Recitation 4

Options Strategies
As mentioned during the Week 4 lecture, a bull spread is an options trading strategy designed
to profit from a rise in the price of a stock. We saw an example of a bull call spread, which
involved the simultaneous purchase and sale of call options with different strike prices. In this case,
an investor pays money upfront, and profits later when the call options expire.

We could have also used a bull put spread, which instead involves the simultaneous purchase and
sale of put options. Specifically, in a bull put spread, the investor purchases an out-of-the-money
(OTM) put option with strike price K1 and sells an in-the-money (ITM) put option with strike
price K2 , where K2 > K1 .

Recall that a bear spread involves selling an out-of-the-money (OTM) put option with strike
price K1 and purchasing an in-the-money (ITM) put option with strike price K2 , where K2 > K1 .
Thus, a bull put spread has payoffs like that of a short position in a bear spread.

In order to yield the same payoff as the bull call spread, a bull put spread also involves the purchase
a zero-coupon bond with face value equal to K2 − K1 . Why? Recall from put-call parity that,
given the price of a European call option, we can always find the price of an equivalent European
put option as follows:
put + S0 = call + e−r×T × K,
where S0 is the spot price of the underlying stock. In other words, the payoff of a portfolio con-
sisting of a call option and a zero-coupon bond with face value K and interest rate r is the same
as that of a portfolio consisting of a put option and the underlying stock.

The figure below displays the payoff of the bull put spread as a function of the underlying stock
price at maturity:

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Recall that a butterfly spread is an options trading strategy that combines bull and bear spreads
to create a market-neutral position with capped profits and losses. In the Week 4 lecture, we saw
how to create a butterfly spread using a combination of four call options. Equivalently, we can
construct the same butterfly spread using a combination of four put options:

1. A long position in one put option with strike price K0 ;

2. A short position in two put options with strike price K1 ;

3. A long position in one put option with strike price K2 ;

(K0 +K2 )
where K0 < K1 < K2 , and K1 = 2 .

Specifically, the above strategy is a long put butterfly spread created by buying one put with
a lower strike price K0 , selling two at-the-money puts with strike price K1 , and buying one put
with a higher strike price K2 . This position achieves a maximum payoff when the underlying stock
remains at the strike price K1 of the intermediate options.

The figure below displays the payoff of the long put butterfly spread as a function of the un-
derlying stock price at maturity:

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What if we reversed the positions in the long put butterfly spread? In particular, say we enter:
1. A short position in one put option with strike price K0 ;

2. A long position in two put options with strike price K1 ;

3. A short position in one put option with strike price K2 .

The payoff from this strategy would look similar to the payoff from the long put butterfly spread,
but “flipped” about the horizontal axis in the figure above. This strategy is referred to as a short
put butterfly spread, and it realizes its maximum payoff when the price of the underlying stock
is either above the upper strike price or below the lower strike price at the maturity date.

In other words, entering into a short put butterfly spread is a good idea when you expect the
volatility of the stock price to increase, implying a higher likelihood of moving beyond the range of
strike prices of the butterfly.

Risk Neutral Pricing

Recall from the Week 4 lecture that there are two main conceptual frameworks for pricing deriva-
tives: (i) replicating portfolios and (ii) risk neutral pricing.

Risk neutral pricing states that the price of any derivative is equal to the expectation of its dis-
counted future payoffs, where the expectation is computed using risk-neutral probabilities and
discounting is at the risk-free rate:

P rice = E ∗ e−r×T × P ayof f .

 

Here, E ∗ [·] denotes the risk neutral expectation, and P ayof f is the payoff of the option at maturity
date T .

We saw an example of how risk neutral pricing can be used to find the price of a call option.

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Can we similarly use it to find the price of a put option?

Suppose that the price of a stock evolves as follows:

Assume that the risk-free rate is 11%. Using risk neutral pricing, what is the price of a put option
on the stock with maturity T = 1 and strike price K = 50?

First, we can find the risk neutral probability q ∗ that the “up” node occurs at t = 1 as:

S0 = q ∗ × S1,u × e−r×T + (1 − q ∗ ) × S1,d × e−r×T .

