Chapter 17 OPTIONS

The Upside Without the Downside

Outline
Terminology Options and Their Payoffs Just Before Expiration Option Strategies Factors Determining Option Values

Binomial Model for Option Valuation

Black-Scholes Model

Equity Options in India

Terminology
Call and put options
Option holder and option writer Exercise price or striking price Expiration date or maturity date European option and American option Exchange-traded options and otc options At the money, in the money, and out of the money options Intrinsic value of an option Time value of an option

Index Option On S & P CNX Nifty

Contract size 200 times s & p cnx nifty

Type
Cycle

European
upto five years

Expiry day
Settlement

last Thursday expiry month

cash - settled

Quotations of Nifty Options

Contracts (Type. Stk. Price Expiry) CE-5250.00 Oct CE-5300.00 Oct CE-5350.00 Oct CE-5400.00 Oct CE-5450.00 Oct CE-5150.00 Nov CE-5200.00 Nov CE-5300.00 Nov CE-5350.00 Nov CE-5400.00 Nov CE-5000.00 Dec CE-5200.00 Dec PE-4700.00 Oct PE-4750.00 Oct PE-4800.00 Oct PE-4850.00 Oct PE-4900.00 Oct PE-4300.00 Nov PE-4400.00 Nov PE-4500.00 Nov PE-4600.00 Nov PE-4700.00 Nov PE-4800.00 Nov PE-4900.00 Dec PE-5000.00 Dec Open 130.00 110.00 85.00 70.00 40.00 189.00 218.20 176.20 121.00 130.00 400.00 201.00 33.00 55.50 40.05 74.00 65.00 40.80 59.95 73.95 85.00 119.90 98.00 224.00 289.00 Premium (Rs.) High 130.00 110.00 90.00 74.00 50.00 189.00 218.20 176.20 139.95 130.00 400.00 296.00 54.00 63.00 74.95 90.00 109.90 40.80 72.00 93.00 117.90 128.95 162.00 225.00 299.00 Low 60.00 45.00 32.05 25.25 18.00 189.00 169.00 132.05 121.00 89.00 300.00 201.00 33.00 47.00 40.05 66.00 63.00 38.00 59.95 73.95 85.00 115.00 98.00 221.00 245.00 Close 65.90 53.55 42.65 29.55 22.80 189.00 187.60 142.95 139.95 89.65 310.15 296.00 46.85 51.05 62.00 77.25 92.40 38.15 69.00 81.20 100.00 121.60 150.00 222.25 245.00 Open Int (000) 313 907 15 425 174 1 208 194 0 13 0 1 1772 57 1902 158 1872 43 17 404 121 108 106 1 0 No. of Cont 3419 15357 214 7989 2897 1 306 584 3 93 3 5 9551 135 12647 160 19661 100 46 606 241 61 309 9 4

Options On Individual Securities

Contract size Type Trading cycle Expiry Strike price not less than Rs.200,000 at the time of introduction American Maximum three months Last Thursday of the expiry month The exchange shall provide a minimum of five strike prices for every option type (call & put) 2 (itm), 2 (otm), 1 (atm) Base price on introduction theoretical value as per b-s model

Base price

Exercise

All itm options would be automatically exercised by NSCCL on the expiration day of the contract
Cash-settled

Settlement

Quotations of Nifty Options (Bharti Airtel)

Contracts Premium (Rs.) High 45.5 5.80 Low 35 4.00 Close 35.95 5.45 Open Int (000) 140 412 No. of Contr 42 521

(type, Stk Price- Open expiry) CE-360-Feb PE-360-Feb 42 5.30

Source: The Economic Times February 4,2012

Option Payoffs
Payoff of a call option
Payoff of a call option

E (Exercise price) Stock price

Pay off of a put option

Payoff of a put option

E (Exercise price)

Stock price

Payoffs To The Seller Of Options

Payoff

E Stock price

(a) Sell a call

Payoff

E Stock price

(b) Sell a put

Options
Buyer/Holder
Rights/ Obligations Call Put Premium Buyers have rightsNO OBLIGATIONS Right to buy/to go long Right to sell/ to go short Paid

Seller/Writer
Sellers have only Obligations-No Rights Obligation to sell/go short on exercise Obligation to buy/go long on exercise Received

