Basic Option Pricing by Bittman

Fundamentals of Options
Part I:
Basic Strategies & Pricing
Gary Trennepohl, Oklahoma State University

and Oklahoma Teachers Retirement System
James Bittman, The Options Institute at CBOE
Disclaimer
In order to simplify the computations, commissions have not been included in the
examples used in these materials. Commission costs will impact the outcome of all stock
and options transactions and must be considered prior to entering into any transactions.
Multiple leg strategies involve multiple commission charges.
Any strategies discussed, including examples using actual securities and price data, are
strictly for illustrative and educational purposes only and are not to be construed as an
endorsement, recommendation, or solicitation to buy or sell securities.
Options involve risks and are not suitable for all investors. Prior to buying or selling
an option, an investor must receive a copy of Characteristics and Risks of Standardized
Options. Copies are available from your broker, by calling 1-888-OPTIONS, or from The
Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois
60606. Investors considering options should consult their tax advisor as to how taxes
may affect the outcome of contemplated options transactions.
CBOE, Chicago Board Options Exchange, OEX and XEO are registered trademarks
and The Options Institute and SPX are servicemarks of CBOE. All other trademarks and
servicemarks are the property of their respective owners.
Copyright © 2012 Chicago Board Options Exchange, Incorporated. All rights reserved.
CHICAGO BOARD OPTIONS EXCHANGE

2
Session Outline
Why Options? Why Bother?

Terminology and Basic Profit-Loss Diagrams
Popular Options Strategies
– Passive Index Strategies
– Strategies for Active Managers
Options Pricing
– The Black-Scholes Option Pricing Model (BSOPM)
– The Greeks tell us how option prices will change
Options and Institutional Investors

3
Why Options? Why Bother?
Without options,
investors have few choices:
+ + + Lending
_ _ _ Borrowing
Long Stock Short Stock Fixed Income

4
With Options, Many Choices
Long Call Short Call Long Put Short Put
Long Straddle Short Straddle Long Strangle Short Strangle
Ratio Call Spread Call Volatility Spread Split-strike Synthetic Put Volatility Spread
Options Give You Options!

5
Options Strategies: Possible Objectives
– Generate income
– Limit risk
– Reduce variability of returns
– Increase exposure to equities
without increasing risk
– Target future equity purchases at
lower prices

6
Options Basics
What are Options?
WHAT ARE OPTIONS?
Options are contracts

_________
rights
– Option buyers get ______
obligations
– Option sellers get __________

7
Call options
• A listed call option on an individual stock is a
contract that allows the call buyer to
– buy from the call option seller (or writer)
– 100 shares of a specified stock*
– at a specified price (strike price)
– any time before the date of expiration for “American-
style,” or at the expiration date for “European-style”
options. (Options can be traded any time prior to expiration.)
– by paying a premium to the option seller
• The call option seller (writer) is obligated to deliver
the underlying if an assignment notice is received.
*Index options are denominated in dollars and are “cash settled”
8
Put options
• A listed put option on an individual stock is

a contract that allows the put buyer to:
– sell to the put option seller (writer)
– 100 shares of a specified stock*
– at a specified price (strike price)
– any time before the date of expiration (American) or
at expiration (European)
– by paying a premium to the option seller
• The put option seller (writer) is obligated to buy the
underlying if an assignment notice is received.
*Index options are denominated in dollars and are “cash settled”

9
Creating profit-loss diagrams
• A profit-loss diagram shows the profit or loss of

a position at option expiration.
• Call example:
– Exercise price = 70 Days to expiration = 90
– Stock price = $70 Call option premium = $5.25
• Long stock and long call profit-loss at expiration
stock price call profit-loss stock profit-loss
65 0 - 5.25 = - 5.25 65 - 70 = - 5.00
70 0 - 5.25 = - 5.25 70 - 70 = 0.00
75 5 - 5.25 = - 0.25 75 - 70 = + 5.00
80 10 - 5.25 = +4.75 80 - 70 = +10.00

10
Risk Management Strategies:
Long stock compared to long call

Profit
long stock @ 70
Long 70 call @ 5.25

70
75.25 stock price at

(5.25) expiration
Market outlook: bullish

Loss

11
Profit/Loss at Expiration
LONG CALL LONG PUT
Bullish Bearish
Buy stock and limit risk Protect a stock or portfolio
SHORT CALL SHORT PUT
Collect premium (income) Collect premium (income)

