Jack Farmer

Introduction to Options
Introduction to Options

Basic Option Positions
Intuitive Option Pricing
Option Premium
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Basic Option Positions
Intuitive Option Pricing
Option Premium
2
Basic Option Positions: Long Forward
Obligated to buy
shares at an agreed
price at a future
point in time.
No cost upfront.
Makes money when
the share price
rises.
Loses money when
the share price falls.
3
P&L
Share Price +
0
-
+
Basic Option Positions: Short Forward
Obligated to sell
shares at an agreed
price at a future
point in time.
No cost upfront.
Make money when
the share price falls.
Lose money when
the share price rises.
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P&L
Share Price
+
0
-
+
Basic Option Positions: Long Call
The right to buy the
share at an agreed
price at a future point
in time.
Pays a percentage of
the share price up front
(premium).
Makes money as the
share price rises above
the strike price.
Loses premium paid
when the share price is
below the strike price.
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P&L
Share Price
+
0
-
+
Strike Price
Breakeven
Loss
Basic Option Positions: Short Call
Obligated to sell shares
should the long call
choose to exercise.
Receives a percentage
of the share price up
front.
Loses money when the
share price rises.
P&L equal to premium
when the share price
falls.
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P&L
Share Price
+
0
+
-
Breakeven
Strike Price
Gain
Basic Option Positions: Long Put
The right to sell the
share at an agreed
price at a future point
in time.
No obligation.
Pay premium up front.
Makes money when
the share price falls.
Loses premium when
the share price rises.
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P&L
Share Price
+
0
+
-
Basic Option Positions: Short Put
Obligated to buy
shares should the
long put choose to
exercise.
Receives premium up
front.
P&L equal to
premium when the
share price rises.
Loses money when
the share price falls.
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P&L
Share Price
+
0
+
-

Basic Option Positions
Intuitive Option Pricing
Option Premium
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Intuitive Option Pricing: Pegboard Game
10
0 0 0 0 0 0 0 10 0 20 0 30 0 40 80 50 90 60 100 70
Intuitive Option Pricing: Rules
Earn the money shown on the tube into which
the ball drops
Drop the ball from anywhere on the board
Pay to drop the ball depending on where you
choose to drop it

How much should each drop cost?
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Which drop should cost more?
12
0 0 0 0 0 0 0 10 0 20 0 30 0 40 80 50 90 60 100 70
Up at the top in
the middle of the
game?
In the middle of the
game both vertically
and horizontally?
Time to Vote
Up at the top in the middle


In the middle both vertically and horizontally
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Drop in Middle Halfway Down
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0 0 0 0 0 0 0 10 0 20 0 30 0 40 80 50 90 60 100 70
In the middle of the
game both vertically
and horizontally?
Drop 1,000 balls
2
18
70
164
246 246
164
70
18
2
Weighted Average Payout
Count Payout Cost Wtd Avg
2 0 0 0.00
18 0 0 0.00
70 0 0 0.00
164 0 0 0.00
246 0 0 0.00
246 10 2,460 2.46
164 20 3,280 3.28
70 30 2,100 2.10
18 40 720 0.72
2 50 100 0.10
1,000 8,660 8.66
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Price to Drop in Middle
Average payout using binomial probability is 8.66
To cover expected losses, game owner has to
collect at least that much
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Drop in Middle at Top
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0 0 0 0 0 0 0 10 0 20 0 30 0 40 80 50 90 60 100 70
Up at the top in
the middle of the
game?
0 0 0 3
7
22
52
96
144
176 176
144
96
52
22
7
3 0 0 0
Drop 1,000 balls
Weighted Average Payout
Count Payout Cost Wtd Avg
3 0 0 0.00
7 0 0 0.00
22 0 0 0.00
52 0 0 0.00
96 0 0 0.00
144 0 0 0.00
176 0 0 0.00
176 10 1,760 1.76
144 20 2,880 2.88
96 30 2,880 2.88
52 40 2,080 2.08
22 50 1,100 1.10
7 60 420 0.42
3 70 210 0.21
1,000 11,330 11.33
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Price to Drop in Middle at Top
Average payout using binomial probability is
11.33
Why should it cost more than further down?
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Ball Drop Cost Along Middle Line
The cost of dropping a
ball rises as you move up
the middle line
Can you explain why?
Rows Cost
19 11.33
17 10.82
15 10.34
13 9.86
11 9.24
9 8.66
7 7.98
5 7.18
3 6.25
1 5.00
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Which drop should cost more?
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0 10 20 40 60 30 50 100 70 110 80 120 90 130 170 140 180 150 190 160
On the right at the
top?
On the right in the
middle?
Time to Vote
On the right at the top


