Options & Futures

Fin 444

Instructor Tsong-Yue Lai, Ph. D.

Class Notes: http://business.fullerton.edu/Finance/tylai Click Material, Click Fin444 S&P 500 Index Futures: http://data.tradingcharts.com/futures/quotes

Euro$ Futures: http://data.tradingcharts.com/futures/quotes/ED.html

Gold Futures: http://online.wsj.com/mdc/public/page/2_3028.html?category=O

Whole Picture of Fin444 Call (Creates) Put (Put-Call parity) Call & Put Forward Contract Futures Contract = A Series of Forward Contracts Swap = A Portfolio of Forward Contracts In Sum, If you know the Call Options, You know all

Chapter 1: Introduction KEY CONCEPTS:

Distinct between Real Asset/Services & Financial Asset Definitions of Options, Forward, Futures, Option on Futures, Swaps Review of the Basic Concepts of Risk-Return, Risk Preferences, Short Selling & Mkt Efficiency Arbitrage & the Law of One Price, Storage & Delivery Advantage of These Markets Criticisms of Derivative Markets & the Difference Between Speculation & Gambling

 1. Markets for Real Asset & Service

Real Assets (Tangible) vs. Services (Intangible) Ex. Real Assets: Food, Car, housing, Clothing etc. (Tangible) Services: Lawyer, CPA, Financial Advice, etc..(Intangible)

2. Financial Assets Markets:

Financial Asset: a claim on an economic unit (e.g., equity, business or individual) Ex. Stock, Bond, Promissory Note Market for Financial Asset (primary & secondary mkts): Money mkt(short-term debt) & Capital mkt(long-term claims)

3. Derivative Markets(Option, Forward, Futures, Swap etc.)

Financial Contract: An Agreement between two parties (buyer vs. seller) in which each party gives something to the other Ex. Option, Forward, Futures, Swap.

Definition
1. Option: gives the buyer the right (not obligation) to buy or sell something at a later date at a price agreed upon today.
Ex. Stock Option, Index Option, Lines of credit, Loan Guaranties, Insurance, Stock(option on the firm's value)

2. Forward Contracts: Same as Option except the obligation (not right)

Ex. Currency Forward Markets

3. Futures Contracts: Same as Forward Contract except traded on Futures Exchange and subject to daily settlement procedure (mark-to-the market) (see p. 272, Table 8.2)

 A Futures Contract = A Series of One Day Forward Contracts Futures Contracts

A Series of Forward Contracts

4. Options on Futures: Same as Option with the Futures Contract as the underlying asset. 5. Swap: A contract in which 2 parties agree to exchange cash flows.

 A Swap = A Portfolio of Forward Contracts

Swap 0 1 2 3 5

Portfolio of Forward

Basic Concepts in Financial & Derivative Mkt (from Fin 340)

1. Risk Preference 2. Short Selling 3. Return & Risk (High Risk <=> High Return) Risk-free Rate = Rf R - Rf = risk premium = (Rm -Rf)

CAPM
Expected Rate of Return

Slope = required return/risk

Rf

Risk (beta )

Call Option Value @ Time T (maturity)

Call
CT

ST (Stock Price)

Put Option Value @ Time T (maturity)

Put
E

ST (Stock Price)

(High Risk <=> High Return) If & Only If Market Must Be Efficient Issue of Market Efficiency:
Current price reflects all relevant information. A market is efficient with respect to a set of information if it is impossible to make a NPV > 0 based upon that information

Note: Market Efficiency is only a hypothesis not a theory

Weak form Market Efficiency : Past Information Semi-strong form Market Efficiency: All Public Information Strong form Market Efficiency: All Information

Linkages Between Spot & Derivatives Mkts : 1. Arbitrage and the Law of One Price
Different location, service could result in different prices for the identical good. Arbitrage: zero investment zero risk with positive NPV No arbitrage => The Law of One Price (two identical goods cannot sell different prices, or the same risk should have the return)

2. Factors affect the price difference between spot and option and futures markets
Storage Delivery & Settlement (i.e., how to fulfill the contract)

The Role of Derivative Markets

1. Hedge Risk(i.e., Risk management) (add no risk into economy, risk transfer) 2. Provide Information (investor's future expectation etc.) 3. Operational Advantages (benefit to whole society)
a. Low transaction cost (compare to the spot market) b. Greater liquidity (large $ transaction) c. Easily sell short

4. Market Efficiency (because arbitrage opp.) 5. Speculation (Re-distribute wealth, neither create nor destroy wealth)

Chapter 2: The Structure of Options Markets

KEY CONCEPTS: Explanation of Puts & Calls Characteristics of Contracts Types of Option Traders Mechanics of Trading Options Exercise Procedure The Clearinghouse Reading Quotes Transaction Costs

Call (Put): A contract that the buyer has the right to buy (sell) an asset at a fixed price (i.e., exercise, striking, strike) before or at a specific date (i.e. the maturity date). Ex. Rain check, Loan guarantee, Callable Bond, Warrants The price of the option is called as Premium. American Option: Can exercise the right before or at the maturity date European Option: Only can exercise at the maturity date. Hedge = A strategy to protect an asset's value