Establish a selling price Establish a purchase price

12
Fundamentals of Options Part I:
Options Strategy and Pricing
Passive Options Strategies
for Institutional Investors
James Bittman
Senior Instructor
The Options Institute at CBOE
Writing covered calls on an index portfolio
Writing cash-secured index puts
13
Prices for Strategy Discussion
February 3, 2012 S&P 500 @ 1,330

Strike June June
Price Calls Puts
1,300 62 39
1,325 46 50
1,350 33 62
1,375 22 75
133 days to June 2012 expiration
14
Passive Strategies
Objectives: Generate income and reduce portfolio

volatility. These strategies have limited and
defined risk.
1. Covered Calls: Sell (write) calls against a
portfolio of stocks that behaves similar to the
index.
2. Cash Secured Puts: Hold cash equal to the
strike price and sell (write) index puts.

15
Writing Covered Calls
Buy (own) stock (portfolio)

Sell calls on a “dollar for dollar” basis
Example: S&P 500 Index @ 1,330
Own S&P Portfolio $10,000,000
Sell 75* 1350-strike SPX Calls @ 33
Benefit: generate premium income ($247,500)
and cushion losses if market declines
Risk: underperform in rising markets
* $10,000,000 portfolio ÷ (1,330 × $100) ≈ 75 calls
16
Writing Covered Calls
S&P 500 Covered Call
150
100
1,297
50 +53
0
1250 1300 1350 1400 1450
-50
-100
1330
-150
Call Expires Call I-T-M
Keep Premium Limited Profit
≈ 7% per year
≈ Sell at 1,383 17
Writing Cash-Secured Puts
Hold “cash” equal to the exercise price of the

options (less the put premium).
Sell Puts on a dollar-for-dollar basis
Example: S&P 500 Index @ 1,330
Own T-Bills ~$10,000,000
Sell 75* SPX 1325-strike Puts @ 50
Benefit: generate premium income ($375,000),
“Buy” into the market at a lower price
Risk: underperform in rising markets
* $10,000,000 portfolio ÷ (1,325 × $100) ≈ 75 puts 18
Writing Cash-Secured Puts
S&P 500 Cash-Secured Put
150
100
1,275
50 +50
0
1250 1300 1350 1400 1450
-50
-100
1330
-150
Put I-T-M Put Expires
Effectively long Keep Premium
at 1,275
≈ 11% per year 19
Options Strategies for
Institutional Investors:
Active Managers
James Bittman
Senior Instructor
The OptionsTarget Buyat
Institute Prices
CBOE – Ratio Put spread
Increase Market Exposure – Long Split Strike Synthetic

20
Target: Buy Price 6% Below Market
Market View: The market will decline 5-10%*

Objective: Bring in cash income and buy
the market down 6%.
Strategy: Cash-secured ratio put spread**
Buy 1 SPX 1325 Put @ (50)
Sell 2 SPX 1300 Puts @ 39 ea
Net Credit: (39 x 2) – 50 = 28
*SPX currently at 1,330
**You need $124,700 in “cash” per spread (see profit-loss diagram)

21
Cash-Secured Ratio Put Spread
S&P 500 Cash-Secured Ratio Put Spread

150
100 1,247 Max +53

50
0
+28
1250 1300 1350 1400 1450
-50
-100
1330
-150
Long
Buy at a Put Puts Expire
level of settles Keep 28
in
1,247
cash ≈ 6% per year 22
Target: Increase Market Exposure
Within Defined Limits
Market View: Think market will decline, but

worried about missing a rally
Objective: Target buying 3% lower or
participate in the upside.
Strategy: Split-strike Synthetic (Long)
Sell 1 SPX 1300 Put @ 39
Buy 1 SPX 1375 Call @ (22)
Net Credit: 17
T-Bills needed: $130,000 – 1,700 = $128,300 per spread

23
Split-Strike Synthetic
S&P 500 Split-Strike Synthetic
150
100
1,283
50
0 +17
1250 1300 1350 1400 1450
-50
-100
1330
-150
Long 1 No Long 1
effective price market effective price
1,283 exposure 1,358 24
Summary of Strategies
• Options can be used to target investment

objectives
• Options give investors more strategies
with unique tradeoffs
• 2-step thinking is required
• Using options requires more decisions
– Expiration date
– Strike price

