Chapter 06

INTRODUCTION TO OPTIONS
CHAPTER 6
Chapter Objectives
• This Chapter intends to provide an overview of option contracts.
• On completion of this chapter you should have a good grasp of option

terminologies and their basic functions.
• You should have a good understanding of mechanics and use of options contracts.
CHAPTER 6: INTRODUCTION TO OPTIONS Copyright © 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
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What are Options?
• Options provide the holder the right but not the obligation to exercise.
• Exchange traded options were introduced in 1973 on The Chicago Board Options
Exchange (CBOE).
• The initial option contracts were written on equities.
• Currently a wide variety of underlying instruments are used for options.

• Example: stock indexes, foreign currencies, commodities and other derivatives like interest
rate futures, stock index futures or swaps.
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Calls and Puts
• All exchange traded options come in two basic forms, calls and puts.
• Call options provide the holder the right but not the obligation to buy the
underlying asset at the predetermined exercise price.
• Put options provide the holder the right but not the obligation to sell the
underlying asset at the predetermined exercise price.
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Calls and Puts
• The predetermined price at which the transaction will be carried is known as the
exercise price or strike price.
• Option Contracts are classified in two forms according to exercising rights.
• A European style option can be exercised only at maturity,

• An American style option can be exercised at or anytime before maturity.
• With this additional flexibility, an American option would be more valuable than a
European option assuming all other features are the same.
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Calls and Puts
• An option contract at the very least specifies the following five features:
1. The type of option, whether call or put
2. The underlying asset
3. The exercise price or strike price
4. The maturity or expiration date
5. The exercise style, whether American or European style.
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Calls and Puts
• The long position (buyer) has a right but not the obligation to exercise, the seller
or short position is obliged to fulfill the buyer’s wants should he choose to
exercise.
• If the holder of the put chooses to exercise at the exercise price, the seller of the
put must stand ready to buy the underlying asset at the exercise price.
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Why Use Options?
• Options like all other derivative contract can be utilized for hedging, arbitrage and
speculation.
• Why use options than futures and forwards is due to added flexibility of options to
exercise only if it is profitable for the holder.
• Example: Suppose you buy a 3-month American style call option on Maybank stock at an
exercise price of RM 20 per share. It means that you can exercise your option, i.e. ‘call it’ at
RM 20 per share at anytime before or on the maturity date in 90 days. Thus, you would only
exercise the option if Maybank stock goes higher than RM 20.
• For this privilege of exercising only if profitable there is an option premium.
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Payoffs to Investing in Stocks Versus Options
• Illustration : A Long Stock Position
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bullish about it and take a
long position in the stock (buy), the payoff given the following possible stock prices over the
next 90 days
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• Illustration : A Long Stock Position
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bullish about it and take a long
position in the stock (buy), the payoff given the following possible stock prices over the next 90
days
• As stock prices fall, the position loses but gains when price rises.
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• Illustration : A Short Stock Position
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bearish about it and decide to
short it.
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• Illustration : A Short Stock Position
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bearish about it and decide to short it.
• The short stock position gains when underlying stock price falls and loses when stock price rises.
• The risk profile is one of unlimited profit/loss potential.
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• Illustration : A Long Call Option
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bullish about it and decide to
buy a call option on Syarikat ABC stock with an exercise price of RM 12.00 at 20 sen premium.
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• Illustration : A Long Call Option
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bullish about it and decide to buy
a call option on Syarikat ABC stock with an exercise price of RM 12.00 at 20 sen premium.
• A long call strategy is superior to that of a long stock or long futures position in that the loss
potential is now limited to the cost of the premium.
• The break even point for calls is the exercise price plus premium.
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• Illustration : A Long Put Option
buy a put option on Syarikat ABC stock with an exercise price of RM 12.00 at 15 sen premium.
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• Illustration : A Long Put Option
buy a put option on Syarikat ABC stock with an exercise price of RM 12.00 at 15 sen premium.
