CHAPTER 12

AN OPTIONS PRIMER

In this chapter, we provide an introduction to options. This

chapter is organized into the following sections:

1. Options and Options Markets

2. Options Pricing

3. The Option Pricing Model

4. Speculating with Options

5. Hedging with Options

Chapter 12 1
 Options and Options Markets

Options

Options are specialized financial instruments that give the

purchaser the right but not the obligation to do something.

That is, the purchaser can do something if he/she wants to,

but he/she does not have to do it.

Options are a relatively new financial instruments dating

back to the 1970’s.

IBM Example:

IBM common stocks trades at $120, an investor

has an option to buy a IBM stock for $100 through
August in the current year.

Chapter 12 2
 Options and Options Markets

There are two classes of options referred to as put and call

options. You may purchase or sell either a call option or a
put option.
Put and call options each give buyers and sellers different
rights and responsibilities as follows:
Call Options
The buyer of a call option has the right but not the
obligation to purchase a pre-specified amount of a pre-
specified asset at a pre-specified price during a pre-
specified time period.
The seller of a call option has the obligation to sell a pre-
specified amount of a pre-specified asset at a pre-specified
price if asked to do so during a pre-specified time period.

Chapter 12 3
 Options and Options Markets

Put Options

The buyer of a put option has the right but not the
obligation to sell a pre-specified amount of a pre-specified
asset at a pre-specified price during a pre-specified time
period.

The seller of a put option has the obligation to purchase a

pre-specified amount of a pre-specified asset at a pre-
specified price if asked to do so during a pre-specified time
period.

Chapter 12 4
 Options and Options Markets
Terminology

The Premium

The buyer of an option pays the seller of the option a

premium on the day that the agreement is entered into.

The Strike Price or the Exercise Price

The pre-specified price is referred to as the strike or the

exercise price.

Expiration

The amount of time specified in the options contract.

Exercise

The option buyer elects to utilize his/her right.

– In the case of a call option, the buyer utilizes his/her right
to buy the stock.

– In the case of a put option, the buyer utilizes her/his right

to sell the stock.

Chapter 12 5
 Options and Options Markets
Terminology

Option Writer
The seller of an option.
Writing an Option
The act of selling an option.
European Options
European options can be exercised only on the maturity
date.
American Options
American options can be exercised any time prior to
maturity.
Covered Call
Writing call options against stock that the writer owns.
Naked Option
Writing a call option on a stock that the writer does not
own.

Chapter 12 6
 Options and Options Markets
Terminology

Intrinsic Value

The value of an option if it is exercised immediately.

Option Clearing Corporation (OCC)

Oversees the conduct of the market and helps to make the

market orderly. Option buyers and sellers only obligations
are to the OCC. If an option is exercised, the OCC
matches buyers and sellers, and manages the completion
of the exercise process.

Chapter 12 7
 Call Option Example

You buy a call option on 100 shares of IBM stock with a

strike price of $50 per share and a premium of $2.50 per
share. The option has 3 months to maturity.
Suppose that at the time you enter into the contract, the
price of IBM stock is $49.50
The buyer pays the seller a $2.50 premium on the day they
enter into the agreement.
Timeline:

0 1 2 3

-$2.50

Chapter 12 8
 Call Option Example

After three months the stock price will have either gone up,
gone down, or stayed the same.

A. Suppose that after three months the price of IBM stock

has gone down to $47 per share.
– The option will expire worthless: that is, the buyer will not
exercise his/her right to purchase the shares for $50 per
share.

– The purchaser of the option loses the $2.50 per share

premium.

B. Suppose that after three months, the price of IBM stock

has stayed at $49.50 per share.
– The option will expire worthless: that is, the buyer will not
exercise her/his right to purchase the shares for $50 per
share.

– The purchaser of the option loses the $2.50 per share

premium.