Solving for q ∗ :
S0 × er×T − S1,d
q∗ = . (1)
S1,u − S1,d
Plugging in S0 = 50, S1,d = 35, S1,u = 70, r = 0.11, and T = 1 into Equation (1), we see that
0.11 −35
q ∗ = 50×e
70−35 = 0.5947. According to the diagram provided, the payoff of the put option is equal
to 0 in the “up” node at t = 1 and max(K − S1,d , 0) = 15 in the “down” node.

Finally, to compute the price of the put option, we simply apply the risk neutral pricing formula:

P rice = e−r×T × E ∗ [P ayof f ] = e−0.11 × [q ∗ × 0 + (1 − q ∗ ) × 15] = 5.4462.

We said that risk neutral pricing can be used to price any derivative, not just options. One example
we’ve seen before is a forward contract.

Recall that a forward contract is an agreement between two parties to buy or sell an underly-
ing asset on an agreed-upon date and price. In the Week 1 lecture, we saw that the forward price
of a non-dividend paying stock is given by:

F0,T = S0 × er×T

where F0,T is the forward price, S0 is the current price of the stock, and T is the time to maturity
of the forward contract. Can we derive the same formula using risk neutral pricing?

The profit at maturity date T from a long position in the forward contract is given by ST − F0,T .
Since it costs nothing to enter into the forward contract, the value of the contract is equal to 0 at
initiation. Thus,
e−rT × E ∗ [ST − F0,T ] = 0 ⇒
F0,T = E ∗ [ST ] .
In a risk neutral world, the return on any stock is equal to the risk-free rate. In the case of a
non-dividend paying stock, this implies that:

S0 = e−r×T E ∗ [ST ] .

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Combining these two equations, we arrive at the same expression for the forward price of a non-
divided paying stock as in the Week 1 lecture:

F0,T = E ∗ [ST ] = S0 × er×T .

In other words, the forward price is the risk neutral expectation of the underlying asset value at T .

Dynamic Replication
As discussed in the Week 4 lecture, the replicating portfolio approach to pricing an option should
imply the same price as the risk neutral pricing approach. In a multi-period setting, however,
constructing the replicating portfolio may be cumbersome.

As an example, consider a stock price that evolves according to the binomial tree below:

Using the replicating portfolio approach, we can price a call option with maturity T = 2 and strike
price K = 50 in five steps.

1. Determine the payoff from the call option at each node of the tree at t = 2.

Let c2,uu be the payoff of the call option in the “up-up” node at t = 2, c2,ud = c2,du be the payoffs
in the “up-down” and “down-up” nodes, and c2,dd be the payoff in the “down-down” node. Since
the strike price of the call option is 50, c2,uu = 50, c2,ud = c2,du = 0, and c2,dd = 0.

2. Find the position “delta” to invest in stocks for the replicating portfolio at each node of the
tree at t = 1.
c −c 50−0 c2,du −c2,dd 0−0
At t = 1, ∆1,u = S2,uu 2,ud
2,uu −S2,ud
= 100−50 = 1 in the “up” node, and ∆1,d = S2,du −S2,dd = 50−25 = 0 in
the “down” node.

3. Find the amount of risk-free bonds in the replicating portfolio at each node of the tree at
t = 1.

Once we know ∆1,u and ∆1,d , we can compute the amount of bonds as B1,u = −e−r (−c2,uu + ∆1,u S2,uu ) =
−44.7917 in the “up” node and B1,d = −e−r (−c2,dd + ∆1,d S2,dd ) = 0 in the “down” node.

4. Find the value of the replicating portfolio at each node of the tree at t = 1. By no arbitrage,
this is also the value of the call option at each node.

The value of the replicating portfolio—and call option—at t = 1 is c1,u = ∆1,u × S1,u + B1,u =
25.2083 in the “up” node and c1,d = ∆1,d × S1,d + B1,d = 0 in the “down” node. The following
binomial tree summarizes Steps 1-4:

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 5. Repeat Steps 2-4 for the t = 0 node, using the fact that the value of the call option is
c1,u = 25.2083 in the “up” node at t = 1 and c1,d = 0 in the “down” node.

The binomial tree below summarizes Step 5. The price of the call option is c0 = 13.4294.