Lecture 2 - Options Payoffs and Strategies: Kenan-Flagler Business School UNC at Chapel Hill

Derivatives - basics
Trading strategies using options
Lecture 2 - Options payos and strategies

BUSI 588, Fall 2011 Diego Garc a
Kenan-Flagler Business School UNC at Chapel Hill
August 29th, 2011
c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011
1 / 27
Outline and handouts

1
Derivatives - basics Denitions Payo tables and payo diagrams Trading strategies using options Rinconete Trading strategies Meeting clients needs Class slides. Case 2 solutions.
Handouts today:
Other random things: Class representatives? Comments/suggestions on webpage.

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 2 - Options payos and strategies 2 / 27
An aside on compounding
There are many dierent interest rate conventions in Finance: Annual compounding (i.e. yield curve). Semi-annual compounding. Daily compounding (i.e. credit cards). Continuously compounding. The book likes the continuously compounding convention. I (and the WSJ) like the annual compounding. Key: read e rT as
1 (1+r )T
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From simple annual rates to continuously compounded

Continuously compounded interest rate rc . For each $1 invested you get $ e rc t in t years. Annual (simple) interest rate r . For each $1 invested you get $ (1 + r )t in t years. To go from one to the other: 1 + r = e rc Examples
1 2
r = 5% is the same as rc = 4.879%. rc = 5% is the same as r = 5.127%.
4 / 27
Derivatives
Denition A derivative security is a legal contract between two counterparties; which species a set of payments (payos) to be received or paid by each counterparty; where the payments depend upon (are a function of) some other assets future price(s), the underlying asset. Sample derivative instruments: futures and forward contracts, options (calls and puts), exotics (lookback, binary, chooser), swaps (collection of forwards), warrants, corporate bonds (callable and convertible), oil wells, gold mines, eletricity mills, marriage, life. Underlying assets can be: stocks, indexes, exchange rates, aluminum, weather, pork bellies, . . . .
Derivatives markets
Most derivative contracts are traded over-the-counter (OTC). But there are also active exchanges (CBOE, CME). Focus on this course on forward and future contracts, plain-vanilla call and put options. But be aware (more on Advanced Derivatives):
Largest segment is interest rate derivatives (swaps). Fastest growing segment is credit derivatives.
Industry trends: Size of the industry about $600 trillion (notional), $30 trillion market value (> NYSE). Last year saw the rst decline in OTC derivatives global notional amounts oustanding. But market values of derivatives traded went up (BIS). Movement to centralized trading (regulations in Congress).
Options
Denition A call option is a contract that gives its owner (buyer) the right to buy a security at a given price before some given date. A put option is a contract that gives its owner (buyer) the right to sell a security at a given price before some given date. Lingo: The security: underlying asset. The date: expiration date. The given price: strike price. In-the-money (out-of-the-money/at-the-money): current option exercise value is positive (negative/zero). European versus American: allowed to exercise at maturity only or at any point prior to maturity.
Forward/futures contracts
Denition A forward is a contract that gives its owner (buyer) the obligation to buy a security at a given price at some given date. In contrast to calls and puts, the buyer must buy the asset at expiration from the seller at the agreed price. Lingo: futures (forward) price: price at which parties agree to exchange asset in the future so no cash initially changes hands (uctuates daily); delivery price: the forward price that prevails at the initial contract date.
8 / 27
A sample contract
Details on exchange traded oil futures (see http://www.cmegroup.com/rulebook/NYMEX/2/200.pdf for more): Asset type and grade: crude light sweet oil (less than 0.42% sulfur).
Deliverable grades: West TX intermediate, South TX sweet, New Mexican sweet, Norwegian Oseberg blend ($0.55 discount/barrel), Nigerian Boony light, . . . .
Contract size: 1000 barrels (42000 US gallons). Delivery location: Cushing, Oklahoma. Delivery time: initiated on or after the rst calendar day of the delivery month and complete by the last calendar day. And more details!! Always, always, read the contracts details. BTW, well mostly ignore details from now on.
Analytical statement of payos

