Options
An Undergraduate Introduction to Financial Mathematics
J. Robert Buchanan
2014
J. Robert Buchanan Options
Definitions and Terminology
Definition
An option is the right, but not the obligation, to buy or sell a
security such as a stock for an agreed upon price at some time
in the future.
J. Robert Buchanan Options
Definitions and Terminology
Definition
An option is the right, but not the obligation, to buy or sell a
security such as a stock for an agreed upon price at some time
in the future.
strike price: agreed upon price for buying or selling.
expiry: deadline by which the option must be exercised
(also known as exercise time, strike time, and
expiry date).
call option: an option to buy a security (sometimes just called
a call).
put option: an option to sell a security (a put for short).
J. Robert Buchanan Options
Some Types of Options
European option: can only be exercised at expiry.
American option: can be exercised at or before expiry.
J. Robert Buchanan Options
Some Types of Options
European option: can only be exercised at expiry.
American option: can be exercised at or before expiry.
Other types exist such as Asian, Bermudan, look-back, etc.
Our objective is to determine a method for pricing the
European-style options.
Their values satisfy the Black-Scholes partial differential
equation.
J. Robert Buchanan Options
Notation
C a : value of an American-style call option
C e : value of a European-style call option
K : strike price of an option
P a : value of an American-style put option
P e : value of a European-style put option
r : continuously compounded, risk-free interest rate
δ: continuously compounded, dividend yield rate
S: price of a share of a security
T : exercise time or expiry of an option (sometimes
called the strike time)
t: current time, generally with 0 ≤ t ≤ T
J. Robert Buchanan Options
Payoff for a Call Option
A call option does not exhibit a positive payoff until the security
price exceeds the strike price.
HSHTL-KL+
SHTL
K
J. Robert Buchanan Options
Profit for a Call Option
The payoff of a call option minus its cost is the call’s profit.
HSHTL-KL+ -C
SHTL
K
-C
J. Robert Buchanan Options
Payoff for a Put Option
A put option does not exhibit a positive payoff until the strike
price exceeds the security price.
HK-SHTLL+
SHTL
K
J. Robert Buchanan Options
Profit for a Put Option
The payoff of a put option minus its cost is the put’s profit.
HK-SHTLL+ -P
SHTL
K
-P
J. Robert Buchanan Options
Properties of Options (1 of 4)
Theorem
C a ≥ C e and P a ≥ P e .
An American form of an option will always be worth as much as
the European version of the option (all other features being the
same).
J. Robert Buchanan Options
Properties of Options (2 of 4)
Assume: C a < C e .
Sell the European option for C e and purchase the
American option for C a .
This generates cash flow C e − C a > 0 at time t = 0 which
is invested at the risk-free rate r .
If the European option holder chooses to exercise the
option at expiry, the American option holder can also
exercise.
If the European option holder does not exercise, the
American option holder can let the American option expire
unused.
At expiry the seller still holds (C e − C a )erT > 0.
J. Robert Buchanan Options
Properties of Options (3 of 4)
Theorem
C e ≥ S − Ke−rT .
J. Robert Buchanan Options
Properties of Options (3 of 4)
Theorem
C e ≥ S − Ke−rT .
Remark: this is equivalent to the inequality
C e + Ke−rT ≥ S.
It can be interpreted as stating that the cost of a European call
plus the present call of the strike is always at least the cost of
the security.
J. Robert Buchanan Options
Properties of Options (3 of 4)
Theorem
C e ≥ S − Ke−rT .
Remark: this is equivalent to the inequality
C e + Ke−rT ≥ S.
It can be interpreted as stating that the cost of a European call
plus the present call of the strike is always at least the cost of
the security.
Develop a similar inequality relating a put, the strike price, and
the security.
J. Robert Buchanan Options
Properties of Options (4 of 4)
Assume: C e < S − Ke−rT .
Short the security for S and purchase the European call for
Ce.
This generates cash flow S − C e at time t = 0. This is
invested at the continuously compounded risk-free rate r .
At expiry the option holder has a risk-free investment worth
(S − C e )erT and spends no more than K to close out the
short position in the security.
