Chapter 4

MECHANICS AND
PRICING OF OPTIONS
By: Prof. N P Singh
singhnp_26@yahoo.com
 What is an option?
 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) on 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
(right to buy) and put options (right to sell).

12/08/21 2
 Call & Put
• Buyer of a call option – long call
• Seller of a call option – short call
• Buyer of a put option – long put
• Seller of a put option – Short Put
 Underlying asset could be
 Stocks, bonds, commodity, indices, foreign
currency & real assets.
 Call Options
 A call option gives the buyer of the option
the right to buy the underlying asset at a
fixed price (strike price or , X or K) at any
time on/ before the expiration date of the
option.
 The buyer pays a price for this right – Call
premium
 Call Option
 At expiration,
 If the value of the underlying asset (S) > Strike
Price(K)
• Buyer exercises the option.
• Call option buyer benefit: S - K
 If the value of the underlying asset (S) < Strike Price
(K)
• Buyer does not exercise

 Payoff on exercise date is Max [ (ST-K), 0]

 More generally,
 the value of a call increases as the value of the
underlying asset increases
 the value of a call decreases as the value of the
underlying asset decreases
 Options Terminology
 Option Writer and Option Holder
 Strike /Exercise Price
 Premium/Option Price
 Expiration Date
 American & European Options.
 In the Money (ITM), At the Money (ATM) and Out
of the Money (OTM)
 Intrinsic value
 Time Value
 Long Call on Co. ABC
Profit from buying one ABC European call option: Call
premium = Rs.5, strike price = Rs.100, option life = 2
months

30 Profit (Rs.)

20

10 Terminal
70 80 90 100 stock price (Rs.)
0
-5 110 120 130
 Short Call on ABC

Profit from writing/selling one ABC European call option:

Option Premium = Rs.5, strike price = Rs.100

Profit (Rs.)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price (Rs.)

-20

-30
ZERO SUM GAME???
 Put Options
 A put option gives the buyer of the option
the right to sell the underlying asset at a
fixed price on/at any time before the expiry
date of the option.

 The buyer pays a price for this right – put

premium
 Put Options
 At expiration,
 If the value of the underlying asset (S) < Strike Price(K)
• Put option buyer profit : K-S
 If the value of the underlying asset (S) > Strike Price (K)
• Buyer does not exercise
 Payoff on exercise date is Max [ (K- ST), 0]

 More generally,
 the value of a put decreases as the value of the underlying asset
increases
 the value of a put increases as the value of the underlying asset
decreases
 Long Put on Hindalco
Profit from buying an Hindalco European put option:
Put premium = Rs.7, strike price = Rs.70
 Long Put on Hindalco
Profit from buying an Hindalco European put option:
Put premium = Rs.7, strike price = Rs.70

30 Profit (Rs.)

20

10 Terminal
stock price (Rs)
0
40 50 60 70 80 90 100
-7
 Short Put on Hindalco

Profit from writing an Hindalco European put option:

option price = Rs.7, strike price = Rs.70
Profit (Rs.)
Terminal
7
40 50 60 stock price (Rs.)
0
70 80 90 100
-10

-20

-30
Position Profit/Loss
Long Call/Call Holder Unlimited profit
Long Put/Put Holder potential & limited loss
to the tune of premium

Short Call/Call Writer Limited profit to the

Short Put/Put Writer tune of premium &
unlimited loss
 PUT-CALL RATIO
 Put/call ratio = put option OI /call option OI

 It is used to measure the level of public

bullishness or bearishness in the market at
a given time.
 Factors affecting option premium
 Variables Relating to Underlying Asset
 Value of Underlying Asset; as this value
increases, the right to buy at a fixed price (calls)
will become more valuable and the right to sell at
a fixed price (puts) will become less valuable.
 Variance in that value; as the variance increases,
both calls and puts will become more valuable
because all options have limited downside and
depend upon price volatility for upside.
 Factors affecting option premium
 Variables Relating to Underlying Asset
 Expected dividends on the asset, which are
likely to reduce the price appreciation
component of the asset, reducing the value of
calls and increasing the value of puts.
 Factors affecting option premium
 Variables Relating to Option
 Strike Price of Options; the right to buy (sell)
at a fixed price becomes more (less) valuable
at a lower strike price.
 Life of the Option; both calls and puts benefit
from a longer life.
 Level of Interest Rates; As rate increases,
the right to buy (sell) at a fixed price in the
future becomes more (less) valuable.
 Determinants of Option Value
Factor Call Put
premium premium
Increase in stock price
Increase in strike price
Increase in variance of
underlying asset
Increase in time to expiration

