Properties

of
Options
Derivatives (Term IV) 2019

Dr. Kulbir Singh

IMT - Nagpur
 Factors affecting the values of Options
 Apart from usual demand and supply in the market, there are six fundamental
variables that affect the prices of calls and puts; though they influence calls and
puts differently.
 The six fundamental variables or factors are:
1. Price of the underlying asset (Stock Price), S
2. Strike Price or exercise price, K
3. Time to expiration or maturity, T
4. Risk-free interest rate, r
5. Volatility of the price of the underlying security, 𝜎, and
6. Income on the underlying security (e.g., dividend paid on stock).
 The effect of each factor is discussed as relationship between the individual
factor and the call and put price, while holding other factors constant.
 In the real world, all the factors act together on the option prices.
Derivatives (Term IV) 2019 Dr. Kulbir Singh (IMT-N) 2
1. Option (Call/Put) Price vs. Underlying (Stock) Price
• On a given date, what is relationship Call/Put Price and Underlying
(Stock) Price?
• What is impact of increasing stock price on a call and a put option
on the stock?
• 𝑐𝑡 = 𝑀𝑎𝑥 𝑆𝑡 − 𝐾, 0
• 𝑝𝑡 = 𝑀𝑎𝑥 𝐾 − 𝑆𝑡 , 0
• Call Price rises with increasing stock price.
• Put price falls as price of underlying rises!

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 29-Aug 2019 Nifty Call Option
(as on 31 May 2019, St = 11922.80)
1800
St ≅ K
1600 ATM
Call Price (Settlement Price) (c)

1400
St < K
1200 OTM

1000

800

600

400 St > K
ITM
200

0
10000 10500 11000 11500 12000 12500 13000 13500 14000
Strike Prices (K)
Derivatives (Term IV) 2019 Dr.
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Kulbir Singh (IMT-N)
 29-Aug 2019 Nifty Call Option
(as on 16 Aug'19, St = 11047.8)
1740.05 St ≅ K
1595.05 ATM
1450.05
Call Price (Settlement Price) (c)

1305.05
1160.05
1015.05
870.05 St < K
725.05 OTM
580.05
435.05
290.05 St > K
145.05
ITM
0.05
9300 9800 10300 10800 11300 11800 12300 12800 13300
Strike Price (K)
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Kulbir Singh (IMT-N)
2. Call Price vs. Strike Price
• On a given date, what is relationship Call Price and Strike Price?
• Observations???
• Call Price falls with increasing strike price.
• As strike price increases, Call price decreases.
• Why?
• 𝑐𝑡 = 𝑀𝑎𝑥 𝑆𝑡 − 𝐾, 0
• At a given St, as K increases, ct becomes zero.

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 29-Aug 2019 Nifty Put Option
(as on 31 May 2019, St = 11922.80)
St ≅ K
ATM
1220

St < K
1020
ITM
Put (Settlement) Price (p)

820

620

420
St > K
OTM
220

20
10400 10900 11400 11900 12400 12900 13400 13900
Strike Price (K)
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Kulbir Singh (IMT-N)
 29-Aug 2019 Nifty Put Option
(as on 31 May 2019, St = 11047.80)
St ≅ K
2535
ATM
2340
2145
1950 St < K
Put (Settlement) Price (p)

ITM
1755
1560
1365
1170
975
780
585
390 St > K
195 OTM
0
9300 9800 10300 10800 11300 11800 12300 12800 13300
Strike Price (K)

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 2. Put Price vs. Strike Price
• On a given date, what is relationship Put Price and Strike Price?
• Observations???
• Put Price rises with increasing strike price.
• As strike price increases, Put price also increases.
• Why?
• 𝑝𝑡 = 𝑀𝑎𝑥 𝐾 − 𝑆𝑡 , 0
• At a given St, as K increases, pt increases.

Derivatives (Term IV) 2019 Dr. Kulbir Singh (IMT-N) 9

 Call Nifty 29-Aug-2019
Strike Price: 11,000 (S0 = 11,922.80)
1400
1300
1200
1100
Call (Settlement) Price (c)

1000
900
800
700
600
500
400
300
200
100
30-May-19 09-Jun-19 19-Jun-19 29-Jun-19 09-Jul-19 19-Jul-19 29-Jul-19 08-Aug-19 18-Aug-19
Time to Expiration (T)

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 Call Nifty 29-Aug-2019
Strike Price: 11,950 (S0 = 11,922.80)

602
552
502
Call (Settlement) Price (c)

452
402
352
302
252
202
152
102
52
2
31-May-19 10-Jun-19 20-Jun-19 30-Jun-19 10-Jul-19 20-Jul-19 30-Jul-19 09-Aug-19 19-Aug-19
Time to Expiration (T)

Derivatives (Term IV) 2019 Dr. Kulbir Singh (IMT-N) 11

 Put Nifty 29-Aug-2019
Strike Price: 10,000, (S0 = 11,922.80)
15.5

14

12.5
Put (Settlement) Price (p)

11

9.5

6.5

3.5

2
10-Jul-19 15-Jul-19 20-Jul-19 25-Jul-19 30-Jul-19 04-Aug-19 09-Aug-19 14-Aug-19 19-Aug-19
Time to Expiration (T)