Exercise
Max. Loss possible Max. Gain possible Closing position of exchange traded

Buyers decision
Cost of premium Unlimited profits Exercise Offset by selling option in market Let option lapse worthless

Seller cannot influence

Unlimited losses Price of premium Assignment of option Offset by buying back option in market Option expires and keep the full premium

Put Call Parity Theorem - 1

Value of stock

Buy stock

position (S1) E-

Value of put position (P1)

Buy put

Stock price (S1) Value of combination

Stock price (S1)

Buy a stock (S1) Combination (buy a call) C1= S1+ P1-E Stock price (S1) Borrow (-E)

Value of borrow position (-E) E

Buy a put (P1)

Stock price (S1) -E ---------------------------------------

-E

Put Call Parity Theorem-2

If C1 is the terminal value of the call option C1 = Max [(S1 - E), 0]

P1 = Max [(E - S1 ), 0]
S1 = Terminal value

E = Amount borrowed
C1 = S1 + P1 - E

Exotic Options
Asian Options: Asian options are options whose payoffs depend on the average price of the underlying asset during some portion of the life of the option. Barrier Options: The payoff of a barrier option depends not only on what the price of the underlying asset is at the time of option expiration but also on whether the price of the underlying asset has crossed some barrier. Binary Options: A binary option provides a fixed payoff, depending on the fulfillment of some condition. Lookback Options: The payoff of a lookback option depends on the maximum or minimum price of the underlying asset during the life of the option.

Option Strategies Protective PUT

PROFITS STOCK PROTECTIVE PUT

ST
S0 = X

-P - S0

Option Strategies Covered Call

A. Stock

B. Written Call

Payoff C. Covered Call

Option Strategies Straddle

Long Straddle : Buy a Call as Well as a Put Same exercise Price
A : CALL PAYOFF AND PROFIT B : PUT PAYOFF AND PROFIT

PAYOFF PROFIT

PAYOFF ST

ST PROFIT C : STRADDLE PAYOFF AND PROFIT PAYOFF PROFIT P+C X ST

Option Strategies Spread

A spread involves combining two or more calls (or puts) on the same stock with differing exercise prices or times to maturity
Payoff and profit of a vertical spread at expiration
A : CALL HELD PAYOFF B : CALL WRITTEN PAYOFF

ST

ST

PAYOFF AND PROFIT PAYOFF PROFIT X1 ST X2

Collar
A collar is an options strategy that limits the value of a portfolio within two bounds An investor who holds an equity stock buys a put and sells a call on that stock. This strategy limits the value of his portfolio between two pre-determined bounds, irrespective of how

the price of the underlying stock moves

Strategies with Stock Index Options

You can use stock index options the way you use individual stock options:
If you expect the market to rise, buy calls on the stock index. If the market does rise, the gain from your calls can be substantial, far greater than the premium paid for the calls. If you expect the market to fall, buy puts on the stock index. If the market does fall, the gain from your puts can be considerable, far greater than the premium paid for the puts. If you own a diversified portfolio of stocks, you can hedge your position by buying puts on the stock index. If the market falls, the erosion in your portfolio value will be offset by the gains on the stock index puts. In effect, you are buying a form of market insurance. Of course, if your portfolio is not perfectly correlated with the market index, you may not achieve complete protection against market decline. As long as your portfolio is adequately diversified with the market index, you will achieve substantial protection against market decline.

Option Value: Bounds

Upper and Lower Bounds for the Value of Call Option

VALUE OF CALL OPTION

UPPER BOUND (S0)

LOWER BOUND ( S0 E)

STOCK PRICE 0 E

Factors Determining The Option Value

Exercise price

Expiration date
Stock price

Stock price variability

Interest rate C0 = f [S0 , E, 2, t , rf ] + - + + +

Variability and Call Option Value

So fundamental is this point that it calls for another illustration. Consider the probability distribution of the price of two stocks, P and Q, just before the call option (with an exercise price of 80) on them expires. P Probability 0.5 0.5 Q Price 50 90 Probability 0.5 0.5

Price 60 80

While the expected price of stock Q is same as that of stock P, the variance of Q is higher than that of P. The call option (exercise price: 80) on stock P is worthless as there is no likelihood that the price of stock P will exceed 80. However, the call option on stock Q is valuable because there is a distinct possibility that the stock price will exceed the exercise price.