From buyer's viewpoint if he (she) exercise his (her) option he (she) will be: In-the-money: if spot price (S) > exercise price (E) for call if S < E for put At-the-money: if S = E Out-of-the money:
if S < E for call, S > E for put

OTC Options Market

Advantage of OTC
1. No Standard terms (E, T, basket option (option on specific portfolio) etc.) 2. Private information 3. Unregulated

Disadvantage of OTC
1. Credit Risk 2. Large size of transaction exclude investors

Size of OTC: Underlying Value $76T with $2.1T Mkt Value in 12/2007 Total transaction contract Volume over $1B in 2004 Trading options on: bonds, interest rates, commodities, swap , foreign currency, and other

(Listing requirement CBOE):

(1) Profit before extraordinary > $1 MM in last 8 Quarters (2) More than 6,000 shareholders (3) More than 7 million shares must be owned by non-inside stockholder (4) Stock price must be greater than $10 in last 3 months (5) More than 2.4 million shares traded over last 12 months

Contract size of option: 1 stock option contract = 100 shares of stock

Note 1: number of shares/option and exercise price will be adjusted if there is a stock dividend. Ex. 20% stock dividend (with E0 = 55) => 1 option = 120 shares (after the stock dividend) and E1 = E0/1.2 = 45.875 (to nearest 1/8) Note 2: split (two for one) => get one option credit/option and exercise price reduce to half of it previous price Note 3: exercise price will not be adjusted for the cash dividend

Exercise price intervals: $ 2.5 intervals if S < $25 $ 5 intervals if $ 25 < S < $200 $ 10 intervals if $ 200 < S Note:Exercise price of index option is $5 intervals, yet exchange has the right to waive this rule.

Expiration Dates: The Sat. following the third Friday of

(1) January cycle: Jan, Apr, July,& Oct (2) February cycle: Feb, May, Aug, Nov (3) March cycle: March, June, Sep, Dec.
Note 1: Current, next, and next two months in the cycle. Note 2: WSJ covers only first 3 months Note 3: Since 1993, CBOE and AMEX offer up to three years option (Long Term Equity Anticipation Securities, LEAPS) Note 4: FLEX options(offered by CBOE) on stock indexes and permit the investors to specify the E, other contract terms, and expiration date T up to 5 yrs (FLEX options are a response the options in OTC)

Participates in Option Market 1. Seat: Membership in an exchange (cost about $875,000 in 2005, w/annual fee &5,400), Lease (a Seat): 0.5%-0.75%/month of Membership Price p. 35 2. Market maker(CBOE & PSE separate Broker & Dealer, But not in Amex & Phlx) Bid price: the purchase price of market maker Ask price: the selling price of market maker Spread = Ask price - Bid price

 3. Option traders (Spreaders):

a. Scalpers: hold a few minutes b. Position traders

4. Floor brokers (executes trade orders) 5. Order book officials (key in order in the
computer & execute the limit order)

Other Option Trading System (Amex & Phlx) (other Option exchanges see Table 2.1, p. 32) 6. Specialist (a market maker) 7. Registered option traders (a trader & a
broker)

Order (Same as in the Stock Mkt):

(1) (2) Market Order: The best price at the market. Limit Order: Buy or sell @ a specific price or better (a) good-till-canceled (b) day order (3) Stop(Loss) Order: Sell at the best available price (4) All or None Order (two different price): All or none, same price order (5) Offsetting Order: to close the position OCC: Options Clearing Corporation is the intermediary in each transaction to guarantee the writer's performance

Procedure of Transaction:(Similar to the Stock Mkt)

Buyer --> personal broker --> brokerage firm --> it's clearing firm (a member of OCC) --> OCC --> seller's clearing firm (a member of OCC) --> seller's brokerage firm --> personal broker --> Seller

Exercising Options: Delivery or Cash Settlement Note: 1n 1998 about 11% of call & 14% of put on the CBOE were exercised, and about 30% of call and 37% of put were expired Cash Settlement = (Index - E)x multiple Open interest = outstanding contracts Option price quotations: (see p.40)

 (1) Stock (equity) Options (2) Index Options: cash settlement & exercise at the end of the day, not at the time of the order(60% @ CBOE trading volume) (S&P 100(x100,A, Most widely traded). S&P 500(x100,E), MMI (x100(major mkt index 20 blue chip),A) . NASDAQ100 is Most Active Traded Index Option Note: Premium difference = 1/16 (if premium < 3) and = 1/8 (if premium 3)

Types of Options:

(3) Interest Rate Options (on bonds): T-bill, T-notes, T-bonds (popular in the OTC)
(4) Currency Option, Warrants, Convertible & Callable Bond (5) Options on Futures, Real Options (Option on

Bid-Ask Spread
Example:. If the market maker would buy (bid) @ $3 and sell (ask) @ $3.25, then the quotation is bid @ $3 and ask @ $3.25 and the spread ask-bid = $3.25-$3 =.$.25

Margin:
Buy option: pay full if T<9 Months. Borrow up to 25% if T>9 Months Sell uncovered option: Deposit = Premium + Margin + Adjustment. Margin requirement for selling a call = Max{.2(S)+C-max{0,ES}, .1(S)+C}x100 Example: S = $100 = E, C = $5, Total Deposit = $2,500 (why?) Margin requirement for selling a put = Max{.2(S)+P-max{0,SE}, .1(E)+P}x100 Ex. p.49 Margin on Index option is 15% (not 20%) of stock's value

