Options Markets

1
Review of Option Types
 A call is an option to buy
 A put is an option to sell
 A European option can be exercised
only at the end of its life
 An American option can be exercised
at any time

2
Option Positions

 Long call
 Long put
 Short call
 Short put

3
Long Call
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months

30 Profit ($)

20

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

4
Short Call
Profit from writing one European call option: option
price = $5, strike price = $100
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30

5
 Long Put
Profit from buying a European put option: option
price = $7, strike price = $70

30 Profit ($)

20

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

6
Short Put
Profit from writing a European put option: option
price = $7, strike price = $70
Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10

-20

-30

7
Payoffs from Options
What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff Payoff

K
K ST ST
Payoff
Payoff
K
K ST ST

8
Specification of
Exchange-Traded Options

 Expiration date
 Strike price
 European or American
 Call or Put (option class)

9
Terminology

Moneyness :
◦ At-the-money option
◦ In-the-money option
◦ Out-of-the-money option

10
Terminology
(continued)

 Option class
 Option series
 Intrinsic value
 Time value

11
Intrinsic value & Time value
 The intrinsic value of an option
represents the current value of the
option, or in other words how much in
the money it is. When an option is in
the money, this means that it has a
positive payoff for the buyer.
• In the money call options: Intrinsic
Value = Price of Underlying Asset -
Strike Price
• In the money put options: Intrinsic
Value = Strike Price - Price of Underlying
Asset
12
Time value
 The time value of an option is an
additional amount an investor is
willing to pay over the current intrinsic
value. Investors are willing to pay this
because an option could increase in
value before its expiration date.
• Time Value = Option Premium -
Intrinsic Value
• Option Premium = Intrinsic Value +
Time Value

13
Dividends & Stock Splits

 Suppose you own N options with a

strike price of K :
◦ No adjustments are made to the option
terms for cash dividends
◦ When there is an n-for-m stock split,
 the strike price is reduced to mK/n
 the no. of options is increased to nN/m
◦ Stock dividends are handled similarly to
stock splits

14
Dividends & Stock Splits
 Consider an exchange-traded call option
contract to buy 500 shares with a strike
price of $40 and maturity in four months.
Explain how the terms of the option contract
change when there is
a) A 10% stock dividend
b) A 10% cash dividend
c) A 4-for-1 stock split

15
a) The option contract becomes one to buy 500 11 = 550 shares with an exercise price
40 1.1 = 3636 .
b) There is no effect. The terms of an options contract are not normally adjusted for cash
dividends.
c) The option contract becomes one to buy 500  4 = 2 000 shares with an exercise price of
40 4 = $10 .

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Market Makers
 Most exchanges use market makers
to facilitate options trading
 A market maker quotes both bid and
ask prices when requested
 The market maker does not know
whether the individual requesting the
quotes wants to buy or sell

17
 Notation

c:
European call C: American call option
option price price
p: P: American put option
European put
price
option price
ST: Stock price at option
S 0:
Stock price today maturity
K:
Strike price D: PV of dividends paid
T:
Life of option during life of option
s: r Risk-free rate for
Volatility of stock
maturity T with cont.
price comp.
18
Effect of Variables on Option Pricing

Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
s + + + +
r + − + −
D − + − +

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20
21
22
Time to expiration(American)
• While strike price has an impact on intrinsic value of the option, the
time to expiration has a time value of the option
• The greater the time to expiration, the higher will be the probability
of the option moving in the favour of the buyer. Hence, the higher
will be the time value of an option subsequently, the higher will be
the option price.

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 Volatility
• As volatility increases, the chance that the stock will do
very well or very poorly increases.
• For the owner of a stock, these two outcomes tend to
offset each other. However, this is not so for the owner of a
call or put. The owner of a call benefits from price
increases but has limited downside risk in the event of
price decreases because the most the owner can lose is the
price of the option.
• Similarly, the owner of a put benefits from price decreases,
but has limited downside risk in the event of price
increases. The values of both calls and puts therefore
increase as volatility increases

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25
 Interest Rate
• As interest rates in the economy increase, the expected
return required by investors from the stock tends to
increase. In addition, the present value of any future cash
flow received by the holder of the option decreases. The
combined impact of these two effects is to increase the
value of call options and decrease the value of put options.

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 Dividend
• Dividends have the effect of reducing the
stock price on the ex-dividend date. This is
bad news for the value of call options and
good news for the value of put options.
• The value of the option is negatively related
to the size of the dividend if the option is a
call and positively related to the size of the
dividend if the option is a put.

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Upper bound of an option
An American or European call option gives the
holder the right to buy one share of a stock for
a certain price. No matter what happens, the
option can never be worth more than the
stock.
c≤S
C≤S
For a put option:
p ≤ K𝑒 −𝑟𝑇
P≤K

28
Lower Bound for European Call
Option Prices; No Dividends

c  max(S0 –Ke –rT, 0)

29
Arbitrage

 Suppose that
c= 3
S0= 20
T=1
r = 10%
K =18
D=0
 What are the arbitrage possibility?

30
Lower Bound for European Put
Prices; No Dividends

p  max(Ke -rT–S0, 0)

31
 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

32
Values of Portfolios

ST > K ST < K
Portfolio A Call option ST − K 0
Zero-coupon bond K K
Total ST K
Portfolio C Put Option 0 K− ST
Share ST ST
Total ST K

33
The Put-Call Parity Result
 Both are worth max(ST , K ) at the
maturity of the options
 They must therefore be worth the
same today. This means that
c + Ke -rT = p + S0

34
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?
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36
 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
 This should not be exercised early

37
Reasons For Not Exercising a Call
Early (No Dividends)

 No income is sacrificed
 You delay paying the strike price
 Holding the call provides insurance
against stock price falling below strike
price

38
Bounds for European or American Call
Options (No Dividends)

39
Bounds for European and American Put
Options (No Dividends)

40
The Impact of Dividends on Lower
Bounds to Option Prices

− rT
c  S 0 − D − Ke
− rT
p  D + Ke − S0

41
Extensions of Put-Call Parity
 American options; D = 0
S0 − K < C − P < S0 − Ke−rT

 European options; D > 0

c + D + Ke −rT = p + S0

 American options; D > 0

S0 − D − K < C − P < S0 − Ke −rT

42
Question-1
The price of a non-dividend paying stock is
$19 and the price of a three-month
European call option on the stock with a
strike price of $20 is $1. The risk-free rate
is 4% per annum with continuous
compounding. What is the price of a three-
month European put option with a strike
price of $20?

43
Question-2
A one-month European put option on a
non-dividend-paying stock is currently
selling for $2.50 . The stock price is $47, the
strike price is $50, and the risk-free interest
rate is 6% per annum with continuous
componding. What opportunities are there
for an arbitrageur?

44
Question-3
The price of a European call that expires in
six months and has a strike price of $30 is
$2. The underlying stock price is $29, and a
dividend of $0.50 is expected in two
months and again in five months. Risk-free
interest rates (all maturities) are 10% per
annum with continuous compounding. What
is the price of a European put option that
expires in six months and has a strike price
of $30?

45
Question-4
A European call option and put option on a
stock both have a strike price of $20 and an
expiration date in three months. Both sell
for $3. The risk-free interest rate is 10%
per annum, the current stock price is $19,
and a $1 dividend is expected in one
month. Identify the arbitrage opportunity
open to a trader.

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