Variability and Call Option Value

Remember that there is a basic difference between holding a stock and holding a call option on the stock. If you are a risk-averse investor you try to avoid buying a high variance stock, as it exposes you to the possibility of negative returns. However, you will like to

buy a call option on that stock because you receive the profit from
the right tail of the probability distribution, while avoiding the loss on the left tail. Thus, regardless of your risk disposition, you will find

a high variance in the underlying stock desirable.

Basic Idea
The standard DCF (discounted cash flow) procedure involves two steps, viz. estimation of expected future cash flows and discounting of these cash flows using an appropriate cost of capital. There are problems in applying this procedure to option valuation. While it is difficult (though feasible) to estimate expected cash flows, it is impossible to determine the opportunity cost of capital because the risk of an option is virtually indeterminate as it changes every time the stock price varies.
Since options cannot be valued by the standard DCF method, financial economists struggled to develop a rigorous method for valuing options for many years. Finally, a real breakthrough occurred when Fisher Black and Myron Scholes published their famous model in 1973. The basic idea underlying their model is to set up a portfolio which imitates the call option in its payoff. The cost of such a portfolio, which is readily observed, must represent the value of the call option. The key insight underlying the Black and Scholes model may be illustrated through a single-period binomial (or two-state) model.

Binomial Model
Option Equivalent Method - 1
A single period binomial (or 2 - state) model S can take two possible values next year, uS OR dS (uS > dS) B can be borrowed .. or lent at a rate of r, the risk-free rate .. (1 + r) = R d < R > u E is the exercise price Cu = Max (u S - E, 0) Cd = Max (dS - E, 0)

Binomial Model
Option Equivalent Method - 1
Portfolio Shares of the stock and B rupees of borrowing Stock price rises : uS - RB = Cu Stock price falls : dS - RB = Cd = Cu - Cd = Spread of possible option price

S (u - d)
B =

Spread of possible share prices

dCu - uCd (u - d) R

Since the portfolio (consisting of shares and B debt) has the same payoff as that of a call option, the value of the call option is C = S - B

Illustration
S = 200, u = 1.4, d = 0.9 E = 220, r = 0.10, R = 1.10
Cu = Max (u S - E, 0) = Max (280 - 220, 0) Cd = Max (dS - E, 0) = Max (180 - 220, 0) = 0 = Cu - Cd = (u - d) S dCu - uCd B = (u - d) R = 0.5 (1.10) 0.5 (200) 0.9 (60) = 98.18 60 = 0.6 = 60

0.6 of a Share + 98.18 Borrowing 98.18 (1.10) = 108 Repayt Portfolio When u occurs When d occurs 1.4 x 200 x 0.6 - 108 = 60 0.9 x 200 x 0.6 - 108 = 0 C = S - B = 0.6 x 200 - 98.18 = 21.82 Call option Cu = 60 Cd = 0

Binomial Model Risk-Neutral Method

We established the equilibrium price of the call option without knowing anything about the attitude of investors toward risk. This suggests alternative method risk-neutral valuation method

1. Calculate the probability of rise in a risk neutral world

2. Calculate the expected future value .. option
3. Convert .. it into its present value using the risk-free rate

Pioneer Stock
1. Probability of rise in a risk-neutral world
Rise 40% to 280 Fall 10% to 180

Expected return = [Prob of rise x 40%] + [(1 - Prob of rise) x - 10%]

= 10% p = 0.4

2. Expected future value of the option Stock price Stock price

Cu = Rs. 60 Cd = Rs. 0

0.4 x Rs. 60 + 0.6 x Rs. 0 = Rs. 24

3. Present value of the option Rs. 24 = Rs. 21.82 1.10

Black-Scholes Model
E
C0 = S0 N (d1) ert N (d) = Value of the cumulative normal density function ln S0 E + 1 r + 2 2 t t N (d2)

d1 =
d2 = d1 - t

r = Continuously compounded risk - free annual interest rate

= Standard deviation of the continuously compounded annual rate of return on the stock

