Options: the basics

Content
• What is option?
• Terminology
• No arbitrage
• Pricing Options
– The Binomial Option Pricing Model
– The Black-Scholes Model
 Why do we study options?
The underlying concern:
Happiness = U(Cnow,Cfuture)
We are happier with more Cfuture, but we are worried about the fluctuation of
Cfuture.

As you will see later, options provide a special payoff structure.

In other words:
Our happiness is derived not only from current consumption but also from
future consumptions which inherently involves uncertainty. This ultimately
constitutes our risk concern over the future payoffs of assets that we own.
Because of the special payoff structure of options, holding options enables us
to adjust our risk exposure, and ultimately change our happiness level.

Options? Terminology Arbitrage Binomial Black-Scholes

 Who trade options?
A quote from Chicago Board Options Exchange (CBOE):

“The single greatest population of CBOE users are not huge financial
institutions, but public investors, just like you. Over 65% of the
Exchange's business comes from them. However, other participants in the
financial marketplace also use options to enhance their performance,
including:

1. Mutual Funds
2. Pension Plans
3. Hedge Funds
4. Endowments
5. Corporate Treasurers”

Options? Terminology Arbitrage Binomial Black-Scholes

 How big is option trading?
Figure 6.1: Total number of option contracts traded in a year in all
exchange 1973 – 1999 (Source: CBOE)

Options? Terminology Arbitrage Binomial Black-Scholes

 How big is option trading?
Figure 6.1: CBOE average daily trading volume 1973 – 1999 (Source: CBOE)

Options? Terminology Arbitrage Binomial Black-Scholes

 How big is option trading?
Figure 6.2: CBOE year-end options open-interest dollar amount (in
thousands)1973 – 1999 (Source: CBOE)

Options? Terminology Arbitrage Binomial Black-Scholes

 Where do we trade options?
Trading of standardized options contracts on a national exchange started
in 1973 when the Chicago Board Options Exchange (CBOE), the world's
first listed options exchange, began listing call options.
Options also trade now on several smaller exchanges, including
• New York - the American Stock Exchange (AMEX)
- the International Securities Exchange (ISE)
• Philadelphia - the Philadelphia Stock Exchange (PHLX)
• San Francisco - the Pacific Stock Exchange (PCX)

Options? Terminology Arbitrage Binomial Black-Scholes

 Where do we trade options?
Trading of non-standardized (tailor-made) options contracts occurs on the
Over-the-counter (OTC) market. And it is in fact bigger than the
exchange-traded market for option trading.

• The OTC market is a secondary market that trades securities (stocks or

options or other financial assets) which are not traded on an exchange
due to various reasons (e.g., an inability to meet listing requirements).
• For such securities, broker/dealers negotiate directly with one another
over computer networks and by phone, and their activities are monitored
by the National Association of Securities Dealers.
• One advantage of options traded in OTC is that they can be tailored to
meet particular needs of a corporate treasurer or fund manager.

Options? Terminology Arbitrage Binomial Black-Scholes

 Standardized VS Non-Standardized
Standardized Options
• The terms of the option contract is standardized.
• Terms include:
1. The exercise price (also called the strike price)
2. The maturity date (also called the expiration date)
• For stock options, this is the third Saturday of the month in which
the contract expires, or the third Thursday of the month if the
third Friday is a holiday.
3. Number of shares committed on the underlying stocks
• In US, usually 1 contract – 100 shares of stock
Non-standardized options also involves these terms, but they can be
anything. For example, 1 contract underlies 95 shares instead of 100
shares of stock. Terms being more flexible for non-standardized options
and are traded in OTC market are the two distinct features.
Options? Terminology Arbitrage Binomial Black-Scholes
 Option Quotation (standardized)
• You will see how standardized options trading would be with a quick look
of option quotation system.
• Option quotes follow a pattern that enables you to easily construct and
interpret symbols once that formula is understood.
• The basic parts of an option symbol are:
Root symbol + Month code + Strike price code
• A root symbol is not the same as the ticker symbol. Please refer to the
option chain for that ticker to find the corresponding root.
• In conjunction with the option root symbol, you can utilize the tables below
to assist you in creating or deciphering options symbols.