At expiry the option holder has (S − C e )erT − K > 0 since
this inequality is equivalent to the assumption that
C e < S − Ke−rT .
Therefore a risk-free positive profit can be had.
J. Robert Buchanan Options
Put-Call Parity Formula
Theorem
For non-dividend paying stocks, if the European put and call
have the same strike price and expiry, then
P e + S = C e + Ke−rT .
J. Robert Buchanan Options
Put-Call Parity Formula
Theorem
For non-dividend paying stocks, if the European put and call
have the same strike price and expiry, then
P e + S = C e + Ke−rT .
Put-Call Parity can be interpreted as stating that the cost of a
European put plus the security equals the cost of the European
call plus the present value of the strike.
J. Robert Buchanan Options
Proof (1 of 2)
Assume: P e + S < C e + Ke−rT .
Borrow P e + S − C e at the continuously compounded
risk-free rate r .
Purchase the European put option for P e , the security for
S, and sell the European call option for C e .
At expiry sell the security for at least K and pay back the
loan with interest.
At expiry this leaves the borrower with
K − (P e + S − C e )erT > 0 since this inequality is
equivalent to the assumption that P e + S < C e + Ke−rT .
Therefore a risk-free positive profit can be had.
J. Robert Buchanan Options
Proof (2 of 2)
Assume: P e + S > C e + Ke−rT .
Short the security for S, sell the European put option for
P e , and purchase the European call option for C e .
At time t = 0 this generates a cash flow of
S + P e − C e > 0. Invest this amount at the continuously
compounded risk-free rate r .
At expiry purchase the security for at most K and close out
the short position.
At expiry the short seller holds (S + P e − C e )erT − K > 0
since this inequality is equivalent to the assumption that
P e + S > C e + Ke−rT .
J. Robert Buchanan Options
Effect of Dividends
Suppose a corporation will pay a dividend to the
shareholders at time td .
The amount of the dividend will be δS(td ).
J. Robert Buchanan Options
Effect of Dividends
Suppose a corporation will pay a dividend to the
shareholders at time td .
The amount of the dividend will be δS(td ).
Payment of the dividend decreases the total assets of the
corporation by the total dividend paid.
J. Robert Buchanan Options
Effect of Dividends
Suppose a corporation will pay a dividend to the
shareholders at time td .
The amount of the dividend will be δS(td ).
Payment of the dividend decreases the total assets of the
corporation by the total dividend paid.
Consider the one-sided limits:
lim S(t) = S(td− )
t→td−
lim S(t) = S(td+ ).
t→td+
These are the values of the corporation’s stock just before
and just after the dividend is paid.
J. Robert Buchanan Options
Effect of Dividends
Suppose a corporation will pay a dividend to the
shareholders at time td .
The amount of the dividend will be δS(td ).
Payment of the dividend decreases the total assets of the
corporation by the total dividend paid.
Consider the one-sided limits:
lim S(t) = S(td− )
t→td−
lim S(t) = S(td+ ).
t→td+
These are the values of the corporation’s stock just before
and just after the dividend is paid.
In the absence of arbitrage,
S(td+ ) = (1 − δ)S(td− ).
J. Robert Buchanan Options
Discrete Dividends
Theorem
If n dividend payments of the form δS(ti− ) will be made at times
ti− for i = 1, 2, . . . , n then the Put-Call Parity Formula for
discrete dividend payments can be expressed as
n
X
P e + S(0) − δ S(ti− )e−rti = C e + Ke−rT .
i=1
J. Robert Buchanan Options
Discrete Dividends
Theorem
If n dividend payments of the form δS(ti− ) will be made at times
ti− for i = 1, 2, . . . , n then the Put-Call Parity Formula for
discrete dividend payments can be expressed as
n
X
P e + S(0) − δ S(ti− )e−rti = C e + Ke−rT .
i=1
The value of the security is discounted by the total of the
present values of the dividends paid.
J. Robert Buchanan Options
Continuous Dividends
Theorem
For European options on securities which pay dividends at a
continuous, constant dividend yield δ, the Put-Call Parity
Formula takes on the form
P e + S(0)e−δT = C e + Ke−rT .
