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Liuren Wu
Zicklin School of Business, Baruch College
Options Markets
Liuren Wu (Baruch)
Payos
Options Markets
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More terminologies
Moneyness: the strike relative to the spot/forward level An option is said to be in-the-money if the option has positive value if exercised right now:
St > K for call options and St < K for put options. Sometimes it is also dened in terms of the forward price at the same maturity (in the money forward): Ft > K for call and Ft < K for put The option has positive intrinsic value when in the money. The intrinsic value is (St K )+ for call, (K St )+ for put. We can also dene intrinsic value in terms of forward price.
An option is said to be at-the-money spot (or forward) when the strike is equal to the spot (or forward).
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More terminologies
The value of an option is determined by the current spot (or forward) price (St or Ft ), the strike price K , the time to maturity = T t , the option type (Call or put, American or European), and the dynamics of the underlying security (e.g., how volatile the security price is). Out-of-the-money options do not have intrinsic value, but they have time value. Time value is determined by time to maturity of the option and the dynamics of the underlying security. Generically, we can decompose the value of each option into two components: option value = intrinsic value + time value.
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Stocks (OMON) Stock indices Index return variance (new) Exchange rate (XOPT) Futures
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Expiration date (T ) Strike price (K ) European or American Call or Put (option class) OTC options (such as OTC options on currencies) are quoted dierently.
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Market makers nowadays all have automated systems to update their quotes, and calculate their optimal hedging ratios. Options market makers are no longer individual persons, but are well-capitalized rms.
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Liuren Wu (Baruch)
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Margins
Margins are required when options are sold/written. When a naked option is written the margin is the greater of: A total of 100% of the proceeds of the sale plus 20 % of the underlying share price less the amount (if any) by which the option is out of the money A total of 100% of the proceeds of the sale plus 10% of the underlying share price. For other trading strategies there are special rules
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Payos
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Payos
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Payos
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Long a call pays o, (ST K ) , bets on index price going up. Shorting a call bets on index price going down.
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Liuren Wu (Baruch)
Payos
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Review the forward pricing formula: Ft ,T = St e (rd rf )(T t ) . rf = rd T 1 t ln(Ft ,T /St ) = .05 ln(1.61/1.6285)/1 = 6.14%. Recall covered interest rate parity: Annualized forward return ( T1 t ln(Ft ,T /St )) on exchange rates equals interest rate dierential (rd rf ) between the two currencies. Long a put option pays o, (K ST )+ , and bets on the underlying currency (pound) depreciates. Shorting a put option bets on pound appreciates. How does it dier from betting using forwards?
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0.2 0.1 0 0.1 0.2 0.3 0.4 0.5 1 1.2 1.4 1.6 Spot at expiry, ST 1.8 2
0.2 0.1 0 0.1 0.2 0.3 0.4 0.5 1 1.2 1.4 1.6 Spot at expiry, ST 1.8 2
0.5 0.4
0.3 0.2 0.1 0 0.1 0.2 0.3 0.4 0.5 1 1.2 1.4 1.6 Spot at expiry, ST 1.8 2
0.2 0.1 0 0.1 0.2 0.3 0.4 0.5 1 1.2 1.4 1.6 Spot at expiry, ST 1.8 2
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20 15 10 5 0 5 10 15 20 80 20 15 10 5
Payoff
0 5 10 15 20 80 20 15 10 5
100 95 90 85 80 80 80 85 90 95
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Liuren Wu (Baruch)
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Put-call conversions
Plot the payo function of the following combinations of calls/puts and forwards at the same strike K and maturity T .
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20 15 10 5 0 5 10 15 20 80
Payoff
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20 15 10 5 0 5 10 15 20 80
0 5 10 15 20 80
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20 15 10 5
Payoff Payoff
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20 15 10 5 0 5 10 15 20 80
Payoff
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20 15 10 5 0 5 10 15 20 80
0 5 10 15 20 80
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The dash and dotted lines are payos for the two composition instruments. The solid lines are payos of the target.
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Liuren Wu (Baruch)
Payos
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Call and put at the same maturity & strike (T , K ) have the same time. Most option pricing models only deal with the time value, and take the forward (nancing) and hence intrinsic value as given (starting point). To estimate these option pricing models, one only needs to use the time value at each (T , K ), which is the out-of-the-money option (call when Ft < K and put otherwise). Normally, the out-of-the-money option is more actively traded, possibly for the same reason. Most professional options traders are trading the time value only.
Liuren Wu (Baruch)
Payos
Options Markets
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In the absence of forward, use spot and bond: Can you use a spot and bond to replicate a forward payo? Whats the payo function of a zero bond?
Liuren Wu (Baruch)
Payos
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Payoff
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Can you generate the above payo structure (solid blue line) using (in addition to cash/bond): two calls two puts a call, a put, and a stock/forward Who wants this type of payo structure?
Liuren Wu (Baruch)
Payos
Options Markets
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20 15 10 5 0 5 10 15 20 25 85 90 95 100 105 Spot at expiry, ST 110 115 120 30 80 85 90 95 100 105 Spot at expiry, ST 110 115 120
Payoff
5 0 5 10 15 20 80
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Liuren Wu (Baruch)
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Payoff
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How many (at minimum) options do you need to replicate the bear spread? Do the exercise, get familiar with the replication. Who wants a bear spread?
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Example: Straddle
30 25 20 15
Payoff
10 5 0 5 10 80
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How many (at minimum) options do you need to replicate the straddle? Do the exercise, get familiar with the replication. Who wants long/short a straddle?
Liuren Wu (Baruch)
Payos
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Example: Strangle
40 35
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Payoff
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10 80
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How many (at minimum) options do you need to replicate the strangle? Do the exercise, get familiar with the replication. Who wants long/short a strangle?
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Payoff
How many (at minimum) options do you need to replicate the buttery spread? Do the exercise, get familiar with the replication. Who wants long/short a buttery spread?
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Payos
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Payoff
Payoff
How many (at minimum) options do you need to replicate the risk reversal? Do the exercise, get familiar with the replication. Who wants long/short a risk reversal?
Liuren Wu (Baruch)
Payos
Options Markets
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Payoff
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How many options do you need to replicate this quadratic payo? You need a continuum of options to replicate this payo. The weight on each strike K is 2dK . Who wants long/short this payo? The variance of the stock price is E[(ST Ft ,T )2 ]. Variance swap contracts on major stock indexes are actively traded.
Liuren Wu (Baruch)
Payos
Options Markets
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(K )(K ST )+ dK (K )(ST K )+ dK
What does this formula tell you? With bonds, forwards, and European options, we can replicate any terminal payo structures. More exotic options deal with path dependence, correlations, etc. You do not need to memorize the formula. Proof: Optimal positioning in derivative securitiesby Carr and Madan, Quantitative Finance, 2001. Can you reconcile this formula with my tips on using calls alone, or puts alone to replicate any payos? Can you provide some tips (suggested steps) to replicate any payos using out-of-the-money options only (plus cash & forwards)? Code them up and see if they work.
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Replication applications
Replicate the return variance swap using options and futures. Variance risk premiums, RFS, 2009, 22(3), 1311-1341. Based on the replication idea, think of ways to summarizing the information in the options market. Information Information Information Information Examples: Price discovery in the U.S. stock and stock options markets: A portfolio approach, Review of Derivatives Research, 2006, 9, 3765. Jianfeng Hu. Put-call parity violations and stock returns Caveat: Far out-of-the-money options may not be actively traded. Quotes may not be reliable. Example: ATM volatility versus synthetic variance swap.
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the directional movement of the underlying. return variance. large movements of a certain direction. large movements of either direction.