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Nick Taylor
nick.taylor@bristol.ac.uk
University of Bristol
Table of contents
1 Learning Outcomes
2 General Information
3 Factors Affecting Option Prices
4 Option Bounds
5 The Put-Call Relationship
6 Early Exercise
7 The Effects of Dividends
8 Trading Strategies
9 Summary
10 Reading
General Information
Key Assumptions:
There are no transaction costs.
All trading profits (net of trading losses) are subject to the same tax
rate.
Borrowing and lending are possible at the risk-free interest rate.
Arbitrage opportunities are taken immediately (and thus removed
immediately). Equivalently, no arbitrage opportunities occur.
Key Notation:
Current stock price: S.
Strike price of option: K .
Time to expiration of option: T .
Stock price on expiration date: ST .
Continuously compounded risk-free interest rate: r .
Value of American call option to buy one share: C .
Value of American put option to buy one share: P.
Value of European call option to buy one share: c.
Value of European put option to buy one share: p.
Affect Directions:
European European American American
Variable Call Put Call Put
Current stock price + − + −
Strike price − + − +
Time to expiration ? ? + +
Volatility + + + +
Risk-free rate + − + −
Expected dividends − + − +
Option Bounds
All Bounds
Upper Bounds (Calls): c ≤ S, C ≤ S.
Upper Bound (Am. Put): P ≤ K .
Upper Bound (Euro. Put): p ≤ Ke −rT .
Lower Bound (Euro. Call): c ≥ max(S − Ke −rT , 0).
Lower Bound (Euro. Put): p ≥ max(Ke −rT − S, 0).
Proofs
Proof that p ≤ Ke −rT :
Terminal Value
Action Initial Value ST ≤ K ST > K
Write Put p −(K − ST ) 0
Lend −Ke −rT K K
Total p − Ke −rT ST K
Proofs (cont.)
Proof that c ≤ S:
Terminal Value
Action Initial Value ST ≤ K ST > K
Write Call c 0 −(ST − K )
Buy Stock −S ST ST
Total c −S ST K
Proofs (cont.)
Proof that c ≥ max(S − Ke −rT , 0):
Terminal Value
Action Initial Value ST ≤ K ST > K
Buy Call −c 0 ST − K
Sell Stock S −ST −ST
Lend −Ke −rT K K
Total S − Ke −rT − c −ST + K 0
Proofs (cont.)
Proof that p ≥ max(Ke −rT − S, 0):
Terminal Value
Action Initial Value ST ≤ K ST > K
Buy Put −p K − ST 0
Buy Stock −S ST ST
Borrow Ke −rT −K −K
Total Ke −rT − S − p 0 ST − K
Examples
Example (1)
Consider a European call option on a non-dividend paying stock. The stock
price is $51, the strike price is $50, the time to maturity is 6 months, and the
risk-free rate of interest is 12% per annum. In this case, S = 51, K = 50,
T = 0.5, r = 0.12, and the lower bound for the option price is
What is the upper bound for the price of this call option?
Examples (cont.)
Example (2)
Consider a European put option on a non-dividend paying stock. The stock
price is $38, the strike price is $40, the time to maturity is 3 months, and the
risk-free rate of interest is 10% per annum. In this case, S = 38, K = 40,
T = 0.25, r = 0.10, and the lower bound for the option price is
What is the upper bound for the price of this put option?
Put-Call Parity
For non-dividend paying stock we have: c + Ke −rT = p + S.
Proof:
Terminal Value
Action Initial Value ST ≤ K ST > K
Write Call c 0 −(ST − K )
Buy Put −p K − ST 0
Buy Stock −S ST ST
Borrow Ke −rT −K −K
Total c + Ke −rT − p − S 0 0
Examples
Example
Suppose that the stock price is $31, the strike price is $30, the risk-free interest
rate is 10% per annum, and the price of a 3-month European call option on the
stock is $3. In this instance, the theoretical price of a put option (on the same
stock, with the same strike price) will be
Example (cont.)
Continuing the above example, what arbitrage profits are available if the put
option (on the same stock, with the same strike price) has a market value of $1?
This would imply that the market price of the put option is too low, and that
c + Ke −rT > p + S,
which in turn implies that an arbitrageur should ‘sell’ the LHS and ‘buy’ the
RHS.
Examples (cont.)
Example (cont.)
Continuing the above example, the arbitrageur should take the following actions:
Terminal Value
Action Initial Value ST ≤ 30 ST > 30
Write Call 3 0 −(ST − 30)
Buy Put −1 30 − ST 0
Buy Stock −31 ST ST
Borrow 29.26 −30 −30
Total 0.26 0 0
Thus yielding a risk-free profit of $0.26 (per option traded).
Early Exercise
Put-Call Parity
It can be shown that c + Ke −rT + D = p + S.
Proof:
Terminal Value
Action Initial Value ST ≤ K ST > K
Write Call c 0 −(ST − K )
Buy Put −p K − ST 0
Buy Stock −S ST + De rT ST + De rT
Borrow Ke −rT +D −K − De rT −K − De rT
Total c + Ke −rT +D −p−S 0 0
Early Exercise
It may be optimal to exercise an American call option on a dividend
paying stock early.
If it is optimal, the exercise will occur immediately prior to an
ex-dividend date.
Basic Strategies
Writing a Covered Call:
Long stock plus short call.
Protective Put Strategy:
Long stock plus long put.
Spreads (cont.)
Box Spreads:
Buying a bull call spread and a bear put spread with the same strike
prices.
Butterfly Spreads:
Buying one call option with a low strike price, buying one call option
with a high strike price, and selling two call options with a strike price
between the low and high strike prices. In this instance, the investor is
hoping that the stock price remains stable (low volatility).
Spreads (cont.)
Calender Spreads:
Selling a call option with a certain strike price, and buying a call option
with the same strike price but with a longer maturity. Payoff is similar
to that observed with a butterfly spread.
Diagonal Spreads:
Taking positions in options with different expirations dates and strike
prices. This leads to a wide variety of profit profiles.
Combinations (cont.)
Strips:
Buying one call option and two put options with the same strike prices
and expiration dates. The investor is hoping that there is a large stock
price change and considers a decrease more likely than an increase.
Straps:
Buying two call options and one put option with the same strike prices
and expiration dates. The investor is hoping that there is a large stock
price change and considers an increase more likely than a decrease.
Determining Factors
Current stock price, strike price, maturity, volatility, interest rate, and
dividends.
Option Bounds and Parity Conditions
Proofs of lower and upper bounds, and put-call parity.
Trading Strategies
Spreads and combinations.
Reading
Essential Reading
Chapters 11 and 12, Hull (2015).
Further Reading
Chaput, J., and L. Ederington, 2003, Option spread and combination
trading, Journal of Derivatives 10, 70-88.