Example: S = $100 = E, C = $5, Total Deposit = $2,500 (why?) Margin requirement for selling a call = Max{.2(S)+Cmax{0,E-S}, .1(S)+C}x100 Margin Requirement = Max{.2($100) + $5 - 0, 0.1($100)+$5}x100 = $2,500 If E = $105 Max{.2($100)+$5-max{$0,$105-$100}, 0.1($100)+ $5} x 100 = $2,000

Chapter 3: Option Pricing

KEY CONCEPTS:

Minimum Values of Options Maximum Values of Options Values of Options @ Expiration Effect of Time to Expiration on Option Prices Effect of Exercise Price on Option Prices
Lower Bound of European Options

Early Exercise & the Difference Between American & European Options Effect of Interest Rates on Option Prices Effect of Volatility of the Stock on Option Prices European & American Put-Call Parity

Notation:
Relax, it is only notations ! S: Stock price Not A Big Deal ! E: Exercise price T: Time to maturity (yearly base) r: Risk-free rate ST: Stock price @ maturity time T C(S,T,E,r,): Call price P(S,T,E, r,): Put price

Note:
T = # of days to the maturity/365, (annual)

Steps to Determine the Risk-free Rate r (see P. 56):

(1) Find the average T-bill rate = (bid + ask)/2 in the same month of maturity of option (2) Calculate # days to options maturity on the same month /360 (3) Find the T-bill price by 100-(1)x(2) = Y (4) Find the yield on T-bill = risk-free rate r by r = (100/Y)365/# of days to maturity of option -1

Example Ex. On x/21, T-bill quoted 5.59 & 5.63 mature on (x+1)/20. (1). (5.63+5.59)/2 = 5.61, (2). 29/360, (3). 100- 5.61(29/360) = 99.5481, (4). r =(100/99.5481)365/29 - 1= 5.866%

Call Option Pricing

S > Ca(S,E,T) > max {0, S-E} intrinsic value (Apply to American Call only). Ce (S,E,T) > Max(0, S-PV(E)) Example: S = $88, E = $85, then $3 = max{0,88-85} = intrinsic value = the minimum price of the call, while the maximum value of call = S Time (Speculative) Value = Ca - max{0,S-E}. Time Value = 0 at expiration.

 The Effect of Time to Maturity on Call Price C/ T > 0, (i.e., Time value decay when T decreases) Deep-in-the-$ if St - E is very high, Deep-out-of-$ if E-St is very high, both have low time value

The Effect of Exercise Price: C/E < 0 1. If E2 > E1 , then E2 -E1 > (E2 -E1 )(1+r) -T >
Ce(S,T,E1 ) - Ce(S,T,E2 ) or Ce(S,T,E1) < Ce(S,T,E2) + (E2-E1)(1+r)-T Ex. IBM Feb 95 (E1) call= $5.4 and Feb 100 (E2) call = $2.3 (on 1/18 Yahoo), E -E = 100-95 = 5 > 5.4-2.3=3.1

American Call Option Also Satisfies: E2 -E1 > Ca(S,T,E1) - Ca(S,T,E2) or Ca(S,T,E1) < Ca(S,T,E2) + E2 -E1 if E2 > E1 2. Ce(S,T,E) + E(1+r)-T > S (why?) American call > European call (why?) Note: If No dividend, then American call should not early exercise Because S-E < S - E(1+r)-T < Ce(S,T,E) < Ca(S,T,E) (alive) Note: Early exercise is likely if there is a dividend Because S-E could be > Ca(S-D,T,E) The Effect of Risk-free Rate on Call Option: C/r > 0 The Effect of Stock Volatility on Call Option: C/2> 0

Principles of Put Option Pricing 1. P(S,T,E) > 0, Pa(S,T,E) > Pe(S,T,E)

Pa(S,T,E) > Max{0,E-S} = intrinsic value of American put, and Pa(S,T,E) - Max{0,E-S} = time value 2. Max{0, E(1+r)-T -S} < Pe(S,T,E) < E(1+r)-T, Pa(S,T,E) < E 3. P(ST,0,E) = Max{0,E-ST} 4. The Effect of Time to Expiration: Pa/T > 0, Pe/T =? 5. The Effect of E: P/E > 0, E2-E1 > (E2-E1 )(1+r)-T > Pe(S,T,E2) - Pe(S,T,E1) > 0,

PV(E) - S < Pe

Payoff from Portfolio @ T Current Value A S ST<E ST ST>E ST

PV(E)-P

E-(E-ST) = ST

 Note: Pe(S,T,E) > Max{0,E(1+r)-T -S} Or if pay constant dividend D Pe(S,T,E) > Max{0,(E+D)(1+r)-T -S} = Max{0,PV(E)-[S-PV(D)]} 6. The Effect of Interest Rate: P/r < 0 7. The Effect of Stock Volatility: P/2 > 0 8. Put-Call parity: Pe = Ce - S + E(1+r)-T Put-Call Parity for American Options (see P.81),S=SPV(D)
Ca(S',T,E)+E +PV(D)> S'+Pa(S',T,E) > Ca(S',T,E)+E(1+r)-T

