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Principles of
Options and Option Pricing
2

We sent the first draft of our paper to the Journal of Political
Economy and promptly got back a rejection letter. We then
sent it to the Review of Economics and Statistics, where it
was also rejected.

Merton Miller and Eugene Famathen took an interest in the
paper and gave us extensive comments on it. They
suggested to the JPE that perhaps the paper was worth
more serious consideration. The journal then accepted the
paper.

- MILAN PATEL
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Outline
Introduction
Option principles
Option pricing
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Introduction
Innovations in stock options have been
among the most important developments in
finance in the last 20 years
The cornerstone of option pricing is the
Black-Scholes Option Pricing Model
(OPM)
Delta is the most important OPM progeny to
the portfolio manager
5
Option Principles
Why options are a good idea
What options are
Standardized option characteristics
Where options come from
Where and how options trade
The option premium
Sources of profits and losses with options

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Why Options Are A Good Idea
Options:
Give the marketplace opportunities to adjust
risk or alter income streams that would
otherwise not be available

Provide financial leverage

Can be used to generate additional income from
investment portfolios
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Why Options Are
A Good Idea (contd)
The investment process is dynamic:
The portfolio managers needs to constantly
reassess and adjust portfolios with the arrival of
new information

Options are more convenient and less
expensive than wholesale purchases or sales
of stock
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What Options Are
Call options
Put options

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Call Options
A call option gives you the right to buy
within a specified time period at a specified
price

The owner of the option pays a cash
premium to the option seller in exchange
for the right to buy
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Practical Example
of A Call Option
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Put Options
A put option gives you the right to sell
within a specified time period at a specified
price

It is not necessary to own the asset before
acquiring the right to sell it
12
Standardized
Option Characteristics
All exchange-traded options have
standardized expiration dates
The Saturday following the third Friday of
designated months for most options

Investors typically view the third Friday of the
month as the expiration date
13
Standardized
Option Characteristics (contd)
The striking price of an option is the
predetermined transaction price
In multiples of $2.50 (for stocks priced $25.00
or below) or $5.00 (for stocks priced higher
than $25.00)

There is usually at least one striking price
above and one below the current stock price

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Standardized
Option Characteristics (contd)
Puts and calls are based on 100 shares of the
underlying security
The underlying security is the security that the
option gives you the right to buy or sell

It is not possible to buy or sell odd lots of
options

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Where Options Come From
Introduction
Opening and closing transactions
Role of the Options Clearing Corporation
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Introduction
If you buy an option, someone has to sell it
to you

No set number of put or call options exists
The number of options in existence changes
every day
Option can be created and destroyed
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Opening and
Closing Transactions
The first trade someone makes in a
particular option is an opening transaction
An opening transaction that is the sale of an
option is called writing an option

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Opening and
Closing Transactions (contd)
The trade that terminates a position by
closing it out is a closing transaction
Options have fungibility
Market participants can reverse their positions by
making offsetting trades

E.g., the writer of an option can close out the
position by buying a similar one
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Opening and
Closing Transactions (contd)
The owner of an option will ultimately:
Sell it to someone else

Let it expire or

Exercise it
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Role of the
Options Clearing Corporation
The Options Clearing Corporation (OCC):
Positions itself between every buyer and seller
Acts as a guarantor of all option trades
Regulates the trading activity of members of
the various options exchanges
Sets minimum capital requirements
Provides for the efficient transfer of funds
among members as gains or losses occur
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OCC-Related
Information on the Web
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Where and How Options Trade
Options trade on four principal exchanges:
Chicago Board Options Exchange (CBOE)

American Stock Exchange (AMEX)

Philadelphia Stock Exchange

Pacific Stock Exchange

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Where and How
Options Trade (contd)
AMEX and Philadelphia Stock Exchange
options trade via the specialist system
All orders to buy or sell a particular security
pass through a single individual (the specialist)
The specialist:
Keeps an order book with standing orders from
investors and maintains the market in a fair and
orderly fashion
Executes trades close to the current market price if
no buyer or seller is available
24
Where and How
Options Trade (contd)
CBOE and Pacific Stock Exchange options
trade via the marketmaker system
Competing marketmakers trade in a specific
location on the exchange floor near the order
book official

Marketmakers compete against one another for
the publics business

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Where and How
Options Trade (contd)
Any given option has two prices at any
given time:
The bid price is the highest price anyone is
willing to pay for a particular option

The asked price is the lowest price at which
anyone is willing to sell a particular option
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The Option Premium
Intrinsic value and time value
The financial page listing
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Intrinsic Value and Time Value
The price of an option has two components:
I ntrinsic value:
For a call option equals the stock price minus the
striking price
For a put option equals the striking price minus the
stock price
Time value equals the option premium minus
the intrinsic value
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Intrinsic Value and
Time Value (contd)
An option with no intrinsic value is out of
the money