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 Put Nifty 29-Aug-2019
Strike Price: 11,900 (S0 = 11,922.80)
1070

970

870
Put (settlement) Price (p)

770

670

570

470

370

270

170
31-May-19 10-Jun-19 20-Jun-19 30-Jun-19 10-Jul-19 20-Jul-19 30-Jul-19 09-Aug-19 19-Aug-19
Time to Expiration (T)

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Option Price vs. Time to Expiration

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 3. Option Price vs. Time to Expiration
• European Calls and Puts usually becomes more valuable as the time to
expiration increases.
• Generally, the closer an option’s strike price to the price of underlying, greater
the chance the underlying will move sufficiently to the given option real or
intrinsic value before expiration, and consequently , the greater the time
value.
• Time value might be referred to as speculative value - value that is derived
from potential movement in the ul’g price as a result of volatility occurring
within the framework of time.
• As expiration approaches, speculative value declines; this phenomenon is
known as time decay.
• At expiration, an option will have only IV remaining; its speculative value
dwindles to zero.
• For this reason, options are sometimes referred to as wasting assets.
• American options become more valuable as time to expiration increases.

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 4. Option (Call/Put) Price vs. Volatility of Ul’g Price
• Volatility refers to the range of prices a security can take.
• Large the volatility, more range of prices the security will take and smaller
the volatility, the range of possible prices for the security are less.
• Larger range of prices implies prices higher than the average and prices lower
than the average.
• For a call option, higher range of prices above the average stock price are
good; for the prices lower than the average, the loss on call option is limited
to the premium paid.
• For a put option, large volatility implies, prices on the lower side are good,
while price on higher side, does not impact a put, as the losses are limited to
the put premium paid by the holder.
• larger volatility increases the value of both call and put option.

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Option (Call/Put) Price vs. Volatility

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 5. Option (Call/Put) Price vs. Risk-Free Interest Rate (r)
• Risk free interest rates are important in the pricing of options, as they are
used for financing of option trades.
• However, the impact of interest rates on option prices is not very clear-cut.
• Perspective #1: IR and FIS
• In general, as the interest rates in the economy increases, the demand for
fixed income securities increases and demand for stocks decreases which
translates into lower stock prices.
• A fall in stock price decreases the value of the call while the value of put
increases.

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 5. Option (Call/Put) Price vs. Risk-Free Interest Rate (r) ..
• Perspective #2: Investors’ Expectations
• Increase in risk-free interest rates makes the equity investors increase their
return expectation from the stock.
• This increase in expectations, effect the stock price, resulting in increase in
call price, and decrease in put price.
• Perspective #3: Impact on Discount Rate
• Increase in interest rates, increases the discount factor resulting in the lower
present value of the future cash flows from the stock.
• This decreases the call price, while increasing the put price.
• Summarizing!
• On average, an increase in interest rates, increases call prices, and decreases
the put prices
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Option (Call/Put) Price vs. Risk-free IR

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 6. Option (Call/Put) Price vs. Dividend/Income
• The relationship between call and put prices with dividends paid is
straightforward.
• When dividend is paid on a stock, the price of the stock decreases on ex-
dividend by approximately the extent of dividend paid.
• A fall in stock price, decreases the price of call while increases the price of
put.

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 European vs. American Options
• Since an American option can be exercised at any time, it must always be at
least as valuable as an European option.

𝐶𝐴 𝑆, 𝐾, 𝑇 ≥ 𝐶𝐸 𝑆, 𝐾, 𝑇

𝑃𝐴 𝑆, 𝐾, 𝑇 ≥ 𝑃𝐸 𝑆, 𝐾, 𝑇

• There are times when the right to early-exercise is worthless for American
options, hence, American and European options have same value.

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 Maximum and Minimum Option Prices
CALLS The price of a European call option
• Cannot be negative (why?)
• …. Utmost calls need not be exercised
• Cannot exceed the stock price (why?)
• … best that can happen with a call is, investor ends up owning a stock.
• Must be at least as great as the price implied by parity with a zero put value
• .. That is, 𝐶 = 𝑆0 − 𝑃𝑉 𝐷𝑖𝑣 − 𝑃𝑉(𝐾)
• Combining these statements together with the result about American
options never being worth less than European options, we have the
boundary conditions for Call Options

𝑆 ≥ 𝐶𝐴 𝑆, 𝐾, 𝑇 ≥ 𝐶𝐸 𝑆, 𝐾, 𝑇 ≥ max[0, 𝑃𝑉 𝑆𝑇 − 𝑃𝑉 𝐾 ]

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 Maximum and Minimum Option Prices
• PUTS The price of a European put option
• Cannot be worth more than the strike price (why?)
• …. Utmost put pays K even of the stock price drops to zero
• Must be at least as great as the price implied by parity with a zero call value
• .. That is, 𝑃 = −𝑆0 + 𝑃𝑉 𝐷𝑖𝑣 + 𝑃𝑉(𝐾)
• Combining with the result about American options never being worth less
than European options, we have the boundary conditions for Put Options