J. Robert Buchanan Options
Binary Model
Call options can be thought of as insurance against a rise
in the price of a security.
An investor does not know with certainty the value of the
security at the strike time, so how much should be paid for
the call?
J. Robert Buchanan Options
Binary Model
Call options can be thought of as insurance against a rise
in the price of a security.
An investor does not know with certainty the value of the
security at the strike time, so how much should be paid for
the call?
Example
Suppose S(0) = $100, at t = T
$200 with probability p,
S(T ) =
$50 with probability 1 − p.
An investor can purchase a European call option whose value
is C. The exercise time and strike price of the option are
respectively T = 1 and $150. In the absence of arbitrage what
is the value of C?
J. Robert Buchanan Options
Present Value, Arbitrage-free Setting
Since two distinct times (t = 0 and t = 1) are involved we
must find the present values of all quantities being
compared.
Assume the simple interest rate for the interval 0 ≤ t ≤ 1 is
r.
In the absence of arbitrage, there should be no expected
profit from either purchasing the security or the call option.
J. Robert Buchanan Options
Purchase the Stock
Suppose an investor purchases the security.
J. Robert Buchanan Options
Purchase the Stock
Suppose an investor purchases the security.
Initial cash flow: −$100.
J. Robert Buchanan Options
Purchase the Stock
Suppose an investor purchases the security.
Initial cash flow: −$100.
At t = 1, the payoff is
−$100 + $200/(1 + r ) with probability p,
payoff =
−$100 + $50/(1 + r ) with probability 1 − p.
J. Robert Buchanan Options
Purchase the Stock
Suppose an investor purchases the security.
Initial cash flow: −$100.
At t = 1, the payoff is
−$100 + $200/(1 + r ) with probability p,
payoff =
−$100 + $50/(1 + r ) with probability 1 − p.
If the expected value of the payoff is 0, then
200 50
0 = p −100 + + (1 − p) −100 +
1+r 1+r
2r + 1
p = .
3
J. Robert Buchanan Options
Purchase the Option
Suppose the investor purchases the call option.
J. Robert Buchanan Options
Purchase the Option
Suppose the investor purchases the call option.
Initial cash flow: −C.
J. Robert Buchanan Options
Purchase the Option
Suppose the investor purchases the call option.
Initial cash flow: −C.
At t = T , the payoff is
−C + ($200 − $150)/(1 + r ) with probability p,
payoff =
−C + ($50 − $150)+ /(1 + r ) with probability 1 − p.
J. Robert Buchanan Options
Purchase the Option
Suppose the investor purchases the call option.
Initial cash flow: −C.
At t = T , the payoff is
−C + ($200 − $150)/(1 + r ) with probability p,
payoff =
−C + ($50 − $150)+ /(1 + r ) with probability 1 − p.
If the expected value of the payoff is 0, then
(50 − 150)+
(200 − 150)
0 = p −C + + (1 − p) −C +
1+r 1+r
50(2r + 1)
C = .
3(r + 1)
J. Robert Buchanan Options
Parametric Plot of (p(r ), C(r ))
2r + 1 50(2r + 1)
If (p(r ), C(r )) = , then as the probability
3 3(r + 1)
of the security reaching $200 at T = 1 increases, so does the
cost of the option.
24
22
C
20
18
0.4 0.5 0.6 0.7 0.8 0.9 1
p
J. Robert Buchanan Options
Example (1 of 3)
Suppose the current value of the stock is S(0) = $100 and
at time T = 1
$150 with probability p = 0.45,
S(1) =
$75 with probability 1 − p = 0.55.
Suppose further that the risk-free interest rate is
r = 8.388%.
A European call option with a strike price of $125 can be
purchased for $10 (note the arbitrage-free price is
$10.3448).
J. Robert Buchanan Options
Example (1 of 3)
Suppose the current value of the stock is S(0) = $100 and
at time T = 1
$150 with probability p = 0.45,
S(1) =
$75 with probability 1 − p = 0.55.
Suppose further that the risk-free interest rate is
r = 8.388%.
A European call option with a strike price of $125 can be
purchased for $10 (note the arbitrage-free price is
$10.3448).
Design an investment scheme which guarantees a positive
profit.