Chapter 12 9
 Call Option Example

C. Suppose that after three months, the price of IBM stock

has gone up to $70 per share. In this case, the buyer
of the call option will exercise his option.
– The purchaser of the option will exercise his/her right to
purchase 100 shares for $50 per share.

– The purchaser will then go to the market to sell his/her

share of stock for $70 per share. Thus the purchaser
makes a profit

Chapter 12 10
 Put Option Example

You buy a put option on 100 shares of IBM stock with a

strike price of $50 per share and a premium of $2.50 per
share. The option has 3 months to maturity.

Suppose that at the time you enter into the contract, the
price of IBM stock is $50.50

The buyer pays the seller a $2.50 premium on the day they
enter into the agreement.

Timeline:

0 1 2 3

-$2.50

Chapter 12 11
 Put Option Example

After three months the stock price will have either gone up,
gone down, or stayed the same.

A. Suppose that after three months the price of IBM stock

has gone down to $45 per share.
– The buyer of option will exercise her/his option to sell the
stock for $50.

– Thus, the buyer will purchase the stock for $45 in the
market and sell it using the put option for $50.

– The purchaser of the put option makes a profit

B. Suppose that after three months, the price of IBM

stock has stayed at $50.50 per share.
– The option will expire worthless: that is, the buyer will not
exercise her/his right to sell the shares for $50 per share.

– The purchaser of the option loses the $2.50 per share

premium.

Chapter 12 12
 Put Option Example

C. Suppose that after three months, the price of IBM stock

has gone up to $70 per share. In this case, the buyer
of the put option will not exercise his/her option.
– The option will expire worthless: that is, the buyer will not
exercise his/her right to sell the shares for $50 per share.

– The purchaser of the option loses $2.50 per share

premium.

Chapter 12 13
 Option Exchanges
Table12.1
Principal Options Exchanges and Option Traded
Exchange Option Traded
Panel 1: Options Exchanges in the United States

Chicago Board Options Exchange (CBOE) Options on Individual Stocks

LongBTerm Options on Individual Stocks
Options on Stock Indexes
Options on Interest Rates

American Stock Exchange (AMEX) Options on Individual Stocks

LongBTerm Options on Individual Stocks
Options on Stock Indexes
Options on Exchange Traded Funds

Philadelphia Stock Exchange (PHLX) Options on Individual Stocks

LongBTerm Options on Individual Stocks
Options on Stock Indexes
Options on Foreign Currency

Pacific Exchange (PSE) Options on Individual Stocks

LongBTerm Options on Individual Stocks

International Securities Exchange (ISE Options on Individual Stocks

Boston Options Exchange (BOX) Options on Individual Stocks
Chicago Mercantile Exchange (CME) Options on futures traded at the CME
Chicago Board of Trade (CBOT) Options on futures traded at the CBOT
New York Mercantile Exchange (NYMEX) Options on futures traded at NYMEX
New York Board of Trade (NYBOT) Options on futures traded at the NYBOT
Kansas City Board of Trade (KCBT) Options on futures traded at the KCBT
Minneapolis Grain Exchange (MGE) Options on futures traded at the MGE

Panel 2: Key Options Exchanges Outside the United States

Eurex (Germany and Switzerland) Options on individual stocks

Options on futures

Euronext (Brussels, Amsterdam, Paris,& London) Options individual stocks

Options on Stock Indexes
Option on Interest rates

[Link] (Brussels, Amsterdam, Paris, & London) Options on futures

Chapter 12 14
 Option Quotations

Insert Figure 12.1 here

Chapter 12 15
 Option Pricing

Five factors affect the price of options on stocks without

cash dividends:

Factor Name Call Put

Option Option
S Stock Price + -
E Exercise Price - +
T Time + +
σ Volatility of Underline Stock (Standard Deviation) + +
r Risk-Free Interest Rates + -

This section considers the effects of the first three

factors. Thus, a call price can be expressed using:

C(S, E, t)

Chapter 12 16
 Pricing Call Options at Expiration

First principle of option pricing

At expiration, a call option must have a value that is equal

to zero or to the difference between the stock price and the
exercise price, whichever is greater. This quantity is
referred to as the intrinsic value of the option:

C(S, E, 0) = max(0, S - E)

If this condition does not hold, an arbitrage opportunity

exists.