Increase in interest rate

Increase in dividend paid
 Determinants of Option Value
Factor Call Put
Value Value
Increase in stock price ↑ ↓
Increase in strike price ↓ ↑
Increase in variance of ↑ ↑
underlying asset

Increase in time to expiration ↑ ↑

Increase in interest rate ↑ ↓
Increase in dividend paid ↓ ↑
 Trading Strategies Involving
Options
 Take a position in the option and the
underlying (A Covered/Protective Option)
 Take a position in 2 or more options of the
same type (A spread)
 Combination: Take a position in a mixture
of calls & puts (A combination)
 Types of Trading Strategies
 Covered Call and Reverse Covered Call
 Protective Put and Reverse Protective Put
 Bull Spreads
 Bear Spreads
 Box Spreads
 Butterfly Spreads
 Calendar Spreads
 Diagonal Spreads
 Straddles
 Strangles
 Strips and Straps
 Covered and Protective
Strategies
 Covered Call: (Fig. a ) D+ PV (K) - P = S - C
 Long Position in a stock and
 Short Position in a Call
 Reverse of Covered Call (Fig. b)
 Short Position in a stock and
 Long Position in a Call
 Protective Put (Fig. c) C + D+ PV (K) = S + P
 Long Position in a Stock and
 Long Position in a Put
 Reverse of Protective Put (Fig. d)
 Short Position in a Stock and
 Short Position in a Put
Covered/Protective Option Strategy:
Positions in an Option & the
Underlying

Profit Profit

K
K ST ST
(a)
(b
Profit Profit )

K
ST K ST

(c (d
) )
25
Bull Spread Using Calls : Long Call (K1) and Short
Call (K2) on the same stock with same expiration
where K2 > K1

Profit

ST
K1 K2

26
Bull Spread Using Puts: Long Put (K1) and Short
Put (K2) on the same stock with same expiration
where K2 > K1

Profit

K1 K2 ST

27
Bear Spread Using Puts: Long Put (K1) and
Short Put (K2) on the same stock with same
expiration where K1 > K2

Profit

K1 K2 ST

28
Bear Spread Using Calls: Long Call (K1) and Short
Call (K2) on the same stock with same expiration
where K1 > K2

Profit

K1 K2 ST

29
 Box Spread
 A combination of a bull call spread and a bear
put spread
 If all options are European a box spread is worth
the present value of the difference between the
strike prices
 If they are American this is not necessarily so.

30
 Butterfly Spread Using Calls:
Long a Call (K1), call (K3) and Short 2 calls (K2)
where K2 = (K1+K3)/2

Profit

K1 K2 K3 ST

31
Butterfly Spread Using Puts

Profit

K1 K2 K3 ST

32
Calendar Spread Using Calls
Figure 10.8, page 228

Profit

ST
K

33
Calendar Spread Using Puts
Figure 10.9, page 229

Profit

ST
K

34
A Straddle Combination
Figure 10.10, page 230

Profit

K ST

35
 Strip & Strap
Figure 10.11, page 231

Profit Profit

K ST K ST

Strip Strap
36
A Strangle Combination

Profit

K1 K2
ST

37
 Put Call Parity

 C + PV (K) = S + P
 Holds true for European Option.
 If this equation does not hold good then
arbitrage will happen.
 If the underlying asset is expected
generate Dividend ( D)
 C + D+ PV (K) = S + P
 Put Call Parity
 For American Option Put Call Parity does not
hold good in absolute sense.

S  K  C  P  S  PV ( K )
 With dividend,

S  D  K  C  P  S  PV ( K )
 Option Pricing Model
 Binomial Option Pricing Model
 Black Scholes Option Pricing Model
 The binomial model is a discrete-time
model for asset price movements, with a
time interval (t) between price
movements.The stock can jump to only
one of two points in each time interval, and
the option value is estimated iteratively.
 Valuing a call option using
Binomial option pricing method
A 3-month call option on the stock has a strike price of
Rs.21. Risk-Free rate of interest = 12% per annum.