Black-Scholes Model
Illustration
S0 = Rs.60 t = 0.5 Step 1 : Calculate d1 and d2 ln d1 = S0 E + 2 r + 2 t E = Rs.56 = 0.30 r = 0.14

t .068 993 + 0.0925 = 0.7614 0.2121

d2 = d1 - t = 0.7614 - 0.2121 = 0.5493 Step 2 : Step 3 : N (d1) = N (0.7614) = 0.7768 N (d2) = N (0.5493) = 0.7086 E = ert Step 4 : e0.14 x 0.5 56 = Rs. 52.21

C0 = Rs. 60 x 0.7768 - Rs. 52.21 x 0.7086 = 46.61 - 37.00 = 9.61

The simplest way to find N(d1) and N(d2) is to use the Excel function NORMSDIST. N(d1) = N (0.7614) = 0.7768 N(d2) = N (0.5493) = 0.7086 If you dont have easy access to the excel function NORMSDIST, you can get a very close approximation by using the Normal Distribution given in Table A.5 in Appendix A at the end of the book. The procedure for doing that may be illustrated with respect to N (0.7614) as follows
1. 2. 3. 0.7614 lies between 0.75 and 0.80. According to the table N (0.75) = 1 0.2264 = 0.7736 and N (0.80) = 1 0.2119 = 0.7881 For a difference of 0.05 (0.80 0.75) the cumulative probability increases by 0.0145 (0.7881 0.7736) The difference between 0.7614 and 0.75 is 0.0114 So, N (0.7614) = N (0.75) + 0.0114 x 0.0145 0.05 = 0.7736 + 0.0033 = 0.7769

Step 2: Finding N(d1) and N (d2)

4. 5

This value is indeed a close approximation for the true value 0.7768.

Sources of Discrepancy
Suppose the observed call price in the above example were Rs. 12 rather than Rs. 9.61 does it mean that the market has mispriced the option? Before jumping to such a conclusion, let us look at two possible sources of discrepancy.
First, the Black-Scholes model, like all models, is based on certain simplifying assumptions which may not be satisfied in the real world. That makes the formula only approximately valid. Second, the parameters used in the formula may not be accurately measured. Recall that there are five parameters in the model: SO, E, r, , and t. Out of these, SO, E, r, and t the stock price, the exercise price, the risk-free interest rate, and the time to expiration are given accurately as they are directly observable. (the standard deviation), however, is not directly observable and must be estimated by relying on historical data, or scenario analysis, or some other method. An error in estimating the standard deviation can result in a discrepancy between the price of an option and its Black Scholes value.

Assumptions
The call option is the European option
The stock price is continuous and is distributed log normally There are no transaction costs and taxes There are no restrictions on or penalties for short selling The stock pays no dividend The risk-free interest rate is known and constant

Implied Volatility
Indeed, market participants often look at an option valuation from a different angle. Instead of calculating a Black-Scholes option value using a given standard deviation, they ask: What standard deviation justifies the observed option price, according to the BlackScholes formula? This is referred to as the implied volatility of the option as this is the volatility level implied by the prevailing option price. If investors believe that the actual standard deviation is more (less) than the implied volatility, than the options fair price is deemed to be greater (lesser) than its observed price. Another variant of this theme is to compare two options on the same stock with the same expiration date but different exercise prices. It makes sense to buy the option with the lower implied volatility and write the option with the higher implied volatility.

Volatility Index
The recently announced volatility index or VIX on the NSE an indication of investor perception of future volatility was inspired

by CBOEs VIX. It is a measure of the amount by which an

underlying index is expected to fluctuate in the near future (calculated as annualised volatility, denoted in percentage for instance 20%) based on the order book of the underlying index options. India VIX is based on option prices of components of the

Nifty 50 Index.

Replicating Portfolio for Calls and Puts

Replicating Portfolio
Option Position
Buy Call Option

Binomial Model Borrow B

Black Scholes Model Borrow Eert N (d2)

Sell Call Option

Buy shares of stock Buy N (d1) shares of stock Lend B Lend Eert N (d2) Sell short shares Lend B Sell short shares Borrow B Buy shares Sell short N (d1) shares Lend Eert (1 N (d2)) Sell short (1 N (d1)) shares Borrow Eert(1 N (d2)) Buy (1 N (d1)) shares

