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8/14/2019 Pricing of Option
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Pricing of OptionsPricing of Options
Presented byPresented by
John C. George 08PG0318John C. George 08PG0318
Mathew John 08PG0323Mathew John 08PG0323
Midhun Jose 08PG0324Midhun Jose 08PG0324Nidhin SkariahNidhin Skariah 08PG032608PG0326
Raja Rakesh 08PG0331Raja Rakesh 08PG0331
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Basic Concepts of OptionsBasic Concepts of Options
RelationshipRelationship
CallsCalls PutsPutsA > SA > S in-the-moneyin-the-money out-of-theout-of-the
moneymoney
A = SA = S at-the-moneyat-the-money at-the-moneyat-the-money
A < SA < S out-of-the-out-of-the- in-the-moneyin-the-money
moneymoney
A denotes the current price of the underlying assetA denotes the current price of the underlying asset
S denotes the strike price of the optionS denotes the strike price of the option
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A Transaction on an OptionA Transaction on an Option
ExchangeExchange
Buyer BuyersBroker
OptionsExchange
3
Buyers BrokersFloor Broker
OptionsClearingHouse
Buyers BrokersClearing Firm
Buyers BrokersClearing Firm
Sellers BrokersFloor Broker
SellersBroker
Seller
1a 1b Buyer and seller instruct their respective brokers to conduct an option transaction.
2a 2b Buyers and sellers brokers request their firms floor brokers execute the transaction.
3 Both floor brokers meet in the pit on the floor of the options exchange and agree on a price.
4 Information on the trade is reported to the clearinghouse.
5a 5b Both floor brokers report the price obtained to the buyers and sellers brokers.
6a 6b Buyers and sellers brokers report the price obtained to the buyer and seller.
7a 7b Buyer deposits premium with buyers broker. Seller deposits margin with sellers broker.
8a 8b Buyers and sellers brokers deposit premium and margin with their clearing firms.
9a 9b Buyers and sellers brokers clearing firms deposit premium and margin with clearinghouse.
1a
6a
7a
2a5a
48a 8b
9a 9b
2b5b
1b
6b
7b
Note: Either
buyer or seller
(or both) could
be a floor trader,
eliminating the
broker and floor
broker.
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Value of an OptionValue of an Option
The two components are,The two components are,Intrinsic Value:Intrinsic Value: of call = Max [A-S, 0]of call = Max [A-S, 0]
of put = Max [S-A, 0]of put = Max [S-A, 0]
Time value:Time value: It is the value in excess of theIt is the value in excess of the
intrinsic value and indicates options potential tointrinsic value and indicates options potential to
become more valuable before it expires. It decaysbecome more valuable before it expires. It decays
with passage of time.with passage of time.
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How is Value of OptionsHow is Value of Options
Affected*?Affected*?
FactorFactor Call ValueCall Value Put ValuePut Value
Increase in asset valueIncrease in asset value IncreaseIncrease DecreaseDecrease
Increase in strike priceIncrease in strike price DecreaseDecrease IncreaseIncrease
Increase in variance ofIncrease in variance ofunderlying assetunderlying asset
IncreaseIncrease IncreaseIncrease
Increase in time toIncrease in time to
expirationexpiration
IncreaseIncrease IncreaseIncrease
Increase in interest rateIncrease in interest rate IncreaseIncrease DecreaseDecrease
Increase in dividend paidIncrease in dividend paid DecreaseDecrease IncreaseIncrease
*American O
ptions
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Call OptionCall Option
Pay-off Diagram:Pay-off Diagram:Net payoffNet payoff
on callon call
StrikeStrike
PricePrice
Price of underlyingPrice of underlying
assetasset
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Put OptionPut Option
Pay-off Diagram:Pay-off Diagram:Net payoffNet payoff
on puton put
StrikeStrike
PricePrice
Price of underlying assetPrice of underlying asset
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Options other than Calls andOptions other than Calls and
PutsPuts
Convertible Bonds: Purchaser buys aConvertible Bonds: Purchaser buys a
straight bond and a call optionstraight bond and a call option
Callable bonds: Purchaser buys a straightCallable bonds: Purchaser buys a straight
bond and sells a call option to issuerbond and sells a call option to issuer
An equity share can be viewed as a callAn equity share can be viewed as a call
option on the assets of a company.option on the assets of a company.
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Buying and Selling Stock:Buying and Selling Stock:
Long PositionLong Position
400
EMP (T)
Profit
(-) 400Loss
0
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Buying and Selling Stock:Buying and Selling Stock:
Short PositionShort Position
MP (T)
Profit240
Loss
0240
E
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Elementary InvestmentElementary Investment
StrategiesStrategies
Long CallLong Call
Short CallShort Call
Long PutLong Put
Short PutShort Put
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Long CallLong Call
MP (T)
Profit
Loss
0400
440
E
(-) 40
This refers to the purchase of a call
These are cash flows when a
bullish
Investor buys a 3-month call on
the
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Short CallShort Call
MP (T)
Profit
Loss
0
400
440
E
(+) 40
This involves writing a call without owning theunderlying asset
These cash flows relate to writing a
3-month call on a stock at an exercise
price of Rs.400 per share
by receiving a premium of Rs.40.
