Econ 174 FINANCIAL RISK MANAGEMENT LECTURE NOTES Foster, UCSD February 4, 2013

OPTIONS I -- MARKETS & STRATEGIES

A. The Mechanics of Options Markets 1. Option Contracts: Stock Option Notation (for 0 t T) S0, St, Spot (stock market) price of stock ST ($/share) a) An option is the right to buy K Strike (exercise) price ($/share) or sell some underlying Pt, Ct American put/call option premium asset up to a specified date ($/share) for a specified price. pt, ct European put/call option premium 1) The right does not have ($/share) to be exercised; it is not T Expiration date or time to maturity an obligation to the (yrs) buyer/holder of the option. (It IS an obligation or promise on the part of the seller/writer of the option.) 2) T = is the specified date, the expiration date or maturity date. 3) K = the specified price of underlying asset, the strike or exercise price per unit. 4) P or C = the price per unit of purchasing the put or call option itself, the premium. 5) Five principal assets underlying option contracts: Stock options (on common stock in about 2,200 U.S. corporations) Foreign currency options Options on stock market indexes (S&P 100/500, DJIA, etc.) Options on futures contracts Interest rate options on T-bonds, CDs, etc. b) Types of options. 1) Call option the right to buy the asset. 2) Put option the right to sell the asset. 3) European-style option (calls or puts) holder may exercise only at maturity. 4) American-style option (calls or puts) holder may exercise any time up to maturity. c) Option positions. 1) The buyers of calls and puts are said to hold long positions. 2) The sellers (or writers) of calls and puts are said to hold short positions. 3) Brokers, exchanges, OTC dealers, Option Clearing Corporation -- match option buyers with option writers, and maintain neutral positions.

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OPTIONS I

d) Payoffs and profits per unit of asset on naked option positions. [Fig. 1] 1) Profit = (payoff) premium to European call option buyer/holder. call = (ST K) c if ST > K and option is exercised call = c if ST K and option expires 2) Profit = (payoff) premium to European put option buyer/holder. put = (K ST) p if ST < K and option is exercised put = p if ST K and option expires 3) Profit to option writer/seller is mirror image of profit to option buyer/holder.

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OPTIONS I

CALL

c 0 c

Fig. 1
holder

K p p 0

PUT

writer

K ST
writer

p p K

K ST
holder

e) Other sources of (call) options. 1) Executive stock options as an incentive to promote effective management, a firm might issue call options on its own stock to its executives. If management responds appropriately, the firms stock price St goes up and managers exercise their options at a profit. 2) Convertibles corp bonds which are convertible to the corporations stock at certain times and at a specified bonds-to-shares ratio. It is a bond with an embedded call option (right to buy the stock at a price denominated in bonds). 3) Warrants corp bonds with a call option on the corporations stock attached to make the bond more attractive to investors. 2. Features of Stock Option Contracts:

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a) Listings example.

OPTIONS I
Table 1. INTEL (INTC) OPTIONS (finance.yahoo.com 1/14/2010) S0 = $21.24 Calls Puts Expirati Stri Las Vol Ope Las Vol Ope on ke t n t n $19 $2. 684 7,300 $0. 716 22,4 FEB 10 $21 31 18,8 48,48 18 1,8 87 Friday $23 0.9 74 2 0.8 14 10,4 2/19/20 0 9,81 20,01 1 205 33 10 0.2 5 0 2.1 1,06 1 5 3 $19 $2. 228 16,58 $0. 249 17,4 APR 10 $21 57 1,43 4 50 150 57 Friday $23 1.2 5 33,90 1.2 22 7,86 4/16/20 8 475 0 0 4 10 0.4 20,58 2.8 838 9 0 5 $19 $2. 57 3,271 $0. 21 10,0 JUL 10 $21 96 207 11,93 92 37 87 Friday $23 1.6 159 9 1.6 49 854 6/16/20 8 5,680 6 302 10 0.8 2.9 2 0

b) The problem of asynchronous listings. 1) There is a very close dependency between the price of the asset (Intel stock in the list-ings above) and the call and put premiums of options on that asset. 2) For stock options, the stock price might be recorded at a different moment than the option premium. Intels price is at the close of trading on the NYSE, but premiums C and P are for the last option transaction of the day, which might have been hours earlier.