There are three basic ways to represent the payos from a derivative security: analytically, in tables, in graphs. Let ST denote the value of the underlying asset at maturity, K the strike, and F the forward price. Analytical payos of a call: max(ST K , 0) Analytical payos of a put: max(K ST , 0) Analytical payos of a forward: ST F
Payo tables
List of relevant payos of a security as a function of the underlying asset value at maturity ST on the top, with payos of dierent securities along the rows. It is useful to include cash ows at date 0 (today) as well. Some examples (including time zero on the side)
Security / State (Long) Call (Long) Put (Long) Asset (Long) Fwd Borrow $50 (Short) Call (Short) Put ST < K 0 K ST ST ST F 50(1 + rf )T 0 (K ST ) ST K ST K 0 ST ST F 50(1 + rf )T (ST K ) 0 Today C P S0 0 +50 +C +P
11 / 27
Payo diagrams - calls and puts

Graph of payos from a security (in the y -axis) as a function of the values of the underlying asset (in the x -axis)
Put payoff, K=20
5 5
Call payoff, K=20
Payoff
Payoff 1 0 16 18 20 22 24 0 1 2
16
18
20
22
24
Underlying asset value
12 / 27
Payo diagrams - fwds and asset

Graph of payos from a security (in the y -axis) as a function of the values of the underlying asset (in the x -axis)
Forward payoff, F=20 Asset payoff
Payoff
Payoff 16 18 20 22 24
16
-4
18
-2
20
22
24
16
18
20
22
24
13 / 27
Payo diagrams - guessing game

4 4 Payoffs 16 18 20 22 24 -4 -2 0 2
Payoffs
-4
-2
16
18
20
22
24
Payoffs
Payoffs 16 18 20 22 24
-2
-4
-4
-2
16
18
20
22
24
14 / 27
Prot diagrams
Graph of prots from a security (in the y -axis) as a function of the values of the underlying asset (in the x -axis). Prots = Payos - Initial Investment
Put profits and payoffs, K=20
5
Payoffs
Payoff and profits
Profits 2
-1
Option premium, $1.40
16
18
20 Underlying asset value
22
24
Note: somewhat strange to add t = 0 dollars with t = T dollars.

Prot diagram for a written call

When taking short positions Prots = - Payos + Premium
Short call K=20: profits and payoffs
2
Profits Option premium $1.25 0
Payoff and profits
Payoffs
-4
-2
16
18
20 Underlying asset value
22
24
Again: somewhat strange to add t = 0 dollars with t = T dollars.

Case overview
Rinconete case: Data on six options on CSCO. Part A: get payos and prots from six combinations of calls/puts/underlying. Part B: match three of the trading strategies from A to clients needs. Calls Bid Ask Jan 20.00 Jan 22.50 Jan 25.00 4.10 2.37 1.14 4.15 2.41 1.17 Puts Bid Ask 0.83 1.58 2.84 0.85 1.60 2.87
Standard trading conventions: (i) buy at ask and sell at bids; or (ii) do all trades at mid-point. We shall stick to (i) in this case.
Payos and prots (c)

Consider trading strategy (c)
Long call K = 20 Short calls K = 25 Combined (c) ST < 20 0 0 0 20 < ST < 25 ST 20 0 ST 20 ST 25 ST 20 (ST 25) 5
Prots are the above quantities minus the cost of the portfolio (cash ow at date 0): 4.15 1.14 = 3.01
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Payos and prots (f)

Consider trading strategy (f)
ST < 20 0 0 0 0 20 < ST < 22.5 ST 20 0 0 ST 20 22.5 < ST < 25 ST 20 2(ST 22.5) 0 25 ST ST > 25 ST 20 2(ST 22.5) ST 25 0
Long call K = 20 2 written calls K = 22.5 Long call K = 20 Combined (f)
Prots are the above quantities minus the cost of the portfolio (cash ow at date 0): 1.17 + 4.15 2(2.37) = 0.58
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Options and underlying