9. Early exercise of American put: if E-S = Pa(S,T,E) > Pe(S,T,E) = Ce(S,T,E)-S+E(1+r)-T or if Ce(S,T,E) < E[1-(1+r)-T] = PV(rE) => Early Exercise. A summary of this Chapter see p.88

Put Call Parity: Pe = Ce - S + E(1+r)-T

Payoff from Portfolio @ T Portfolio Current Value ST < E ST > E A Pe + S (E - ST) + ST 0 + ST

Ce+PV(E)

0+ E

(ST - E) +E

Same Future Cash Flow <=>Same Current Value

Chapter 4: Binomial Option Pricing Model KEY CONCEPTS:

The Binomial Model How Arbitrage Forces the Option Price to Equal the Price from the Binomial Model How the Hedge Is Constructed and Adjusted Through Time

Binomial Model Time 0 Time 0

1 Su

1 Cu

S Sd

Cd

Procedure to valuate C:
1. Find hedge ratio h= # stocks/option = C/S
=(Cu-Cd)/(Su-Sd ), where Su = S(1+u) and Sd=S(1+d)

2. Construct a risk-free portfolio consists of h of stocks and short one call option, its portfolio value V @ time 0 is V = hS C 3. @ time 1, (1+r)V = hSu -Cu = hSd - Cd Hence V = (hSd-Cd)/ (1+r), plug in V = hS - C @ time 0 to solve for C Alternative Method. C = [pCu + (1-p)Cd]/(1+r), where p = (r-d)/(u-d)

Example
S = $100, u = 30%, d = -20%, r = 10%, E = $110 Cu = $20, Cd = $0, h = (20-0)/(130-80) = .4 V = (.4x80-0)/1.1 = 29.09, C = .4x100 - 29.09 = $10.91 Or by the Alternative

p = [.1-(-.2)]/[.3-(-.2)] = .6 C = [.6(20) + 0(.4)]/1.1 = $10.91

What if C is not equal to $10.91?

Consider a hedged portfolio which consists of short of 100 call and long 40 stocks, the net worth V p @ time 0 is
Vp = 40($100) - 100($10.91) = $2,909 The net worth at time 1 is:

1. if Su = $130, Call value @ time 1 is $20,

then Vp = 40(130) -100(130-110) = 3,200 =(2,909)(1.1)

2. if Sd = $80, Call value @ time 1 is 0

then Vp = 40(80) = 3,200

 3. if C = $12 @ time 0, the Vp is

Vp = 40($100) - 100($12) =$2,800 @ time 1, the portfolio value is $3,200 (why) then the return of $2,800 investment is 3,200/2,800 -1 =14.286% > 10% of risk-free rate.

4. if C = $10, what is the rate of return on this portfolio?

@ time 0, Vp = 40($100) - 100($10) = $3,000 @ time 1, the portfolio value is $3,200 always (why?) the rate of return is $3,200/$3,000 - 1 = 6.667% < 10%

Two-Periods Binomial Model Suu Sud Sdu

Sdd

Su Sd Cu

Cuu C Cd Cud Cdu Cdd

Two-Period Binomial Model: Procedures to value a Call 1. Find the hedge ratios hu for up and hd for down at time 1
2. Create the risk-free portfolio consists of long h shares of stock and short one call. 3. Find the value of the risk-free portfolio's value V2 at time 2 given the stock value and the call option's value 4. Discount the risk-free portfolio value to time 1, and then find the call option value at time 1 for up and down respectively.

5.Go to step 1 to get call value at time 0.

Note: h = C/S, V = hS - C.

Alternative Method: Formula from the book(page 106)

Cu = [pCuu + (1-p)Cud]/(1+r)
Cd = [pCud + (1-p)Cdd]/(1+r) C = [pCu + (1-p)Cd]/(1+r) where p = (r-d)/(u-d)

Mispriced => Arbitrage Opportunity N-Periods Formula see p. 116

2-Periods Binomial Model: Example

hu = 30/30 = 1 V1 = 1Su-Cu=90 S = $100, E = $90, r = 10% C=1S-V=130-90/1.1 150 =130-81.82= 48.18

100

130 80
Cu 48.18 Cd 6.36

120 hd = 10/40 = 1/4 100

V1 = Sd/4 -Cd= 15 60 C=S/4-V=80/4-15/1.1 60 =20-13.64 = 6.36

C 28.593

30 h = 41.82/50 = .8364 10 V = hS -C = 60.552 1 d d 0 C = hS-V = 28.593

Pricing Put: 1.Put-Call parity

2.Following the same procedure as in the call a. Find the hedge ration hp = -P/S b. Create a risk-free portfolio consists of a put and long hp stock (because put and stock are perfectly negative correlated c. Find the risk-free portfolio value at time 1 given the value of stock and put by: V1 = hpSu + Pu d. Discounted the risk-free portfolio value back to time 0 and solve for P from the equation V0 = V1/ (1+r) = (h )S + P, I.e,. P = PV(V) - (h )S