c) Asset specification, contract size, and style. 1) Stock options one lot (100 shares) of common stock in the corporation. Mostly Ameri-can style. 2) Currency options -- the right to buy or sell a given number of units of a foreign currency (e.g. 31,250 or 6.25 million) at a specified exchange rate (strike price). Trade on Phila-delphia Stock Exchange; volume is low. 3) Futures options the right to open a long position (call option) or short position (put option) in one futures contract at a futures price (F0) set at the option strike price (K). Both American and European-style. 4) Index options Right to buy or sell $100 index at specified index level K. Settled for cash equivalent value. Mostly European style. Investors bet on whole market instead of individual stocks and avoid transactions costs of stock deliveries at exercise. d) Expiration dates. 1) Stock options expire on the Saturday following the third Friday of the expiration month. The holder of the option has until 4:30 pm Central Time on that Friday to instruct a broker to exercise. The broker has until 11 pm the next day to execute.

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OPTIONS I

2) At any given time, stock options are usually being traded with expiration dates in the current and the next month, plus at least two more months. On January 14, 2010, Intel options were trading for JAN, FEB, APR and JUL. 3) Longer run stock options called LEAPS (Long-Term Equity Anticipation Securities) trade on about 500 U.S. stocks and always expire in January. Intel LEAPS with maturities in JAN 2011 and JAN 2012 were also listed and trading in January 2010. e) Strike price. 1) Exchanges let option writers set strike prices at specified intervals called ticks. 2) When trading begins in options with a new expiration month, the exchange picks strike prices which bracket the current stock spot price S0 more or less as follows: For S0 < $25, intervals are $2.50 For $25 < S0 < $200, intervals are $5 For $200 < S0, intervals are $10 3) For Intel, S0 $21 on January 14, 2010, but July options were being written with various ticks as low as $1: K {$10, 12.50, 15, 16, 17, 18, 19, 20, 21, 22, 23, 24, 25}. f) Terminology. 1) Option class All the options of the same kind (call or put) on a given stock. All of the Intel put options shown above are a class, and all the calls are another. 2) Option series all options of a given class with the same K and T. The Intel July 2010 $23 puts are a series; the April $19 calls are another. 3) Flex options exchange-traded but with nonstandard terms to compete with OTC. 4) Naked option an option written without an offsetting position in the asset itself. 5) At time t and stock spot price St, an option with strike price K is said to be: In the money if immediate exercise would generate a positive payoff At the money if St = K Out of the money if immediate exercise would yield a negative payoff

g) Option values. 1) The value of an option at time t is the premium Ct or Pt at which it can be bought or sold. Because option holder cant be forced to exercise at a loss, C and P are never < $0. 2) The value has two components. Intrinsic value (exercise value) = max {immediate payoff, 0} Time value = total value (the premium Pt or Ct) intrinsic value 3) Example July 2010 $23 call from the Intel listings; C = $0.82. Call payoff = St K = $21.24 $23 < $0, and option is out of the money

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OPTIONS I

Intrinsic value = $0 Time value = Ct - $0 = $0.82; with time, might get St > $23, making option valuable

h) Dividend and split protection. 1) Stock options are adjusted for stock splits. If you own the right to buy or sell 100 shares of Intel at K = $30 per share, and then Intel declares a 3for-1 stock split, your option becomes the right to buy or sell 300 shares of Intel for K* = $10/share. 2) Options are also adjusted for stock dividends (which are like stock splits), but not for cash dividends. But cash dividends are fairly predictable and are already incorporated into the option premium, as we will see when we get to option pricing. (An exception is sometimes made if the cash dividend is unexpected and greater than about 10% of the stocks price.) i) Position and exercise limits. 1) The CBOE, among others, puts limits on the total number of option positions on a given asset that an investor can hold on one side of the market (long calls + short puts, or short calls + long puts). 2) There are also exercise limits on the number of options on a given asset which an invest-tor may exercise within 5 consecutive business days. 3) The purpose of the limits, as with futures contracts, is to prevent any one investor or institution from having undue influence on the market. 3. Option Trading on an Exchange with a Clearinghouse: a) Margin requirements. 1) Buyers of options with T < 9 months pay full premium (P or C) at time of purchase. 2) Buyers of options with T > 9 months may buy on margin, borrowing up to 25% of the price from the broker. 3) Writers of options must maintain margin accounts to ensure they do not default if and when the option is exercised. 4) For a naked call, the margin requirement is the greater of the following: Sale proceeds (C units) + 20% of stock price (S0) less the amount (if any) by which the option is out of the money Sale proceeds + 10% of S0 5) For a naked put, the margin requirement is the greater of the following: Sale proceeds (P units) + 20% of S0 less amount the option is out of the money Sale proceeds + 10% of strike price (K)

b) The steps to the original (purchase/sale) transaction. Buyer and writer tell their brokers of intent to enter option position (given K and T). Brokers contact floor traders who execute the transaction at a price (call or put premium) at which both parties are willing to agree.