Buy Put Option

Sell Put Option

Adjustment For Dividends Short-Term Options

Divt (1 + r)t E Value of call = S N (d1) S E N (d2) ert 2 2

Adjusted stock price =

ln
d1 =

+
t

r +

Adjustment For Dividends 2 Long-Term Options

C = S e -yt N (d1) - E e -rt N (d2)
ln d1 d2
The adjustment

S E

r-y +

2 2

= = d1 - t

Discounts the value of the stock to the present at the dividend yield to reflect the expected drop in value on account of the dividend payments
Offsets the interest rate by the dividend yield to reflect the lower cost of carrying the stock

Put Call Parity - Revisited

Just before expiration C1 = S1 + P1 - E S0 + P0 - E e -rt

If there is some time left C0 =

The above equation can be used to establish the price of a put option & determine whether the put - call parity is working

Value of a Put Option

You can calculate the value of a put option by first calculating the value of a call option and using the put-call parity relationship. An example may be given to show how this is done. Let us assume the following: Stock price = Rs. 60 Exercise price = Rs. 50 Risk free rate = 8% Time of expiration = 3 months (t = 0.25) Standard deviation = s = 0.4 What is the value of the put using the same information? The value of the call option is calculated as follows: Step 1: Calculate d1 and d1

60 d1 = ln + 50 0.08 +

0.16 0.25 2

0.40

0.25

0.1823 + 0.04 = 0.20 = 1.1115 d1 - t 1.1115 0.20 = 0.9115

d2

=
=

Value of a Put Option

Step 2: Find N(d1) and N(d2). N(d1) and N(d2) represent the probabilities that a random variable that has a standardised normal distribution will assume values less than d1 and d2. N(d1) = N(1.1115) = 0.8668 N(d2) = N(0.9115) = 0.8190 Step 3: Estimate the present value of the exercise price, using the continuous discounting principle. E Rs 50 Rs 50 = = = Rs 49.01 ert e 0.08 x 0.25 1.0202

Step 4: Plug the numbers obtained above in the Black-Scholes formula. C0 = S0 N(d1) E N(d2) ert = 60 0.8668 49.01 0.8190 = Rs 11.87 The value of the put option as per the put-call parity relationship is as follows: P0 = C0 S0 + E ert = 11.87 60 + 49.01 = Rs 0.88

Option Calculators
TYPE EXERCISE STYLE GREEKS TYPE: CALL Call Put American European STYLE: AMERICAN DELTA
STRIKE PRICE INTEREST RATE SPOT PRICE DIVIDEND YIELD : : : :

GAMMA THETA VEGA

NO OF DAYS

VOLATILITY

Premium

RHO

NOTE

: All calculations for European style are done using BLACK-SCHOLES FORMULA All calculations for American style are done using Binomial method (255 level) Calculate Reset

Option Greeks
Option Greeks (represented as they are by Greek alphabets) reflect the sensitivity of option price to changes in the value of the underlying factors. The following are the commonly used option Greeks: Delta: Delta represents the change in the value of an option for a given change in the value of the underlying share. Gamma: Gamma represents the change in delta for a given movement in the share price.

Vega: Vega stands for a change in option value with respect to the change in the volatility of the underlying price.
Theta: Theta stands for the change in option value with respect to time to expiration.

Summing Up
An option gives its owner the right to buy or sell an asset on or before a given date at a specified price. An option that gives the right to buy is called a call option; an option that gives the right to sell is called a put option.
A European option can be exercised only on the expiration date whereas an American option can be exercised on or before the expiration date.

The payoff of a call option on an equity stock just before expiration is equal to:
Stock
Max

Exercise

price -

price, 0

Puts and calls represent basic options. They serve as building blocks for developing more complex options. For example, if you buy a stock along with a put option on it (exercisable at price E), your payoff will be E if the price of the stock (S1) is less than E; otherwise your payoff will be S1. A complex combination consisting of (i) buying a stock, (ii) buying a put option on that stock, and (iii) borrowing an amount equal to the exercise price, has a payoff from buying a call option. This equivalence is referred to as the put-call parity theorem.

The value of a call option is a function of five variables: (i) price of the underlying asset, (ii) exercise price, (iii) variability of return, (iv) time left to expiration, and (v) risk free interest rate. The value of a call option as per the binomial model is equal to the value of the hedge portfolio (consisting of equity and borrowing) that has a payoff identical to that of the call option.

The value of a call option as per the Black - Scholes model is: C0 = S0 N (d1) E ert N (d2)