𝐾 ≥ 𝑃𝐴 𝑆, 𝐾, 𝑇 ≥ 𝑃𝐸 𝑆, 𝐾, 𝑇 ≥ max[0, 𝑃𝑉 𝐾 − 𝑃𝑉 𝑆𝑇 ]

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 Boundary for Call Options

Option
Price 𝑪𝑨 𝐨𝐫 𝑪𝑬 > 𝑺
cash − and − carry arbitrage opportunities

Range of option prices between UB and LB

𝐶𝐴 𝑆, 𝐾, 𝑇 ≥ 𝐶𝐸 𝑆, 𝐾, 𝑇
max[0, 𝑃𝑉 𝑆𝑇 − 𝑃𝑉 𝐾 ]

𝑪𝑨 𝐨𝐫 𝑪𝑬 < 𝒎𝒂𝒙 𝟎, 𝑷𝑽 𝑺𝑻 − 𝑷𝑽 𝑲
reverse cash − and − carry arbitrage opportunities

Time
t=0 t=T

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 Boundary for Put Options

Option
Price 𝑷𝑨 𝐨𝐫 𝑷𝑬 > 𝑲
cash − and − carry arbitrage opportunities

Range of option prices between UB and LB

𝑃𝐴 𝑆, 𝐾, 𝑇 ≥ 𝑃𝐸 𝑆, 𝐾, 𝑇
max[0, 𝑃𝑉 𝐾 − 𝑃𝑉 𝑆𝑇 ]

𝑷𝑨 𝐨𝐫 𝑷𝑬 < 𝒎𝒂𝒙 𝟎, 𝑷𝑽 𝑺𝑻 − 𝑷𝑽 𝑲
reverse cash − and − carry arbitrage opportunities

Time
t=0 t=T

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Different Strike Prices
• Consider three strike prices, 𝐾1 < 𝐾2 < 𝐾2 with corresponding
• Call prices 𝐶(𝐾1 ), 𝐶(𝐾2 ), and 𝐶(𝐾3 ), and
• Put prices 𝑃(𝐾1 ), 𝑃(𝐾2 ), and 𝑃(𝐾3 )

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Different Strike Prices…
• Propositions:
1. A call with low strike price is at least as valuable as an otherwise identical call
with a higher strike price.
𝐶(𝐾1 ) ≥ 𝐶(𝐾2 )
A Put with high strike price is at least as valuable as an otherwise
identical put with a low strike price.
𝑃(𝐾2 ) ≥ 𝑃(𝐾1 )
• If the above eqns. are NOT true, then
 BUY low-strike call 𝐶(𝐾1 ) and SELL high-strike call 𝐶(𝐾2 )
[CALL BULL SPREAD]
 BUY high-strike put 𝑃(𝐾2 ) and SELL low-strike put 𝑃(𝐾1 )
[PUT BEAR SPREAD]

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Different Strike Prices…
• Propositions…
2. The premium difference between otherwise identical calls with different strike
prices cannot be greater than the difference in strike prices.
𝐶(𝐾1 ) − 𝐶(𝐾2 ) ≤ 𝐾2 − 𝐾1
The premium differences for otherwise identical puts also cannot be
greater than the difference in strike prices.
𝑃(𝐾2 ) − 𝑃(𝐾1 ) ≤ 𝐾2 − 𝐾1
• If the above eqns. were NOT true, then
 SELL low-strike call 𝐶(𝐾1 ) and BUY high-strike call 𝐶(𝐾2 )
[CALL BEAR SPREAD]
 BUY low-strike put 𝑃(𝐾1 ) and SELL high-strike put 𝑃(𝐾2 )
[PUT BULL SPREAD]

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Different Strike Prices…
• Propositions…
3. Premiums decline at a decreasing rate as investors consider calls with
progressively higher strike prices.
𝐶(𝐾1 ) − 𝐶(𝐾2 ) 𝐶(𝐾2 ) − 𝐶(𝐾3 )
≥
𝐾2 − 𝐾1 𝐾3 − 𝐾2
The same is true for puts as strike prices decline.
𝑃(𝐾2 ) − 𝑃(𝐾1 ) 𝑃(𝐾3 ) − 𝑃(𝐾2 )
≤
𝐾2 − 𝐾1 𝐾3 − 𝐾2
• This is called convexity of the option w.r.t the strike prices, or strike price
convexity.
• If the above equations do not hold, then there is an asymmetric butterfly spread
with positive profits at all prices.

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Different Strike Prices …
• Proposition #3 ….
Since 𝐾2 is between 𝐾1 and 𝐾3 , we can write it as weighted average of the two
strikes,
𝐾2 = 𝛽𝐾1 + (1 − 𝛽)𝐾3
where
𝐾3 − 𝐾2
𝛽=
𝐾3 − 𝐾1
• With this expression for 𝛽, the equation can be written as:

𝐶(𝐾2 ) ≤ 𝛽𝐶(𝐾1 ) +(1 − 𝛽) 𝐶(𝐾3 )

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