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OPTIONS I

The brokers report to their clients that the purchase/sale is completed, and inform the clearinghouse of the details. The writer deposits $ of margin requirement, which his broker delivers to clearinghouse. This is insurance against option writer default if option is exercised. Buyer deposits $ of option premium, which her broker delivers to the clearinghouse. The clearinghouse clears the transaction, and passes the premium to the writers broker.

Buyer/ Holder

Broker

Exchang e Floor Traders

Broker

Seller /Write r

Fig. 2 -ExchangeTraded Options

$ Option Clearinghou se

c) The Options Clearing Corporation (OCC), the exchange clearing house, protects writers and holders from counterparty risk. Basically, the clearing house bought the sellers option and then wrote the buyers option. Both writer and buyer have positions vis--vis the OCC, not each other. d) When an option is exercised: Holder tells her broker to exercise option. Broker notifies clearinghouse. Clearinghouse randomly selects (assigns) an option writer who wrote the given option (call or put, given K and T), and whose position is still open (has not exited) to honor the option obligation. It will not be the original writer who was party to the original transaction. e) Closing an option position. 1) There are three ways an investor can close an option: Buyer can exercise the option (1/5 of stock options are exercised) Buyer can let the option expire (1/3 of stock options) Buyer or seller can exit the position (1/2 of stock options) 2) To exit a position, investor opens the opposite position (an offsetting order). If you bought a put (call), you must write a put (call) with the same K and T. If you wrote a put (call), you must buy a put (call) with the same K and T. Easy to exit a position with exchange-traded options; harder with OTC.

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B. Basic Option Strategies1 1. Buy a Call Option: INT EL K

OPTIONS I

Calls

Puts JUL $0. 92 1.6 6 2.9 0

a) When used investor is bullish FE AP JUL FEB APR (i.e., thinks stock price will B R rise). $19 $2. $2. $2. $0. $0.5 1) Could buy 100 shares of $21 31 57 96 18 0 stock itself at S0 and sell at $23 0.9 1.2 1.6 0.8 1.20 ST. 0 8 8 1 2.85 0.2 0.4 0.8 2.1 s = ST S0 1 9 2 5 Break even at ST = S0 S0 = $21.24 (January 14, 2010) Max = + Fig. 3 Min = -S0 (lose Buy investment) Call 2) Can buy call option, the right to buy 100 shares at $K, up to time T. 0 call = (ST K) C if ST > K 19 21 -0.82 call = C if ST 23 ST -1.68 K -2.96 Break even at ST = K+C Max = + Min = -C 21.2

b) Notes. 1) For options of a given T, the profit is smaller as K rises, but the maximum loss is smaller too. [Fig. 3 July Intel Calls] 2) If the investor buys stocks and sells them at time T, the transactions costs are higher than for buying an option, and 100% of the investment ($S0) might be lost. The call option gives the same unlimited profit potential for a limit to possible loss. 3) The call buyer pays no transactions costs at time T if he lets option expire. If he exer-cises, he buys and takes delivery of stock from the option writer and sells it in the market. But he could exit his position just before T and make almost the same profit without the stock delivery and associated transactions costs. 4) For a given K, the premium is higher for longer-term calls. For K = $19, C = $2.31 for February calls, $2.57 for April calls, and $2.96 for July calls. More time allows the stock price to rise further at least once before expiration, and make the call more valuable. c) If the investor thinks the stock price will NOT rise, he might write and sell a call option. 1) Profits are the mirror-image negative of profits to the call buyer/holder. 2) In particular:
We assume that options are European style and that the stocks pay no cash dividends. We also ignore the time value of money.
1

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Max = +C Min = - (lose everything)