Options? Terminology Arbitrage Binomial Black-Scholes

 Option Quotation (standardized)
• Expiration Month codes:

• Strike Price codes:

Exercise: quoting price for a call option on Microsoft (MSQ) at $27.5

expiring December 2006. (MSQ LY)
Options? Terminology Arbitrage Binomial Black-Scholes
 What is an option contract?
• There are 2 basic types of options: CALLs & PUTs
• A CALL option gives the holder the right, but not the obligation
• To buy an asset
• By a certain date
• For a certain price
• A PUT option gives the holder the right, but not the obligation
• To sell an asset
• By a certain date
• For a certain price

• an asset – underlying asset

• Certain date – Maturity date/Expiration date
• Certain price – strike price/exercise price
Options? Terminology Arbitrage Binomial Black-Scholes
 What is an option contract?
• For example, as of Nov 1, 2005 at around 5pm, Intel was selling at $22.65
per share.
• A call option that allows the holder to buy a share of Intel at the third
Saturday of November 2005 for a price of $20 has a market price of $2.80
• ONE stock option contract is a contract to buy or sell 100 shares. Thus,
you need $280 to buy ONE such call option contract in the market.

Options? Terminology Arbitrage Binomial Black-Scholes

 Call Option’s payoff
• Assuming you hold ONE contract of that Calls, i.e., the call contract
allows you to buy 100 shares of Intel on the third Saturday of December
at an exercise price of $20/share.
What is your payoff if Intel at that date is:
(a) Selling @ $25
• You will be very happy. To cash in, you do two things simultaneously:
• [1] exercise your right, and buy 100 Intel at $20. Total amount
you use is $2,000.
• [2] sell 100 shares of Intel at the market price (i.e., $25/share).
Total amount you get is $2,500.
• Your payoff is $2,500 - $2,000 = $500.
(b) Selling @ $19
• You will be very sad. You would not exercise the rights. The contract
is thus expired without exercising.
• Your payoff is $0.
Options? Terminology Arbitrage Binomial Black-Scholes
 Call Option’s payoff
• Exercise Price = $20/share.
• If at maturity, market Price = $25 > $20
(You exercise and get profit, the option you hold is said to be
“in-the-money” because exercising it would produce profit)
• If at maturity, market price = $19 < $20
(You do not exercise, the option you hold is said to be
“out-of-the-money” because exercising would be unprofitable)
• In general, if you hold a call option contract, you want Intel’s stock price to
skyrocket. If Intel is selling at $100, you will be really happier.
• That means, the value of a call option is higher if the underlying asset’s
price is higher than the exercise price.
• That also means, the value of a call option is zero if the underlying asset’s
price is lower than the exercise price. Whether it is $18, $19 or $2.50, it
does not matter, the call option will still worth zero.

Options? Terminology Arbitrage Binomial Black-Scholes

 Put Option’s payoff
• Assuming you hold ONE contract of that Puts, i.e., the put contract allows
you to sell 100 shares of Intel on the third Saturday of December at an
exercise price of $22.50/share. (current price of this option = 0.65)
What is your payoff if Intel at that date is:
(a) Selling @ $25
• You will be very sad. You would not exercise the rights. The contract
is thus expired without exercising.
• Your payoff is $0
(b) Selling @ $19
• You will be very happy. To cash in, you do two things simultaneously:
• [1] you buy 100 shares of Intel at $19, total purchase = $1,900
• [2] exercise your right, and sell 100 Intel at $22.5. Total amount
you get is $2,250.
• Your payoff is $2,250 - $1,900 = $350.

Options? Terminology Arbitrage Binomial Black-Scholes

 Put Option’s payoff
• Exercise Price = $22.50/share.
• If at maturity, market Price = $25 > $22.50
(You do not exercise, and the option you hold is said to be “out-of-the-
money” because exercising would be unproductive)
• If at maturity, market price = $19 < $22.50
(You exercise, and the option you hold is said to be “in-the-money”
because exercising would be profitable)
• In general, if you hold a put option contract, you want Intel to go broke. If
Intel is selling at a penny, you will be even happier.
• That means, the value of a put option is higher if the underlying asset’s
price is lower than the exercise price.
• That also means, the value of a put option is zero if the underlying asset’s
price is higher than the exercise price. Whether it is $23, $24 or $1000, it
does not matter, the put option will still worth zero.