25
Option Pricing Basics –
Calculating the option price and
how it changes over time.
James Bittman
Senior Instructor
The Options Institute at CBOE
The Black-Scholes Option Pricing Model
Option “Greeks” – How prices will behave
26
Rule 1 for Pricing Options
At expiration, an option is worth its

intrinsic value or zero:
Call = Max (0, Stock Price – Strike Price)
Put = Max (0, Strike Price – Stock Price)

27
Rule 2 for Pricing Options
Prior to expiration, an option’s price

can be estimated from five inputs:
– Price of the underlying asset (i.e. stock’s price), a
known value.
– Exercise price of the option – known value
– Time to expiration of the option – known value
– Current interest rates – known value.
– The expected volatility of the underlying over the life
of the option contract (e.g. the stock’s volatility) – an
unknown that must be estimated!

28
The Black-Scholes Model (BSOPM)*
A Formula to Calculate Call and Put Values -

C = S 0 N ( d 1 ) − Ke − rT N ( d 2 ) or
long stock and borrow
P = − S 0 N ( − d 1 ) + Ke − rT N ( − d 2 ) or
short stock and lend
S 0 = stock price, K = strike price

r = riskless rate, T = time to expiration
ln( S 0 / K ) + ( r + σ 2 / 2 )T
d1 =
σ T
d 2 = d1 − σ T
*Technically, the BSOPM is appropriate only for European options on
stocks paying no dividends prior to option expiration.
29
How Option Prices are
Affected by the “Greeks”
James Bittman
Senior Instructor
The Options Institute atTime
CBOE – called “theta”
Price of the Underlying – called “delta”
Volatility of the Underlying – called “vega”
30
Time and Option Prices
“Theta”

31
Time and Option Prices
• The greater the time to expiration, the more

valuable the option (except for deep in-the-money European
options).
• As options approach expiration, the time decay
affect changes.
– At-the-money (ATM) options change less early in their
life but the time impact increases as expiration nears.
– Out-of-the-money (OTM) options decay in a more
linear fashion (least erosion near expiration).

32
Time Decay – ATM vs. OTM
SPX @ 1,300
25.00
20.00
1300 Call (ATM)
15.00
10.00
1350 Call (OTM)
5.00
0.00
35 Days 28 Days 21 Days 14 Days 7 Days Exp.
Assumes SPX remains @1,300, and volatility expectations remain constant .

33
Stock Prices and Call Prices
Long 1300 Call

Two months prior to expiration
Option One month prior to expiration
Value At expiration
Black Scholes Option Price
Time Value
Intrinsic Value
X = 1300 Index Price
* Stylistic presentation; drawing is not to scale

34
Put Prices and Stock Prices
Long 1300 Put

Two months prior to expiration
Option One month prior to expiration
Value At expiration
Black-Scholes Option Price
Time Value
Intrinsic
Value
X = 1300 Index Price

35
Underlying Price and Option Prices
“Delta”

36
Delta (∆): A Measure of Exposure
Delta (∆) is the ∂call price/∂stock price

Option 1300 call value before
Value expiration
ITM
∆ = .95
ATM
∆ = .50
OTM
∆ = .10 X = 1300
Index Price
S = 1200 S = 1300 S = 1400
* Stylistic presentation; drawing is not to scale & deltas are approximated

37
Deltas change as time passes
Long 1300 Call: At expiration, delta is either 0.00 or 1.00

Option Prior to expiration
Value At expiration
As time goes to
expiration ITM
∆ = 1.00
OTM
∆ = 0.0
S = 1200 S = 1300 S = 1400 Index Price

38
Volatility and Option Prices
“Vega”
Volatility is a key component to option pricing.

Volatility cannot be observed directly;
it must be estimated
39
Volatility of the underlying asset and
option prices
•Refers to the variation in security returns over time –

usually measured by the standard deviation of the
underlying asset’s returns.
∑ i
( r − r ) 2
σ 1day = i =1
N −1
annualized it is σ = σ 1 day ≈ 250 trading days
•Consider three different meanings of “volatility”

40
Three meanings of “Volatility”
• Historical volatility as measured by the

standard deviation of returns over a prior time
period (e.g. 30 to 50 days).
• Implied volatility, the volatility used in the
BSOPM, which produces the observed option
price.
• Realized volatility, the volatility the underlying
asset will exhibit during the life of the option.