J. Robert Buchanan Options
Example (2 of 3)
Solution: Borrow funds to take a position of x shares of the
stock and y call options (x and y can be positive or negative).
At t = 0, the portfolio is worth 100x + 10y .
At t = T , the investor owes (100x + 10y )e0.08338 .
If S(1) = 150, the portfolio generates a cash flow of
150x + (150 − 125)y = 150x + 25y .
If S(1) = 75, the portfolio generates a cash flow of 75x.
J. Robert Buchanan Options
Example (3 of 3)
A positive profit is guaranteed in the region where
150x + 25y > (100x + 10y )e0.08338
75x > (100x + 10y )e0.08338
which implies 3x + y > 0.
10
0
y
-5
-10
-10 -5 0 5 10
x
J. Robert Buchanan Options
Black-Scholes Equation
We now turn our attention to mathematically modeling the value
of a European call option.
Suppose a stock obeys an Itô process of the form:
dS = µS dt + σS dW (t)
An investor will create a portfolio Y , consisting of a short
position in a European call option and a long position of ∆
shares of the stock.
Y = F (S, t) = C e (S, t) − (∆)S
J. Robert Buchanan Options
Black-Scholes Equation
We now turn our attention to mathematically modeling the value
of a European call option.
Suppose a stock obeys an Itô process of the form:
dS = µS dt + σS dW (t)
An investor will create a portfolio Y , consisting of a short
position in a European call option and a long position of ∆
shares of the stock.
Y = F (S, t) = C e (S, t) − (∆)S
Use Itô’s lemma to find the stochastic process followed by
Y.
J. Robert Buchanan Options
Itô Process for dY
1 2 2
dY = µSYS + σ S YSS + Yt dt + (σSYS ) dW (t)
2
e
1 2 2 ∂2C e ∂C e
∂C
= µS −∆ + σ S + dt
∂S 2 ∂S 2 ∂t
e
∂C
+ σS − ∆ dW (t)
∂S
J. Robert Buchanan Options
Itô Process for dY
1 2 2
dY = µSYS + σ S YSS + Yt dt + (σSYS ) dW (t)
2
e
1 2 2 ∂2C e ∂C e
∂C
= µS −∆ + σ S + dt
∂S 2 ∂S 2 ∂t
e
∂C
+ σS − ∆ dW (t)
∂S
∂C e
Note: the process becomes deterministic if ∆ = ∂S .
1 2 2 ∂2C e ∂C e
dY = σ S + dt
2 ∂S 2 ∂t
J. Robert Buchanan Options
No Arbitrage Assumption
The payoff from the portfolio should be the same as that
generated by investing an equivalent amount of money to Y in
savings earning interest compounded continuously at rate r .
dY = rY dt
= r (C e − (∆)S) dt
∂C e
e
= r C −S dt
∂S
J. Robert Buchanan Options
No Arbitrage Assumption
The payoff from the portfolio should be the same as that
generated by investing an equivalent amount of money to Y in
savings earning interest compounded continuously at rate r .
dY = rY dt
= r (C e − (∆)S) dt
∂C e
e
= r C −S dt
∂S
Recall from Itô’s lemma that
1 2 2 ∂2C e ∂C e
dY = σ S + dt.
2 ∂S 2 ∂t
J. Robert Buchanan Options
No Arbitrage Assumption
The payoff from the portfolio should be the same as that
generated by investing an equivalent amount of money to Y in
savings earning interest compounded continuously at rate r .
dY = rY dt
= r (C e − (∆)S) dt
∂C e
e
= r C −S dt
∂S
Recall from Itô’s lemma that
1 2 2 ∂2C e ∂C e
dY = σ S + dt.
2 ∂S 2 ∂t
Equating the two expressions for dY yields the Black-Scholes
partial differential equation
∂C e ∂C e 1 ∂2C e
r Ce = +rS + σ2S2 .
∂t ∂S 2 ∂S 2
J. Robert Buchanan Options
Final and Boundary Conditions (1 of 2)
In order to solve the Black-Scholes PDE we must have some
boundary and final conditions.