Two possibilities may arise, regarding the relationship

between the exercise price (E) and the stock price (S).

SE
S>E
Where t = 0.

Chapter 12 17
 Pricing Call Options at Expiration

First Possibility: S  E

Example:
A call option with an exercise price of $80 on a
stock trading at $70. The option is about to expire.

If an option is at expiration and the stock price is less than

or equal to the exercise price, the call option has no value.

Max(0, S-E)
Max(0, 70-80) = 0

Chapter 12 18
 Pricing Call Options at Expiration

Second Possibility: S > E

If the stock price is greater than the exercise price, the call
option must have a price equal to the difference between
the stock price and the exercise price.

Max(0, S-E) = S – E

If this relationship did not hold, there would be an arbitrage

opportunity.
Example 1:
Consider a call option that is selling with an
exercise price of $40 on a stock trading at $50.
The option is selling for $5.
An arbitrageur would make the following trades:
Transaction Cash Flow
Buy a call option $ -5
Exercise the option to buy the stock -40
Sell the stock 50
Net Cash Flow $ 5

Chapter 12 19
 Pricing Call Options at Expiration

Example 2:

A call option with an exercise price of $40 on a

stock trading at $50. The option is now selling
$15. The option is about to expire.

An arbitrageur would make the following trades:

Transaction Cash Flow

Write a call option $ 15

Buy the stock - 50
Initial Cash Flow -$35

If owner of the call option exercises the option. The

arbitrageur’s transactions are:

Transaction Cash Flow

Initial cash flow -$ 35

Deliver stock 0
Collect exercise price +$40
Net Cash Flow $ 5

Chapter 12 20
 Pricing Call Options at Expiration

If the owner of the call option allows the option to expire.

The arbitrageur’s transactions are:

Initial cash flow -$ 35

Sell Stocks +$50
Net Cash Flow $ 15

In order for these arbitrage opportunities not to exist,

principle 1 must hold.

Chapter 12 21
Graphical Analysis of Option Values and
Profits Expiration

Assume a call and a put option both with $100 striking

price. We can graph the payoff on these options as
demonstrated in Figure 12.2.

Insert Figure 12.2 Here

Chapter 12 22
 Option Values and Profits Expiration

Assume a call and a put option both with $100 striking

price. Trades had taken place for the options with
premiums of $5 on each of the put and call options.
Figure 12.3 illustrates the alternatives outcomes.

Insert Figure 12.3a here

Chapter 12 23
 Option Values and Profits Expiration

Insert Figure 12.3b here

Chapter 12 24
 Pricing Prior to Maturity

Second principle of option pricing:

A call option with a zero exercise price and an infinite time

to maturity must sell for the same price as the stock. This
is because the buyer of the call option can convert his/her
option into the stock and sell it.

C(S, 0, ) = S

Combining principle #1 and #2, we can establish bounds

for the price of an option. That is, establish upper and
lower limits for the price of the option.

The bounds for the price of a call option are a function of

the stock price, the exercise price, and the time to
expiration. Figure 12.4 presents these boundaries.

Chapter 12 25
 A Call Option with Zero Exercise Price
and an Infinite Time until Expiration

Insert Figure 12.4 here

Chapter 12 26
 Relationship Between Option Prices

Third principle of option pricing

If two call options are alike, except the exercise price of the
first is less than that of the second, then the option with the
lower exercise price must have a price that is equal to or
greater than the price of the option with the higher exercise
price.

The relationship can be defined as follows:

If E1 < E2, C(S, E1, t)  C(S, E2, t)

If this relationship does not hold, an arbitrage profit can be

earned.

