Option Basics

Goals
All these slides (slides1-38) are covered in the Option Basics lecture video (43:10 long)

What are options? Why are they useful? How are they valued?

Why do we care?
Option valuation is useful both directly and conceptually in many aspects of finance.
Capital Structure Capital budgeting (real options, embedded options) Hedging and risk management
Hedging vs. Speculating

Agency Problems
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Options and Derivatives

Derivatives are simply a class of securities whose prices are determined from the prices of other assets. The asset on which the derivatives value is based is called the underlying or primary asset. Options, futures, and swaps are just some examples of derivatives Options are traded on various underlying assets.
Individual stocks as well as stock indexes Futures, Foreign currency, Interest rates

Financial engineering is the practice of combining derivatives to construct specialized financial arrangements

Option Contracts
A call option gives the holder the right (but not the obligation) to buy an asset for a specified price (strike or exercise price) on or before a specified expiration date.
Example: A MSFT July 120 call would give the buyer the right to purchase 100 shares of MSFT stock at $120 per share on or before the third Friday in July.

Why would someone want to buy this option?

Call Options
Call options give investors the right to BUY an asset at a fixed strike price on or before an expiration date. Investors would choose to purchase call options for many reasons. However, the most obvious is that they expect the stock will increase above the strike price before the expiration date of the option.
Why would someone buy the July $120 MSFT call? They expect that MSFT will trade above $120 per share BEFORE the third Friday in July.
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Option Contracts
A put option gives the holder the right (but not the obligation) to sell an asset for a specified price (strike or exercise price) on or before a specified expiration date.
Example: An INTC September 95 put would give the buyer the right to sell 100 shares of INTC stock at $95 per share on or before the third Friday in September.

Why would someone want to buy this option?

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Put Options
Put options give investors the right to SELL an asset at a fixed strike price on or before an expiration date. Investors would choose to purchase put options for many reasons. However, the most obvious is that they expect the stock price will decrease below the strike price before the expiration date of the option.
Why would someone buy the INTC September $95 put? They expect that INTC will trade below $95 per share BEFORE the third Friday in September. 6

Some Terminology
In order for someone to buy an option, someone must be willing to sell it (options are zero sum games). Selling an option is also known as writing the option, and the seller of an option is called the writer of the option.
Because option writers give the buyers the right to exercise, writers are obligated to fulfill their commitment. Thus, the option aspect (i.e. choice of what to do) of options is really given to the buyer and the writer is forced to live with the buyers decision.

An option is in the money when its exercise would produce a positive payoff. An option is out of the money when its exercise would produce a negative payoff. The option is at the money when the price of the underlying asset equals the strike price of the option.

 The price paid for an option contract is called the premium. Option contracts on stock are generally for 100 shares, but quoted on a per share basis.
Thus, if the quote for an option is $5, the cost of purchasing that option is $500 because it is $5 per share for 100 shares.

Terminology

An American option allows its holder to exercise it on or before the expiration date. A European option can only be exercised on the expiration date. However, both American and European options can always be sold prior to expiration.
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Quick Review
When would a call option be in the money? Out of the money? At the money?
For call options:
In the money underlying asset price is above the option strike price Out of the money underlying asset price is below the option strike price At the money underlying asset price exactly equals the option strike price

What about a put option?

For put options:
In the money underlying asset price is below the option strike price Out of the money underlying asset price is above the option strike price At the money underlying asset price exactly equals the option strike price

Why would investors write (sell) options?

Investors would write (i.e. sell) options in order to get paid the premium. They would do this if they expect that the option they write will expire out of the money and thus the investor they sell the option to wont 9 exercise against them.

Quick Review
If you wanted to have the option to purchase 800 shares of MSFT, how many calls would you need to buy?
To have the option to purchase 800 shares of MSFT, you would need to buy 8 calls since each option is for 100 shares.

What is the difference between an American and a European option?

The only difference between an American and European option is when you can exercise it. American options can be exercised at any time, European options can only be exercised on the expiration date (both can be sold at any time however)

What are the three things an option holder can do with their option?
The three things an option holder can do are: 1. Sell the option, 2. Exercise the option, or 3. Let the option expire. 10

The Value of Options

The value of an option (either a put or a call) is comprised of two components
The intrinsic value
This is the value associated with exercising the option immediately and simultaneously trading the underlying asset.
In the money (At and Out of the money) options have positive (zero) value from exercising immediately.

The value of waiting to exercise.

This essentially captures the option part of an option. Since you can choose to exercise or not, that flexibility has value. The value of that flexibility 11 must be non-negative.

