Understanding Options

Alddon Christner C. Ang Basfin2 Source: BMA

Outline

Calls, Puts and Shares

Financial Alchemy with Options What Determines Option Values?

Option Terminology
Call Option Right to buy an asset at a specified exercise price on or before the exercise date.
Put Option Right to sell an asset at a specified exercise price on or before the exercise date.

Option Obligations
Long Short Call option Right to buy asset Obligation to sell asset Put option Right to sell asset Obligation to buy asset
Right to buy

Call option

Buyer/ Holder Obligation to sell Right to sell

Seller/ Writer

Put option

Buyer/ Holder Obligation to buy

Seller/ Writer

Option Terminology
Derivatives - Any financial instrument that is derived from another. (e.g.. options, warrants, futures, swaps, etc.) Option - Gives the holder the right to buy or sell a security at a specified price during a specified period of time. Call Option - The right to buy a security at a specified price within a specified time. Put Option - The right to sell a security at a specified price within a specified time. Option Premium - The price paid for the option, above the price of the underlying security. Intrinsic Value - Difference between the strike price and the stock price

Option Terminology

Time Premium - Value of option above the intrinsic value

Exercise Price - (Striking Price) The price at which you buy or sell the security. Expiration Date - The last date on which the option can be exercised. American Option - Can be exercised at any time prior to and including the expiration date. European Option - Can be exercised only on the expiration date.

Example
3 1

A call option to buy five thousand shares of ABC Co. stocks at PHP 80 per share at the end of six months. The option price is PHP 1,000. 4
5 (1) Underlying (2) Exercise Price The financial variable from which the derivative derives its value The stated price for which an underlying may be purchased or sold

(3) Notional Amount

The quantity of the underlying to which the contract applies

Example
3 1

A call option to buy five thousand shares of ABC Co. stocks at PHP 80 per share at the end of six months. The option price is PHP 1,000. 4
5 (4) Expiration Date (5) Option Premium The maturity date, which gives rise to the notion of an options time to expiration Also known as option price, which is the money paid when the option contract is initiated

Option Terminology

American Option - Can be exercised at any time prior to and including the expiration date.
Exercise anytime before expiry

Grant date

Expiry date

European Option - Can be exercised only on the expiration date.

Exercise only on this date

Grant date

Expiry date

Option Value

The value of an option at expiration is a function of the stock price and the exercise price.
Example - Option values given a exercise price of $80

Stock Price $60 Call Value 0 Put Value 20

70 0 10

80 0 0

90 10 0

100 20 0

110 30 0

Moneyness of an Option

In the future, the option buyer will find it beneficial to

Exercise Not

the option when its payoff is positive, i.e. the option is in-the-money exercise the option when its payoff is nil, i.e. the option is at-the-money or out-of-the-money
Possible Outcomes
Market > Exercise Market = Exercise Market < Exercise

Call Option
Put Option

In-the-money
Out-of-the-money

At-the-money
At-the-money

Out-of-the-money
In-the-money

Example

Selected prices for puts and calls of Google Shares September 2008

Option Value

Google Call option value (of buyer) given a $430 exercise price.
Call option value
$430

$430

Share Price

Option Value

Google Put option value (of buyer) given a $430 exercise price.
Put option value
$430

$430 Share Price

Option Value

Google Call option payoff (to seller) given a $430 exercise price.
Call option payoff

$430 $430

Share Price

Option Value

Google Put option payoff (to seller) given a $430 exercise price.
Put option payoff

$430 $430 Share Price

Option Value

Call buyer profit assume strike of $430 and option price of $54.35

Position Value

Break even

-54.35 430 484.35

Share Price

Option Value

Put seller profit assume strike of $430 and option price of $48.55

Position Value

Break even +48.55

Short put

381.45 430

Share Price

Option Value

Masochists Strategy?- Long stock and short call

Long Stock

Position Value

Silly Strategy

Short Call Share Price

Option Value

Protective Put - Long stock and long put

Long Stock

Position Value

Protective Put

Long Put
Share Price

Option Value

Straddle - Long call and long put

Strategy

for profiting from high volatility Long put Long call

Position Value

Straddle

Share Price

Financial Alchemy

Financial Alchemy

Financial Alchemy

Financial Alchemy

Financial Alchemy

Components of Option Price

1.
2. 3. 4.

Underlying stock price = Ps

Striking or Exercise price = S Volatility of the stock returns (standard deviation of annual returns) = v Time to option expiration = t = days/365

5.
6.

Time value of money (discount rate) = r

PV of Dividends = D = (div)e-rt

Components of Option Price

For a call, intrinsic value is the greater of nil and the excess of market price over exercise price
= max( , 0)

For a put, intrinsic value is the greater of nil and the excess of exercise price over the market price = max( , 0)
The component of an options market value that can be realized by exercising the option immediately

Intrinsic Value

Components of Option Price

Expiry date

European options: As time to maturity increases, both a call and put option increases in value Dividend payment Expiry date

American options: Generally similar to European options. However, if a dividend payment takes place, which decreases the value of a stock, the call option decreases in value and the put option increases in value.

Time Decay Chart

Option prices decline, ceteris paribus, when the time to expiration declines.
90 days to expiration 30 days to expiration

Option Price

60 days to expiration

Stock Price

Components of Option Price

Theoretically, increasing the risk-free interest rates (which normally serves as the discount rate) leads to an increase in the expected return required by stock investors. The present value of future cash flows received by the holder of the option decreases.
Call Option Current Stock Price Strike Price

Put Option

Strike Price

Current Stock Price

Components of Option Price

The greater the distribution of possible outcomes, relative to the final price of the stock, the higher the value of the option. This is due to the greater potential for profit. Thus, Y will have a higher option price, ceteris paribus.

Components of Option Price

Similar to time decay, the value of an option will be higher when more volatility exists.

Summary
Determining Factors
1. Current asset price 2. Strike price 3. Stock price volatility 4. Risk-free interest rate

Effect of increase on:

Call Value Increase Decrease Increase Increase Put Value Decrease Increase Increase Decrease

5. Term to expiration
6. Expected dividends

Increase*
Decrease

Increase*
Increase

*For American options, could be increasing or decreasing These are considered as fundamental in the sense that as long as investors are presumed to take advantage of arbitrage opportunities, these variables must matter.

Which would you prefer?