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    Options: Spring 2007 Lecture Notes 4.6.1 Readings:Mayo 28

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    Gudikandula Ravinder
    This document defines options and describes different types of option strategies. It discusses call options, which give the holder the right to buy the underlying asset at a set strike price, and put options, which give the holder the right to sell the underlying asset. The document provides examples of buying and writing call and put options. It also describes option strategies like covered calls, protective puts, and straddles that involve holding both put and call options.

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    Options: Spring 2007 Lecture Notes 4.6.1 Readings:Mayo 28

    Uploaded by

    Gudikandula Ravinder
    55 views34 pages
    This document defines options and describes different types of option strategies. It discusses call options, which give the holder the right to buy the underlying asset at a set strike price, and put options, which give the holder the right to sell the underlying asset. The document provides examples of buying and writing call and put options. It also describes option strategies like covered calls, protective puts, and straddles that involve holding both put and call options.

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    Options

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    This document defines options and describes different types of option strategies. It discusses call options, which give the holder the right to buy the underlying asset at a set strike price, and put options, which give the holder the right to sell the underlying asset. The document provides examples of buying and writing call and put options. It also describes option strategies like covered calls, protective puts, and straddles that involve holding both put and call options.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    55 views34 pages

    Options: Spring 2007 Lecture Notes 4.6.1 Readings:Mayo 28

    Uploaded by

    Gudikandula Ravinder
    This document defines options and describes different types of option strategies. It discusses call options, which give the holder the right to buy the underlying asset at a set strike price, and put options, which give the holder the right to sell the underlying asset. The document provides examples of buying and writing call and put options. It also describes option strategies like covered calls, protective puts, and straddles that involve holding both put and call options.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 34

    Options

    Spring 2007
    Lecture Notes 4.6.1
    Readings:Mayo 28
    Goals
    • Definitions
    • Options
    – Call option
    – Put option
    • Option strategies
    Derivatives: Definition
    • Derivative: Any security whose payoff
    depends on any other security
    Goals
    • Definitions
    • Options
    – Call option
    – Put option
    • Option strategies
    Options
    • Two types
    – Call: Option to buy
    – Put: Option to sell
    • Parts:
    – Option price
    – Strike price
    – Expiration
    Call Option
    • Option to purchase asset at the strike price
    • Horizon:(two types)
    – American: Anytime between now and the
    expiration date
    – European: On the expiration date only
    • Strike price: Price at which the security
    can be purchased
    Example:
    Buying a call option on Amazon
    • Amazon share price = $100
    • Purchase American call option
    – Option price = $5
    – Strike price = $120
    – Expiration = 2 months from now
    • Case A: price goes to $150
    – Exercise option
    • Buy at $120, sell at $150
    • Total = 150-120-5 = +$25
    • Case B: price goes to $50
    • Don’t exercise option
    • Total = -5 (lose entire investment)
    Example:
    Writing (selling) a call option on Amazon
    • Amazon share price = $100
    • Write American call option
    – Option price = $5
    – Strike price = $120
    – Expiration = 2 months from now
    • Case A: price goes to $150
    – Purchaser exercises option
    • Buy at $150, sell at $120
    • Total = -150+120+5 = -25
    • Case B: price goes to $50
    • Purchaser doesn’t exercise option
    • Total = +5
    Options and Insurance
    • The writer is kind of selling insurance to the
    buyer
    • As long as the price doesn’t go up by too
    much ($20) the writer gets to pocket the $5
    • Like an insurance premium
    • Danger: If price rises by large amount,
    option writer can lose lots of money
    How do you lose big money with
    options?
    • Write (sell) a naked call on Amazon.com (p =
    100), strike price = 150
    – Sell for $5
    • You feel very happy (+5)
    • Then Amazon goes to $250
    • The other side of your option trade exercises the
    option
    • You must buy Amazon at $250, and sell it for
    $150
    Option Terms
    • In-the-money
    • Stock price > call option strike price
    • At-the-money
    • Stock price = call option strike price
    • Out-of-the-money
    • Stock price < call option strike price
    Intrinsic Value
    Value of option if used today