The Value of Options Jan $17.50 Call

On November 11th, 2004, Cisco Systems stock was trading at $18.70. Below are option prices on that date. Cisco Systems - Nov 11th, 04 Call Prices Put Prices Stock Price Strike Price Jan 05 Apr 05 Jan 05 Apr 05 $18.70 $15.00 $3.90 $4.10 $0.30 $0.50 $18.70 $17.50 $1.80 $2.30 $0.90 $1.75 $18.70 $20.00 $0.60 $1.05 $2.15 $3.80 $18.70 $22.50 $0.15 $0.40 $4.00 $6.50
Lets look at the Jan 05 $17.50 call. The option gives you the right to buy the stock for $17.50 per share, but the stock is CURRENTLY selling for $18.70. Exercising this option would allow you to buy the stock for $17.50 from the option writer. You could then turn around and sell it in the market for $18.70 per share. This would give you an immediate profit of $1.20. This $1.20 is exactly what we call the intrinsic value of the option (and reflects that the option is in the money). It is the value associated with immediate exercise. Since the price of the option is $1.80 while the intrinsic value is only $1.20, it means that the value associated with waiting to exercise is $0.60. The option doesnt expire until the third Friday in January, so we can choose to wait to exercise it. Given the option price, the value of having that flexibility is $0.60. 12

The Value of Options April $20 Call

Cisco Systems - Nov 11th, 04 Stock Price Strike Price $18.70 $15.00 $18.70 $17.50 $18.70 $20.00 $18.70 $22.50 Call Prices Jan 05 Apr 05 $3.90 $4.10 $1.80 $2.30 $0.60 $1.05 $0.15 $0.40 Put Prices Jan 05 Apr 05 $0.30 $0.50 $0.90 $1.75 $2.15 $3.80 $4.00 $6.50

Lets look at the April 05 $20 call. The option gives you the right to buy the stock for $20.00 per share, but the stock is CURRENTLY selling for $18.70. This means that you could buy the stock in the open market for $18.70. You would never choose to exercise this option and pay the option writer $20 per share. There is no value of exercising this option immediately. Hence, the intrinsic value of the Jan $20 call is $0 (and thus why this option is out of the money). However, the price of the option is $1.05. The value comes from the flexibility of waiting. The option doesnt expire until the third Friday in April and the value of waiting to exercise is worth $1.05. 13

The Value of Options Jan $17.50 Put

Cisco Systems - Nov 11th, 04 Call Prices Put Prices Stock Price Strike Price Jan 05 Apr 05 Jan 05 Apr 05 $18.70 $15.00 $3.90 $4.10 $0.30 $0.50 $18.70 $17.50 $1.80 $2.30 $0.90 $1.75 $18.70 $20.00 $0.60 $1.05 $2.15 $3.80 $18.70 $22.50 $0.15 $0.40 $4.00 $6.50 Lets look at the Jan 05 $17.50 put. The option gives you the right to sell the stock for $17.50 per share, but the stock is CURRENTLY selling for $18.70. This means that you could sell the stock in the open market for $18.70. Thus, you would never choose to exercise this option and sell the stock to the option writer for only $17.50 per share. There is no value of exercising this option immediately. Hence, the intrinsic value of the Jan $17.50 put is $0 (and thus why this option is out of the money). However, the price of the option is $0.90. The value comes from the flexibility of waiting. The option doesnt expire until the third Friday in January and the value of waiting to exercise is worth $0.90.
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The Value of Options April $20 Put

Cisco Systems - Nov 11th, 04 Call Prices Put Prices Stock Price Strike Price Jan 05 Apr 05 Jan 05 Apr 05 $18.70 $15.00 $3.90 $4.10 $0.30 $0.50 $18.70 $17.50 $1.80 $2.30 $0.90 $1.75 $18.70 $20.00 $0.60 $1.05 $2.15 $3.80 $18.70 $22.50 $0.15 $0.40 $4.00 $6.50 Lets look at the April 05 $20 put. The option gives you the right to sell the stock for $20 per share, but the stock is CURRENTLY selling for $18.70. You could buy the stock in the open market for $18.70. You could then immediately exercise this option, which would allow you to sell the stock to the option writer for $20. This would give you an immediate profit of $1.30. This $1.30 is exactly what we call the intrinsic value of the option (and reflects that the option is in the money). It is the value associated with immediate exercise. Since the price of the option is $3.80, it means that the value associated with waiting to exercise is $2.50. The option doesnt expire until the third Friday in April, so we can choose to wait to exercise it. Given the option price, the value of having that flexibility is $2.50. 15