• A long put position limits the loss potential. The potential loss is limited to the amount of the
premium.
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• Illustration : A Short Call Option
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bearish to neutral about it
and decide to short a call option on Syarikat ABC stock with an exercise price of RM 12.00 at
20 sen premium.
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• Illustration : A Short Call Option
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bearish to neutral about it and decide
to short a call option on Syarikat ABC stock with an exercise price of RM 12.00 at 20 sen premium.
• A short call has limited upside potential but unlimited loss potential.
• This arises from the fact that the seller has obligation and faces assignment should the long position
choose to exercise.
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• Illustration : A Short Put Option
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bullish to neutral about it and
decide to short a put option on Syarikat ABC stock with an exercise price of RM 12.00 at 15
sen premium.
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• Illustration : A Short Put Option
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bullish to neutral about it and
decide to short a put option on Syarikat ABC stock with an exercise price of RM 12.00 at 15 sen
premium
• A short put has limited upside potential but unlimited loss potential.
• This arises from the fact that the seller has obligation and faces assignment should the long
position choose to exercise.
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Stock Versus Option Positions
• Illustration : Long Stock vs Long Call Option
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bullish about it. The long call
option is available at an exercise price of RM 12.00 at 20 sen premium.
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• Illustration : Long Stock vs Long Call Option
• There are three key differences to note.
• First, the long call position cuts off loses to a maximum of 20 sen. For a stock price below RM 11.80, the
stock position loses much more than a call position.
• Second, when prices rise, both positions make money but the call position has a payoff that is always 20
sen lower than that of the stock position. This difference being due to the call premium.
• The third difference is that the long call position only makes money after the break-even point is
reached. In this case, RM 12.20 (Exercise price + Call premium).
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• Illustration : Short Stock Versus Long Put Position
• Syarikat ABC stock is currently selling at RM 12.00 each. You are bearish about it. The long put
option is available at an exercise price of RM 12.00 at 15 sen premium.
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• Illustration : Short Stock Versus Long Put Position
• The three key differences between option and stock positions.
• First, the long put position cuts off loses to a maximum 15 sen which is the amount of the premium. The short
stock position, however, has potentially unlimited losses.
• Second, when the underlying stock price falls, both positions gain; however, the profit from the long put position is
always lower by 15 sen relative to the stock position. This lower profit reflects the premium paid for the put.
• Thirdly, while the short stock begins to profit below RM 12.00, the put position requires a further fall in the
underlying stock to at least RM 11.85 before it begins to make money.
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Expectations and Option Positions
• The payoff to positions at expiry of the options depends on the underlying asset’s
price performance.
• Example: The long call position makes money when the underlying asset moves up in price.
• Expectations play a key role. One would be willing to sell a call if he or she believes
that the underlying asset will likely not move in price or if it does move, the price
could go down slightly. Such an expectation is, neutral to bearish. On the other hand,
if someone is neutral to bullish then he would be willing to sell a put.
• If one were to take naked or speculative positions with options, the option strategy
would clearly depend on the expectation of the underlying asset’s performance.
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Options: Uses and Applications
• Options Provide Leverage
• This arises from the fact that options provide the same exposure to the underlying asset but
at a much lower cost.
• While an investment in the underlying asset, stocks for example, would require upfront payment of
the full cost of the shares, acquiring the options on the stock would require only the payment of
the option premium.
• Risk Management and Arbitrage

• Options are used extensively for hedging.
• To hedge an underlying exposure to rising prices, or to seek protection from rising prices, one
would long a call option. If rising prices would hurt our position in the underlying asset, than a long
call position would gain from rising prices and so offset the losses.
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• Enhance Portfolio Revenue
• Options can also be used to enhance portfolio revenue. Portfolio managers often use options
to increase their returns. A common strategy is to sell calls on stocks already owned.
• Flexibility and Ease of Use

• Much of their flexibility comes from the fact that options are nonobligatory.
• Aside from being able to design numerous types of payoffs, options can also be used to create
strategies to take advantage of different situations/outcomes.
• Managing Information Asymmetries

