Chapter 18 OPTIONS

The Upside Without the Downside

OUTLINE Terminology Options and Their Payoffs Just Before Expiration Option Strategies Factors Determining Option Values Binomial Model for Option Valuation Black-Scholes Model Equity Options in India

TERMINOLOGY

CALL AND PUT OPTIONS

OPTION HOLDER AND OPTION WRITER

EXERCISE PRICE OR STRIKING PRICE

EXPIRATION DATE OR MATURITY DATE EUROPEAN OPTION AND AMERICAN OPTION EXCHANGE-TRADED OPTIONS AND OTC OPTIONS AT THE MONEY, IN THE MONEY, AND OUT OF THE
MONEY OPTIONS

INTRINSIC VALUE OF AN OPTION TIME VALUE OF AN OPTION

OPTION PAYOFFS
PAYOFF OF A CALL OPTION
PAYOFF OF A CALL OPTION

E (EXERCISE PRICE)

STOCK PRICE

PAY OFF OF A PUT OPTION

PAYOFF OF A PUT OPTION

E (EXERCISE PRICE)

STOCK PRICE

PAYOFFS TO THE SELLER OF OPTIONS

PAYOFF

E STOCK PRICE

(a) SELL A CALL

PAYOFF

E STOCK PRICE

(b) SELL A PUT

OPTIONS
BUYER/HOLDER
RIGHTS/ OBLIGATIONS CALL PUT PREMIUM EXERCISE MAX. LOSS POSSIBLE MAX. GAIN POSSIBLE CLOSING POSITION OF EXCHANGE TRADED BUYERS HAVE RIGHTSNO OBLIGATIONS RIGHT TO BUY/TO GO LONG RIGHT TO SELL/ TO GO SHORT PAID BUYERS DECISION COST OF PREMUIM UNLIMITED PROFITS EXERCISE OFFSET BY SELLING OPTION IN MARKET LET OPTION LAPSE WORTHLESS

SELLER/WRITER
SELLERS HAVE ONLY OBLIGATIONS-NO RIGHTS OBLIGATION TO SELL/GO SHORT ON EXERCISE OBLIGATION TO BUY/GO LONG ON EXERCISE RECEIVED SELLER CANNOT INFLUENCE UNLIMITED LOSSES PRICE OF PREMIUM ASSIGNMENT ON OPTION OFFSET BY BUYING BACK OPTION IN MARKET OPTION EXPIRES AND KEEP THE FULL PREMIUM

PUT CALL PARITY THEOREM - 1

Value of stock

Buy stock

position (S1) E-

Value of put position (P1)

Buy put

Stock price (S1) Value of combination

Stock price (S1)

Buy a stock (S1) Combination (buy a call) C1= S1+ P1-E Stock price (S1) Borrow (-E)

Value of borrow position (-E) E

Buy a put (P1)

Stock price (S1) -E ---------------------------------------

-E

PUT CALL PARITY THEOREM - 2

IF C1 IS THE TERMINAL VALUE OF THE CALL OPTION C1 = MAX [(S1 - E), 0] P1 = MAX [(E - S1 ), 0]

S1 = TERMINAL VALUE
E = AMOUNT BORROWED

C1 = S1 + P1 - E

OPTION STRATEGIES PROTECTIVE PUT

PROFITS STOCK PROTECTIVE PUT

ST
S0 = X

-P - S0

OPTION STRATEGIES COVERED CALL

A. STOCK

B. WRITTEN CALL

PAYOFF C. COVERED CALL X

OPTION STRATEGIES STRADDLE

LONG STRADDLE : BUY A CALL AS WELL AS A PUT SAME EXERCISE PRICE
A : CALL PAYOFF AND PROFIT B : PUT PAYOFF AND PROFIT

PAYOFF PROFIT

PAYOFF ST

ST PROFIT C : STRADDLE PAYOFF AND PROFIT PAYOFF PROFIT P+C X ST

OPTION STRATEGIES SPREAD

A SPREAD INVOLVES COMBINING TWO OR MORE CALLS (OR PUTS) ON THE SAME STOCK WITH DIFFERING EXERCISE PRICES OR TIMES TO MATURITY PAYOFF AND PROFIT OF A VERTICAL SPREAD AT EXPIRATION
A : CALL HELD PAYOFF B : CALL WRITTEN PAYOFF

ST

ST

PAYOFF AND PROFIT PAYOFF PROFIT X1 ST X2

COLLAR A collar is an options strategy that limits the value of a portfolio within two bounds An investor who holds an equity stock buys a put and sells a call on that stock. This strategy limits the value of his portfolio between two predetermined bounds, irrespective of how the price of the underlying stock moves

OPTION VALUE : BOUNDS

UPPER AND LOWER BOUNDS FOR THE VALUE OF CALL OPTION

VALUE OF CALL OPTION

UPPER BOUND (S0)

LOWER BOUND ( S0 E)

