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    Basics of Options BB

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    krishna priya
    An option provides the holder the right, but not the obligation, to buy or sell an underlying asset at a fixed strike price on or before the expiration date. There are two main types of options: calls, which give the right to buy; and puts, which give the right to sell. The value of a call option increases as the underlying asset price rises above the strike price, while the value of a put option increases as the underlying asset price falls below the strike price. Key factors that influence the value of an option are the price of the underlying asset, the strike price, the volatility of the underlying asset, time to expiration, and risk-free interest rates. Models like Black-Scholes can be used to

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    Basics of Options BB

    Uploaded by

    krishna priya
    29 views14 pages
    An option provides the holder the right, but not the obligation, to buy or sell an underlying asset at a fixed strike price on or before the expiration date. There are two main types of options: calls, which give the right to buy; and puts, which give the right to sell. The value of a call option increases as the underlying asset price rises above the strike price, while the value of a put option increases as the underlying asset price falls below the strike price. Key factors that influence the value of an option are the price of the underlying asset, the strike price, the volatility of the underlying asset, time to expiration, and risk-free interest rates. Models like Black-Scholes can be used to

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    An option provides the holder the right, but not the obligation, to buy or sell an underlying asset at a fixed strike price on or before the expiration date. There are two main types of options: calls, which give the right to buy; and puts, which give the right to sell. The value of a call option increases as the underlying asset price rises above the strike price, while the value of a put option increases as the underlying asset price falls below the strike price. Key factors that influence the value of an option are the price of the underlying asset, the strike price, the volatility of the underlying asset, time to expiration, and risk-free interest rates. Models like Black-Scholes can be used to

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    29 views14 pages

    Basics of Options BB

    Uploaded by

    krishna priya
    An option provides the holder the right, but not the obligation, to buy or sell an underlying asset at a fixed strike price on or before the expiration date. There are two main types of options: calls, which give the right to buy; and puts, which give the right to sell. The value of a call option increases as the underlying asset price rises above the strike price, while the value of a put option increases as the underlying asset price falls below the strike price. Key factors that influence the value of an option are the price of the underlying asset, the strike price, the volatility of the underlying asset, time to expiration, and risk-free interest rates. Models like Black-Scholes can be used to

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 14

    Basics of Option Pricing

    An option provides the holder with the right to buy or sell a specified
    quantity of an underlying asset at a fixed price (called a strike price
    or an exercise price) at or before the expiration date of the option.

    Since it is a right and not an obligation, the holder can choose not to
    exercise the right and allow the option to expire.

    There are two types of options – call options and put options .
    Call and Put Options: Description and Payoff Diagrams
    A call option gives the buyer of the option the right to buy the underlying asset
    at a fixed price, called the strike or the exercise price, at any time prior to the
    expiration date of the option: the buyer pays a price for this right – the
    premium.

    Payoff on a Call Option

    Net Payoff

    Strike Price

    Price of underlying asset


    A put option gives the buyer of the option the right to sell the underlying
    asset at a fixed price, again called the strike or exercise price, at any time
    prior to the expiration date of the option. The buyer pays a price for this right
    – the premium

    Payoff on a Put Option

    Net Payoff

    Strike Price

    Price of underlying asset


    The Value of a Call Option on the Expiration Date

    Buy a Call

    Value of
    Call
    at Expiration (€)

    Value of common stock (ST)


    0 50 at expiration (€)

    If ST > €50, then call-option value = ST - €50.


    If ST  €50, then call option value = 0 4
    The Value of a Put Option on the Expiration Date

    Value of Buy a Put


    Put
    at Expiration (€)
    50

    Value of common stock (ST)


    0 50 at expiration (€)

    If ST  €50, then put-option value = 50


    If ST < €50, then put option value = €50 - ST 5
    Buy a Call Buy a Put
    Value of Value of
    Call Put

    Value of Stock Value of Stock

    Sell a Call Sell a Put

    Value of
    Value of
    Call
    Put

    Value of Stock Value of Stock


    Options can be combined to generate a
    risk free hedge
    Put Call Parity
    Value of + Value of - Value of = Present value of
    Stock Put Call exercise price

    S + P - C = PV (X)
    Stock Put option Call Option Bond
    market market market market

    (underlying) (derivative) (derivative)


    or
    S + P = C + PV(X)
    Put Call Parity ST Higher €58

    S
    €44 ST Lower €34
    Consider:
    Call Option with exercise price Xc = €55
    Put Option with exercise price Xp = €55
    Offsetting strategy:
    S + P - C = PV (X)
    Buy the stock Buy the put sell the call = PV (exercise price)
    Put Call Parity ST Higher €58

    S
    €44 ST Lower €34
    Consider:
    Call Option with exercise price Xc = €55
    Put Option with exercise price Xp = €55
    Offsetting strategy:
    S + P - C = PV (X)
    Buy the stock Buy the put sell the call = PV (exercise price)

    Payoffs on the Expiration Date


    Stock prices Stock price
    S+P-C rises to $58 falls to $34

    Value of common stock. 58 34


    Value of Put 0 21
    Value of Call - 3 0
    Total $55 $55
    Factors influencing the value of a Call option value:
    C = f(S, X, 2, T, rf) C
    S = value of underlying asset. S
    X = exercise price X
    2 = the (implied) variance of the 2
    return on the underlying asset
    T = time to expiration T
    rf = risk free rate rf
    10
    Option on a Stock Value of Call

    S Current Stock price

    X Exercise Price

    r Riskfree interest rate

    variance of rate of
    return of the stock

    T Time in years to
    expiration date
    Valuing Options
    Fundamentally a question of
    Risk (2)
    and
    Time (T)

    -As risk of asset increases,


    option value increases

    -As time to maturity lengthens,


    option value increases.
    Option Valuation Models:
    - Binomial
    - Black-Scholes

    Binomial Model

    pu
    Suu
    Su
    pu
    1 - pu
    S0 Sud = Sdu
    pu
    1 - pu Sd
    1 - pu Sdd
    T0 T1 T2
    Black-Scholes OPM
    C = SN(d1) – Xe-rf t N(d2)

    d1 = [ln (S/X) + (r + ½ 2) t] / 2 t

    d2 = d1 - 2 t
    Where
    S = Current stock price
    X = Exercise price of call
    rf = Continuous risk-free rate of return (annualized)
    2 = Variance (per year) of the continuous return on the stock
    t = Time in years to expiration date

    N(d1) and N(d2) represent in approximate terms the range of probability that the
    option will be in the money at expiration, i.e, the probability that S>X.
    Since N(d1) will always be greater than N(d2), it represents the upper end of the range.

    Note: S, X, r, t are observable σ2 is not observable 14

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