Options &

Different Strategies of Options

RBA
Instructor: M.Jibran Sheikh

Contact : Jibransheikh@comsats.edu.pk

Determinants of Option
Value
The value of an option is determined by a number of variables

relating to the underlying asset and financial markets.

Current Value of the Underlying Asset
The buyer of an option acquires the right to buy or sell the
underlying asset at a fixed price. The higher the variance in the
value of the underlying asset, the greater will the value of the
option be1. This is true for both calls and puts. While it may
seem counter-intuitive that an increase in a risk measure
(variance) should increase value, options are different from
other securities since buyers of options can never lose more
than the price they pay for them; in fact, they have the
potential to earn significant returns from large price
movements.
Variance in Value of the Underlying Asset
Options are assets that derive value from an underlying asset.
Consequently, changes in the value of the underlying asset
affect the value of the options on that asset. Since calls provide
the right to buy the underlying asset at a fixed price, an
increase in the value of the asset will increase the value of the
calls.Puts, on the other hand, become less valuable as the
value of the asset increase.

Dividends Paid on the Underlying Asset

The value of the underlying asset can be expected to decrease if dividend payments are
made on the asset during the life of the option. Consequently, the value of a call on
the asset is a decreasing function of the size of expected dividend payments, and
the value of a put is an increasing function of expected dividend payments.

Strike Price of Option

In the case of calls, where the holder acquires the right to buy at a fixed price, the value
of the call will decline as the strike price increases. In the case of puts, where the
holder has the right to sell at a fixed price, the value will increase as the strike price
increases.

Time To Expiration On Option

Both calls and puts become more valuable as the time to expiration
increases. This is because the longer time to expiration provides
more time for the value of the underlying asset to move,
increasing the value of both types of options. Additionally, in the
case of a call, where the buyer has to pay a fixed price at
expiration, the present value of this fixed price decreases as the
life of the option increases, increasing the value of the call.
Risk-free Interest Rate Corresponding To Life Of Option
Increases in the interest rate will increase the value of calls and
reduce the value of puts.

Variables Affecting Call and

Put Prices

Combinations - Straddles
A straddle - an investment in a call and a
put at the same exercise price
Essentially a bet on volatility
If the price of the security increases or
decreases sufficiently the strategy will be
profitable

25

Straddles
This is a strategy to adopt whenever there
is considerable short term uncertainty
about the price of a share, and it is
anticipated that this uncertainty will be
resolved before the expiry of the options. A
straddle will lose investor money if there is
little change in the share price, but large
price changes in either direction will
produce gains.

Example
Consider the following example:
Call price
12p
Put price
8p
Exercise price
120p
Total Outlay
(12p + 8p) = 20p
If the share price at expiry is less than 120p
the investor will exercise the put and the
call will be valueless, whereas if the share
price at expiry exceeds 120p the investor
will exercise the call and the put will be
valueless.
Now main Question is when will investor earn
profit??

Profit on Straddle
The investor can only make a profit if the
price of the share at the maturity date
must fall below 100p or exceed 140p, ie,
the share price at expiry must deviate
from the exercise price by an amount at
least equal to the initial cost of the
options. At a share price of 100p the
value of the put will be 20p whereas a
share price of 140p will produce the
value for the call of 20p.

Straddle Profit Graph

Profit\Loss
Put

Call

+
Profitable

Unprofitable

Profitable

Cost = C0+P0

Exercise the put

Exercise the call
A profitable straddle requires (ST - X) > (C0+P0)
or (X - ST) > (C0+P0)

Straddle in Efficient market

If all investors are aware of the impending
announcement, and appreciate the possibility of
using a straddle to benefit from the likely price
movement, the higher demand for calls and puts will
push up their prices.
These price rises will
eliminate the expected profit from the transaction.
So this suggests that in an efficient market an
investment in a straddle does not have a positive
expected value, and an investor without access to
inside information can expect to breakeven.
(See page 18 0f your notes for further elaboration of
this concept)

Covered Calls
A covered call involves writing a call and investing
in the underlying asset.
It is a strategy employed by the writers of calls to
control their risk exposure
The threat of large losses is eliminated by
foregoing the potential for large gains on the share
being held.
This combination most frequently employed
by financial institutions that regularly write
calls. It is used above all else as a fee
generating strategy by portfolio managers
when the outlook for share prices is neutral
to mildly bearish.

The profit (loss) positions from writing a

covered call

Example
Lets assume that a call has been written by
Mr. X at an exercise price of 150p (X), the
current price of the share is 140p ( S0 =
26p), and the market price of the call is
20p.
Than there are following possibilities:
if the share price at expiry is zero the
investor's maximum loss will be 120p the
initial investment in the share (140p) less
the proceeds from writing the call (20p).

 for share prices up to 150p, the exercise

price of the option, the combination is
more profitable than simply holding the
share as a result of the contribution of
the premium received from the writing
of the call;
at a share price of 150p the profit will be
30p, the capital gain on holding the
share (150p - 140p) plus the proceeds
from writing the call (20p);

 If share price is above 150p the call

option will be exercised, and the net
profit will be restricted to 30p as any
gain from increases in the price of the
share beyond 150p will be absorbed
by the losses associated with the
written call.

Covered Call (5) A Share and Written Call, Net

Effect
Profit / Loss
Capital Gain/Loss
Covered
Call

+ C= 20p
Share Price

Written Call

- 120
-140

Losses on call offset by the

gains on the share.

Strangles

A strangle, like a straddle involves investments in both

a call and a put, but for a strangle the exercise prices
of the call and put differ. The exercise price of the call
is chosen to exceed that of the put i.e., X c > X p.
Purchasing a put with a lower exercise price than
would be the case in a straddle reduces the probability
of the put being exercised. This implies that the
market cost of the put used in a strangle will be lower
than that in a straddle.
Similarly the higher the exercise price for a call the
lower the probability that it will be exercised and the
lower its market value.
But while the overall cost of a strangle may be lower
so are the benefits: the movement in share price
necessary to recover the cost of a strangle exceeds
that necessary to recover the outlay on the straddle.

A STRANGLE AND STRADDLE

COMPARED