Protective put positions: long asset and a long put. Covered call positions: long asset and a short call.
Protective put Covered call
26
24
Payoff
22
Payoff 18 20 22 24 26
20
18
18 18
20
22
24
26
20
22
24
26
20 / 27
Spreads
Bull spreads: long call K1 and short call K2 with K1 < K2 . Bear spreads: long put K1 and short put K2 with K1 > K2 .
Bull spread
5 5
Bear spread
Payoff
Payoff 1 0 18 20 22 24 26 0 18 1 2
20
22
24
26
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Other strategies
Buttery spreads: long call K1 , long call K3 and short 2 calls with K2 where K1 < K2 < K3 . Strangles: buy call K1 and buy put K2 , where K2 K1 (if K1 = K2 it is called straddle).
Butterfly spread
3.0 3.0
Strangle
2.5
2.0
Payoff
Payoff 18 20 22 24 26
1.5
1.0
0.5
0.0
0.0 18
0.5
1.0
1.5
2.0
2.5
20
22
24
26
22 / 27
Rinconetes work for today (part B)
Three clients with (restricted) CSCO stock. Rinconete owns 20,000 shares, and he wants to get some cash. Cortadillo owns 40,000 shares, and his goal is to protect their value. He is willing to spend money. Rodaja has 100,000 shares. He wants to bet on an increase in the volatility of CSCOs stock.
23 / 27
Rinconete part B
By inspection: A covered call position seems appropriate for Rinconete: say write 200 calls with K = 22.5. A protective put position seems appropriate for Cortadillo: say buy 400 puts with K = 22.5. This would guarantee Cortadillo to be able to sell CSCOs shares for $22.5. For Rodaja some type of net straddle or strangle seems like a good idea. Actual size of the positions is the real assignment. The following two slides are meant to illustrate the case for Rinconete.
24 / 27
Rinconete part B
Is there a tradeo? Yes! (***) Consider the following options for Rinconete: (a) Write 200 calls with K = 22.5. (b) Write 100 calls with K = 22.5. (c) Write 100 calls with K = 22.5 and write 100 calls with K = 25. Compared to (a): (b) generates less cash, but keeps some exposure to stock price gains; (c) generates less cash, but keeps some exposure to stock price gains if ST (22, 25).
25 / 27
Payo diagrams - dierent covered calls

Full covered call (a)
550 550
Partial covered call (b)
Payoffs (1000s)
Payoffs (1000s) 18 20 22 24 26
450
350
350
450
18
20
22
24
26
Partial/full covered call (c)

550 550
Yet another covered call (*)
Payoffs (1000s)
Payoffs (1000s) 18 20 22 24 26
450
350
350
450
18
20
22
24
26
26 / 27
Wrap-up
Today: Basics - denitions, institutional details, payos, prots, graphs. Combining options into portfolios. Next class: Lecture 3, put-call parity and arbitrage.
Rocinante case.
Readings:
On parity relations, chapter 10.
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Lecture 2 - Options Payoffs and Strategies: Kenan-Flagler Business School UNC at Chapel Hill

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Derivatives - basics

Trading strategies using options

Lecture 2 - Options payos and strategies

August 29th, 2011

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011

Lecture 2 - Options payos and strategies

Trading strategies using options

Outline and handouts

Other random things: Class representatives? Comments/suggestions on webpage.

Trading strategies using options

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011

Lecture 2 - Options payos and strategies

Trading strategies using options

From simple annual rates to continuously compounded

r = 5% is the same as rc = 4.879%. rc = 5% is the same as r = 5.127%.

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011

Lecture 2 - Options payos and strategies

Trading strategies using options

Trading strategies using options

Trading strategies using options

Trading strategies using options

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011

Lecture 2 - Options payos and strategies

Trading strategies using options

Trading strategies using options

Analytical statement of payos

Trading strategies using options

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011

Lecture 2 - Options payos and strategies

Trading strategies using options

Payo diagrams - calls and puts

Call payoff, K=20

Underlying asset value

Underlying asset value

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011

Lecture 2 - Options payos and strategies

Trading strategies using options

Payo diagrams - fwds and asset

Underlying asset value

Underlying asset value

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011

Lecture 2 - Options payos and strategies

Trading strategies using options

Payo diagrams - guessing game

Underlying asset value

Underlying asset value

Underlying asset value

Underlying asset value

c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011

Lecture 2 - Options payos and strategies

Trading strategies using options

Payoff and profits

Option premium, $1.40

20 Underlying asset value

Note: somewhat strange to add t = 0 dollars with t = T dollars.

Trading strategies using options

Prot diagram for a written call

Profits Option premium $1.25 0

Payoff and profits

20 Underlying asset value

Again: somewhat strange to add t = 0 dollars with t = T dollars.

Trading strategies using options