Example:
V = hpS + P S = $100, Su = 130, Sd = $80, E = $110, Pu = 0, Pd = $30, r = 10%, hp = -(0-30)/(130-80) = .6 V1 = .6(130) + 0 = 78 = .6(80) + 30, V0 = V1/ (1+r)=78/1.1= 70.91, P = 70.91 - .6(100) = $10.91

American Options & Early Exercise

Replace Su by Su ' = Su - D & Sd by Sd ' = Sd - D [ Or S' = S - PV(D) ] in the Binomial Model. Note: In a two period model, replace the option's value by intrinsic value (i.e., early exercise) if the former is less than the later. Example. See p. 112

Chapter 5: Black and Scholes Model

Variables Influencing the Black-Scholes Model & the Effect of Changing those Variables Effect of Dividends on Black-Scholes Model Estimating the Risk-free Rate and Volatility Use of the Black-Scholes Model in Pricing Put

Black-Scholes Option Pricing Model: (p. 133) C = SN(d1) - Ee-rTN(d2) Easy? 2 [ln(S/E) + (r + /2)T] Yes where: d1 = , d2 = d 1 - T No? T
N(.) = cumulative normal distribution

= the annualized variance of the return on the stock

2

Example: S = 100, E = 105, r =5%, 2 = 9%, T = .36. d1 = [ln(100/105)+0.095x.36]/(.3x.6)=(-.04879+.0342)/.18= = -.081, d2 = -.081-.18 =-.261, N(-.081)=.4681, N(-.261)= =.3974, C=100(.4681) - 103.12691(.3974)=5.827366 see p. 135

B/S Call Option Value

Call Value

ST Upper Bound

ST - E
Intrinsic Value S

B/S Put Option Value

Put Value
E

Upper Bound

Intrinsic Value

Comparative Static of B/S model: C(S,T,E, ,r) 1. C/S = N(d1) > 0 : Delta
i.e., S increases $1 => C will increase approximately by $ (.4681 = ) Example. Delta hedge consists S and short one Calls is risk-free 2. C/E = -e-rTN(d2) < 0 i.e., E $1 => C $ C/ E Ex. 3. C/r = ETN(d2)e-rT > 0 : Rho i.e., increase 1% of r => increase $ of call Ex.

 4. -C/T =p. 158: Theta, C/T > 0 Ex. 5. (or ) C/ = STN'(d1) > 0: Vega (or Kappa, or Lambda) Ex. 6. () 2C/S2 = N'(d1)/(S T) > 0 :Gamma
the gamma => the difficulty to create a

risk-free portfolio (increase gamma increase delta)

A summary for put see Table 8, p. 169

B/S Model with Dividend:

Replace the S by the dividend-adjusted stock value SD in B/S Model. 1. Discrete Dividend: SD = S - De-rt, t is the time to the ex-dividend date Ex. See p. 154

2. Continuous Dividend:
SD = Se-T, = annual dividend yield EX: see p. 155

Estimate r & Note:

Continuously compound rate = ln (1+simple rate) ecompound rate = 1 + simple rate Should get the same present value no matter use continuous or discrete risk-free rate.

To Estimate the for using B/S Model:

 2 = (rci-rc)2/(n-1) Note:

1.

Historical volatility:

Annualized 2 = 2 (52) for weekly, (250) for daily, and (12) for monthly (see p. 158) Ex. (see Table 6, p.158-159), rc = ln(1+ri)

2.

Implied Volatility:

a. try-and-error (Fig 17, p. 162) b. T= 2)C/S if S=PV(E) (see. p.163 Brenner & Subrahmanyam) c. Short-cut by Manaster & Koehler see p.180 (Iteration method) d. T= N-1(C/S) - N-1[erT(- C/E)] = N-1(C/S) - N-1[(S C/ S) - C)/PV(E)] (Lai, Lee & Tucker (Journal of Financial Engineering1992))

A Formula to Compute ISD by Lai (2009)

Review of Pacific Basin Financial Markets and Policies

Let a = 4(S + K) - (S - K)ln(S/K), where K = PV(E) b = 2 2 (2C - S + K) c = 2[4(S - K) - (S + K)ln(S/K)]ln(S/K) b + b ac ) T= a 1 1 C T = 2N ( + ) @ PV ( E ) = S 2S 2

2

A Formula to Compute ISD by Lai (2009)

1 C T = 2 N ( ) 2 2S 1 1 C = 2N ( + ). 2S 2
1

(21)

ln( K 3 / K1 ) T= 1 C1 C 2 1 C 2 C3 2[ N ( ) N ( )] K 2 K1 K3 K2

Note:
The relationship among call, put, risk-free rate, stock see Fig 21, p. 175

Chapter 6: Basic Option Strategies

Basic Profit Equations for Stocks, Calls and Puts How the Choice of Exercise Price Enters into the Investor's Decision How to Determine the Profit & Breakeven for Different Option Strategies? How Maximum and Minimum Profits and Breakeven Stock Prices are Determined That the Writer's Position is the Mirror Image of the Buyer's Position How the Combination and Advanced Strategies are Merely Portfolios of Certain Basic Option Positions How Stock Positions are Protected with Short Calls or Long Puts Synthetic Puts and Calls and How Conversions and

Buy a Stock

Profit & Breakeven Determination for a Long/Short Call @ Time T (maturity)

