Options
Prof. Anirban Banerjee
IIM Ahmedabad
October 23, 2024
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 1 / 53
Introduction
Outline
1 Introduction
2 Mechanics of Options Markets
3 Put–Call Parity
4 Factors Affecting Option Prices
5 The Black-Scholes Formulae
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 2 / 53
Introduction
Introduction
Options offer one-sided protection against price moves and so are instruments of financial
insurance.
Options can be used to take positions on market direction (bullish: long call, short put;
bearish: long put, short call) or on market volatility (bullish: long options, bearish: short
options).
The presence of non-linearity in their payoffs also means that options can be combined into
portfolios to produce precise and targeted payoff patterns.
The most commonly used strategies in practice (such as straddles) exploit precisely the
special feature of options that they respond to volatility.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 3 / 53
Introduction
Options: Basic Definitions
An option is a financial security that gives the holder the right to buy or sell a specified quantity
of a specified asset at a specified price on or before a specified date.
Buy = Call option. Sell = Put option
On/before: American. Only on: European
Specified price = Strike or exercise price
Specified date = Maturity or expiration date
Specified asset = “underlying”
Buyer = holder = long position
Seller = writer = short position
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 4 / 53
Introduction
Broad Categories of Options
Exchange-traded options:
Stocks (e.g. - TCS Call Option with K=2300 and expiry = 27Aug2020 trading in
NSE).
Futures (E-mini S&P 500 Options Contract).
Indices (NIFTY Call Option with K=11400)
Currencies (USD-INR Option)
OTC options:
Vanilla (standard calls/puts as defined above).
Exotic (everything else—e.g., Asians, barriers, digitals).
Embedded options:
Callable bonds.
Convertible bonds?
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 5 / 53
Introduction
Example of European Long Call Option
Suppose an investor purchases 1 NIFTY-May-12000-Call at premium 43
One contract consists 75 index share.
The contract is cash settled.
If at the end of this option life NIFTY value is more than 12000
He exercises the option and receives the amount by which NIFTY exceeds 12000 for
one index share times Rs. 75.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 6 / 53
Introduction
Example of European Long Call Option – contd.
Suppose the final day value of NIFTY is 12100.
By exercising he gets (12100 – 12000) = 100 per index share or Rs. 75X100 = Rs.
7,500 for one contract
However, if the final day value is below 12000
He will not exercise the option.
For this privilege, he pays a fee of Rs.3225 (Rs.43 a share for 75 shares).
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 7 / 53
Introduction
Example of American Option – Long Call
Suppose an investor purchases 1 Reliance-Aug-2200-Call at premium Rs.35.
Lot size is 505
The contract is cash settled
This contract allows him to buy 505 shares of Reliance at Rs.2200 per share at any time
between the current date and the option expiry date of August.
If the price goes above Rs. 2200 he can exercise the option.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 8 / 53
Introduction
Example of American Option – Long Call – contd.
Suppose the price goes to 2260 and he exercises the option.
This is equivalent to buying the option @ 2200 and selling it @ 2260.
He will get Rs. (2260 – 2200) = Rs. 60 per share or Rs. 60 * 505 = Rs. 30,300 for
one contract
If the price remains below Rs. 2200 over the life of the option.
He will not exercise the option.
For this privilege, he pays a fee of Rs.17675 (Rs.35 a share for 505 shares).
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 9 / 53
Introduction
Example of American Option – Short Call
Suppose an investor writes/shorts 1 Reliance-Aug-2200-Call at premium Rs. 35.
Lot size is 505
The contract is cash settled
This contract gives an obligation on him to sell 505 shares of Reliance at Rs.2200 per share
at any time between the current date and the option expiry date of Aug.
If the price goes above Rs. 2200 long position holder will exercise the option.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 10 / 53
Introduction
Example of American Option – Short Call – contd.
Suppose the price goes to 2260 and long position holder exercises the option.
For short position holder this is equivalent to selling the option @ 2200 after buying it
@ 2260.
He will make loss Rs. (2260 – 2200) = 60 per share or RS. 60* 505 = Rs. 30,300 for
one contract
However, he receives a fee of Rs.17675 (Rs.35 a share for 505 shares) from long
position holder.
However, if the price remains below 2200 over the life of the option
Long position will not exercise the option.
The entire fee of Rs.17675 (Rs.35 a share for 505 shares) is the profit of short position
holder.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 11 / 53
Introduction
Payoff Diagram – Long Call
The payoff from a long position in a call option = Max(ST –K , 0) (K = Strike price, ST =
Price of the underlying security at maturity, C = Call option premium )
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 12 / 53
Introduction
Payoff Diagram – Short Call
The payoff from a short position in a call option = –Max(ST –K , 0) = Min(K − ST , 0) (K =
Strike price, ST = Price of the underlying security at maturity, C = Call option premium )
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 13 / 53
Introduction
Payoff Diagram – Long Put
The payoff from a long position in a put option = Max(K –ST , 0) (K = Strike price, ST =
Price of the underlying security at maturity, P = Put option premium )
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 14 / 53
Introduction
Payoff Diagram – Short Put
The payoff from a short position in a put option = –Max(K –ST , 0) = Min(ST –K , 0) (K =
Strike price, ST = Price of the underlying security at maturity, P = Put option premium )
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 15 / 53
Introduction
Payoff diagram – Combined
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 16 / 53
Mechanics of Options Markets
Outline
1 Introduction
2 Mechanics of Options Markets
3 Put–Call Parity
4 Factors Affecting Option Prices
5 The Black-Scholes Formulae
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 17 / 53
Mechanics of Options Markets
Specification of Options Traded in NSE
Specification of Options Traded in NSE
Option contracts are available on many traded stocks.