Intrinsic Value vs. Value of Waiting

Cisco Systems - Nov 11th, 04 Stock Price Strike Price $18.70 $15.00 $18.70 $17.50 $18.70 $20.00 $18.70 $22.50 Intrinsic Values Stock Price Strike Price $18.70 $15.00 $18.70 $17.50 $18.70 $20.00 $18.70 $22.50 Value of Waiting Stock Price Strike Price $18.70 $15.00 $18.70 $17.50 $18.70 $20.00 $18.70 $22.50 Call Prices Jan 05 Apr 05 $3.90 $4.10 $1.80 $2.30 $0.60 $1.05 $0.15 $0.40 Calls Jan 05 Apr 05 $3.70 $3.70 $1.20 $1.20 $0 $0 $0 $0 Jan 05 $0.20 $0.60 $0.60 $0.15 Calls Apr 05 $0.40 $1.10 $1.05 $0.40 Put Prices Jan 05 Apr 05 $0.30 $0.50 $0.90 $1.75 $2.15 $3.80 $4.00 $6.50 Puts Jan 05 $0 $0 $1.30 $3.80 Jan 05 $0.30 $0.90 $0.85 $0.20 Apr 05 $0 $0 $1.30 $3.80 Puts Apr 05 $0.50 $1.75 $2.50 $2.70

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 Notice that the price of every option is greater than its intrinsic value.

Intrinsic Value vs. Value of Waiting

If that were not true, there would be an arbitrage opportunity. You could simply buy the option, immediately exercise it, and simultaneously trade the shares in the market. If prices are less than intrinsic value, that strategy would generate riskless profits. Thus, we dont see this exist in reality.

For calls (puts), the intrinsic value is higher when the strike price decreases (increases).
The right to buy (sell) at a lower (higher) price is more valuable, all else equal. Notice that the length of time to expiration has no impact on the intrinsic value of the option.

For both calls and puts, notice that the value of waiting is higher for the April options than the corresponding January option with the same strike price.
Having a longer time to over which to potentially exercise is more valuable than having a shorter time. 17

 As we have seen, there are two components to option value: the intrinsic value, and the value of waiting to exercise.
If we know how to determine these values, we can figure out what the value of an option should be.

How to Value Options

Of the two, the intrinsic value is easier to calculate. As such, lets first focus on that.
One way to do this is to look at options immediately before they expire. At that point in time, the value of waiting to exercise is zero because if you wait, the option expires worthless. We will look at the payouts and profits associated with different options at the point of expiration. Well come back to the value of waiting to exercise later, after we have a better handle on these strange securities.
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Value of Call Options at Expiration

To examine this issue in a general framework, we need to develop some notation. Recall that call options give the holder the right to purchase a security at the exercise price. We will denote the price of the underlying security (at expiration time T) as ST and the exercise price as X Since the option need not be exercised, the value is contingent on the relative values of ST and X. Recall that to purchase the call, an investor must pay the premium (to the writer) which we will denote by C (for calls) or P (for puts).
The amount of the premium will be the difference between looking at the payoffs of an option and the profits associated with the option.
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Value of Call Options at Expiration

Call Buyer Call Writer In the money (ST > X) ST X - (ST X) Out of (or at) the money (ST X) 0 0 Max[0, ST-X] Min[0, X-ST] Overall:
Profits to: Call Buyer Call Writer If ST > X (in the money) (ST X) C - (ST X)+C If ST X (at or out of money) -C C Overall Max[0,ST -X]-C Min[0,X-ST]+C

Payoffs to:

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Value of Call Options at Expiration

Suppose you bought a MSFT 120 call for $13. What are the payoffs and profits at expiration for certain stock prices?
Realize that only one of these prices can occurwe want to examine possibilities though.

Stock Price Call Value Profit Profit Buyer Writer 110 0 -13 13 120 0 -13 13 130 10 -3 3 133 13 0 0 140 20 7 -7 150 30 17 -17

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Value of Call Options at Expiration (Buyer)

40 20 0 -20 85 95 105 115 125
X+C 120 + 13 = 133

payoff profit Max [0, ST-X] Max [0, ST-X] - C

X = $120

135

145

155

Price per share of MSFT on expiration date

X = Exercise price = $120 C = Call premium = $13
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 Notice that the value of the call option is $0 until the stock reaches the strike price of $120. Then, the value of the option increases dollar for dollar with the stock. The resulting graph looks something like a hockey stick. However, in order for someone to buy this option, they would have had to pay the seller $13 up front. Thus, even though the option is valuable for prices of MSFT above $120, the call buyer will have lost money unless the stock price rises above $133 (which is X + C). When MSFT stock is $133 at expiration, the option will be worth exactly $13, which is the same price at which the buyer purchased the option, so that is the breakeven point.
To see why the option would be worth $13 if MSFT is at $133 realize that the option allows the buyer to buy the stock at $120 per share. If the stock is trading at $133 per share, buying at $120 is something the buyer would want to do. In fact, it is worth $13 per share to have that benefit and thus, the price of the option is $13.