J. Robert Buchanan Options
Final and Boundary Conditions (1 of 2)
In order to solve the Black-Scholes PDE we must have some
boundary and final conditions.
At expiry the call option is worth (S(T ) − K )+ , so
C e (S, T ) = (S(T ) − K )+ ,
this is the final condition.
J. Robert Buchanan Options
Final and Boundary Conditions (1 of 2)
In order to solve the Black-Scholes PDE we must have some
boundary and final conditions.
At expiry the call option is worth (S(T ) − K )+ , so
C e (S, T ) = (S(T ) − K )+ ,
this is the final condition.
The stock will have a value in the interval [0, ∞). The boundary
at S = 0 is absorbing, so if there is a time t ∗ ≥ 0 such that
S(t ∗ ) = 0, then S(t) = 0 for all t ≥ t ∗ . In this case the option
will never be exercised and is worthless. Thus
C e (0, t) = 0,
which is the boundary condition at S = 0.
J. Robert Buchanan Options
Boundary Conditions (2 of 2)
From the Put-Call Parity Formula:
Ce = P e + S − Ke−rT
lim C e = lim P e + S − Ke−rT
S→∞ S→∞
C e → S − Ke−rT as S → ∞.
J. Robert Buchanan Options
Boundary Conditions (2 of 2)
From the Put-Call Parity Formula:
Ce = P e + S − Ke−rT
lim C e = lim P e + S − Ke−rT
S→∞ S→∞
C e → S − Ke−rT as S → ∞.
As the security unbounded in value:
a put option (right to sell at a finite price) becomes
worthless, and
the call option is worth the difference between the security
price and the present value of the strike.
J. Robert Buchanan Options
Initial Boundary Value Problem
For (S, t) in [0, ∞) × [0, T ],
∂C e ∂C e 1 ∂2C e
rC e = + rS + σ2S2
∂t ∂S 2 ∂S 2
e +
C (S, T ) = (S(T ) − K ) for S > 0,
C e (0, t) = 0 for 0 ≤ t < T ,
C (S, t) = S − Ke−r (T −t)
e
as S → ∞.
J. Robert Buchanan Options
Initial Boundary Value Problem
For (S, t) in [0, ∞) × [0, T ],
∂C e ∂C e 1 ∂2C e
rC e = + rS + σ2S2
∂t ∂S 2 ∂S 2
e +
C (S, T ) = (S(T ) − K ) for S > 0,
C e (0, t) = 0 for 0 ≤ t < T ,
C (S, t) = S − Ke−r (T −t)
e
as S → ∞.
The solution of this IBVP is the subject of the next chapter.
J. Robert Buchanan Options
Spreads
Definition
A trading strategy involving two or more options of the same
type on the same stock is called a spread.
J. Robert Buchanan Options
Spreads
Definition
A trading strategy involving two or more options of the same
type on the same stock is called a spread.
Definition
A long call position with a strike price of K1 and a short call
position with a strike price of K2 > K1 is called a bull spread.
Remark: We are assuming the underlying stock is the same
and the expiry of the two calls is the same.
J. Robert Buchanan Options
Bull Spread (1 of 2)
Since K2 > K1 then C2 < C1 (why?).
Initial outlay of capital in amount C1 − C2 > 0.
Payoff of long call (S(T ) − K1 )+ .
Payoff of short call −(S(T ) − K2 )+ .
J. Robert Buchanan Options
Bull Spread (1 of 2)
Since K2 > K1 then C2 < C1 (why?).
Initial outlay of capital in amount C1 − C2 > 0.
Payoff of long call (S(T ) − K1 )+ .
Payoff of short call −(S(T ) − K2 )+ .
S(T ) Long Call Short Call Total
Payoff Payoff Payoff
S(T ) ≤ K1 0 0 0
K1 < S(T ) < K2 S(T ) − K1 0 S(T ) − K1
K2 ≤ S(T ) S(T ) − K1 K2 − S(T ) K2 − K1
J. Robert Buchanan Options
Bull Spread (2 of 2)
PayoffProfit
SHTL
K1 K2
C2 -C1
J. Robert Buchanan Options
Example: Bull Spread
Example
Suppose we create a bull spread purchasing a call option with
strike price $115 and selling a call option with strike price $130.
