Question 4

Options Traded on Marks & Spencer Shares

Share Exercise Market Prices of
Market Prices of Puts
Price Price Calls
Sep Oct Nov Sep Oct Nov
210 205 12.0 24.0 27.0 6.0 17.5 19.5
210 9.5 21.5 24.5 8.5 20.0 22.0

a) Explain carefully why the November calls are trading at higher prices than the
September calls.
(5 marks)

In finance, options are contractual arrangements giving the buyer (holder) the right, but not the obligation to buy or sell
specific asset, at a given price, before the expiration time. Simply put it, it is an option the buyer has to exercise the
contracted price, with specific premium which varies depending on the expiry month as illustrated in the Marks and
Spenser option trading table above.

In the option market, call option is where holder has the right to buy the share at the contracted exercise price, whilst put
option is a in a scenario where the holder on the other hand has the right to sell the share at the contracted exercised
price. These can be concluded at a paid price, a premium which is a cost of a small fraction of the share price, and it
provides the holders the opportunity to gain benefits while limiting their risk to a known amount. The premium varies as
we can see table above for September, October or November month respectively for both calls and puts options. Figure
4.1 shows various general factors influencing premium cost as a whole.

Figure 4.1: Factors influencing option premium price

No. Influencing Factor
1 Share price
2 The option exercise price
3 Option time to expiry
4 The risk-free interest rate
5 Volatility in the underlying The greater the volatility in share price, the more likely it is that the exercise price
value share returns
6 Dividends
Explanation
The higher the share price, the greater the premium value of options written on it
The lower the exercise price, the greater the premium value of the options
The lengthier the time to option trading expiry, the higher the premium of the
option of the exercise price
As short-term interest rates rise, the value of the call option also increases
will be exceeded and, hence, the option value will rise
The price of a call option will normally fall with the share price as a share goes
ex-dividend

Noticeably on the options traded on Mark & Spenser shares, the premium paid for all 3 months in September, October
and November varies, overall on incremental rate, whether the options are calls or puts, or of different exercise prices.
The incremental premium rate against the period of expiry is true for all options trading. One of the reasons why
November price is higher than September price is the length to expiry date as explained in Figure 4.1. Options that
mature in later months has more time to fluctuate above or below the exercise price for calls and puts option
respectively. Thus the seller (writer) of the options, would place higher premium on Mark & Spenser options for both
exercise price of 205 and 210 that expires in November in comparison the options which expired in September.

Another reason for the variation of premium would be the company share price volatility. Such volatility can be subjected
to volatile market where in market boom or recession, company share price is likely to follow the market movement
trend. Apart from market forces, the type of company may play a role in the premium incremental rate against time.
Volatile company such as those in the technology group, tends to have higher options premium than the option for
smaller share price fluctuation company such as utility stocks. As we can observe Mark & Spenser 205 exercise call
price had substantially jumped from September to October, from premium of 12.0 to 24.0 and finally a small increase to
27.0 in November, which may explain this share carry some extend of volatility. This explains why the writer would place
high premium in the month of October compared to September to cover the volatility movement, and by month of
November, only small increase in premium is required as volatility had been covered. Nonetheless, the volatility in Mark
& Spenser share price may play major role to increase November options prices generally higher than September prices
for all call and put options, and for the different exercise prices.

Generally the characteristic of options premium, which has later months to maturity would be more expensive compared
 to those in near-term expiration dates is because the stock price will have more time to move in the desired direction.
This is a function of the state of market, carrying an underlying risk to the writers who sell options. To counter such risk,
the writer thus placed higher premium on November options in comparison to September options. Therefore, we can
conclude the option price is of somewhat the risk that the writer is exposed to, and to reduce their risk, the writer
increases the premium of options with later month to expiry date. In other words, an option is therefore a contingent
claim security that depends on the value and riskiness of the underlying share on which it is written

Ins and outs of puts and calls, The Kiplinger Magazine, Changing Times page 49-56 April
1984

b) Draw a diagram to illustrate the possible payoffs from investing a straddle, using calls
and puts expiring in November and an exercise price of 210. Explain the circumstances
in which an investor might consider it worthwhile to invest in a straddle.
(5 marks)
Investment in a straddle is a combination investment of put and a call option, written on a share at the same exercise
price and expiry date. It is an investment which essentially bet on volatility. Figure 4.2 explains the fundamental of the
straddle investment. Firstly, illustrating the call option and put option profitability for exercise price at 210, which expires
in November is represented in dashed red line and dashed green line respectively. The red dashed line that is the call
option profitability against share price movement shows the holder (buyer) would experience maximum lost of 24.5, also
equivalent to the investment in taking up the call option. This occurred because the holder would choose not to exercise
the contracted exercise price, thus only loosing the premium invested. As share price increase above the 210 value, the
holder will exercise the contracted call option to either reduce losses, or gaining profit for if share moves above the 234.5
value for the call option invested. This would happen in vice versa manner for put option exercise price of 210 for month
of November, with possible maximum lost equivalent to premium of 22.0, and its profitability that would follow for if the
share price moved below the 210 exercise price.

Figure 4.2: Straddle Investment Graph

A straddle on the other hand will have profitability progressing in an incremental line whether the share price is moving
above or below the exercise price as illustrated in the blue line in Figure 4.2. Reason is the straddle investor can either
exercise both call or put option depending on the share prices movement. However, in such investment, the cost would
be substantial where price is equivalent to calculation shown as follow

Cost of Straddle = Cost of Call Option (C0) + Cost of Put Option (P0)
= 24.5 + 22
= 46.5
As we can observed from the calculation above, the cost of straddle is high, almost double the value of call option or put
option value alone for Mark & Spenser options traded. Therefore, for this investment to work, the holders must believe
that the price of the underlying share is going to change quite significantly, without the knowledge or ability to predict the
direction share price movement. Example of such circumstances to arise would be the investor knows that a company is
going to make an important announcement, but has no knowledge of the content of the announcement.