Profit of Buying/Selling a Call Breakeven Point of Buying/Selling a Call
Profit -C+Max{0,ST-E}=CT-C

C 0 -C E

ST-C-E = Long a Call ST C+E-ST = Short a Call

C-Max{0,ST-E}=C-CT

Long a Stock, a Call, a Put & a Bond Profit

E-P 0 -C -S Long a Put
E

Long a Stock: ST-S Long a Call Long a Bond ST

-P+Max{0,E-ST}

Short a Stock, a Call, a Put & a Bond

Profit = C 0 P-E
P -Max{0,E-ST}

Short a Put ST Short a Bond

Short a Call Short a Stock

Note:
= -C+Max{0,ST-E}=CT-C for a Long Call, - for a Short Call = -P+Max{0,E-ST}=PT-P for a Long Put, - for a Short Put = -S + ST for a Long Stock, - for a Short Stock

Long Calls with Different Exercise Prices @ T Profit = -C +Max{0,ST-E}=CT-C

Long Calls ST-E-C 0 -C3 -C2 -C1 E1 E2 E3 ST

Short Calls with Different Exercise Prices @ T Profit = C - Max{0, ST -E}=C-CT

C1 C2 C3 0 E1

E2

ST E3 C+E-S Short Calls

Short Puts: Different Exercise Prices @ T

Profit = P - Max{0, E- ST}=P-PT P2 P1 0 P1 -E1 P2- E2 E1 E2 ST

Write Calls with Different Holding Periods

Profit C T2 T1 0 E T

ST

T1

T2

Covered Call = Long a Stock & Short a Call

Profit E+C-S C 0
E

Long a Stock Covered Call ST

Short a call C-S -S Short a Stock & Long a Call = Synthetic Put

Covered Call w/ Different Exercise Prices

Profit E2+C2-S E1+C1-S 0
E1 E2

Covered Call ST

Short a call C1-S C2-S Short a Stock & Long a Call = Synthetic Put

Covered Call w/ Different Holding Periods

Profit E+C-S 0 C-S
E

T1 < T T
T1

ST Short a call

Short a Stock & Long a Call = Synthetic Put

Short a Stock & Long a Call = Synthetic Put Synthetic Put = S-ST-C+Max{0,ST-E} =S-C-E+Max{0,E-ST}=S-C-E+Put S S-C 0 -C -P
E

Long a call

S-C-E

ST Actual Put Synthetic Put Short a Stock

Long a Stock & Long a Put ( =Synthetic Call=Protective Put)

Profit E-P Long a Put 0 E-P-S
-C

Long a Stock Synthetic Call Actual Call ST Long a Put

-S Synthetic Call = Protective Put = -S+ST-P+Max{0,E-ST} = E-P-S+Max{0,ST-E} = E-P-S + Call

Protective Puts w/ Different Exercise Prices Profit E1<E2 0

E2-S-P2 E1-S-P1 E1 E2

Buy a Stock & Buy a Put = Protective Put = Synthetic Call

Protective Puts w/ Different Holding Periods Profit

T1 T

E T1 <T

E-S-P

Buy a Stock & Buy a Put = Protective Put = Synthetic Call

Synthetic Call (Long a Stock and a Put) Profit of Buying a Stock and a Put = -S+STP+Max {0,E-ST} = -S-P+E+Max{0,ST-E} Profit of Buying a Actual Call = -C+ Max{0,S T-E} Cost of Synthetic Call at Beginning = -S-P Cost of Actual Call at Beginning = -C Put-Call Parity: S+P-C=PV(E), If Violates (Say <) [i.e., Actual Call is Overpriced or Synthetic Call is Under-priced] Then Buy Synthetic Call & Sell Actual Call (So Called Conversion)

Synthetic Put (Short a Stock and Long a Call) Profit of Selling a Stock and Buying a Call = S-S TC+Max{0,ST-E}=S-C-E+Max{0,E-ST} Profit of Buying a Put = -P +Max(0, E-S T} Cost of Synthetic Put @ Beginning= S-C Cost of Actual Put @ Beginning= -P Put-Call Parity: S-C+P=PV(E), If Violates (Say >) [i.e., Actual Put is Overpriced or Synthetic Put is Under-priced] Then Sell Actual Put & Buy a Synthetic Put (So Called Reversal)

Note:
Long a Call & Short a Stock = Synthetic Put Long a Put & Stock = Synthetic Call Conversion, Sell a Actual Call Buy a Synthetic Call Reverse Conversion, Buy a Synthetic Put & Sell an Actual Put

Chapter 7: Advanced Option Strategies KEY CONCEPTS 7

Basic Principles of Money Spreads and Combinations Difference Between Bull and Bear Spreads and the Types of Options that are More Appropriate for Each Relative Rates of Time Value Decay in a Calendar Spread Ratio Spread How Closing Position Prior to Expiration Affects Spreads, Straddles and Variations of Straddles Difference Between Straps and Strips versus Straddles and Why You Choose One Strategy Over Another How to Evaluate a Box Spread

A: Spreads: One Long & One Short Option 1. Vertical(or Money) Spread (Same T Different E)
Call Bull Spread Call Bear Spread Put Bull Spread Put Bear Spread