Suppose that C(115) = 5 and C(130) = 3. Find the payoff and
net profit if at expiry,
S = 110
S = 115
S = 125
S = 130
S = 135.
J. Robert Buchanan Options
Bull Spread with Puts (1 of 2)
Suppose an investor has a long position in a put with strike
price K1 and a short position in a put with strike price K2 > K1 .
S(T ) Long Put Short Put Total
Payoff Payoff Payoff
S(T ) ≤ K1 K1 − S(T ) S(T ) − K2 K1 − K2
K1 < S(T ) < K2 0 S(T ) − K2 S(T ) − K2
K2 ≤ S(T ) 0 0 0
J. Robert Buchanan Options
Bull Spread with Puts (2 of 2)
PayoffProfit
P2 -P1
SHTL
K1 K2
J. Robert Buchanan Options
Example: Bull Spread
Example
Suppose we create a bull spread purchasing a put option with
strike price $95 and selling a put option with strike price $105.
Suppose that P(95) = 5 and P(105) = 8. Find the payoff and
net profit if at expiry,
S = 90
S = 95
S = 100
S = 105
S = 110.
J. Robert Buchanan Options
Bear Spreads
Definition
A short call position with a strike price of K1 and a long call
position with a strike price of K2 > K1 is called a bear spread.
Remarks:
We are assuming the underlying stock is the same and the
expiry of the two calls is the same.
The positions in the bear spread are opposite those of the
bull spread.
J. Robert Buchanan Options
Bear Spread (1 of 2)
Since K2 > K1 then C2 < C1 .
Initial income of capital in amount C1 − C2 > 0.
Payoff of long call (S(T ) − K2 )+ .
Payoff of short call −(S(T ) − K1 )+ .
J. Robert Buchanan Options
Bear Spread (1 of 2)
Since K2 > K1 then C2 < C1 .
Initial income of capital in amount C1 − C2 > 0.
Payoff of long call (S(T ) − K2 )+ .
Payoff of short call −(S(T ) − K1 )+ .
S(T ) Long Call Short Call Total
Payoff Payoff Payoff
S(T ) ≤ K1 0 0 0
K1 < S(T ) < K2 0 K1 − S(T ) K1 − S(T )
K2 ≤ S(T ) S(T ) − K2 K1 − S(T ) K1 − K2
J. Robert Buchanan Options
Bear Spread (2 of 2)
PayoffProfit
C1 -C2
SHTL
K1 K2
J. Robert Buchanan Options
Example: Bear Spread
Example
Suppose we create a bear spread purchasing a call option with
strike price $150 and selling a call option with strike price $125.
Suppose that C(150) = 5 and C(125) = 10. Find the payoff
and net profit if at expiry,
S = 120
S = 125
S = 150
S = 150
S = 160.
J. Robert Buchanan Options
Bear Spread with Puts (1 of 2)
Suppose an investor has a short position in a put with strike
price K1 and a long position in a put with strike price K2 > K1 .
S(T ) Long Put Short Put Total
Payoff Payoff Payoff
S(T ) ≤ K1 K2 − S(T ) S(T ) − K1 K2 − K1
K1 < S(T ) < K2 K2 − S(T ) 0 K2 − S(T )
K2 ≤ S(T ) 0 0 0
J. Robert Buchanan Options
Bear Spread with Puts (2 of 2)
PayoffProfit
SHTL
K1 K2
P2 -P1
J. Robert Buchanan Options
Example: Bear Spread
Example
Suppose we create a bear spread selling a put option with
strike price $50 and purchasing a put option with strike price
$60. Suppose that P(50) = 3 and P(60) = 5. Find the payoff
and net profit if at expiry,
S = 45
S = 50
S = 55
S = 60
S = 65.
J. Robert Buchanan Options
Butterfly Spreads
Definition
A long call position with a strike price of K1 , a long call position
with a strike price of K3 > K1 , and a short position in two calls
with strike price K2 = (K1 + K3 )/2 is called a butterfly spread.
Remark: We are assuming the underlying stock is the same
and the expiry of the three calls is the same.