Options? Terminology Arbitrage Binomial Black-Scholes

 Bunch of Jargons
Option is a derivative – since the value of an option depends on the price of
its underlying asset, its value is derived.

In the Money - exercise of the option would be profitable

Call: market price>exercise price
Put: exercise price>market price

Out of the Money - exercise of the option would not be profitable

Call: market price>exercise price
Put: exercise price>market price

At the Money - exercise price and asset price are equal

• Long – buy
• Short – sell

e.g., Long a put on company x – buy a put contract of company x.

Short a call on company y – sell a call contract of company y

Options? Terminology Arbitrage Binomial Black-Scholes

 Bunch of Jargons
American VS European Options

An American option – allows its holder to exercise the right to purchase (if a
call) or sell (if a put) the underlying asset on or before the expiration date.

A European option – allows its holder to exercise the option only on the
expiration date.

Options? Terminology Arbitrage Binomial Black-Scholes

 Bunch of Jargons

If the underlying asset of an option is:

(a) A stock – then the option is a stock option

(b) An index – the option is an index option
(c) A future contract – the option is a futures option
(d) Foreign currency – the option is a foreign currency option
(e) Interest rate – the option is an interest rate option

• ECMC49F will only focus on stock option. But you should know that there
are other options trading in the market. You should definitely know them
when you do interview with a firm or an i-bank for financial position. You
will fail your CFA exam if you don’t know them.

Options? Terminology Arbitrage Binomial Black-Scholes

 Stock options VS stocks
Let’s say you hold a option contract for GE. How does that differ from
holding GE’s stock?
Similarities:
• GE’s options are securities, so does GE’s stocks.
• Trading GE’s options is just like trading stocks, with buyers making bids and
sellers making offers.
• Can easily trade them, say in an exchange.

Differences:
• GE’s options are derivatives, but GE’s stocks aren’t
• GE’s options will expire, while stocks do not.
• There is not a fixed number of options. But there is fixed number of stock shares
available at any point in time.
• Holding stocks of GE entitles voting rights, but holding GE’s option does not
• GE has control over its number of stocks. But it has no control over its number of
options.

Options? Terminology Arbitrage Binomial Black-Scholes

 Notations

Strike price = X
Stock price at present = S0
Stock price at expiration = ST
Price of a call option = C
Price of a put option = P
Risk-free interest rate = Rf
Expiration time = T
Present time = 0
Time to maturity = T – 0 = T

Options? Terminology Arbitrage Binomial Black-Scholes

 Payoff of Long Call
If you buy (long) a call option, what is your payoff at expiration?

Payoff to Call Holder at expiration

Strike price = X (ST - X) if ST >X
Stock price at present = S0 0 if ST < X
Profit to Call Holder at expiration
Stock price at expiration = ST
Payoff – Purchase Price
Price of a call option = C $
Payoff
Price of a put option = P
Risk-free interest rate = Rf
Profit
Expiration time = T
Present time = 0 ST
Purchase price x
Time to maturity = T – 0 = T

Options? Terminology Arbitrage Binomial Black-Scholes

 Payoff of Short Call
If you sell (short) a call option, what is your payoff at expiration?

Payoff to Call seller at expiration

Strike price = X -(ST - X) if ST >X
Stock price at present = S0 0 if ST < X
Profit to Call seller at expiration
Stock price at expiration = ST
Payoff + Selling Price
Price of a call option = C $
Price of a put option = P
Risk-free interest rate = Rf
Selling price
Expiration time = T
Present time = 0 ST
x
Time to maturity = T – 0 = T
Profit

Payoff

Options? Terminology Arbitrage Binomial Black-Scholes

 Payoff of Long Put
If you buy (long) a put option, what is your payoff at expiration?

Payoff to Put Holder at expiration

Strike price = X 0 if ST >X
Stock price at present = S0 (X – ST) if ST < X
Profit to Put Holder at expiration
Stock price at expiration = ST
Payoff - Purchasing Price
Price of a call option = C $
Price of a put option = P
Risk-free interest rate = Rf
Expiration time = T Payoff
Present time = 0 ST
x Purchasing price
Time to maturity = T – 0 = T
Profit

Options? Terminology Arbitrage Binomial Black-Scholes

 Payoff of Short Put
If you sell (short) a put option, what is your payoff at expiration?