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Long PutLong Put
MP (T)
Profit
Loss
0240
216
E
(-) 24
(+) 216
This involves buying a put the right to sell theUnderlying asset at a specified price
These cash flows relate to a bearish investor
Buying 3-month put with a exercise price of
Rs.240 per share by paying a premium of Rs.24
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Short PutShort Put
MP (T)
Profit
Loss
0240216
E
(-) 216
This involves writing a put
These cash flows relate to a bullish investor
Writing a put at an exercise price of Rs.240
Per share receiving a premium of Rs.24.
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Complex InvestmentComplex Investment
StrategiesStrategies
Covered Call WritingCovered Call Writing
Protective PutProtective PutStraddlesStraddles
StranglesStrangles
SpreadsSpreads
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Covered Call WritingCovered Call Writing
It involves buying the stock and writing callIt involves buying the stock and writing call
on that.on that.Profit
MP (T)
(+)48
(-)302
302350
E
These are cash flows when webuy100 shares @310 and write aMay 350 call for Rs.8 so thatinitialInvestment is Rs.302
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Covered Call:Covered Call:Why better than stock or only short calls?Why better than stock or only short calls?
Reduces the risk of uncovered call writing.Reduces the risk of uncovered call writing. Downside risk is reduced by the premium amount.Downside risk is reduced by the premium amount.
Loss of upward gains can be minimized by rolling up the exerciseLoss of upward gains can be minimized by rolling up the exercise
price.price.
When call ends up out-of-the-money, profits increase by every dollarWhen call ends up out-of-the-money, profits increase by every dollarby which the stock price exceeds the original price.by which the stock price exceeds the original price.
Has a lower B.E.P. compared to only stock.Has a lower B.E.P. compared to only stock.
Writing a covered call at lower exercise price is conservative, itWriting a covered call at lower exercise price is conservative, it
reduces the loss but also the upward gains.reduces the loss but also the upward gains.
Writing at higher exercise price is risky. Downside loss is higherWriting at higher exercise price is risky. Downside loss is higher
(less protective) and also gains are higher.(less protective) and also gains are higher.
A short holding period reduces the stock movement possibility and isA short holding period reduces the stock movement possibility and is
the best.the best.
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Protective PutProtective Put
It involves buying the stock and buying put onIt involves buying the stock and buying put on
that.that.Profit
Loss
(-)42
MP (T)270 312
E
These are cash flows when
buy
100 shares @ Rs.310 and buy
a
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Protective PutProtective Put
Guards against fall and also participate in gains. Put ensuresGuards against fall and also participate in gains. Put ensuresmin. selling price for stock.min. selling price for stock.
Gain on upside movement is restricted by the premium.Gain on upside movement is restricted by the premium.
Smaller downside risk and smaller upward gains and higherSmaller downside risk and smaller upward gains and higher
BEP.BEP.
Higher strike price costs maximum but also provides maximumHigher strike price costs maximum but also provides maximum
protection. Reduces the profits maximum.protection. Reduces the profits maximum.
Lower strike price costs less, less protective and reduces profitsLower strike price costs less, less protective and reduces profits
less.less.
Long holding period has chances of recovery of time value dueLong holding period has chances of recovery of time value due
to more chances of price movements.to more chances of price movements.
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Synthetic Put and CallSynthetic Put and Call
AA synthetic putsynthetic put involves long calls andinvolves long calls and
short sale of an equal number of sharesshort sale of an equal number of shares
of stock.of stock.
Synthetic callSynthetic call involves buying stockinvolves buying stock
and an equal number of puts and isand an equal number of puts and is
nothing but protective put.nothing but protective put.
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Long StraddleLong Straddle
Involves buying a put and a call, each with sameInvolves buying a put and a call, each with sameexercise priceexercise price
and same time to expiration.and same time to expiration.Profit247
Loss
(-)63
MP (T)247 373
E1
Buying a Jun 310 call for Rs.21
And Jun 310 put for Rs.42 per
Share. Initial investment Rs63.
310
E2
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Short StraddleShort Straddle
Involves selling a put and a call, each with sameInvolves selling a put and a call, each with sameexercise priceexercise price
and same time to expiration.and same time to expiration.
Profit
Loss(-)247
(63)
MP (T)247 310
E2
373
E1
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Straddle VariantsStraddle Variants
Straps:Straps:
A bullish variation of straddle, involves two callsA bullish variation of straddle, involves two calls
and one put. Investors are more bullish thanand one put. Investors are more bullish than
bearish and therefore increase calls.bearish and therefore increase calls.
Strips:Strips:
It is a slightly bearish variation of straddle, hasIt is a slightly bearish variation of straddle, haslong position in two puts and one call andlong position in two puts and one call and
involves ones bet that the market will go down.involves ones bet that the market will go down.