• Options, given their features, come in handy for managing information asymmetries.
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• Managing Contingent Liabilities/Claims
• The management of contingent liabilities or contingent claims is a key justification for the need for
innovation behind options.
• Contingent claims or liabilities are business situations that involve at least two levels of uncertainties.
• Illustration:
• A Malaysian company involved in the manufacturing of a certain electrical component has just
submitted a bid in an international tender by a foreign government for supply of the components.
• Assume that payment will be in a foreign currency, the foreign government will choose among several
international bidders and will make known its chosen bid and supplier in one month’s time. The chosen
supplier will supply over the following five months and will be paid in full at the end of the sixth month.
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• Illustration:
• From the viewpoint of the Malaysian company, they will know the outcome in a month and if selected
will supply and receive payment in foreign currency six months from today.
• There are two simultaneous sets of uncertainties here. First, uncertainty regarding the ringgit amount
that will be received given currency fluctuation and second, uncertainty whether their bid would be
chosen.
• Options the company has to hedge its risks are :
1. Enter into a forward contract, but A forward would be unsuited since if not chosen, a forward
contract cannot be easily reversed out.
2. With futures, the company has two choices:
(a) take a short position in a 6-month currency futures contract now and reverse out in a month if not
selected, or
(b) wait until the result is known in a month’s time and then if chosen, take a short position in 5-
month currency futures
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• Illustration:
• Problems with using Forward contract are displayed:
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• Illustration:
• Problems with using Futures contract are displayed:
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• Illustration:
• Solution by Using Option Contracts

• The Malaysian company at the time of submitting the bid (today) would simply have to buy (long) 6-
month put options on the foreign currency.
• The number of contracts needed would depend on contract size.
• In the event the company’s bid is not chosen, the put options could be left unexpired with losses limited
to the cost of the premium; on the other hand should the company be selected and receive a
depreciated foreign currency, the put options purchased become profitable and would be exercised.
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Options Moneyness
• Option moneyness refers to terminologies used to describe whether an option is
currently profitable.
• In-the-Money (ITM)
• An option is said to be in-the-money if exercising it now will mean profits.
• For a call to be in-the-money, its exercise price must be lower than the current value or spot
price of the underlying asset.
• For a put option to be in-the-money, its exercise price must be higher than the value of the
underlying asset.
• Call: Exercise price < Spot price of underlying

• Put: Exercise price > Spot price of underlying
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Options Moneyness
• At-the-Money (ATM)
• An option is said to be at-the-money if its exercise price equals the spot price of the underlying.
• Call: Exercise price = Spot price of underlying
• Put: Exercise price = Spot price of underlying
• Out-of-the-Money (OTM)
• An option is said to be out-of-the-money if exercising it will mean losses.
• A call would be out-of-the-money if its exercise price is higher than the current spot price of the
underlying asset.
• A put would be out-of-the-money if its exercise price is lower than the underlying asset’s spot
price.
• Call: Exercise price > Spot price of underlying

• Put: Exercise price < Spot price of underlying
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Option Valuation
• An option is purchased by paying the premium stated for it.
• How is the correct premium determined?
• Binomial Option Pricing Model
• Black-Scholes Option Pricing Model
• What constitutes the value of the premium?

• The premium of an option, or the option’s value, comes from two sources; the intrinsic value and time
value.
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Option Valuation
• The premium of an option, or the option’s value, comes from two sources; the intrinsic value and
time value.
• Intrinsic Value (IV)

• The intrinsic value of an option can be thought as the profit that can be attained by the
immediate exercise of the option.
• The intrinsic value equals the amount by which the option is in-the-money.
• If the option is at or out-of-the-money, then it is said to have zero intrinsic value.
Call IV = Spot price – Exercise price

Put IV = Exercise price – Spot price
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Option Valuation
• The premium of an option, or the option’s value, comes from two sources; the intrinsic value and
time value.
• Time Value (TV)