2. Horizontal Spread (Same E Different T)

1.Vertical Spread (Same T Different E) a. Call Bull Spread: Long a Call @E1 & Short a Call @ E2 (here E1 < E2) Profit
0 T1 T Holding Period

E2-E1+C2-C1 0 E1 -C1+C2 E2 ST

Call Bull Spread: Make $ in a Bull Market

a: Call Bull Spread Profit Determination :

= Max(0,ST-E1) - C1 - Max(0,ST - E2) + C2 = -C1 + C2 < 0 = ST - E1 - C1 + C2 if ST < E1 < E2 if E1 < ST < E2

= E2- E1 - C1 + C2 > 0 if E1 < E2 < ST Breakeven ( = 0) at ST = ?

b: Call Bear Spread: Long a Call @ E2 & Short a Call @ E1 Profit C1-C2 0 E2 E1 T1 ST T2 T
Call Bear Spread Make $ in a Bear Market

E1-E2+C1-C2
T1 T2 T

b: Call Bear Spread Profit Determination

= -Max(0,ST-E1) + C1 + Max(0,ST-E2) - C2 = C1 - C2 > 0 = - ST + E1 + C1 - C2 if ST < E1 < E2 if E1 < ST < E2

= E1 - E2 + C1 - C2 < 0 if E1 < E2 < ST

Breakeven, ST =E1+C1 - C2

The Spread Delta: Note:C(E1) C(E2), C(E1)/S C(E2)/S 0.

Call

C(E1)

C(E2)

E1

E2

ST

c: Put Money Spreads: Bull Spreads: Long a Put @ E1 & Short a Put @ E2 Bear Spreads: Long a Put @ E2 & Short a Put @ E1 why?

c:Put Money Spreads: Bull Spreads Profit

P2-Max{0,E2-ST}-P1+Max{0,E1-ST} = Profit Short a Put @ E2 E1 E2

E1-P1 P2-P1 E1-P1-E2+P2 P2-E2

ST
Long a Put @ E1

E1 < E2

Breakeven at ST=? Max Profit @ ST =? & Min Profit @ ST =?

d: Put Money Spreads: Bear Spreads Profit

E2-P2 E2-P2-E1+P1 P1-P2 P1-E1 E1 E2 Long a Put @ E2 Breakeven at ST=? Max Profit @ ST =? & Min Profit @ ST =? -P2+Max{0,E2-ST}+P1-Max{0,E1-ST} = Profit Short a Put @ E1

ST

e: Collars: Buy a stock & Buy a Put @ E1 , Sell a Call @

E2 , where E1 < E2 = ST-S0 +Max(0, E1 - ST)-P1- Max(0, ST - E2 ) + C2

=E1 S0-P1 + C2 < 0 = ST -S0 - P1 + C2

= E2 S0-P1 + C2 >0

if ST <E1< E2 if E1 < ST < E2 if E2 < ST

Break Even ?

E2 S0-P1 + C2 Collar ST -S0 - P1 + C2 E1 E1 S0-P1 + C2 -C1+C2 E2 ST -E1 - P1 + C2 Bull Spread

e: Butterfly Spreads: Short 2 Calls @ E2 , Long calls @

E1 & @ E3 , where E1 < E2 < E3 .
= Max(0, ST - E1 )-C1- 2Max(0, ST - E2 ) + 2C2 + Max(0, ST

- E3 ) - C3 = -C1 + 2C2 - C3 < 0 = ST - E1 - C1 + 2C2 - C3

= - E1 + 2 E2 - E3 - C1 + 2C2 - C3

if ST <E1< E2 if E1 < ST < E2 if E3 < ST

= - ST + 2 E2 - E1 - C1 + 2C2 - C3 if E2 < ST < E3

Butterfly Spreads
Profit
T Short 2 Middle Calls & Long a Low and a High Call Each 0 T1 T E3

E1

E2

ST
T1

-C1 + 2C2 - C3

-E1 + 2 E2 - E3 - C1 + 2C2 - C3

Breakeven = 0, ST = ?, Min Profit @ S =? & Max Profit @ ST = E2 why? = ?

2. Horizontal (Calendar) Spread:Same E Different T

Long A Longer Maturity Call & Short A Shorter Maturity Call (Different Time Values). Profit T

0
0

T1 E T1 T

ST

The Time Value Decay Time Value

0 t T

Longer Maturity Call Spread Shorter Maturity Call 0 T- t

Time to Maturity

Ratio Spreads: long N1 call @ C1 and N2 call @ C2 (Applies to Money or Calendar Spread)
Find N1 and N2 such that this portfolio value V is risk-free to Stock, where V = N1C1 + N2C2, i.e., Solve for N1/N2 = -(C2/S)/(C1/S) < 0, so ratio spread is N1 long @ C1 and N2 short @ C2. Ex. see p.241

End of Spread

Straddles: Long A Call and A Put @ the Same E & T

(to capitalize the volatility of stock in two sides) = Max(0, ST - E) - C + Max(0, E - ST ) - P = ST - E - C - P = E - ST - C - P if ST > E if ST < E

Straddles
Profit
= 0 @ ST=?