These securities are traded in the Capital Market segment of the Exchange.
Expiration date:
Last Thursday of the expiry month. If the last Thursday is a trading holiday, then the
expiry day is the previous trading day.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 18 / 53
Mechanics of Options Markets
Specification of Options Traded in NSE
Trading Cycle:
3 month trading cycle:
The near month
The next month
The far month
On expiry of the near month contract, new contracts are introduced at new strike
prices for both call and put options, on the trading day following the expiry of the near
month contract.
The new contracts are introduced for three month duration.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 19 / 53
Mechanics of Options Markets
Option Class and Option Series
All options of the same type (calls or puts) are referred to as an option class.
For example, Reliance calls are one option class while Reliance puts are another class.
An option series consists of all the options of a given class with the same expiration date
and strike price.
Reliance September Calls with 2200 strike price are one option series.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 20 / 53
Mechanics of Options Markets
Market Makers
Most exchanges use market makers to facilitate options trading.
A market maker quotes both bid and ask prices when requested.
The ask is higher than the bid and the amount by which the ask exceeds the bid is
referred to as the bid-ask spread.
The market maker does not know whether the individual requesting the quotes wants to buy
or sell.
The exchange sets upper limits for the bid-ask spread.
The existence of the market maker ensures that buy and sell orders can always be executed
at some price without any delays.
Market makers therefore add liquidity to the market.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 21 / 53
Mechanics of Options Markets
Offsetting Orders and Open Interest
An investor who has purchased an option can close out position by issuing an offsetting
order to sell the same option.
An investor who has written an option can close out position by issuing an offsetting order
to buy the same option.
If, when an options contract is traded, neither investor is offsetting an existing position
The open interest increases by one contract.
If one investor is offsetting an existing position and the other is not
The open interest stays the same.
If both investors are offsetting existing positions
The open interest goes down by one contract.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 22 / 53
Mechanics of Options Markets
Executive Stock Options
Executive stock options are a form of remuneration issued by a company to its executives.
They are usually at the money when issued.
When options are exercised the company issues more stock and sells it to the option holder
for the strike price.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 23 / 53
Mechanics of Options Markets
Executive Stock Options – contd.
They become vested after a period of time (usually 1 to 4 years).
They cannot be traded.
They often last for as long as 10 or 15 years.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 24 / 53
Mechanics of Options Markets
Convertible Bonds
Convertible bonds are regular bonds that can be exchanged for equity at certain times in
the future according to a predetermined exchange ratio.
It is therefore a bond with an embedded call option on the company’s stock.
The call provision is a way in which the issuer can force conversion at a time earlier than the
holder might otherwise choose.
Convertible bonds are like warrants and executive stock options in that their exercise leads
to more shares being issued by the company.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 25 / 53
Put–Call Parity
Outline
1 Introduction
2 Mechanics of Options Markets
3 Put–Call Parity
4 Factors Affecting Option Prices
5 The Black-Scholes Formulae
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 26 / 53
Put–Call Parity
Put-Call Parity
One of the most important results in all of option pricing theory.
It relates the prices of European puts and calls.
Consider two portfolios:
Portfolio A Investment of PV (K )
Long call with strike K and maturity T .
Portfolio B Long stock
Long put with strike K and maturity T .
Payoffs from these portfolios are described on the next two pages.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 27 / 53
Put–Call Parity
Portfolio A: Payoffs at Maturity
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 28 / 53
Put–Call Parity
Portfolio B: Payoffs at Maturity
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 29 / 53
Put–Call Parity
The Parity Result
The time-T payoffs are identical.
Thus, the costs of the portfolios must be identical:
P + S = C + PV (K ).
This expression is put–call parity for options.
If dividends are present, the expression must be adjusted slightly:
P + S = C + PV (K ) + PV (D).
For American-style options, an approximate version of parity obtains:
C + K ≥ P + S ≥ C + PV (K ).
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 30 / 53
Put–Call Parity
Uses of Put-Call Parity
Put–call parity is one of the most important results in all option-pricing theory.
Based on arbitrage arguments alone.
Also proves very powerful in applications:
Pricing puts in terms of calls and vice versa.
Synthetic creation of one option from another.
Judging relative parameter sensitivity (e.g., volatility).