An option with intrinsic value is in the
money

If an options striking price equals the stock
price, the option is at the money
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The Financial Page Listing
The following slide shows an example from
the online edition of the Wall Street
Journal:
The current price for a share of Disney stock is
$21.95
Striking prices from $20 to $25 are available
The expiration month is in the second column
The option premiums are provided in the Last
column

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The Financial Page Listing
31
The Financial
Page Listing (contd)
Investors identify an option by company,
expiration, striking price, and type of
option:

Disney JUN 22.50 Call

Company
Expiration Striking
Price
Type
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The Financial
Page Listing (contd)
The Disney JUN 22.50 Call is out of the money
The striking price is greater than the stock price
The time value is $0.25

The Disney JUN 22.50 Put is in the money
The striking price is greater than the stock price
The intrinsic value is $22.50 - $21.95 = $0.55
The time value is $1.05 - $0.55 = $0.50

33
The Financial
Page Listing (contd)
As an option moves closer to expiration, its
time value decreases
Time value decay

An option is a wasting asset
Everything else being equal, the value of an
option declines over time

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Sources of Profits and
Losses With Options
Option exercise
Exercise procedures
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Option Exercise
An American option can be exercised at
any time prior to option expiration
It is typically not advantageous to exercise
prior to expiration since this amount to
foregoing time value

European options can be exercised only at
expiration
36
Exercise Procedures
The owner of an option who decides to
exercise the option:
Calls her broker
Must put up the full contract amount for the
option
The premium is not a downpayment on the option
terms

37
Exercise Procedures (contd)
The option writer:
Must be prepared to sell the necessary shares to
the call option owner

Must be prepared to buy shares of stock from
the put option owner
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Exercise Procedures (contd)
In general, you should not buy an option
with the intent of exercising it:
Requires two commissions

Selling the option captures the full value
contained in an option
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Profit and Loss Diagrams
For the Disney JUN 22.50 Call buyer:

-$0.25
$22.50
$0
Maximum loss
Breakeven Point = $22.75
Maximum profit
is unlimited
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Profit and Loss Diagrams
For the Disney JUN 22.50 Call writer:

$0.25
$22.50
$0
Maximum profit
Breakeven Point = $22.75
Maximum loss
is unlimited
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Profit and Loss Diagrams
For the Disney JUN 22.50 Put buyer:

-$1.05
$22.50
$0
Maximum loss
Breakeven Point = $21.45
Maximum profit = $21.45
42
Profit and Loss Diagrams
For the Disney JUN 22.50 Put writer:

$1.05
$22.50
$0
Maximum profit
Breakeven Point = $21.45
Maximum loss = $21.45
43
Option Pricing
Determinants of the option premium
Black-Scholes Option Pricing Model
Development and Assumptions of the model
Insights into the Black-Scholes Model
Delta
Theory of put/call parity
Stock index options
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Determinants of the
Option Premium
Market factors
Accounting factors
45
Market Factors
Striking price
For a call option, the lower the striking price,
the higher the option premium

Time to expiration
For both calls and puts, the longer the time to
expiration, the higher the option premium
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Market Factors (contd)
Current stock price
The higher the stock price, the higher the call
option premium and the lower the put option
premium

Volatility of the underlying stock
The great the volatility, the higher the call and
put option premium
47
Market Factors (contd)
Dividend yield on the underlying stock
Companies with high dividend yields have a
smaller call option premium than companies
with low dividend yields

Risk-free interest rate
The higher the risk-free rate, the higher the call
option premium
48
Accounting Factors
Stock splits:
The OCC will make the following adjustments:
The striking price is reduced by the split ratio
The number of options is increased by the split ratio

For odd-lot generating splits:
The striking price is reduced by the split ratio
The number of shares covered by your options is
increased by the split ratio
49
Black-Scholes
Option Pricing Model
The Black-Scholes OPM:

| | | |
1 2
2
1
2 1
( ) ( )
ln( / ) ( / 2)
rt
C S N d Ke N d
S K R t
d
t
d d t
o
o
o

=
(
+ +

=
=
50
Black-Scholes
Option Pricing Model (contd)
Variable definitions:
C = theoretical call premium
S = current stock price
t = time in years until option expiration
K = option striking price
R = risk-free interest rate
51
Black-Scholes
Option Pricing Model (contd)
Variable definitions (contd):
= standard deviation of stock returns
N(x) = probability that a value less than x will
occur in a standard normal distribution
ln = natural logarithm
e = base of natural logarithm (2.7183)

o
52
Black-Scholes
Option Pricing Model (contd)
Example

Stock ABC currently trades for $30. A call option on ABC
stock has a striking price of $25 and expires in three
months. The current risk-free rate is 5%, and ABC stock
has a standard deviation of 0.45.

According to the Black-Scholes OPM, but should be the
call option premium for this option?




