Fintech

Chapter 12: Options

Derivatives
• Linear- Futures, Forwards, Swaps
• Non-linear- Insurance aspect: CDS, Options
 Options
• Options grant the buyer or long, the right but not the obligation
to own the underlying asset at a specified or “strike” price
• For this right, the buyer pays a fee or “premium”
• The seller or short is under the obligation to sell the underlying
asset at the strike price if the buyer so desires.
• In return for being required to sell at what might be a below
current market price, the seller of the option collects a fee or
“premium
Options
Options are traded on many financial assets:
• Equities
• Equity indexes
• Bonds
• Currencies
• Commodities
• Futures
Options
• Call option: gives the buyer the right to own or go long the
underlying asset
• Put option: gives the buyer the right to sell or go short the
underlying asset
Options

Four basic option strategies:

• Long call
• Short call
• Long put
• Short put

More complex option strategies are a result of combining two or

more of these four basic positions.
Options

Option name:
• Underlying issue
• Expiry Date
• Put or Call
• Strike Price

Example: SQ September 2018 Call $0.95

Options
Exchange traded options: terms specified by the Exchange
• Equity options on CBOE, NYSE, Nasdaq
• Monthly, quarterly and longer dated
• Energy options on NYMEX and ICE
• OTC: customized terms
Options
When can buyer exercise their option rights?
• American options: at any time during the life of the
options
• European options: exercisable only at expiry
 Options
Options are “in the money”, “at the money”, or “out of the money”.
• At-the-money options have a strike price equal to the current underlying asset price.
• A call option is in-the-money if the strike price is below the current asset price
• A put option is in-the-money if the strike price is above the current asset price.
• A call option is out-of-the-money if the strike price is above the current asset price;
• A put option is out-of-the-money if the strike price is below the current asset price.
Options
Risks in trading options:
• Option buyers risk losing the amount of premium paid
• Call sellers risk being short in a rising market,
theoretically unlimited
• Put sellers risk being long in a falling market. Their risk
would be the total of the strike price minus the
premium received.
Options
Figure 12.1 Long Call

Net Position at Expiry

Long XYZ 60 call
Maximum Gain: Unlimited
Maximum Loss: Premium
paid
Options
Figure 12.2 Long Put

Net Position at Expiry

Long XYZ 60 put
Maximum Gain: Strike price – premium paid
Maximum Loss: Premium paid
 Options
Figure 12.3 Short Call

Net Position at Expiry

Short XYZ 60 call
Maximum Gain: Premium received
Maximum Loss: Unlimited
Options
Figure 12.4 Short Put

Net Position at Expiry

Short XYZ 60 put
Maximum Gain:
Premium received
Maximum Loss:
Strike price –
premium received
(substantial)
Options
Advanced option strategies:
• Covered call: own a stock, sell a call.
• Investor owns stock, collects any dividend, and collects option
premium.
• The covered call doesn’t have the same unlimited risk as the short
call alone. The investor can deliver the underlying stock if call is
exercised.
• Investor still has risk to the downside on the original equity
position, but call premium provides a (modest) cushion
Options
Advanced option strategies:
• Vertical call spread (also called a “bull” or “debit” call spread). Here, the
investor buys a lower strike call and sells a second higher strike call.
• For example, the investor might buy XYZ 60 call and sell XYZ 65 call.
If the price of XYZ at expiry is above 60, the investor exercises the
long 60 call and is increasingly profitable until XYZ is valued at 65.
• The investor’s risk is limited to loss of the net premium paid for the
strategy.
Options
Advanced option strategies:
• Vertical put spread. This is the mirror image of the vertical call spread. In
this strategy, the investor wants some coverage to the bearish side of the
market. In our example, the investor might buy the XYZ 60 put and sell
the XYZ 55 put.
• As the market trades lower, at expiry, the 60 put goes in the money
and the strategy begins to be profitable. At 55, the investor can be
expected to be assigned a long position which would offset the
short acquired at 60.
Options

Advanced option strategies:

• Collar (or Cap and Floor). In this strategy, options are used to
protect a range. An investor long an equity might wish to buy a
put to protect against the downside. They might also wish to
offset some of the cost of the put by being willing to sell the
equity at a price above the current market price. This can be
accomplished by selling a call.
• The combination of the long put and short call establishes a floor
and cap, or collar on the position. In our example, with XYZ
currently trading at 60, the investor could buy the 55 put and sell
the 65 call.
Options
Advanced option strategies:

• View of market direction:

• Going higher:
• Long call
• Short put
• Long call spread
• Short put spread
• Going lower:
• Short call
• Long put
• Short call spreads
• Long put spreads
Options

Advanced option strategies:

• Increased volatility, but not sure of market direction
• Greater volatility
• Buy straddle
• Buy strangle
• Lesser volatility
• Sell straddle
• Sell strangle

• Long Straddle. The long straddle consists of both a long call

and a long put, at the same strike price.
• Long Strangle. Similar to straddle, but the put strike is lower
than the call strike.
Options
Figure 12.5 Long Straddle

Net Position at Expiry

Long 1 XYZ 60 call
Long 1 XYZ 60 put
Maximum Gain: Unlimited to the upside. Strike price – total premia to the downside
Maximum Loss: Total premia paid
Options
Option Pricing
There are six factors that influence the pricing of options.
They are:
• Strike price of the option
• Price of the underlying asset at the current time
• Interest rate
• Time to expiry of the option
• Volatility in the price of the underlying asset
• Dividend that might be expected from the underlying
asset
Options
The Black-Scholes-Merton and other models are used to develop
theoretical option prices. Changes in the above factors are seen to
each have an impact on option pricing, and a convention has been
developed of referring to some of these incremental impacts by the
following Greek letters:
• Delta refers to the sensitivity of an option’s theoretical value to a
change in the price of the underlying asset
• Gamma refers to the change in delta for a change in the
underlying price
• Vega is a measure of the sensitivity of the option value to
changes in volatility
• Theta is a measure of time decay, the change in the
option’s
value over time
• Rho is a measure of the sensitivity of the option value to
changes in interest rates
Options
Fintech Applications in Options

• AI for pricing and trading of options

• Blockchain in post-trade processing