Others.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 31 / 53
Factors Affecting Option Prices
Outline
1 Introduction
2 Mechanics of Options Markets
3 Put–Call Parity
4 Factors Affecting Option Prices
5 The Black-Scholes Formulae
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 32 / 53
Factors Affecting Option Prices
Factors Affecting the Price of A Stock Option
There are six factors affecting the price of a stock option:
1 S0 , Current stock price
2 K, Strike price
3 T, Life of option or the time to expiration
4 σ,Volatility of stock price
5 r, Risk-free rate of interest
6 The dividends expected during the life of the option
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 33 / 53
Factors Affecting Option Prices
Factors Affecting Option Price – Stock Price and Strike Price
If the option is exercised at some time in the future, the payoff from a call option will be the
amount by which the stock price exceeds the strike price
Call options therefore become more valuable as the stock price increases and less
valuable as the strike price increases
For a put option, the payoff on exercise is the amount by which the strike price exceeds the
stock price
Put options therefore become less valuable as the stock price increases and more
valuable as the strike price increases.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 34 / 53
Factors Affecting Option Prices
Call Option Price Vs. Stock Price
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 35 / 53
Factors Affecting Option Prices
Put Option Price Vs. Stock Price
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 36 / 53
Factors Affecting Option Prices
Call Option Price Vs. Strike Price
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 37 / 53
Factors Affecting Option Prices
Put Option Price Vs. Strike Price
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 38 / 53
Factors Affecting Option Prices
Factors Affecting Option Price – Time to Expiration
Both put and call American options become more valuable as the time to expiration
increases.
As the owner of the long-life option has all the exercise opportunities open to the
owner of the short-life option-and more, the long-life option must therefore always be
worth at least as much as the short-life option.
European put and call options do not necessarily become more valuable as the time to
expiration increases.
The owner of the long-life European option can only exercise at the maturity of that
option.
Consider two European call options on a stock, one with an expiration date in 1
month, the other with an expiration date in 2 months.
Suppose that a very large dividend is expected in 6 weeks.
The dividend will cause the stock price to decline.
It is possible that this will lead to the short-life option being worth more than the
long-life option.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 39 / 53
Factors Affecting Option Prices
Call Option Price Vs. Time to Expiration
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 40 / 53
Factors Affecting Option Prices
Put Option Price Vs. Time to Expiration
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 41 / 53
Factors Affecting Option Prices
Factors Affecting Option Price – Stock Price Volatility
The volatility of a stock price is a measure of how uncertain we are about future stock price
movements.
As volatility increases, the chance that the stock will do very well or very poorly increases.
The values of both calls and puts therefore increase as volatility increases.
The owner of a call benefits from price increases but has limited downside risk in the
event of price decreases since the most that he or she can lose is the price of the
option.
Similarly, the owner of a put benefits from price decreases but has limited downside
risk in the event of price increases.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 42 / 53
Factors Affecting Option Prices
Call Option Price Vs. Stock Price Volatility
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 43 / 53
Factors Affecting Option Prices
Put Option Price Vs. Stock Price Volatility
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 44 / 53
Factors Affecting Option Prices
Factors Affecting Option Price – Risk Free Interest Rate
Put option prices decline as the risk-free interest rate increases.
As interest rates in the economy increase, the expected growth rate of the stock price
tends to increase.
However, the present value of any future cash flows received by the holder of the
option decreases.
These two effects both tend to decrease the value of a put option.
The prices of calls always increase as the risk-free interest rate increases.
Expected growth rate effect tends to increase the price.
Present value effect tends to decrease the price.
However the first effect always dominates the second effect.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 45 / 53
Factors Affecting Option Prices
Call Option Price Vs. Risk Free Interest Rate
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 46 / 53
Factors Affecting Option Prices
Put Option Price Vs. Risk Free Interest Rate
S0 =50, K=50, r=5%, σ=30%, T=1
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 47 / 53
Factors Affecting Option Prices
Factors Affecting Option Price – Amount of Future Dividends
Dividends have the effect of reducing the stock price on the ex-dividend date.
The values of call options are therefore negatively related to the sizes of any anticipated
dividends.
The values of put options are positively related to the sizes of any anticipated dividends.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 48 / 53
Factors Affecting Option Prices
Effect of Variables on Option Pricing
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 49 / 53
The Black-Scholes Formulae
Outline
1 Introduction
2 Mechanics of Options Markets
3 Put–Call Parity
4 Factors Affecting Option Prices
5 The Black-Scholes Formulae
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 50 / 53
The Black-Scholes Formulae
Call Prices in the Model
The call-pricing formula in the Black-Scholes model is
C = S0 · N(d1 ) − e −rT K · N(d2 )
where N(·) is the cumulative standard normal distribution [N(x) is the probability under a
standard normal distribution of an observation less than or equal to x], and
1 S0 1
d1 = √ ln + (r + σ 2 )T
σ T K 2
√
d2 = d1 − σ T
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 51 / 53
The Black-Scholes Formulae
Put Option Prices in the Model
The price of a put in the Black-Scholes model is given by
P = [PV (K ) × N(−d2 )] − [S0 × N(−d1 )],
where d1 and d2 are as defined earlier.
The interpretation of the components follows in the same manner as that of the call.
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 52 / 53
The Black-Scholes Formulae
Thank You
Prof. Anirban Banerjee (IIM Ahmedabad) Financial Markets October 23, 2024 53 / 53