Chapter 12 27
 Relationship Between Option Prices

Example:

You have two identical options. The first option

has an exercise price of $100 and sells for $10.
The second option has an exercise price of $90
and sells for $5.

An arbitrageur would make the following trades:

Transaction Cash Flow

Sell the option with the $100 exercise price $10

Buy the option with the $90 exercise price -5

Net Cash Flow $5

Figures 12.5a creates an arbitrage opportunity and figure

12.5b graphs the combined positions.

Chapter 12 28
 Relationship Between Option Prices

Insert figure 12.5a here

Insert figure 12.5b here

Chapter 12 29
 Relationship Between Option Prices

Consider the profit and loss position on each option and

the overall position for alternative stock prices that might
prevail at expiration.

Profit or Loss on the Option Position

Stock Price at For E = $90 For E = $100 For Both
Expiration
80 - $5 +$10 + $5
90 - $5 +$10 + $5
95 0 +$10 +$10
100 + $5 +$10 +$15
105 +$10 + $5 +$15
110 +$15 0 +$15
120 +$25 - $10 +$15

The result is graphed in figure 12.5c.

Chapter 12 30
 Relationship Between Option Prices

Insert figure 12.5c here

Notice in figure 12.5c that regardless of the ultimate stock

price, a positive profit is earned. In order to avoid this
arbitrage principle 3 must hold.

Chapter 12 31
 Relationship Between Option Prices

Fourth principle of option pricing (expiration date

principle)

If there are two options that are otherwise alike, the option
with the longer time to expiration must sell for an amount
equal to or greater than the option that expires earlier.

If t1 > t2, C(S, t1, E)  C(S, t2, E)

If the option with the longer period to expiration sold for

less than the option with the shorter time to expiration,
there would also be an arbitrage opportunity.

Chapter 12 32
 Relationship Between Option Prices

Example:

Two options on the same stock both having a

striking price of $100. The first option has a time
to expiration of 6 months and trades for $8. The
second option has 3 months to expiration and
trades for $10.

An arbitrageur would make the following transactions:

Transaction Cash Flow

Buy the 6-month option for $8 -$ 8

Sell the 3-month option for $10 +$10
Net Cash Flow +$ 2

The option with the longer time to expiration must be worth

more than the option with the shorter time to expiration.

Figure 12.6 illustrate this

Chapter 12 33
 Relationship Between Option Prices

Insert figure 12.6 here

Chapter 12 34
 Call Option Prices and Interest Rates

Example:

Assume that a stock now sells for $100. Over the

next year, its value can change by 10% in either
direction (100 shares equal to $9,000 or $11,000)
The risk-free rate of interest is 12%. A call option
exists with a striking price of $100/share and
expiration one year from now.

Assume two portfolios:

Portfolio A 100 shares of stock, current value

$10,000.

Portfolio B A $10,000 pure discount bond maturing

in one year, with a current value of
$8,929 (PV with 12% interest rate).
One option contract, with an exercise
price of $100/share ($10,000/ entire
contract)

Table 12.2 illustrates the impact of price changes on each

portfolio.

Chapter 12 35
 Call Option Prices and Interest Rates

Table 12.2
Portfolio Values in One Year
Stock Price Change
+10% B10%
Portfolio A
Stock $11,000 $9,000

Portfolio B
Maturing Bond $10,000 $10,000
Call Option $1,000 0

Portfolio B is the best portfolio to hold. If the stock price

goes down, Portfolio B is worth $1,000 more than Portfolio
A. If the stock price goes up, Portfolios A and B have the
same value.