Payoff to Put seller at expiration

Strike price = X 0 if ST >X
Stock price at present = S0 -(X – ST) if ST < X
Profit to Put seller at expiration
Stock price at expiration = ST
Payoff + Selling Price
Price of a call option = C $
Price of a put option = P
Risk-free interest rate = Rf Profit
Selling price
Expiration time = T Payoff
Present time = 0 ST
x
Time to maturity = T – 0 = T

Options? Terminology Arbitrage Binomial Black-Scholes

 Payoff of Long Put & Short Call
If you buy (long) a put option and sell (short) a call, assuming their exercise
prices are the same, what is your payoff at expiration?
Payoff to Call seller at expiration Payoff to Put Holder at expiration
-(ST - X) if ST >X 0 if ST >X
+
0 if ST < X (X – ST) if ST < X

$ $

Payoff
ST ST
x x

Payoff

Options? Terminology Arbitrage Binomial Black-Scholes

 Payoff of Long Put & Short Call
If you buy (long) a put option and sell (short) a call, assuming their exercise
prices are the same, what is your payoff at expiration?
Payoff to Call seller at expiration Payoff to Put Holder at expiration
-(ST - X) if ST >X 0 if ST >X = -(ST – X)
+
0 if ST < X (X – ST) if ST < X = (X - ST)

ST
x
Payoff

Options? Terminology Arbitrage Binomial Black-Scholes

 Long Put & Short Call & Long stock
If you buy (long) a put option and sell (short) a call, as well as holding 1
stock. Assuming the options’ exercise prices are the same, what is your
payoff at expiration?

-(ST – X) if ST >X X if ST >X

+ Stock price (ST) at time T =
(X - ST) if ST < X X if ST < X
Payoff (long the stock)
$

Total Payoff (risk-free)

x

ST
x
Payoff (short call & long put)

Options? Terminology Arbitrage Binomial Black-Scholes

 Put-Call Parity
What we just do introduces a very important concept for pricing options.
Holding a portfolio with (a) 1 stock (which costs S0)
(b) selling one call (which earns C)
(c) buying one put (which costs P)
Total value of constructing portfolio = S0 + P - C

Payoff (long the stock) The payoff at maturity/expiration

$ is always X !!!

Total Payoff (risk-free)

x

ST
x
Payoff (short call & long put)

Options? Terminology Arbitrage Binomial Black-Scholes

 Put-Call Parity
Total value of constructing portfolio = S0 + P – C
Get back X at maturity for sure.
Thus X discounted at the risk-free rate should equal to the portfolio value now.
Thus, S0 + P – C = X/(1+Rf)T
In words: “Current stock price plus price of a corresponding put option at exercise
price X minus the price of a corresponding call option with exercise price X is equal
to the present value of X at maturity discounted at risk-free rate.
Payoff (long the stock)
$

Total Payoff (risk-free)

x

ST
x
Payoff (short call & long put)

Options? Terminology Arbitrage Binomial Black-Scholes

 Put-Call Parity
S0 + P – C = X/(1+Rf)T
Let’s do an exercise. What is the risk-free interest rate?
From the data below, S0 = 22.65,
05 DEC 22.50 Call sells at 0.90, C = 0.90, X = 22.50
05 DEC 22.50 Put sells at 0.65, P = 0.65, X = 22.50
Time to maturity is roughly 6 weeks. Thus, T = 6/52
We have 22.65 + 0.65 – 0.90 = 22.50/(1+Rf)6/52

Options? Terminology Arbitrage Binomial Black-Scholes

Readings for next class on pricing options

• Forget about the textbook. Read online free

sources and the lecture notes.
• Many of the course materials are drawn from
CBOE learning center Online tutorials
Click on “Options Basics” and read:
[1] Options Overview
[2] Introduction to Options Strategies
[3] Expiration, Exercise and Assignment
[4] Options Pricing 1
• There are some other online sources you may
find useful. For example, optionscentral.com.
• Check out the websites for US exchanges.