Options

Options
? Put Options
? Call Options

? Examples of derivatives

Peter O’Grady

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Put Options Put Options

? A put option is a contract that gives the
owner the right, but not the obligation, to
sell an underlying asset, at a fixed price
($K), on (or on or before) a specific day.
? The put writer is obligated to buy the
underlying asset, and pay $K for it.
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? Define S as the price of the underlying
asset, and K as the strike price.
? In, out of, and at the money for puts
– In the money if S < K
– Out of the money if S > K
– At the money if S ~ K
– Deep in (out of) the money if S << K
(S >> K)
? Intrinsic value of a put = max(0,K-S)

Value of Put at Expiration (A.K.A. Profit Diagram -- Long Put

Payoff Diagram) (Buying a Put)
PT Profit Just lower the payoff diagram
by the put premium (price of
put)to get the profit diagram

0
0 K ST
ST
K

put premium

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 Example of a Put Option Example of a Put Option (cont.)
? buy a put option to purchase 100 Exxon shares
Profit ($)
– strike price = $70 3000

– price of an option to buy one share = $7 2500

2000
? initial investment is 100 x $7 = $700 1500

? The outcome 1000 Terminal stock price ($)

500
– Exxon’ s share price is $55 at the expiration 0
40 50 60 70 80 90 100
– to exercise the option for a gain of -700
-1000
($70-$55) x 100 = $1,500
-1500
– the net gain = $1,500 - $700 = $800
Figure Profit from buying a Put Option on 100 Exxon share. Option
price = $7; strike price = $70

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Profit Diagram – Short Put Insurance

(Selling a Put) ? Insurance. If you own the underlying
Profit
asset, buying a put provides
protection against the possibility that
the underlying asset price will fall
below $K. Of course, insurance costs
0 money (the put premium).
K ST

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Call Options Call Options

? A call option is a contract that gives the ? In, out of, and at the money: Define S
owner the right, but not the obligation, to as the price of the underlying asset, and
buy an underlying asset, at a fixed K as the strike price. Then, for a call:
price, on (or on or before) a specific – In the money if S > K
day. – Out of the money if S < K
? The fixed price is called the strike price, – At the money if S ~ K
or the exercise price. – Deep in (out of) the money if S >> K
(S << K)
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 Value of Call at Expiration, (A.K.A. Profit Diagram -- Long Call
Payoff Diagram) (Buying a Call Option)
CT Just lower the payoff diagram
Profit by the call premium (price of the option), to get the
profit diagram

call premium
0
K
ST 0
K ST

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Example of a Call Option Example of a Call Option (cont.)

? buy a call option to purchase 100 MSFT share
– strike price = $52 Profit ($)
1200
– current share price = $50 1000

– price of an option to buy one share = $2 800

? initial investment is 100 x $2 = $200 600

400
? The outcome 200 Terminal stock price ($)
– MSFT’ s share price is $55 at the expiration 0
50 60 70 80 90
-200
– to exercise the option for a gain of ($55-$52) x 100 -400
= $300 -600

– the net gain = $300 - $200 = $100

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Example of a Call Option Example of a Call Option (cont.)

? buy a call option to purchase 100 IBM shares
– strike price = $100
Profit ($)
– current share price = $98 3000
2500
– price of an option to buy one share = $5
2000
? initial investment is 100 x $5 = $500 (Worse case is 1500

that this will be lost) 1000

500 Terminal stock price ($)
? The outcome
0
90 100 110 120 130
– IBM ’s share price is $115 at the expiration -500
-1000
– to exercise the option for a gain of
-1500
($115-$100) x 100 = $1,500
Figure Profit from buying a Call Option on 100 IBM share. Option
– the net gain = $1,500 - $500 = $1,000 price = $5; strike price = $100

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 Profit Diagram – Short Call
Example of a Call Option (cont.)
(Selling a Call Option)
Profit ($)
1000
Profit 500
0 Terminal stock price ($)

-500 90 100 110 120 130

-1000
-1500
0 -2000

K ST -2500
-3000

-3500

Figure Profit from writing a Call Option on 100 IBM share. Option
price = $5; strike price = $100

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Example of a Put Option (cont.) Option Positions (cont.)

Profit Profit
Profit ($)
Terminal stock price ($)
700
0 X
40 50 60 70 80 90 100
-500
X ST ST
-1000

-1500 (a) long call (b) short call

-2000
Profit Profit
-2500
-3000
-3500

-4000
ST X ST
Figure Profit from writing a Put Option on 100 Exxon share. Option X
price = $7; strike price = $70
(c) long put (d) short put
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