This implies that the value of the option should be at least:

C  S  Present Value (E)

$10,000
C  $10,000 - = $1,071
(1.12)

Chapter 12 36
 Call Option Prices and Interest Rates

Fifth principle of option pricing

Other things being equal, the higher the risk-free rate of
interest, the greater must be the price of a call option.
Thus, the interest rate principle can be expressed as:

If r1 > r2, C(S, E, t, r1)  C(S, E, t, r2)

Recall that the price of the call must be either zero or S - E

at expiration or:

C  S  Present Value (E)

The call price must be greater than or equal to the stock

price minus the present value of the exercise price. So the
higher the interest rate, the higher the value of call option.

Using the data from previous example, now assume that

interest rates goes up to 20%. The new value of the option
should be:
$10,000
C  $10,000 - = $1,667
(1.20)

Chapter 12 37
 Prices of Call Options and The
Riskiness of Stocks

Sixth principle of option pricing (the risk principle)

The riskier the stock on which an option is written, the

greater will be the value of a call option. Thus the sixth
principle can be stated as:

If σ1 > σ2, C(S, E, t, r, σ1)  C(S, E, t, r, σ2)

Other things being equal, a call option on a riskier good will

be worth at least as much as a call option on a less risky
good.

Chapter 12 38
 Prices of Call Options and The
Riskiness of Stocks

Table 12.3 shows the impact that stock price changes have
on option prices.

Table 12.3
Portfolio Values in One Year
Stock Price Change
+10% B10%
Portfolio B
Maturing Bond $10,000 $10,000
Call Option $1,000 0
In Portfolio B, the call option must be worth at
least $1,071.

Stock Price Change

+20% B20%
Portfolio A
Stock $12,000 $8,000

Portfolio B
Maturing Bond $10,000 $10,000
Call Option $2,000 0

Chapter 12 39
 Option Pricing Model

Recall that the price of an option must be at least as great

as the stock price minus the present value of the exercise
price. However, options have an inherent insurance policy.

The insurance character of the option can be seen by

comparing the payoffs from Portfolio A and B from Table
12.3. Holding the options insures that the worst outcome
from the investment will be $10,000.

To reflect this, the value of the option must be equal to the

stock price minus the present value of the exercise price,
plus the value of the insurance policy (I) inherent in the
option or:

C(S, E, t, r, σ) = S - Present Value(E) + I

Option pricing models can be used to determined the

insurance policy value.

Chapter 12 40
 Option Pricing Model (OPM)

The Black and Scholes Option Pricing Model (OPM)

assumes that stock prices follow a stochastic process or
Wiener process. Where a stochastic process is a
mathematical description of the change in the value of
some variable through time.

Wiener process shows that the changes over any given

time interval are distributed normally.

Figure 12.7 shows a graph of the path that stock prices

might follow if they followed a Wiener process.

Chapter 12 41
 Option Pricing Model (OPM)

Insert figure 12.7 here

Chapter 12 42
 Option Pricing Model (OPM)

The Black-Scholes OPM is given by:

C = SN(d1) - E e-rt N(d2)
The Black-Scholes OPM can be used to calculate the
theoretical price of an option. If we know the value of the
following variables:

d1 
 
ln(S / E )  r  .5 2 t
 t

d 2  d1   t
N (d1 ), N (d 2 )  cumulative normal probability values of d1 and d 2

Where
+S = stock price
-E = exercise price
+t = time to expiration
+r = risk-free interest rate
+σ = variability of the stock

Chapter 12 43
 Option Pricing Model (OPM)

Example: assume the following values:

S = $100
E = $100
t = 1 year
r = 12%
σ = 10%

Step 1: calculate the values for d1 and d2.

d1 
 
ln(S / E )  r  .5 2 t
 t

ln(100 / 100)  .12  .5(.01)1

d1 
(.1)(1)

0  .1250
d1   1.25
.1

d 2  d1   t

d 2  1.25  (.1)(1)  1.15

Chapter 12 44
 Option Pricing Model (OPM)

Step 2: calculate N(d1) and N(d2)

The cumulative normal probability can be obtained from
tables that are widely available or by using the excel
function: “=normsdist(d)”
Using a standardized normal probability distribution table
N(d1) = N(1.25) = .8944
N(d2) = N(1.15) = .8749
Step 3: calculate the call option price using OPM
C = S N(d1) - E e-rt N(d2)
C = $100 (.8944) - $100 e-(.12)(1) (.8749)
C = $89.44 - $100 (.8869) (.8749)
C = $89.44 - $77.60 = $11.84
The value of the option is $11.84
Recall form Table 12.2 that option value was $10.71.
The difference is due to the value of the insurance policy
that is captured by the Black-Scholes OPM.

