option
If your view is correct, then you can benefit from the asset price
movement, by paying only option premium (which is typically
much lower than the asset price). So it gives you the leverage.
This is how options were initially used (the right to use olive presses by
Thales around 350 B.C. and the formal option contracts during the
tulip bulb bubble of 1637
Option strategies 14
 The use of options
In general, options (and other derivatives) are useful to
construct tailor made payoff functions
The flexibility makes it easy to suit individual hedging
needs.
The standardization of option contracts (size, strike price,
expiration date) by CBOE in 1973 and the creation of
Options Clearing Corporation (OCC) by SEC in 1975
significantly boosted the trading (especially for
speculation) in stock options

Option strategies 15
 Payoff functions
We will typically consider European options that
are settled in cash
The only effect of the option (after its been bought) is
a time T cash-flow
The time T cash-flow is known as the payoff
The payoff is a function of the time T value of the
underlying and on the type of option
The payoff function for a call option is max(0,ST X)
The payoff function for a put option is max(0,X ST)

Option strategies 16
 Payoff diagrams
We often illustrate the payoffs of an option or some
portfolio of instruments in so-called payoff diagrams
Asset value Risk-free Bond Call option Put option
$ $ $ $

FV
X

ST ST X ST X ST

The diagrams show the value at maturity (not today)

The cost of establishing the position is not included
Diagrams that include the cost are called profit diagrams
Option strategies 17
 Option strategies
In a complete market, we can generate any payoff
function by an appropriate combination of
instruments
Some combinations are common enough to have
their own name
Protective put
Covered call
Straddle
Butterfly spread
and many others

Option strategies 18
 Protective put
Components
One stock (or whatever the underlying is)
One long put
Purpose/benefit: A form of portfolio insurance, guaranteeing
a lowest possible value of the position
Cost: You always have to pay the option premium, even if you
dont end up using it
Protective put
$
ST X ST > X
Stock ST ST
+Put X - ST 0 X
=Total X ST

X ST
Option strategies 19
 Covered call
Components
One short call
One stock
Purpose/benefit: Gain the call premium
Cost: Loss of upside from the stock

Stock (Short) call Portfolio

$ $ $
option

ST X ST X ST

Option strategies 20
 Straddle
Components
One long call with strike price X
One long put with strike price X
Purpose/benefit: Bet on high volatility
Cost: The net premiums are positive (why?)

Straddle
$
ST X ST > X
Call 0 ST - X
X - ST X
+Put 0
=Total X - ST ST - X

X ST

Option strategies 21
 Butterfly spread
Components
One long call with strike price X
One long call with strike price X +
Two short calls (i.e., selling two calls) with strike price X
Purpose/benefit: Bet on low volatility (underlying price will be within a
narrow range of X)
Butterfly spread
Cost: The net premiums are positive (why?)
$

X- X X+ ST

payoff ST <= X - X - < ST <= X X < ST <= X + X>X+

one (X )-strike call max(0,ST X + ) 0 ST X + ST X + ST X +
- two X-strike calls -2*max(0,ST X) 0 0 -2*(ST X) -2*(ST X)
+ one (X + )-strike call max(0,ST X - ) 0 0 0 ST X -
= Total 0 ST X + X + - ST 0
22
Option strategies
 Replicating a covered call
Consider a portfolio consisting of
one short put option (written on a stock) with a strike price
of X
one zero-coupon bond with the face value X
the portfolio payoff is exactly the same as that of the
covered call
Bond Short put option Portfolio
$ $ $

X X

ST X ST X ST

-X -X

Put call parity 23

 Put call parity
The covered call and its replication are worth
exactly the same at time T regardless of ST
In the absence of arbitrage they must also be
worth the same at any time t < T
St ct = PV(X) pt
Where PV(X) is the value of the bond, which is the present value of
the time T cash flow X, ct and pt are premiums (prices) of the call
and put options.
This no-arbitrage relationship is called put-call
parity
Put call parity 24
 Continuous compounding
Up until now we have used annually compounded interest
rates
We imagined interest payments arriving at the end of each year
So if a bank offers to pay you once per year at an annual interest rate,
say rAnnual, by depositing $1 at the beginning of the year, you will
actually get $(1+ rAnnual) at the end of the year.
We could (and often do) have more frequent interest
payments
For instance, the bank offers to pay you twice a year at an annual
interest rate, say r2-compounded, which effectively means an interest rate
of r2-compounded /2 every half-year.
By depositing $1 at the beginning of the year, you will actually get $(1+
r2-compounded /2)2 at the end of the year.
In this case, r2-compounded is only the nominal annual interest rate (for
quotation purpose). The effective (actual) annual interest rate is: (1+
r2-compounded /2)2 -1

Put call parity 25

 Continuous compounding
To make annually compounded interest rate effectively the
same as the semi-annually compounded one, the two interest
rates should satisfy:
(1+ rAnnual) = (1+ r2-compounded /2)2
This equation gives you the conversion between annually
compounded and semi-annually compounded interest rates.

We could increase the frequency of interest payments to an

arbitrary number n
n
r
(1 + rAnnual ) = 1 + ncompunded
n

Put call parity 26

 Continuous compounding
It is often mathematically convenient to express interest rates
as continuously compounded, i.e. by letting n go to infinity
n

(1 + rAnnual ) = lim 1 + n compounded

r
= e rContinuous
n n
So rcontinuous = ln(1+ rAnnual)
And T-year gross return is: (1 + rAnnual )T = e r Continuous T

This is just a way to express interest rates

It does not change underlying interest rates in any way
We can always switch from expressing our interest rates as
continuously compounded to expressing them as annually
compounded via the equation
Unless otherwise stated, we will from now on express the interest rate
using continuous compounding, and simply denote it r

Put call parity 27

 Put call parity
Recall put-call parity: St ct = PV(X) pt
time t price of the bond (which pays a cash flow of X at time
T)
In T years, a deposit of V0 will grow at the continuous-compounded
rate r to V0erT
The present value of a cash-flow of X in T years with the continuous-
X
compounded rate r is rT = Xe rT
e
Hence, time t price of the bond we used in the put-call parity
discussion is PV ( X ) = Xe
r (T t )

The put-call parity can be expressed as

r (T t )
St=
ct Xe pt
We can use the parity to infer the value of any component with the
values of the other three.

Put call parity 28