    • Strike price = $100

    Intrinsic Value

    0 Stock Price
    100 104 105
    Option Pricing
    • Is it as easy as
    • (Price – strike price) when strike < stock price
    • 0 if strike is > stock price
    • Why does this get more complicated?
    • Have to consider today plus all days to the
    expiration date
    • Even though the price is in the zero value range
    today (out-of-the-money, it might move into the
    positive value range tomorrow
    General Properties of an option
    price
    • Option value will be higher:
    – When the expiration date is farther in the future
    – When the stock price moves around more
    • (This is known as higher volatility)
    Option Pricing
    • There are different formulas that try to take
    account of all this stuff
    • Black/Scholes is the most famous of these
    • Techniques used
    – Arbitrage
    – Stochastic calculus
    Option Price (red) versus
    Intrinsic Value (black)
    Value of option if used today
    • Strike price = $100

    Intrinsic Value

    0 Stock Price
    100 104 105
    Goals
    • Definitions
    • Options
    – Call option
    – Put option
    • Option strategies
    • Real options
    Put Option
    • Same as Call
    – Price
    – Strike price
    – Expiration
    • Difference: Option to Sell
    Example: Put Value
    • Strike price = $100

    Intrinsic Value
    10
    5

    Stock Price
    0
    90 95 96 100
    Goals
    • Definitions
    • Futures
    • Options
    – Call option
    – Put option
    • Option strategies
    Options+Stocks
    • Holding option alone is known as holding a
    “naked option”
    • Holding option with the stock is known as a
    “covered option”
    Insuring gains by buying a put
    option
    • Purchasing a put option on stock you
    already own sets a floor on what you can
    sell
    • Buy stock at 75, price rises to 100
    • Lock in gains, buy put at strike = 100
    • Gains will be at least 100-75
    • Cost = price of the put option
    Example 1: Buy Stock + Put
    • Strike price = $100
    • How much would your portfolio (option +
    stock) be worth for different prices?
    Total Value

    105

    100 Stock Price


    100 105
    Example 2: Option Straddle
    • Purchase a put and call at the same strike
    price
    • Strategy makes money when stock price
    moves a lot (volatility is high)
    Straddle Example
    • Current stock price = 100
    • Purchase at-the-money call (strike = 100)
    for $2
    • Purchase at-the-money put (strike = 100)
    for $3
    • What is the total value of your option
    portfolio for different stock prices?
    Straddle Performance
    • Lose money when no change in price
    • Price goes up: Call makes money
    • Price goes down: Put makes money
    • Strategy makes money when price moves a
    lot (depends on option prices)
    Straddle Contingency Graph
    Plot of net $ gain as a function of stock price

    • Strike price = $100


    • Option prices: call = $2, put = $3

    Net Gain
    1
    0
    -5 Stock Price
    94 95 100 105 106
    Writing Call Options
    • Writing a naked call
    • Writing a naked put
    Writing a Naked Call Option
    (1 share, option price = $5, strike = 100)

    +5

    105 110
    0
    100 Stock
    Price
    -5
    Writing a Covered Call Option
    (1 share, option price = $5, strike = 100, stock purchased at
    100)

    +5

    90
    0
    95 100 Stock
    Price
    -5
    Other Combinations
    • Many other combinations are possible
    • As with futures, you can use options to
    reduce risk or increase risk if you want
    Exotic Options
    • More complicated functions of prices
    • Often involve time path of prices
    • Ordinary options do not care about path
    • Example: Barrier option
    – “deactivates” if price crosses a barrier any time
    during a given period
    Other Applications
    • Stock options
    • Investment options
    Option Summary
    • Can be used to either reduce, or increase
    risk
    • Have insurance like characteristics
    • Derivatives as fire

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