OPTIONS I

2. Buy a Put Option: a) When used investor is bearish (i.e., thinks stock price will fall). 1) Could short 100 shares of the stock itself, selling at S0 and buying back at ST. ss = S0 ST Break even at ST = S0 Max ss = S0 per share Fig. 4 21.2 Min ss = - (lose everything) Buy 4 2) Can buy put option, the right to sell 100 shares at $K, up to timePut T. ss put = (K - ST) p if ST < K 20.0 put = p if ST K 8 Break even at ST = K-p Max = K-p Min = -p per share

0 b) Notes. 1) For options of a given T, the profit is higher as K rises, but the maximum -0.92 loss is higher too. [Fig. 4 July Intel Puts] -1.66 2) Short-selling a stock is very expensive and very risky, because potential loss is unlimited. Betting on a drop -2.90 in stock price with the put option is much cheaper and the maximum loss is limited, although the maximum profit is also limited. 3) For a given K, the premium is higher for longer-term calls. For K = $19, P = $0.18 for February puts, $0.50 for April puts, and $0.92 for July puts. More time allows the stock price to fall further at least once before expiration, and make the put more valuable.
c) If the investor thinks the stock price will NOT fall, he might write and sell a put option. 1) Profits are the mirror-image negative of profits to the put buyer/holder. 2) In particular: Max = +p Min = p-K 3. Protective Put: a) When used -- Investor wants to buy stock in hope of large positive capital gains, but wants to protect against downside risk if stock price St falls below $K. b) Procedure and payoff/profit. [Fig. 5] 1) At time t = 0:

19 23 ST

21

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OPTIONS I

Buy stock at S0 per share Buy put option for p with strike price K per share 2) At time t = T: If ST < K, exercise option and sell stock to writer, for = K S0 p per share If ST > K, let option expire and hold stock, for paper = ST S0 p per share

($/share) Kp put K 0 p S0 total Fig. 5 Protective Put ST stock

KS0p

S0

c) Example. 1) Data for November 2007: Intel stock price S0 = $27 JAN 2009 Intel put options with K = $25 trade at p = $3.15 2) Investor buys 100 Intel shares for $2,700 and a JAN 09 put (100 shares) for $315. 3) If ST = $20, loss on stock is s = ST S0 = 20 27 = $7 per share, but put is exercised for gain p = (K ST) p = (25 20) 3.15 = $1.85 per share. With put, total = s + p = K S0 p = 25 27 3.15 = $5.15/share, or $515 Without put, = ST S0 = $7/share, or $700 4) If ST = $31, put expires and gain on stock s = ST S0 = 31 27 = $4/share. total = ST S0 p = 4 3.15 = $0.85/share, or $85. 4. Covered Call: a) When used Institutional investor (pension or mutual fund) already owns the stock, but intends to sell it if the price St reaches some attractively high level of about $K per share. b) Procedure and payoff/profit. [Fig. 6] 1) At time t = 0:

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OPTIONS I

Already own stock, currently at S0 per share Write and sell (for c) a call option with strike price K per share 2) This call is covered because the writer has the shares which might have to be deli-vered if buyer of call decides to exercise. Establishes sell discipline. 3) If ST < K, option holder wont exercise and option writer wont want to sell stock. Profit to option writer = ST S0 + c per share, of which ST S0 is paper gain Without the call, = ST S0 4) If ST K, option holder exercises and option writer sells the stock at K. Profit to option writer is = K S0 + c per share, cash Without the call, = K S0, since they would have sold at St = K anyway KS0+ ($/share) c KS0 c 0 S0+c S0

stoc
k

total
Sell at K

S0 Fig. ST 6 Covered Call

call

c) Example. 1) Data for November 2007: Intel stock price S0 = $27/share JAN 2009 Intel call options with K = $35 trade at c = $1.18/share 2) Mutual fund owns 5,000 Intel shares worth 27 5000 = $135,000, and thinks that if the price rises to $35, they should sell and take the capital gain. 3) The mutual fund writes 50 JAN 09 $35 calls to sell for 1.18 100 50 = $5,900. 4) If ST = $33, the call option expires. The mutual fund shows a paper gain on its stock portfolio of ST S0 = 33 27 = $6/share. With the call written, total = ST S0 + c = 33 27 + 1.18 = $7.18/share Without the call, profit would have been = ST S0 = $6share 5) If ST = $37, the call is exercised. The stock gain s = ST S0 = 37 27 = $10, while the loss on the call option c = K ST + c = 35 37 + 1.18 = $0.82. With the call written, total = K S0 + c = 35 27 + 1.18 = $9.18/share