J. Robert Buchanan Options
Butterfly Spread
Note that K3 > K2 > K1 .
Payoffs of long calls are (S(T ) − K1 )+ and (S(T ) − K3 )+ .
Payoff of two short calls −2(S(T ) − K2 )+ .
J. Robert Buchanan Options
Butterfly Spread
Note that K3 > K2 > K1 .
Payoffs of long calls are (S(T ) − K1 )+ and (S(T ) − K3 )+ .
Payoff of two short calls −2(S(T ) − K2 )+ .
Payoff 1st Payoff 2nd Payoff Payoff
S(T ) Long Call Long Call Short Calls Total
S(T ) ≤ K1 0 0 0 0
K1 < S(T ) < K2 S(T ) − K1 0 0 S(T ) − K1
K2 ≤ S(T ) < K3 S(T ) − K1 0 −2(S(T ) − K2 ) K3 − S(T )
K3 ≤ S(T ) S(T ) − K1 S(T ) − K3 −2(S(T ) − K2 ) 0
J. Robert Buchanan Options
Butterfly Spread with Calls
PayoffProfit
SHTL
K1 K2 K3
C1 -2C2 +C3
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Example: Butterfly Spread
Example
Suppose we create a butterfly spread purchasing a call options
with strike prices $150 and $200 selling 2 call options with
strike price $175. Suppose that C(150) = 60, C(175) = 35,
and C(200) = 10. Find the payoff and net profit if at expiry,
S = 100
S = 150
S = 175
S = 200
S = 250.
J. Robert Buchanan Options
Straddles
Definition
Simultaneous long position in a call and a put is called a long
straddle. Simultaneous short position in a call and a put is
called a short straddle.
Remarks: We will assume
the underlying stock is the same for both options,
the strike prices are the same,
the expiry dates are the same.
J. Robert Buchanan Options
Long Straddle (1 of 2)
Suppose an investor has a long straddle with strike prices K .
S(T ) Put Call Total
Payoff Payoff Payoff
S(T ) ≤ K K − S(T ) 0 K − S(T )
K < S(T ) 0 S(T ) − K S(T ) − K
J. Robert Buchanan Options
Long Straddle (2 of 2)
PayoffProfit
SHTL
K-HC+PL K+HC+PL
-HC+PL
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Example: Long Straddle
Example
Suppose we create a long straddle purchasing call and put
options with strike prices of $150. Suppose that C(150) = 20
and P(150) = 10. Find the payoff and net profit if at expiry,
S = 100
S = 140
S = 150
S = 160
S = 200.
J. Robert Buchanan Options
Strangles
Definition
A long strangle is a simultaneous long position in a call and a
put. A short strangle is a simultaneous short position in a call
and a put.
Remarks: We will assume
the underlying stock is the same for both options,
the expiry dates are the same,
the strike prices may be different (this characteristic
distinguishes a strangle from a straddle).
J. Robert Buchanan Options
Long Strangle (1 of 2)
Suppose an investor has a long strangle with strike prices KP
for the put and KC > KP for the call.
S(T ) Put Call Total
Payoff Payoff Payoff
S(T ) ≤ KP KP − S(T ) 0 KP − S(T )
KP < S(T ) < KC 0 0 0
KC < S(T ) 0 S(T ) − KC S(T ) − KC
J. Robert Buchanan Options
Long Strangle (2 of 2)
PayoffProfit
SHTL
KP KC
C+P
J. Robert Buchanan Options
Example: Long Strangle
Example
Suppose we create a long strangle purchasing a call option
with a strike price of $150 and a put option with a strike price of
$130. Suppose that C(150) = 20 and P(130) = 10. Find the
payoff and net profit if at expiry,
S = 100
S = 140
S = 150
S = 160
S = 200.
J. Robert Buchanan Options
Credits
These slides are adapted from the textbook,
An Undergraduate Introduction to Financial Mathematics,
3rd edition, (2012).
author: J. Robert Buchanan
publisher: World Scientific Publishing Co. Pte. Ltd.
address: 27 Warren St., Suite 401–402, Hackensack, NJ
07601
ISBN: 978-9814407441
J. Robert Buchanan Options