FRM: Options

Options Contracts
• Options on stocks were first traded in 1973.
That was the year the famous Black-Scholes
formula was published, along with Merton’s
paper - a set of academic papers that literally
started an industry.
• There are two basic types of options:
– A Call option is the right, but not the obligation,
to buy the underlying asset by a certain date for a
certain price.
– A Put option is the right, but not the obligation,
to sell the underlying asset by a certain date for a
certain price.
 Options Contracts
• The date when the option expires is known as
the exercise date, the expiration date, or the
maturity date.
• The price at which the asset can be purchased
or sold is known as the strike price.
• If an option is said to be European, it means
that the holder of the option can buy or sell
(depending on if it is a call or a put) only on the
maturity date.
• If the option is said to be an American style
option, the holder can exercise on any date up
to and including the exercise date.
 Options Contracts
• Let’s say that you entered into a call option on
IBM stock:
– Today IBM is selling for roughly $78.80/share, so
let’s say you entered into a call option that would
let you buy IBM stock in December at a price of
$80/share.
– If in December the market price of IBM were
greater than $80, you would exercise your option,
and purchase the IBM share for $80.
 – If, in December IBM stock were selling for less
than $80/share, you could buy the stock for less
by buying it in the open market, so you would not
exercise your option.
• Thus your payoff to the option is $0 if the IBM
stock is less than $80
• It is (ST-K) if IBM stock is worth more than $80
• Thus, your payoff diagram is:
 Options Contracts
Long Call on IBM
with Strike Price (K) = $80

80

60

40
Payoff

20

0
0 20 40 60 K =80 100 120 140 160
-20
IBM Terminal Stock Price

T
 Options Contracts
– What if you had the short position?
– Well, after you enter into the contract, you have
granted the option to the long-party.
– If they want to exercise the option, you have to do
so.
– Of course, they will only exercise the option when
it is in there best interest to do so – that is, when
the strike price is lower than the market price of
the stock.
• So if the stock price is less than the strike price
(ST<K), then the long party will just buy the
stock in the market, and so the option will
expire, and you will receive $0 at maturity.
• If the stock price is more than the strike price
(ST>K), however, then the long party will
exercise their option and you will have to sell
them an asset that is worth ST for $K.
• We can thus write your payoff as:
payoff = min(0,ST-K),
 Options Contracts
Short Call Position on IBM Stock
with Strike Price (K) = $80

21.25

0
Payoff to Short Position

0 20 40 60 80 100 120 140 160

-21.25

-42.5

-63.75

-85
Ending Stock Price
 Options Contracts
• This is obviously the mirror image of the long
position.
• Notice, however, that at maturity, the short
option position can NEVER have a positive
payout – the best that can happen is that they
get $0.
– This is why the short option party always demands
an up-front payment – it’s the only payment they
are going to receive. This payment is called the
option premium or price.
 Options Contracts
Long and Short Call Options on IBM
with Strike Prices of $80

100
80
60
40 Long Call
20
Net Position
Payoff

0
-20 0 20 40 60 80 100 120 140 160

-40
-60
Short Call
-80
-100
Ending Stock Price
 Options Contracts
• Recall that a put option grants the long party the
right to sell the underlying at price K.
• Returning to our IBM example, if K=80, the long
party will only elect to exercise the option if the
price of the stock in the market is less than $80,
otherwise they would just sell it in the market.
• The payoff to the holder of the long put position,
therefore is simply
payoff = max(0, K-ST)
 Options Contracts
Payoff to Long Put Option on IBM
with Strike Price of $80

80
70
60
50
Payoff

40
30
20
10
0
-10 0 20 40 60 80 100 120 140 160

Ending Stock Price

 Options Contracts
• The short position again has granted the
option to the long position. The short has to
buy the stock at price K, when the long party
wants them to do so. Of course the long party
will only do this when the stock price is less
than the strike price.
• Thus, the payoff function for the short put
position is:
payoff = min(0, ST-K)
 Options Contracts
Short Put Option on IBM
with Strike Price of $80

0
0 20 40 60 80 100 120 140 160

-21.25
Payoff

-42.5

-63.75

-85
Ending Stock Price
 Options Contracts
• Since the short put party can never receive a
positive payout at maturity, they demand a
payment up-front from the long party – that is,
they demand that the long party pay a premium
to induce them to enter into the contract.

• Once again, the short and long positions net out

to zero: when one party wins, the other loses.
 Options Contracts
Long and Short Put Options on IBM
with Strike Prices of $80

100
80
60 Long Position
40
Net Position
20
Payoff

0
-20 0 20 40 60 80 100 120 140 160
-40
-60 Short Position
-80
-100
Ending Stock Price
OPTION STRATEGIES
 REMEMBER…
• The four basic strategies that underpin your
entire options trading knowledge are:
• ■ Long Call
• ■ Short Call
• ■ Long Put
• ■ Short Put
 Option trading strategies*
• Basic classification:
– Single option strategies
– Spreads ( taking position in one or more
options of the same type)
• Bull spread,bear spread,butterfly
spread.
– Combination (taking positions in both calls
& puts in the Same stock)
• Staddles,strips,straps,strangles …..
• Condors,box spreads…..
 Single option strategy

• Hedging a long position in stock : taking a

offsetting position.
• (covered calls/puts)
• Example # 1: investor buys a stock @ 100;
buys a put @ 16 with E=110. then , fill the
table …..
 Table # 1
Share Price Exercise price Profit on Profit on Net Profit
exercise (a) holding the (a+b)
share (b)
70 110 ……. ……. …….

80 …….. …….

90 110 …….

100 110 …….

110 …….

120

130

140
 Single option strategy

• Hedging a short position in stock : taking a

offsetting position.

• Short seller

• Example # 2: investor sells a stock @ 100; buys

a call @ 4 with E=105. then , fill the table …..