Value of Call Options at Expiration

Notice that buying a call option has a limited downside. The most a buyer can lose is the $13 if the option expires worthless. However, there is unlimited upside, since there is technically no limit to how high a stock price can be.

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Value of Call Options at Expiration (Writer)

20 10 0 -10 -20 -30 -40 85

X+C 120 + 13 = 133

X = $120 Min [0, X-ST]

payoff

Min [0, X-ST] + C

profit

95

105

115 125

135 145

155
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Price per share of MSFT on expiration date

X = Exercise price = $120 C = Call premium = $13

Value of Call Options at Expiration

The graph for the seller is simply the mirror image of the one for the buyer. Remember that options are zero sum games. The option seller would have received the $13 premium up front and would be hoping that the option expires worthless. Thus, as long as MSFT shares are lower than $133 (X + C) by expiration, the seller would have made money.
To see this, consider if MSFT was selling at $133. The option writer would have given the buyer the right to buy the stock at $120 per share. Thus, the seller would be obligated to fulfill this promise and sell the buyer shares for $120 each. However, the market value is $133, so selling the shares at $120 results in a loss of $13 per share. However, the option writer received a premium of $13 per share when he sold the option, so he effectively has broken even (ignoring time value of money for the moment)

However, notice that the seller has limited upside potential. The most he can make is $13 if the option expires worthless. On the other hand, a seller has unlimited downside risk because there is no limit 25 how high a stock can go.

Selling Call Options

Selling a call option gives someone else the right to buy stock from you. Sellers either already own shares of the stock or they dont.
If you sell a call option on stock you already own, you are said to have written a covered call. You are covered because no matter how high the price of the stock goes, you already own shares that you can sell to the call buyer if they choose to exercise their option. If you sell a call option on a stock that you dont already own, you are said to have written a naked call. You are naked because without owning the stock already, you are fully exposed to the price changes in the stock. You would need to go into the market and purchase the stock at the prevailing price if the call buyer chooses to exercise their option.
Writing naked calls is risky since call writers have limited upside, but unlimited downside. Most brokers will require you to post margin if you try to write naked calls.
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Value of Put Options at Expiration

Put Buyer Put Writer Out of (or at) the money (ST X) 0 0 In the money (ST < X) X ST - (X ST) Max[0,X-ST] Min[0,ST-X] Overall:
Put Buyer Put Writer -P P If ST X (at or out of the money) X- ST - P -(X - ST) + P If ST < X (in the money) Overall Max[0,X-ST]-P Min[0,ST-X]+P
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Payoffs to:

Profits to:

Value of Put Options at Expiration

Suppose you bought an INTC 95 put for $9. What are the payoffs and profits at expiration for certain stock prices? Stock Put Profit Profit Price Value Buyer Writer 65 30 21 -21 75 20 11 -11 85 10 1 -1 86 9 0 0 95 0 -9 9 105 0 -9 9

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Value of Put Options at Expiration (Buyer)

50 40 30 20 10 0 -10

Max [0, X ST]

option value

Max [0, X ST] - P

profit

X = $95

X P = 95 9 = 86

55 65 75 85 95 105 115 125

X = Exercise price = $95 P = Put premium = $9
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 Notice that the value of the put option is $0 as long as the stock is above the strike price of $95. Below $95, the value of the option increases one dollar for every dollar decrease of the stock. However, in order for someone to buy this option, they would have had to pay the seller $9 up front. Thus, even though the option is valuable for prices of INTC below $95, the put buyer will have lost money unless the stock price falls below $86 (which is X - P). When INTC is $86 at expiration, the option will be worth exactly $9, which is the same price at which the buyer purchased the option, so that is the breakeven point.
To see why the option would be worth $9 if INTC is at $86 realize that the option allows the buyer to sell the stock (to the option writer) at $95 per share. If the stock is trading at $86 per share, selling at $95 is something the option buyer would want to do. In fact, it is worth $9 per share to have that benefit and thus, the price of the option is $9.

Value of Put Options at Expiration

Notice that buying a put option has a limited downside. The most a buyer can lose is the $9 if the option expires worthless. However, unlike buying a call option, buying a put option provides a limited upside. The reason is that the value of the stock can never decrease below zero, so the value of the put is inherently limited.