E Straddle (Long a Calls & a Put)

ST

a. Straps: Long 2 Calls & One Put (bet market will go up)
= 2 Max(0, ST - E) - 2C + Max(0, E - ST ) - P = 2ST - 2E - 2C - P = -2C + E - ST - P if ST > E if ST < E

Breakeven @ ST such that = 0 (2 solutions) Where is the minimum of ?

Straps
Profit Straddle (Long a Call & a Put)

E Strap (Long 2 Calls & a Put)

ST

b. Strips: Long 2 Puts & One Call (bet market will go down)
= Max(0, ST - E) - C + 2Max(0, E - ST ) - 2P = ST - E - C - 2P = -C + 2E - 2ST - 2P if ST > E if ST < E

There are 2 Breakeven points, where ? Where is the minimum of ? When the of Straddle = the of Strip (or Strap)? Profit on Short the Straddle, Strip, Strap ?

Strips
Profit Straddle (Long a Call & a Put)

E Strip (Long 2 Puts & a Call)

ST

Strangle Buy a Call @ E2& a Put @ E1

E1

E2

c.

Box Spreads:Long One Call & Short One Put @ E1 & Short one Call & Long One Put @ E2

= Max(0,ST-E1) - C1 - Max(0, ST -E2) + C2 + Max(0, E2 - ST) - P2 - Max(0, E1 - ST) + P1 = E2 - E1 - C1 + C2 -P2+P1 (risk-free, check) From put-call parity @ E1 and @ E2 are S = C1 -P1+ PV(E1) S = C2 -P2+ PV(E2) PV(E2 - E1) = (C1 - C2) - (P1-P2) = Cost of Box Spread

Box Spread=Bull Call + Bear Put

Exotic Options (p.501):For Fun

A Variety of Complex Options (Created by Financial Engineers) are Collectively Called as Exotic Options Plain Vanilla Options Depends on S,T,E,r, and . Forward-Start Options: Price of Option is Paid at Present, But the Life of the Option Starts at a Future Date (Grant Date). (@-the-$ when Options Life Starts). Eg., Stock Options

 Compound Options: Option on Option (i.e., The Underlying Good is Option (Call or Put, eg., Call on Call, or Call on Put, Put on Call, Put on Put) Chooser Options (As-You-Like-It Option): Owner has the Right to Determine Whether the Chooser Option Will Become a Call or Put by a Specified Choice Date. After the Date, Chooser Option=Plain Vanilla Option Barrier Options: In Option and Out Option. In Barrier Option Has No Value Until the S Touches a Certain Barrier Price and the In Barrier Option Becomes a Plain Vanilla Option. Out Option is Vanilla Option Except S Penetrates the Stated Barrier and the Option is Expired Worthless Immediately.

 8 Types of Barrier Options: Down-and-In Call (Put), Up-and-In Call (Put), Down-and Out Call (Put), Upand-Out Call (Put) Barrier Options May Also Pay a Rebate (Booby Prize). The Rebate is Paid Immediately when The Barrier is Hit and the Option Passed out of Existence for Out Barrier Option. The Rebate Is Paid if the Option Expires without ever Hitting the Barrier Price.

5 Payoffs for Down-and-In Call

1. Barrier ST E; Payoff= ST - E 2. ST Barrier E, &Barrier was Touch, Payoff=ST -E 3. ST Barrier E, & Barrier was Never Touched, Rebate 4. ST E Barrier, &Barrier was Touch, Payoff=ST -E 5. ST E Barrier, & Barrier was Never Touched, Rebate

Binary Options (All or Nothing): Payoffs are not

Continuous. Either 0 or a Considerable Amount Cash-or-Nothing Call:. Pay Nothing if ST < E and Pay Fixed Amount of Cash if ST E . (Reverse for Put) Asset-or-Nothing (Pay Underlying Asset or Nothing) Supershares: Get Pay only if Market Value is between Lower and Upper Bound. Eg., Payoff= ST/ELif ELS EU ; 0

 Lookback Options: Max{0, ST-Min[St, St+1, St+2, , ST]} for Call Purchased @ t Mature @ T For Put: Max{0, Max[St, St+1, St+2, , ST)-ST]} for Put Purchased @ t Mature @ T Average Price Options (Asian Option: Offered by Bankers Trust was the 1st to Offer such Products in Tokyo Office). Payoff=Average of the S t, t=tT Exchange Options: Option to Exchange one Asset for Another Rainbow Options: Options on 2 Risky Assets (# of Risky Assets =# of Colors in the Rainbow) 1. Call on the Best of 2 Risky Assets & Cash (No Exercise Price): 3 Choices @T, Risky Asset 1, Risky Asset 2, Fixed Cash Amount

 http//www.hedgestreet.com http//www.intrade.com

 Call on Maximum of 2 Risky Assets w/Exercise Price E. Payoff= Max {S1T, S2T, E}-E Call on the Better of 2 Risky Assets (a Special Case of a Call on 2 Risky Assets & Cash) with Cash=0 Call on Minimum of 2 Risky Assets: Payoff=Max{0, Min(S1T, S2T)-E} Call on the Worse of 2 Risky Assets, Payoff= Min(S1T, S2T) Put On the Maximum of 2 Risky Assets, Payoff=Max{0, E-Max (S1T, S2T)} Put on the Minimum of 2 Risky Assets Payoff=Max{0, E-Min(S1T, S2T)}