Chapter 12 45
 The Value of Put Options and Put-Call
Parity

While the Black-Schole OPM applies to call options, we

can infer the corresponding value of a put option by
utilizing a concept called Put-Call Parity.

The Put-Call Parity tells us that the value of a put option

can be computed as follows:

E
P S C
1  r  t

For example, suppose a stock is trading for $100 per

share. Using the Black-Scholes OPM, we have
computed the value of a call option with a $100 striking
price to be $11.84. The interest rate is 12%. The value of
the put option is computed as:

$100
P= - $100 + $11.84 = $1.13
(1.12)

Chapter 12 46
 Speculating with Options

Using our prior calculations, what would be the effect of a

1% change in stock prices? What are the speculating
opportunities?

Original Values 1% Increase 1% Decrease

S = $100 S = $101 S = $99

C = $11.84 C = $12.73 C$10.95

Options can be used to take very low risk speculative

positions by using options in combinations. The
combinations are virtually endless, including combinations
called strips, straps, spreads and straddles.

Chapter 12 47
 Speculating with Options

A straddle is a combination of positions involving a put and

a call option on the same stock. To buy a straddle, the
investor buys both call and put options. Consider a call and
put option, both with an exercise price of $100. The call
trades for $40 and the put for $7. Table 12.5 shows the
payoff on the straddle at various stock prices.

Table 12.5
Payoffs for Calls, Puts, and a Straddle at Expiration
Stock Price Call Put Straddle
at Expiration Profit/Loss Profit/Loss Profit/Loss
$50 B$10 +$43 +$33
$80 B$10 +$13 +$ 3
$83 B$10 +$10 0
$85 B$10 +$ 8 B$ 2
$90 B$10 +$ 3 B$ 7
$95 B$10 B$ 2 B$12
$100 B$10 B$ 7 B$17
$105 B$ 5 B$ 7 B$12
$110 0 B$ 7 B$ 7
$115 +$ 5 B$ 7 B$ 2
$117 +$ 7 B$ 7 0
$120 +$10 B$ 7 +$ 3
$150 +$40 B$ 7 +$33
Note: Profit/Loss figures reflect the amounts paid for the instruments:
Call = $10
Put = $7
Straddle = Call + Put = $17

Chapter 12 48
 Speculating with Options

The payoff is graphically displayed in Figure 12.9.

Insert figure 12.9 here

Chapter 12 49
 Hedging with Options

Options can be used to control risk. Consider an original

portfolio comprised of 8,944 shares of stock selling at $100
per share and assume that a trader sells 100 option
contracts, or options on 10,000 shares, at $11.84. The
entire portfolio would have a value of $776,000.
Table 12.6 shows a hedged portfolio.

Table 12.6
A Hedged Portfolio
Original Portfolio: S = $100 C = $11.84
8,944 shares of stock $894,400
A short position for options on 10,000 shares (100 contracts) B$118,400
Total Value $776,000
Stock Price Rises by 1%: S = $101 C = $12.73
8,944 shares of stock $903,344
A short position for options on 10,000 shares (100 contracts) B$127,300
Total Value $776,044
Stock Price Falls by 1%: S = $99 C = $10.95
8,944 shares of stock $885,456
A short position for options on 10,000 shares (100 contracts) B$109,500
Total Value $775,956

Notice that by hedging, the value of the portfolio did not

change as a result of the change in stock prices.

Chapter 12 50