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Value of Put Options at Expiration (Writer)

20 10 0 -10 -20 -30 -40 -50 55
X P = 95 9 = 86

X = $95 Min [0, ST - X ] Min [0, ST - X] + P

payoff

profit

65

75

85

95

105

115

125
31

X = Exercise price = $95

P = Put premium = $9

Value of Put Options at Expiration

The graph for the seller is simply the mirror image of the one for the buyer. Remember that options are zero sum games. The option seller would have received the $9 premium up front and would be hoping that the option expires worthless. Thus, as long as INTC shares are higher than $86 (X - P) by expiration, the seller would have made money.
To see this, consider if INTC was selling at $86. The put writer would have given the buyer the right to sell stock (to the writer) at $95 per share. Thus, the put writer would be obligated to fulfill this promise and buy shares for $95 each. However, the market value is $86, so buying the shares at $95 results in a loss of $9 per share. However, the option writer received a premium of $9 per share when he sold the option, so he effectively has broken even (ignoring time value of money for the moment)

However, notice that the seller has limited upside potential. The most he can make is $9 if the option expires worthless. The sellers downside is also somewhat limited because the stock can never sell below $0.

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Factors that Impact Option Values

So far, we have seen that at expiration, the value of options are dependent on the relative values of the strike price (X) and the stock price (S). This leads us to the first two factors that impact option values. There will be others we examine later. Exercise price: X
The lower the exercise price, the higher (lower) the call (put) value

Stock price: S
The higher the stock price, the higher (lower) the call (put) value

We also saw that time to expiration (T) mattered. The longer time to expiration, the more valuable the option. This is true for BOTH calls and puts. 33

Many complex payoff structures can be created using combinations of calls and puts. Spreads, straddles, collars, etc. How can we determine the payoff structure (at expiration) of a portfolio of options? A three step process
1. Calculate the intrinsic value of each individual option at the exercise price of every option in the portfolio, a price above the the highest strike price, and a price below the lowest strike price. 2. Add the payoffs of all the options together to get the total payoff to the portfolio. Graph these points 3. Connect the dots with straight lines. For prices below and above the range, extend the straight lines.
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Portfolios of Options

Example of Combination of Options

Consider the following combination for a stock that currently sells at $50
Sell $50 call Sell $50 put Buy $40 put Buy $60 call
All options have the same time to expiration.

Determine value of each option at every exercise price (40, 50, & 60), a price above the highest (something above 60, i.e. 70), and a price below the lowest (something below 40, i.e. 30).
Essentially, determine the intrinsic value at each of those points (30, 40, 50, 60, & 70) and graph them against the stock value.

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Example of Combination of Options

Option Stock Price

30 0

40 0 -10 0 0 -10

50 0 0 0 0 0

60 -10 0 0 0 -10

70 -20 0 0 10 -10
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Sell 50 Call

Sell 50 Put -20 Buy 40 Put Buy 60 Call Sum 10 0 -10

Option Payoff Diagram

0 -1 Value of Portfolio -2 -3 -4 -5 -6 -7 -8 -9 -10 30 40 50 60 70 Underlying Price

This option portfolio is known as a butterfly spread. Look at the graph with a creative eyesort of a butterfly with wings.

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 Notice that the payoffs from this portfolio range from 0 to a loss of 10. In other words, the payoff (at expiration) to this portfolio is NEVER positive. Why would anyone choose to take such a position?
Dont forget that you are buying 2 options and selling 2 options. When you buy options, you pay the premiums, when you sell them, you receive the premiums. Since the payoff of the portfolio is always negative, the only reason someone would do this is because they are receiving money up front when they enter the position.
It must be the case that the premiums you get from selling the 50 call and 50 put are greater than the premiums you pay from buying the 60 call and 60 put. If that is not true, arbitrage profits can be made Notice also that the amount by which the premiums you get exceed the premiums you pay must be less than $10. Since the most negative the payoff can be is $10, you cant be paid more than this to enter the position, otherwise arbitrage will occur.
Technically, the premiums must be less than the present value of $10 because time value of money matters.

Portfolio of Options Butterfly Spread

Investors might enter a butterfly spread if they believed that the price of the underlying asset was not going to change dramatically before the expiration date. Notice that the highest payoff (although that is $0) of the portfolio is when the price of the stock remains at 50. At that price, the investor would pay $0 and get to keep all of the premiums they collected up front. Essentially a 38 butterfly spread is a bet that volatility will be low.