41
Why Volatility is Important
• Small changes in volatility have a noticeable

impact on the option’s price.
• Implied volatility reacts very quickly to new

information, which causes option prices to adjust.
• Typically, implied volatility rises when stock

prices are falling, and falls when stock prices are
rising (volatility and changes in underlying price
negatively correlated).

42
Options and
Institutional Investors
Educate Trustees
Define Strategy Objectives
Implementation of Strategies
Educate Trustees
Remember, in many cases the trustees are not

investment professionals but representatives of
plan beneficiaries.
Learn the benefits and costs of using options.

Don’t “overpromise and under deliver”.

44
Set objectives
Conservative option writing programs to
increase cash flow
Covered call writing, cash-secured put writing
Sale of straddles and strangles
Put and Call ratio spreads
Risk management strategies to
reduce downside exposure
Protective puts, Collars
Put or Call spreads or put or call ratio spreads
VIX Options and VIX option spreads

45
Implement the Strategy
• Use a dedicated options manager who selects

stocks and options (e.g. a covered write
strategy).
• Hire an “overlay” manager who implements
options strategies against stocks currently held
with custodian. The options manager only
trades options.
• Coordinate the back office processes between
your custodian, the investment managers and
the plan’s chief investment officer.

46
Are Options a “Zero-Sum Game”?
No!
Investors have different objectives.
Some want insurance.
Some focus on income.
Some want leverage.
Options offer all investors more
strategy alternatives.
Options Give You Options!
47
Options Fundamentals Part 1
Visit us at: www.cboe.com
Seminar offerings at The Options Institute

http://www.cboe.com/LearnCenter/Seminars.asp
Jim Bittman: [email protected]
Gary Trennepohl: [email protected]

48

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Fundamentals of Options

Gary Trennepohl, Oklahoma State University

CHICAGO BOARD OPTIONS EXCHANGE

Why Options? Why Bother?

CHICAGO BOARD OPTIONS EXCHANGE

Long Stock Short Stock Fixed Income

CHICAGO BOARD OPTIONS EXCHANGE

Long Call Short Call Long Put Short Put

Long Straddle Short Straddle Long Strangle Short Strangle

Options Give You Options!

CHICAGO BOARD OPTIONS EXCHANGE

Options are contracts

CHICAGO BOARD OPTIONS EXCHANGE

• A listed put option on an individual stock is

*Index options are denominated in dollars and are “cash settled”

• A profit-loss diagram shows the profit or loss of

CHICAGO BOARD OPTIONS EXCHANGE

Long stock compared to long call

Long 70 call @ 5.25

75.25 stock price at

Market outlook: bullish

CHICAGO BOARD OPTIONS EXCHANGE

LONG CALL LONG PUT

SHORT CALL SHORT PUT

Collect premium (income) Collect premium (income)

CHICAGO BOARD OPTIONS EXCHANGE

February 3, 2012 S&P 500 @ 1,330

Objectives: Generate income and reduce portfolio

CHICAGO BOARD OPTIONS EXCHANGE

Buy (own) stock (portfolio)

Hold “cash” equal to the exercise price of the

CHICAGO BOARD OPTIONS EXCHANGE

Market View: The market will decline 5-10%*

CHICAGO BOARD OPTIONS EXCHANGE

S&P 500 Cash-Secured Ratio Put Spread

100 1,247 Max +53

Market View: Think market will decline, but

CHICAGO BOARD OPTIONS EXCHANGE

• Options can be used to target investment

CHICAGO BOARD OPTIONS EXCHANGE

At expiration, an option is worth its

Put = Max (0, Strike Price – Stock Price)

CHICAGO BOARD OPTIONS EXCHANGE

Prior to expiration, an option’s price

CHICAGO BOARD OPTIONS EXCHANGE

A Formula to Calculate Call and Put Values -

S 0 = stock price, K = strike price

CHICAGO BOARD OPTIONS EXCHANGE

• The greater the time to expiration, the more

CHICAGO BOARD OPTIONS EXCHANGE

Assumes SPX remains @1,300, and volatility expectations remain constant .

Long 1300 Call

Black Scholes Option Price

X = 1300 Index Price

* Stylistic presentation; drawing is not to scale

Long 1300 Put

Black-Scholes Option Price

X = 1300 Index Price

* Stylistic presentation; drawing is not to scale

CHICAGO BOARD OPTIONS EXCHANGE