On the right in the middle
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Which drop should cost more?
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0 10 20 40 60 30 50 100 70 110 80 120 90 130 170 140 180 150 190 160
On the right in the
middle?
2
18
70
164
246 246
164
70
18
2
Drop 1,000 balls
Weighted Average Payout
Count Payout Cost Wtd Avg
2 50 100 0.10
18 60 1,080 1.08
70 70 4,900 4.90
164 80 13,120 13.12
246 90 22,140 22.14
246 100 24,600 24.60
164 110 18,040 18.04
70 120 8,400 8.40
18 130 2,340 2.34
2 140 280 0.28
1,000 95,000 95.00
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Price to Drop on Right in Middle
Average payout using binomial probability is 95
This is the average of the values in the reachable
range
25
Which drop should cost more?
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0 10 20 40 60 30 50 100 70 110 80 120 90 130 170 140 180 150 190 160
On the right at the
top?
0 0 0 3
7
22
52
96
144
176 176
144
96
52
22
7
3 0 0 0
Drop 1,000 balls
Weighted Average Payout
Count Payout Cost Wtd Avg
3 30 90 0.09
7 40 280 0.28
22 50 1,100 1.10
52 60 3,120 3.12
96 70 6,720 6.72
144 80 11,520 11.52
176 90 15,840 15.84
176 100 17,600 17.60
144 110 15,840 15.84
96 120 11,520 11.52
52 130 6,760 6.76
22 140 3,080 3.08
7 150 1,050 1.05
3 160 480 0.48
1,000 95,000 95.00
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Price to Drop on Right at Top
Average payout using binomial probability is still
95
What is going on?
Please take a moment and explain this to each
other.
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Ball Drop Cost on the Right
The cost of dropping a
ball does not change as
you move up the right
side.
Can you explain why?
For the price to rise, what
would have to be the
case?
Rows Cost
19 95.00
17 95.00
15 95.00
13 95.00
11 95.00
9 95.00
7 95.00
5 95.00
3 95.00
1 95.00
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Asymmetrical Payouts
The key lies with the payouts of 0
If no 0s are in reach, the price to drop stays the
same
Each additional tube higher is offset by the
additional tube lower
+10 on the right means -10 on the left
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Which drop should cost more?
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0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 10 0
On the left at the
top?
On the left in the
middle?
Both drops cost nothing since neither can reach any payouts.
Analogies to Options
Premium

Strike

Time

Volatility


Cost to drop ball. Game
owner is option seller.
Boundary between 0 and
positive payouts
Height of drop (number of
rows)
Bounciness of game: ball,
pegs, backing


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Basic Option Positions
Intuitive Option Pricing
Option Premium
33
Option Premium: Buyers & Sellers
Call buyers
Long shares
Own all upside in share
Unlimited gains
Can only lose premium
already paid
Limited losses
Call sellers
Short shares
Must pay all upside in share
Unlimited losses
Can only earn premium
already paid
Limited gains
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Option Premium: Google
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Source: Bloomberg
Strikes
Call
Prices
Expiries
Share
Focus on
Option Premium: Google Jan 08 Calls
On November 2, 2007
Google shares are
$706.28
Strike of $700
American style exercise
Last trade at $49.00 per
call
Call costs 6.94% of share
price (leverage).
How much higher would
Googles price need to rise
for a call buyer to break
even?
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Source: Bloomberg
Learning about Options on Lehman Live
LL: Equities
Products and Services
Derivatives
Listed Derivatives

Option Class Materials

Class 1 Basics.ppt
Definitions
Payoff Diagrams and Examples
Moneyness
Leverage
Put-Call Parity







Class 2 Basics.ppt
Put-Call Parity Revisited
Introduction to Delta
Introduction to Gamma
Volatility and Vega
Effect of Time to Maturity
and Theta
Effect of Interest and
Dividend

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