STOCK PRICE 0 E

FACTORS DETERMINING THE OPTION VALUE

EXERCISE PRICE

EXPIRATION DATE
STOCK PRICE

STOCK PRICE VARIABILITY

INTEREST RATE
C0 = f [S0 , E, 2, t , rf ] + - + + +

BINOMIAL MODEL OPTION EQUIVALENT METHOD - 1

A SINGLE PERIOD BINOMIAL (OR 2 - STATE) MODEL

S CAN TAKE TWO POSSIBLE VALUES NEXT YEAR, uS OR dS (uS > dS)
B CAN BE BORROWED .. OR LENT AT A RATE OF r, THE RISK-FREE RATE .. (1 + r) = R d < R > u E IS THE EXERCISE PRICE

Cu = MAX (u S - E, 0)
Cd = MAX (dS - E, 0)

BINOMIAL MODEL : OPTION EQUIVALENTMETHOD - 2

PORTFOLIO SHARES OF THE STOCK AND B RUPEES OF BORROWING STOCK PRICE RISES : uS - RB = Cu STOCK PRICE FALLS : dS - RB = Cd = Cu - Cd = SPREAD OF POSSIBLE OPTION PRICE

S (u - d)
B =

SPREAD OF POSSIBLE SHARE PRICES

dCu - uCd (u - d) R

SINCE THE PORTFOLIO (CONSISTING OF SHARES AND B DEBT) HAS THE SAME PAYOFF AS THAT OF A CALL OPTION, THE VALUE OF THE CALL OPTION IS C = S - B

ILLUSTRATION
S = 200, u = 1.4, d = 0.9 E = 220, r = 0.10, R = 1.10 Cu = MAX (u S - E, 0) = MAX (280 - 220, 0) = 60 Cd = MAX (dS - E, 0) = MAX (180 - 220, 0) = 0 =

Cu - Cd
= (u - d) S dCu - uCd

60
= 0.6 0.5 (200) 0.9 (60) = = 98.18 0.5 (1.10)

B = (u - d) R

0.6 OF A SHARE + 98.18 BORROWING 98.18 (1.10) = 108 REPAYT PORTFOLIO WHEN u OCCURS WHEN d OCCURS 1.4 x 200 x 0.6 - 108 = 60 0.9 x 200 x 0.6 - 108 = 0 CALL OPTION Cu = 60 Cd = 0

C = S - B = 0.6 x 200 - 98.18 = 21.82

BINOMIAL MODEL RISK-NEUTRAL METHOD

WE ESTABLISHED THE EQUILIBRUIM PRICE OF THE CALL OPTION WITHOUT KNOWING ANYTHING ABOUT THE ATTITUDE OF INVESTORS TOWARD RISK. THIS SUGGESTS ALTERNATIVE METHOD RISK-NEUTRAL VALUATION METHOD 1. CALCUL ATE THE PROBABILITY OF RISE IN A RISK NEUTRAL WORLD 2. CALCULATE THE EXPECTED FUTURE VALUE .. OPTION 3. CONVERT .. IT INTO ITS PRESENT VALUE USING THE RISK-FREE RATE

PIONEER STOCK
1. PROBABILITY OF RISE IN A RISK-NEUTRAL WORLD
RISE 40% TO 280 FALL 10% TO 180 EXPECTED RETURN = [PROB OF RISE x 40%] + [(1 - PROB OF RISE) x - 10%] = 10% p = 0.4

2. EXPECTED FUTURE VALUE OF THE OPTION STOCK PRICE STOCK PRICE

Cu = RS. 60 Cd = RS. 0

0.4 x RS. 60 + 0.6 x RS. 0 = RS. 24 3. PRESENT VALUE OF THE OPTION RS. 24 = RS. 21.82 1.10

BLACK - SCHOLES MODEL

E
C0 = S0 N (d1) ert N (d) = VALUE OF THE CUMULATIVE NORMAL DENSITY FUNCTION ln S0 E + 1 r + 2 2 t t N (d2)

d1 =
d2 = d1 - t

r = CONTINUOUSLY COMPOUNDED RISK - FREE ANNUAL INTEREST RATE = STANDARD DEVIATION OF THE CONTINUOUSLY COMPOUNDED ANNUAL RATE OF RETURN ON THE STOCK

BLACK - SCHOLES MODEL

ILLUSTRATION
S0 = RS.60 t = 0.5 E = RS.56 r = 0.14 2 r + 2 = 0.30

STEP 1 : CALCULATE d1 AND d2 ln d1 = S0 E + t

t .068 993 + 0.0925 = 0.7614 0.2121

d2 = d1 - t = 0.7614 - 0.2121 = 0.5493 STEP 2 : STEP 3 : N (d1) = N (0.7614) = 0.7768 N (d2) = N (0.5493) = 0.7086 E = ert STEP 4 : e0.14 x 0.5 56 = RS. 52.21

