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7 OptionsPricingStrategies

This document discusses options, including terminology, features of call and put options, risk and rewards of different option strategies, factors affecting option prices, and models for pricing options like Black-Scholes and binomial models. It defines options, describes long and short call and put positions, and covers option valuation components of intrinsic value and time value. Types of option trading strategies like covered calls, protective puts, and spreads are also briefly mentioned.
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0% found this document useful (0 votes)
24 views22 pages

7 OptionsPricingStrategies

This document discusses options, including terminology, features of call and put options, risk and rewards of different option strategies, factors affecting option prices, and models for pricing options like Black-Scholes and binomial models. It defines options, describes long and short call and put positions, and covers option valuation components of intrinsic value and time value. Types of option trading strategies like covered calls, protective puts, and spreads are also briefly mentioned.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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MBA(FinTech)

Financial Derivatives (MFT706)


Options, Pricing & Strategies

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 - Loss 4


Options: PUT
Long Put
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.
Strike Price
Features: 0
- Put option gives the right to Sell. Option
Spot Price
- Option holder or buyer is Long Premium
- Option Seller or writer is Short
- It is exchange traded
- Counter-party risks non-existent
- Loss
- Standardized products
- European option is exercised on Short Put
expiration date. + Profit
- American option is exercised on or
before expiration/maturity date.
- Settled through Clearing House. Option
- This is regulated through Premium
exchange.
0
Spot Price
Strike Price

MFT706 Options - Loss 5


Option Risk & Rewards

Strategy Risk Reward


Long Call Premium Unlimited
Long Put Premium Almost Unlimited
Short Call Unlimited Premium
Short Put Almost Unlimited Premium
Long Future Almost Unlimited Unlimited
Short Future Unlimited Almost Unlimited

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

- Option Price or Premium(Ct)


Ct = IV + TV

MFT706 Options 9
• Options Volatility:
Factors Affecting Option Prices:

Factor Call Option’s Value Put Option’s Value

Increase in underlying asset value Increases Decreases

Increase in Strike Price Decreases Increases

Increase in variance of underlying Increases Increases


asset
Increase in time to expiration Increases Increases

Increase in Interest Rates Increases Decreases

Increase in Dividends Paid Decreases Increases

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=

Backward Induction C0 = e-rT{PCu + (1-P)Cd}

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

MFT706 Options - Loss 14


Short Asset, Long Call
- Short asset position Long Call
+ Profit Short Asset
- Long Call option

0
Spot Price

Portfolio

- Loss
Short Asset, Short Put
- Short asset position + Profit Short Asset
- Short Put option

Short Put

0
Spot Price

Portfolio

MFT706 Options - Loss 15


Bullish Call Option Spread
- Long Call option with low strike price Long Call
- Short Call option with high strike price + Profit
Portfolio

0
Spot Price

- Loss Short Call


Bullish Put Option Spread
- Long Put with low strike price + Profit
Short Put
- Short Put with high strike price

Portfolio

0
Spot Price
Long Put

MFT706 Options - Loss 16


Bearish Vertical Call Option Spread
- Long Call option with high strike price Long Call
- Short Call option with low strike price + Profit

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

MFT706 Options - Loss 17


Butterfly Call Option Spread
- Long Call (1) option with low strike price Long Call 2
+ Profit Long Call 1
- Long Call (2) option with high strike price
- Short two Call option with between strike price

0
Spot Price
Portfolio

- Loss Short Call


Butterfly Put Option Spread
- Long Put (1) with low strike price + Profit Short Put
- Long Put (2) with high strike price
- Short two Put with low strike 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

MFT706 Options - Loss 19


Long Strangle
Bet predicting volatility, with different strike but same expiry Long Call
- Long Call option + Profit
- Long Put option

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 - Loss 20


• Hedging with Options:
Types of Hedging Strategies
- Covered call writing
- Stop-Loss Strategy
- Zero-Cost Option Strategy.
- Delta Hedging

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

∆ = N(d1), where d1 = (which is Black-Scholes pricing model)

GAMMA: Gamma is the rate of change of portfolio’s Delta with respect to the price of the underlying asset.

Gamma г = ∂2∏ / ∂S2 ie. N’(d1) / S σ √T

VEGA: Vega is the rate of change of portfolio’s value with respect to the volatility of the underlying asset.

Vega Ѵ= ∂∏ / ∂σ ie. ∆ Premium / ∆ Volatility

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

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