Stock Price = Rs.22

Option Price = Rs.1
Stock price = Rs.20
Option Price=?
Stock Price = Rs.18
Option Price = Rs.00
 Binomial Option Pricing Risk-Neutral
Valuation
S0u = 22
p ƒu = 1
S0
ƒ
(1– S0d = 18
p) ƒd = 0
 Since p is the probability that gives a return on the stock
equal to the risk-free rate.
 We can find it from 20e0.12 0.25 = 22p + 18(1 – p )
which gives p = 0.6523
 Alternatively, we can use the formula
0.120.25
e d e
rT
 0.9
p   0.6523
ud 1.1  0.9
Valuing the Option Using Risk-
Neutral Valuation
S0u = 22
52 3 ƒu = 1
0. 6
S0
ƒ
0.34 S0d = 18
77
ƒd = 0
The value of the option is
e–0.120.25 (0.65231 + 0.34770)
= 0.633
 Choosing u and d
One way of matching the volatility is to set
 t
u  e
 t
d 1 u  e
where  is the volatility andt is the length
of the time step. This is the approach used
by Cox, Ross, and Rubinstein
 Work -Out
A 6-month call option on the stock has a
strike price of 300. Risk-Free rate of
Interest = 12% per annum. Current market
price is Rs. 310 and u = 1.5 and p =
0.6523. Find out the Call premium ?
 A Two-Step Example
A 6-month call option on the stock has a strike
price of 21.

24.2
22

20 19.8

18
16.2
 Each time step is 3 months
 X=21, r=12%
 Valuing a Call Option
24.2
D
3.2
22
B
20 2.0257 19.8
A E
1.2823 0.0
18
C
0.0 16.2
F 0.0
 Value at node B

 = e–0.120.25(0.65233.2 + 0.34770) = 2.0257

 Value at node A
 = e–0.120.25(0.65232.0257 + 0.34770) = 1.2823
 Valuing a Put Option
A 6-month put option on the stock has a
strike price of 300. Risk-Free rate of
Interest = 12% per annum. Current market
price is Rs. 310 and u = 1.5 and p =
0.6523. Find out the put premium ?
 Put Option Valuation
K = 52, S= 50, time period = 2 years in time step = 1yr, r
= 5% per annum
Value the Put option. p= 0.6282. Find the put premium

72
D
0
60
B
50 1.4147 48
A E
4.1923 4
40
C
9.4636 32
F 20
 What Happens When an Option is American ?

 At each node, we have to check whether early

exercise is better.
 At node B, payoff from early exercise is negative 8 – not
optimal
 At node C, payoff from early exercise is 12. At this node, the
option value is 9.4636
 Hence at node C, the option value will be 12.
72
D
0
60
B
50 1.4147 48
A E
5.0894 4
40
C
12.0 32
F 20
 Everything remaining as it is, an American
option premium ________ European
Option.
 Option Pricing Model
 The Black-Scholes model applies when
the underlying asset return distribution is
the normal distribution , and explicitly
assumes that the price process is
continuous and that there are no jumps in
asset prices.
 The Black-Scholes Model
 The value of a call/put option in the B&S
model can be written as a function of the
following variables:
S = Current value of the underlying asset
K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the
life of the option
2 = Variance in the of the underlying asset
return
The Black-Scholes Formulas
 rT
c  S 0 N ( d1 )  K e N (d 2 )

 rT
pK e N ( d 2 )  S 0 N ( d1 )

2
ln( S 0 / K )  ( r   / 2)T
d1 
 T

2
ln( S 0 / K )  ( r   / 2)T
d2   d1   T
 T
 Adjusting for Dividends
 If the dividend yield (y = dividends/ Current
value of the asset) of the underlying asset is
expected to remain unchanged during the life of
the option, the Model is modified
 C = S e-yt N(d1) - K e-rt N(d2)

 S  2
ln   + (r -y+ ) t
d1 = K 2
 t

d2 = d1 -  √t
 Example
 MTNL share is quoting Rs.130 today. The risk‑free rate
of interest is 6 per cent, the time to maturity is 3 months,
the exercise price is Rs.140 and the volatility is 20 per
cent per annum. No dividend is expected within 3 months.

S = 130
X = 140
r = 0.06 or 6% per annum
 = 0.20 or 20%
T = 0.25 years

 d1 = -0.5411 N(d1) = 0.2942

 d2 = -0.6411 N(d2) = 0.2607

 Call value = 2.29

 Assignment
 MTNL share is quoting Rs.130 today. The
risk‑free rate of interest is 6 per cent, the time to
maturity is 3 months, the exercise price is
Rs.140 and the volatility is 20 per cent per
annum. MTNL is expected to pay Rs. 3.50 as
dividend 45 days from today. Value the call
Option.
 Option Calculator
Option Calculator which uses Black-Scholes Opti
on Pricing formula.
 http://www.bseindia.com/derivatives/optioncalc
.asp

 Forms a base price.

 Option Greeks
 Delta () is the rate of change of the option price
with respect to the underlying
 Theta () of a derivative (or portfolio of
derivatives) is the rate of change of the value
with respect to the passage of time
 Gamma () is the rate of change of delta () with
respect to the price of the underlying asset
 Vega () is the rate of change of the value of a
derivatives portfolio with respect to volatility
 Rho is the rate of change of the value of a
derivative with respect to the interest rate