C0 = RS. 60 x 0.7768 - RS. 52.21 x 0.7086 = 46.61 - 37.00 = 9.61

ASSUMPTIONS

THE CALL OPTION IS THE EUROPEAN OPTION

THE STOCK PRICE IS CONTINUOUS AND IS DISTRIBUTED LOGNORMALLY THERE ARE NO TRANSACTION COSTS AND TAXES

THERE ARE NO RESTRICTIONS ON OR PENALTIES FOR SHORT SELLING

THE STOCK PAYS NO DIVIDEND THE RISK-FREE INTEREST RATE IS KNOWN AND CONSTANT

ADJUSTMENT FOR DIVIDENDS

SHORT - TERM OPTIONS

ADJUSTED STOCK PRICE = S = E VALUE OF CALL = S N (d1) N (d2) Divt (1 + r)t

ert
ln S E + t 2 r + 2 t

d1 =

ADJUSTMENT FOR DIVIDENDS - 2

LONG - TERM OPTIONS
C = S e -yt N (d1) - E e -rt N (d2)

ln
d1 d2 =

S E

r-y +

2 2

= d1 - t

THE ADJUSTMENT DISCOUNTS THE VALUE OF THE STOCK TO THE PRESENT AT THE DIVIDEND YIELD TO REFLECT THE EXPECTED DROP IN VALUE ON ACCOUNT OF THE DIVIDEND PAYMENS OFFSETS THE INTEREST RATE BY THE DIVIDEND YIELD TO REFLECT THE LOWER COST OF CARRYING THE STOCK

PUT - CALL PARITY - REVISITED JUST BEFORE EXPIRATION C1 = S1 + P1 - E S0 + P0 - E e -rt

IF THERE IS SOME TIME LEFT C0 =

THE ABOVE EQUATION CAN BE USED TO ESTABLISH THE PRICE OF A PUT OPTION & DETERMINE WHETHER THE PUT - CALL PARITY IS WORKING

INDEX OPTION ON S & P CNX NIFTY CONTRACT SIZE TYPE CYCLE 200 TIMES S & P CNX NIFTY EUROPEAN ONE, TWO, AND THREE MONTHS LAST THURSDAY EXPIRY MONTH CASH - SETTLED

EXPIRY DAY

SETTLEMENT

QUOTATION

FEB. 12, 2002 CONTRACT (STRIKE PRICE) PREMIUM [TRADED, VALUE, NO, QTY, RS. IN LAKH] 114 [2000, 22.71, 10] OPEN INT EXPIRY DATE

NIFTY (1020)

6400

28 - 02 - 02

OPTIONS ON INDIVIDUAL SECURITIES

CONTRACT SIZE TYPE NOT LESS THAN RS.200,000 AT THE TIME OF INTRODUCTION AMERICAN

TRADING CYCLE
EXPIRY STRIKE PRICE

MAXIMUM THREE MONTHS

LAST THURSDAY OF THE EXPIRY MONTH THE EXCHANGE SHALL PROVIDE A MINIMUM OF FIVE STRIKE PRICES FOR EVERY OPTION TYPE (CALL & PUT) 2 (ITM), 2 (OTM), 1 (ATM) BASE PRICE ON INTRODUCTION THEORETICAL VALUE AS PER B-S MODEL ALL ITM OPTIONS WOULD BE AUTOMATICALLY EXERCISED BY NSCCCL ON THE EXPIRATION DAY OF THE CONTRACT CASH-SETTLED

BASE PRICE EXERCISE

SETTLEMENT

QUOTATIONS

CONTRACTS (STRIKE PRICE) CALL RELIANCE (340)

PREMIUM (QTY, VALUE, NO)

EXPIRY DATE

5.50, 5.70 [26400, 9107, 44]

28.02.02

PUT RELIANCE (320)

14.15, 21.00 [5400, 18.25, 9]

28.02.02

SUMMING UP
An option gives its owner the right to buy or sell an asset on or before a given date at a specified price. An option that gives the right to buy is called a call option; an option that gives the right to sell is called a put option.

A European option can be exercised only on the expiration date whereas an American option can be exercised on or before the expiration date. The payoff of a call option on an equity stock just before expiration is equal to: Max Stock price Exercise price, 0

The payoff of a put option on an equity stock just before expiration is equal to: Max

Exercise
price -

Stock
price, 0

 Puts and calls represent basic options. They serve as building blocks for developing more complex options. For example, if you buy a stock along with a put option on it (exercisable at price E), your payoff will be E if the price of the stock (S1) is less than E; otherwise your payoff will be S1. A complex combination consisting of (i) buying a stock, (ii) buying a put option on that stock, and (iii) borrowing an amount equal to the exercise price, has a payoff that is identical to the payoff from buying a call option. This equivalence is referred to as the put-call parity theorem. The value of a call option is a function of five variables: (i) price of the underlying asset, (ii) exercise price, (iii) variability of return, (iv) time left to expiration, and (v) risk-free interest rate. The value of a call option as per the binomial model is equal to the value of the hedge portfolio (consisting of equity and borrowing) that has a payoff identical to that of the call option.

The value of a call option as per the Black - Scholes model is: E C0 = S0 N (d1) N (d2) ert