It would only be a good strategy to pursue if investor believes that a stock's price will move significantly for the investor to
make profit. As shown in the Figure 4.3, should only a small movement in price occur in either direction, the investor will
experience losses for the change is unable to cover the cost of straddle investment. As a result, a straddle is extremely
risky to perform. Additionally, on stocks that are expected to jump, the market tends to price options at a higher premium,
which ultimately reduces the expected payoff should the stock move significantly.

Profitability would only be achieve if:

1. Marks and Spenser Share price moving above exercise price scenario:
Share Price (ST) – Exercise Price (X) greater than Cost of Straddle
ST – X > (C0+P0)
ST – 210 > 46.5
ST > 46.5 +210
ST > 256.5 ; Mark & Spenser share price move above 256.5 before options maturity
Or,
2. Marks and Spenser Share price moving below exercise price scenario:
Exercise Price (X) – Share Price (ST) greater than Cost of Straddle
X – ST > (C0+P0)
210 – ST > 46.5
ST < 210 – 46.6
ST < 163.5 ;

From above calculation, we can deduce a profitable straddle would requires (ST – X) > (C0+P0) or (X – ST) > (C0+P0) as
illustrated in the Figure 4.3, where Mark & Spenser share price must either move above 256.5, or below 163.5 to achieve
net profitable gain. Any fluctuation of price falling between the mentioned value (163.5 < X < 256.6), the investor would
then experience losses in this investment.

Figure 4.3: Straddle Profitability Graph

c) Comment on the contention that options are a zero sum game for the writer and
investor in options.
(5 marks)
Zero-Sum Game is a situation in which one participant's gains result only from another participant's equivalent losses.
The net change in total wealth among participants is zero; where the wealth is just shifted from one to another. Options
and future contracts, or activity like gambling are examples of zero-sum games. In options traded, for every person who
gains on a contract, there will be a counter-party who loses an equal amount. Figure 4.4 summarises the profit
possibilities of buyer (holder) and the seller (writer) of the call option, with denomination of ST=Market Share Price,
X=Exercise Price, and C=Call Option Premium:

Figure 4.4: Profit or loss formulation associated with call option

Share Price Holder Writer Combined
If ST < X -C +C 0
If ST > X ST -[X+C] [X+C] – ST 0

Using Mark & Spenser Call Option with exercise price of 205, expiring in the month of September, the formulation in
Figure 4.4 can be explained in graphs as illustrated in Figure 4.5, Figure 4.6, and Figure 4.7
Figure 4.5: Holder’s Call Option Figure 4.6: Writer’s Call Option

Figure 4.7: Illustration of zero-sum game in option trading

Figure 4.5 shows holder’s position after taking up Mark & Spenser Option to exercise 205 price that mature in the month
of September. For Mark & Spenser share price moving below the price of 205, the holder would find no meaning in
exercising the option, thus incurring maximum lost of 12.0 (thus –C in Figure 4.4), which is the value of the premium. If
 Mark & Spenser share price moves beyond the 205 value (equivalent to ST > X scenario in Figure 4.4), the holder would
then exercise the option contracted, either to cut losses or begin pocketing the profit if share value rises above the
breakeven point of 217 (Represented by ST -[X+C] formula in Figure 4.4). Thus the linear incremental as share price
rises above 205 as shown in Figure 4.5.

Figure 4.6, on the other hand show the position of writer who sell the same Mark & Spenser option, purchased by the
holder. Explained by the formulation in Figure 4.4 for writer’s profitability position, which is the exact opposite of holder’s
position, thus the profitability line of writer’s is tabulated in Figure 4.6 came out as exact opposite of holder’s position
graph with maximum profitability received is 12.0, but the profitability will drop as Mark & Spenser share price moved
higher than 205.

Finally, combining Figure 4.5 and Figure 4.6, we get Figure 4.7 illustrating the summation of holder’s and writer’s
position will give result of zero as shown in the red line. Figure 4.7 shows very well that option trading is a zero-sum
game, where money is not created, but instead shifted between the holder and the writer. The zero sum game concept
is similarly applicable to Put Option trading, as we can see from Figure 4.8 below with P=Put Option Premium,
ST=Market Share Price, and X=Exercise Price. This would produce similar graph as we observed in Figure 4.5, Figure
4.6 and Figure 4.7, but in mirror image against the share price axis. This is because in put option scenario, the holder
would only benefit from the sell of Mark & Spenser share if market share price falls below the exercise price as we can
see in formulation in Figure 4.8. Nonetheless, the summation of holder’s position and writer’s position would produce
similar zero-sum effect.

Figure 4.8: Profit or loss formulation associated with put option

Share Price Holder Writer Combined
If ST ≥ X -P +P 0
If ST < X (X - ST ) - P P - (X - ST) 0

(TOTAL 15 MARKS)

(TOTAL 100 MARKS)

References:

“Ins and outs of puts and calls”, The Kiplinger Magazine, Changing Times (April 1984): page 49-56

“Zero-Sum Game Definition”, Investopedia, http://www.investopedia.com/terms/z/zero-sumgame.asp, accessed 15th January

2011

“Straddle Definition”, Investopedia, http://www.investopedia.com/terms/s/straddle.asp, accessed 20th January 2011

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