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Long StrangleLong StrangleInvolves buying a call and a put on the same underlyingInvolves buying a call and a put on the same underlying
assetasset
for same expiration period atfor same expiration period at different exercise pricesdifferent exercise prices
Profit247
-23
Loss
E1 E2333247
270 310
Buy Jun 310 call for Rs.21 and Jun 270
Put for Rs. 2. Initial investment Rs.23.
Usually one in-the-money and another
Out-of-the-money. Initial investment
Can be less than straddle
MP (T)
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SpreadsSpreads
Involve buying of one option and selling of another.Involve buying of one option and selling of another.
Offer potential for small profit and limit the risk.Offer potential for small profit and limit the risk.
VerticalVertical Spreads also calledSpreads also called StrikeStrike oror MoneyMoney spreads.spreads.
Could be written as say, July 120/125 Spread.Could be written as say, July 120/125 Spread.HorizontalHorizontal Spreads also called asSpreads also called as TimeTime oror CalendarCalendar
Spreads. Could be written as June/July 120 Spread.Spreads. Could be written as June/July 120 Spread.
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SpreadsSpreads
For Vertical Spreads:For Vertical Spreads:
A July 120/125 call spread is a net longA July 120/125 call spread is a net long
position and is called Buying the Spread,position and is called Buying the Spread,sometimes referred to as Debit Spread.sometimes referred to as Debit Spread.
A July 120/125 put spread is a net shortA July 120/125 put spread is a net short
position and is called Selling the Spread,position and is called Selling the Spread,
sometimes referred to as Credit Spread.sometimes referred to as Credit Spread.
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SpreadsSpreads
For Horizontal Spreads:For Horizontal Spreads:
A June/July 120 call spread is a net shortA June/July 120 call spread is a net short
position and is called Selling the Spread,position and is called Selling the Spread,sometimes referred to as Credit Spread.sometimes referred to as Credit Spread.
A July/June 120 call spread is a net longA July/June 120 call spread is a net long
position and is called Buying the Spread,position and is called Buying the Spread,
sometimes referred to as Debit Spread.sometimes referred to as Debit Spread.
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Horizontal SpreadsHorizontal Spreads(Across Expiration(Across ExpirationMonths)Months)
Involve buying an option and selling another of sameInvolve buying an option and selling another of same
type with same exercise price but with differenttype with same exercise price but with different
expiration time.expiration time.
In a horizontal bull spread, we buy back month and sellIn a horizontal bull spread, we buy back month and sellthe front month. In a horizontal bear spread, we buythe front month. In a horizontal bear spread, we buy
front month and sell back month.front month and sell back month.
Horizontal bull spread has similar pay-off as that of aHorizontal bull spread has similar pay-off as that of a
short straddle and horizontal bear spread has similarshort straddle and horizontal bear spread has similar
payoff as that of a long straddle.payoff as that of a long straddle.
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Diagonal SpreadsDiagonal Spreads
They are vertical and horizontalThey are vertical and horizontal
at the same time i.e. the areat the same time i.e. the are
across both strike price andacross both strike price and
expiration month.expiration month.
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Butterfly SpreadButterfly Spread
Involves four options, all calls or all puts.Involves four options, all calls or all puts.
All have same expiration month and sameAll have same expiration month and same
underlying asset.underlying asset.
One option has high strike price, one hasOne option has high strike price, one has
low strike price and two have same strikelow strike price and two have same strike
price which is between those of high strikeprice which is between those of high strike
and low strike.and low strike.
Two middle strike price are sold and the twoTwo middle strike price are sold and the two
end options are purchased.end options are purchased.
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Reverse Butterfly or SandwichReverse Butterfly or Sandwich
SpreadsSpreads
This is strategy reverse of theThis is strategy reverse of the
butterfly spread.butterfly spread.
The two middle strike price optionsThe two middle strike price options
are purchase and the two end strikeare purchase and the two end strike
price options are sold.price options are sold.
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Evaluation of theEvaluation of the
StrategiesStrategies Transaction costs have not been considered andTransaction costs have not been considered and
should be kept in mind.should be kept in mind.
Bid-ask spreads may affect payoffs.Bid-ask spreads may affect payoffs.
They are not dividend protected.They are not dividend protected.
Margin requirements are applicable to optionMargin requirements are applicable to option
writing.writing.
Possibility of early exercise may pose new risks.Possibility of early exercise may pose new risks.
Timing of cash flows can make a difference.Timing of cash flows can make a difference.
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Futures vs. Options:Futures vs. Options:PerformancePerformance
Option purchasers do not post margins sinceOption purchasers do not post margins since
they have no obligationsthey have no obligations
An option clearing house serves the similarAn option clearing house serves the similar
functions as those of clearing associations infunctions as those of clearing associations in
futures tradingfutures trading
Option writers have to post margins toOption writers have to post margins toclearing housesclearing houses
Options are also OTC and dealers may requireOptions are also OTC and dealers may require
margins or guarantees.margins or guarantees.
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