7 OptionsPricingStrategies
7 OptionsPricingStrategies
Leben Johnson
8th Feb 2019
MFT706 Options 1
• Options:
It is the derivative product between two parties, where one party purchases the
right, but not the obligation, to buy or sell a specific quantity of an asset at an
agreed price, on or before a particular date.
Terminology:
- The buyer of the option who is also called the option holder, has the right to
buy or sell.
- The seller of the option who is also called the option writer, does not have a
right, but has to oblige when the buyer exercises their right.
- To obtain this right the buyer pays a predetermined premium to the seller.
- The premium is non-refunded, whether the right is exercised or not.
- The right to buy the underlying asset is called the “Call Option”, the buyer of a
call is said to have a “Long Call” position and the seller or writer is said to have
a “Short Call” position.
- The right to sell the underlying asset is called the “Put Option”, the buyer of a
put is said to have a “Long Put” position and the seller or writer is said to have
a “Short Put” position.
MFT706 Options 2
• Options:
- The date on which the option contract expires is called the Expiration Date.
- The Exercise Date is when the option is exercised, no later than the Expiration.
- Option Type:
- In-The-Money
- Out-of-the-Money
- At-the-Money
- There are both OTC and Exchange Traded options.
- Seller of options have higher risk and hence need to maintain a margin
account for exchange traded options.
MFT706 Options 3
Options: CALL
Long Call
Option is a contract where a party
obtains the right, but not the + Profit
obligation, to buy or sell a product, at a
specified price on or before a specified
Break-even Price
date.
Features: 0
Option
- Call option gives the right to buy. Premium Spot Price
- Option holder or buyer is Long
- Option Seller or writer is Short Strike Price
- It is exchange traded
- Counter-party risks non-existent
- Loss
- Standardized products
- European option is exercised on Short Call
expiration date. + Profit
- American option is exercised on or
before expiration/maturity date. Strike Price
- Settled through Clearing House.
- This is regulated through
exchange.
0
Spot Price
MFT706 Options 6
Factors effecting Option Price
MFT706 Options 7
• Options Valuations:
- Value of an option has two components:
- Intrinsic Value
- Time Value
MFT706 Options 8
• Options Valuations:
- Value of an option has two components:
- Intrinsic Value(IV):
For Call IV = Max ((St – X), 0)
For Put IV = Max ((X - St), 0)
- Time Value
For Call TV = Ct – IV
For Put TV = Pt – IV
MFT706 Options 9
• Options Volatility:
Factors Affecting Option Prices:
MFT706 Options 10
• Options Pricing:
– Black-Scholes Option Pricing Model
Assumption:
- Frictionless Market: No transaction cost, short sales, similar borrowing and
lending rates
- Zero Dividends Paid
- European Style Option: Expiration date is execution date.
Option Price:
Where
Call C = S * N(d1) – K * e-rt * N(d2) N(.) = Cum normal distribution
Put P = K * e * N(-d2) - S * N(-d1)
-rt ln = Natural logarithm
S = Spot price of the stock
K = Exercise price of the stock
d1 = R = Annual risk-free interest rate
T = Time to expire of the option
σ = Annual volatility of the stock
d2 = d1 –
Annual Volatility = Daily Volatility * √T , where T is number of days
MFT706 Options 11
• Options Pricing:
– Binomial Model
Assumption:
- Frictionless Market: No transaction cost, short sales, similar borrowing and
lending rates
- Zero Dividends Paid
- European Style Option: Expiration date is execution date.
Where
Up-factor U = r = Annual risk-free interest rate
T = Time to expire of the option
σ = Annual volatility of the stock
Down-Factor D = n = Number of time steps
Transition Probability P=
MFT706 Options 12
• Options Trading Strategies:
Option trading strategies are customized to suit the risk appetite, speculate or
hedge the risk exposure of customers. There are various types:
Types of Option Trading Strategies
- Covered call writing
- Protective put
- Spreads, which typically speculate on price changes, by taking positions in two
or more options.
- Vertical spreads: Same underlying asset, same expiry but different exercise
price. Can be Bullish or Bearish.
MFT706 Options 13
Covered Call Writing
- Long asset position Long Asset
- Short Call option + Profit
Portfolio
0
Spot Price
Short Call
- Loss
Protective Put
- Long asset position + Profit Long Asset
- Long Put option Portfolio
0
Spot Price
Long Put
0
Spot Price
Portfolio
- Loss
Short Asset, Short Put
- Short asset position + Profit Short Asset
- Short Put option
Short Put
0
Spot Price
Portfolio
0
Spot Price
Portfolio
0
Spot Price
Long Put
0
Spot Price
Portfolio
Short Call
- Loss
Bearish Vertical Put Option Spread
- Long Put with high strike price + Profit
- Short Put with low strike price Portfolio
Short Put
0
Spot Price
Long Put
0
Spot Price
Portfolio
0
Spot Price
Long Put 1
Long Put 2
MFT706 Options - Loss 18
Long Straddle
Bet predicting volatility, with same strike and expiry Long Put Long Call
- Long Call option + Profit
- Long Put option
Portfolio
0
Spot Price
- Loss
Short Straddle
Bet predicting less volatility + Profit
- Short Put
- Short Call Short Put
Short Call
0
Spot Price
Portfolio
Portfolio
0
Spot Price
Long Put
- Loss
Short Strangle
Bet predicting less volatility + Profit
- Short Put
Short Call
- Short Call
Short Put
0
Spot Price
Portfolio
MFT706 Options 21
• The Greek Variables
DELTA: Delta of a portfolio is the sensitivity of the portfolio to market movements. It is the rate of change of the
option price with respect to the price of the underlying asset.
Delta ∆ = ∆∏ / ∆S or ∂∏ / ∂S
GAMMA: Gamma is the rate of change of portfolio’s Delta with respect to the price of the underlying asset.
VEGA: Vega is the rate of change of portfolio’s value with respect to the volatility of the underlying asset.
THETA Φ: Theta is the rate of change of value of the portfolio with respect to the passage of time, this is also
referred to as the time decay of the portfolio.
THETA Φ = ∆ Premium / ∆ Time
RHO: Rho is the rate of change of value of the portfolio with respect to the level of domestic interest.
RHO = ∆ Premium / ∆ domestic interest rate
PHI = ∆ Premium / ∆ foreign interest rate
MFT706 Options 22