• Time value (TV) refers to the value that arises from the probability that an option could become
profitable by the time of its maturity.
• The longer the time left to maturity, the higher the time value will be. As an option approaches
maturity, time value reduces.
• Time value equals zero at maturity.
• If an option expires at or out-of-the-money, its premium/ value is zero since both the intrinsic and
time values are zero.
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Option Valuation
• The premium of an option, or the option’s value, comes from two sources; the intrinsic value
and time value.
• Illustration: Suppose we have a call option on a stock with a zero exercise price and infinite maturity.
Its value will be equal to the value of the underlying asset.
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Option Valuation
• Illustration: Suppose we have a call option on a stock with a zero exercise price and infinite maturity.
Its value will be equal to the value of the underlying asset.
• Line A shows the value of a call with a zero exercise price and infinite time to maturity, therefore it
represents the maximum value of the call option.
• The highest possible value for an option equals the value of the underlying asset.
• Suppose the call now has an exercise price of RM 5.00 and is exercisable immediately. The value of
the call is now given by Line C. Line C begins at RM 5.00 and is parallel to Line A. this means is that at
any price below RM 5.00 the call is worthless and has zero value. However, at any price above RM
5.00, the call has a value equal to the difference between the exercise price and stock price. This
equals the intrinsic value. Which means that the line C gives the plot of intrinsic value.
• The line Ctakes off at a 45° angle from RM 5.00. The 45° angle is shows that there will be a one-to-
one correspondence in the values of the stock and call beyond the RM 5.00 level.
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Option Valuation
• Illustration: (Contd.)
• Line C represents the intrinsic value which is also the minimum value for the call.
• Suppose keep the exercise price stays at RM 5.00 but now the time left to maturity is extended from
zero to 30 days. The value of the call will be more than that represented by Line.
• Now however, the call’s value must include time value since there is now 30 days left to maturity.
Surely, the value would be higher than Line C.
• The curve depicting the value of the call is a plot of points for call value at different exercise prices.
• Time value (TV) is represented by the area between the intrinsic value line and the call value curve.
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Option Valuation
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Option Valuation
• If the exercise is kept the same but the time to maturity changes, longer maturity curves
would have a higher call value for any given stock price, meaning that time value is higher
for any stock price.
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Time Decay and Options
• Options are often also known as a ‘wasting asset’.
• A wasting asset is a financial asset that is subject to time decay
• Wastage or time decay happens because options lose their value with the passage of
time.
• Even if the underlying asset price is unchanged, the passage of time would mean the loss of time
and so reduced option value/premium.
• Time decay works against the long position and in favour of the short position.
• The holder of the call loses as call value reduces. Any loss for the long position represents a gain
for the short position.
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Intrinsic and Time Values for Puts
• Similar to Call Option, the intrinsic value and time value have similar relationship for Put
Options.
• The one difference being that the regions within which the put would be out-of-the-money
and in-the-money is reversed.
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Intrinsic Value and Time Value
• Intrinsic Value (IV)
• Lowest value is zero, intrinsic value is never negative.
• IV is positive for in-the-money options.
• IV is zero for at-the-money options.
• IV is zero for out-of-the-money options.
• At maturity, option value equals IV.
• Time Value (TV)

• TV is always positive (>O) before maturity, even for deep out-of-the-money options.
• Ceteris paribus, the longer the time left to maturity, the greater is the time value.
• As the option approaches maturity, time value reduces; this is time decay.
• At option maturity, TV = zero.
• The more out-of-the-money the option is, the lower is its TV and so the lower is its premium/ value.
• Time value is highest when an option is near or at-the-money and reduces as the option goes deep in-the-
money or deep out-of-the-money.
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Thank You

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INTRODUCTION TO OPTIONS

• On completion of this chapter you should have a good grasp of option

• The initial option contracts were written on equities.

• Currently a wide variety of underlying instruments are used for options.

• Option Contracts are classified in two forms according to exercising rights.

• A European style option can be exercised only at maturity,

2. The underlying asset

3. The exercise price or strike price

4. The maturity or expiration date

5. The exercise style, whether American or European style.

• For this privilege of exercising only if profitable there is an option premium.

• Risk Management and Arbitrage

• Flexibility and Ease of Use

• Managing Information Asymmetries

• Solution by Using Option Contracts

• The number of contracts needed would depend on contract size.

• Call: Exercise price < Spot price of underlying

• Call: Exercise price > Spot price of underlying

• What constitutes the value of the premium?

• Intrinsic Value (IV)

• If the option is at or out-of-the-money, then it is said to have zero intrinsic value.

Call IV = Spot price – Exercise price

• Time Value (TV)

• Time value equals zero at maturity.

• Time Value (TV)

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