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L E C T U R E 4

2.1

Introduction to Options

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Reviewof Option Types

2.2

y Acall is an option to buy

y Aput is an option to sell

y AEuropean option can beexercised only at theend

of its life

y An American option can beexercised at any time

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Options

2.3

y Acall or put option gives the holder of the option theright but not the obligation to buy (sell) an

underlying security at fixed price on (European) orbefore (American) a specified date.

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Terminology

2.4

y Holders

y Writers

y Premium

y Expiration Date

y Exercise

y Exercise/Strike price

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Assets UnderlyingExchange-Traded Options

2.5

y Stocks

y Foreign Currency

y Stock Indices

y Futures

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Option Types & Moneyness

2.6

y Plain Vanilla Options

y In-the-Money

y At-the-Money

y Out-of-the-Money

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Option Positions

2.7

yLong call

yLong putyShort call

yShort put

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Long Call on Barclays

2.8

Buying one Barclays European call option: option price =20.5p, strike price = 300p, option life = 2 months

100

0-20.5

200 300

400

Profit ()

Terminal

stock price ()

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Payoff of a Long Call

2.9

y Strike price K

y Final priceSTy Payoff at theexpiration date

)0,max( KST

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Short Call on Barclays

2.10

Writing one Barclays European call option: option price= 20.5, strike price = 300

020.5

100 200 300

400

Profit ()

Terminal

stock price ()

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Payoff of a Short Call

2.11

y Strike price K

y Final priceSTy Payoff at theexpiration date

)0,min()0,max( TT SKKS !

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Long Put on Barclays

2.12

Buying an Barclays European put option: option price =54.5p, strike price = 300p

100

0

-54.5300200 400

Profit ()

Terminal

stock price ()

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Payoff of a Long Put

2.13

y Strike price: K

y Final price: STy Payoff at the Expiration Date:

)0max( ,TS

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Short Put on Barclays

2.14

Writing an Barclays European put option: option price =54.5, strike price = 300

-30

-20

-10

54.5

0300

200

400

Profit ()Terminal

stock price ()

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Payoff of a Short Put

2.15

y Strike price: K

y Final price: STy Payoff at the Expiration Date:

)0,min()0max( , KSSK TT !

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Payoffs from Options

2.16

K= Strike price, ST

= Price of asset at maturity

Payoff Payoff

ST

ST

K

K

Payoff Payoff

ST

ST

K

K

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Dividends & StockSplits

2.17

y Suppose you own an option on N shareswitha strike price ofK : No adjustments aremade to the option terms for cash

dividends When there is an n-for-m stock split,

the strike price is reduced to mK/n

the no. of shares is increased to nN/m

Stock dividends are handled in am

anner sim

ilar tostock splits

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Dividends & StockSplits2.18

y Consider a call option to buy 100 sharesfor 20/share

y Howshould terms be adjusted:

for a 2-for-1 stock split?

for a 5% stock dividend?

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Portfolios Involving Options2.19

y Thevalue of a portfolio consisting of units of s theunderlying stock, c call options and p put options

y The profit of the portfolio is,

)()0,max(K,0)-max(SS TcTs pcTp VVSK ! EEET

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Example2.20

Portfolio: buying 2 calls, selling 1 put

Kc=Kp=50, Vc=5, Vp=10

Q: What is the profit of this portfolio,

ifS50?