53
Black-Scholes
Option Pricing Model (contd)
Example (contd)

Solution: We must first determine d
1
and d
2
:






2
1
2
ln( / ) ( / 2)
ln(30/ 25) 0.05 (0.45 / 2) 0.25
0.45 0.25
0.1823 0.0378
0.978
0.225
S K R t
d
t
o
o
( + +

=
( + +

=
+
= =
54
Black-Scholes
Option Pricing Model (contd)
Example (contd)

Solution (contd):





2 1
0.978 (0.45) 0.25
0.978 0.225
0.753
d d t o =
=
=
=
55
Black-Scholes
Option Pricing Model (contd)
Example (contd)

Solution (contd): The next step is to find the normal
probability values for d
1
and d
2
. Using Excels
NORMSDIST function yields:






1
2
( ) 0.836
( ) 0.774
N d
N d
=
=
56
Black-Scholes
Option Pricing Model (contd)
Example (contd)

Solution (contd): The final step is to calculate the option
premium:






| | | |
| | | |
1 2
(0.05)(0.25)
( ) ( )
$30 0.836 $25 0.774
$25.08 $19.11
$5.97
rt
C S N d Ke N d
e

=
=
=
=
57
Using Excels
NORMSDIST Function
The Excel portion below shows the input
and the result of the function:

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Development and
Assumptions of the Model
Introduction
The stock pays no dividends during the options
life
European exercise terms
Markets are efficient
No commissions
Constant interest rates
Lognormal returns
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Introduction
Many of the steps used in building the
Black-Scholes OPM come from:
Physics
Mathematical shortcuts
Arbitrage arguments

The actual development of the OPM is
complicated
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The Stock Pays no Dividends
During the Options Life
The OPM assumes that the underlying
security pays no dividends

Valuing securities with different dividend
yields using the OPM will result in the same
price
61
The Stock Pays no Dividends
During the Options Life
The OPM can be adjusted for dividends:
Discount the future dividend assuming
continuous compounding

Subtract the present value of the dividend from
the stock price in the OPM

Compute the premium using the OPM with the
adjusted stock price
62
European Exercise Terms
The OPM assumes that the option is
European

Not a major consideration since very few
calls are ever exercised prior to expiration
63
Markets Are Efficient
The OPM assumes markets are
informationally efficient
People cannot predict the direction of the
market or of an individual stock

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No Commissions
The OPM assumes market participants do
not have to pay any commissions to buy or
sell
Commissions paid by individual can
significantly affect the true cost of an option
Trading fee differentials cause slightly different
effective option prices for different market
participants
65
Constant Interest Rates
The OPM assumes that the interest rate R in
the model is known and constant

It is common use to use the discount rate on
a U.S. Treasury bill that has a maturity
approximately equal to the remaining life of
the option
This interest rate can change
66
Lognormal Returns
The OPM assumes that the logarithms of
returns of the underlying security are
normally distributed

A reasonable assumption for most assets on
which options are available
67
Insights Into the
Black-Scholes Model
Divide the OPM into two parts:

| | | |
1 2
( ) ( )
rt
C S N d Ke N d

=
Part A Part B
68
Insights Into the
Black-Scholes Model (contd)
Part A is the expected benefit from
acquiring the stock:
S is the current stock price and the discounted
value of the expected stock price at any future
point
N(d
1
) is a pseudo-probability
It is the probability of the option being in the money
at expiration, adjusted for the depth the option is in
the money

69
Insights Into the
Black-Scholes Model (contd)
Part B is the present value of the exercise
price on the expiration day:
N(d
2
) is the actual probability the option will be
in the money on expiration day
70
Insights Into the
Black-Scholes Model (contd)
The value of a call option is the difference
between the expected benefit from
acquiring the stock and paying the exercise
price on expiration day
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Delta
Delta is the change in option premium
expected from a small change in the stock
price, all other things being equal:

where the first partial derivative of the call premium
with respect to the stock price
C
S
C
S
c
A =
c
c
=
c
72
Delta (contd)
Delta allows us to determine how many
options are needed to mimic the returns of
the underlying stock

Delta is exactly equal to N(d
1
)
E.g., if N(d
1
) is 0.836, a $1 change in the price
of the underlying stock price leads to a change
in the option premium of 84 cents
73
Theory of Put/Call Parity
The following variables form an interrelated
securities complex:
Price of a put
Price of a call
The value of the underlying stock
The riskless rate of interest
If put/call parity does not hold, arbitrage is
possible
74
Theory of
Put/Call Parity (contd)
The put/call parity relationship:

(1 )
where price of a call
price of a put
option striking price
risk-free interest rate
time until expiration in years
T
K
C P S
R
C
P
K
R
T
=
+
=
=
=
=
=
75
Stock Index Options
A stock index option is the option
exchanges most successful innovation
E.g., the S&P 100 index option

Index options have no delivery mechanism
All settlements are in cash
76
Stock Index Options (contd)
The owner of an in-the-money index call
receives the difference between the closing
index level and the striking price

The owner of an in-the-money index put
receives the difference between the striking
price and the index level