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OPTIONS I

Without the call, fund would have sold at St = $35 for = 35 27 = $8/share

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C. Selected Advanced Option Strategies 1. Long Straddle:

OPTIONS I

a) When used an investor expects a big price movement in St, either up or down, depending on the resolution of some merger decision or product liability or antitrust suit. b) Procedure and payoff/profit. [Fig. 7] 1) At time t = 0 buy both a put and a call, with same strike price K and expiration T; K S0. 2) At time t = T: If ST < K, let call expire but exercise put, buying stock at ST and selling at K, for cash profit = K ST (c+p) If ST > K, let put expire but exercise call, buying stock at K and selling at ST for cash profit = ST K (c+p) ($/share )

put

Fig. 7 Straddl e
KS0

call

0 c p (c+p)

K(c+p) (c+p) ST

K+

total

c) Example. 1) Data for November 2007: Intel stock price S0 = $27 JAN 08 Intel calls and puts with K = $27.50 trade at c = $1.21 and p = $1.85 2) Investor buys one Jan 08 $27.50 put and one call, betting that Intel stock is more volatile than the market expects it to be. The cost to open position is (p+c) 100 = $306. 3) If Intel rises to ST = $32: put option expires payoff on call is ST K = $4.50 total profit = [(ST K) (c + p)] 100 = $144 > 0 Investor was right about volatility and wins bet 4) If Intel falls to ST = $25: call option expires payoff on put is K ST = $2.50 total profit = [(K ST) (c + p)] 100 = $56 < 0 Investor was wrong about degree of volatility and loses bet

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OPTIONS I

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2. Butterfly Spread:

OPTIONS I

a) When used an investor expects very LITTLE price movement in St, neither up or down. (The investor is betting against volatility; this is the opposite of the straddle.) b) Procedure and payoff/profit. [Fig. 8] 1) At time t = 0: Buy call #1 with strike K1 and call #3 with strike K3 > K1, same T Write/sell two calls #2 with K2 = (K1 + K3)/2, same T Net cost to open position is c1 + c3 2c2 > 0 2) If, at time T, ST < K1, all options expire. = 2c2 (c1 + c3) < 0 3) If K1 < ST < K2, options #2 and #3 expire. Investor exercises #1, buying stock at K1 and selling at ST. = ST K1 + 2c2 (c1 + c3) 4) If K2 < ST < K3, option #3 expires. Investor buys 1 share from writer of option #1 and 1 share at ST and sells both to holder of options #2 for 2K2. Payoff = 2K2 K1 ST = 2[(K1 + K3)/2] K1 ST = K3 ST = K3 ST + 2c2 (c1 + c3) 5) If ST > K3, all options are exercised. Investor buys stock at K1 and K3 and delivers to holders of options #2 for 2K2. Payoff = 2K2 (K1 + K3) = 2[(K1 + K3)/2] (K1 + K3) = 0 = 2c2 (c1 + c3) < 0 c) Example. 1 for November 2007: 1) Data ($/share) Intel stock price S0 = $27 2c 08 Intel calls at right JAN 2 2) Investor buys 10 $25 and 10 $30 calls, and writes 20 total $27.50 calls. 3) If Intel ST = $28, = [30 28 + 2(1.21) (2.61 + 0.47)] 100 10 = $1,340. K $25. 00 $27. 3 50 $30. 00 c $2.6 1 $1.2 1 $0.4 7

0 2c2-c1-c3 -c3 -c1

K1

K3

ST Fig. 8 Butterfly Spread

K2 S0 2 2

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3. Bull Spread with Call Options:

OPTIONS I

a) When used investor believes stock price will rise, wants to protect against downside risk, and will trade some upside potential for a reduced cost of establishing the position. b) Procedure and payoff/profit. [Fig. 9] 1) At time t = 0: Buy call option #1 with strike price K1 and expiration T, paying premium C1 Write/sell call option #2 with same T and with strike price K2 > K1, receiving premium c2 < c1 Net cost per share of opening position is c1 c2 > 0 2) If, at time T, ST < K1, then both options expire. Cash = c2c1 < 0 3) If K1 < ST < K2, option #2 expires. Investor exercises #1, buys stock from writer of option #1 at K1 and sells at ST. Cash = ST K1 + c2c1 4) If ST > K2, then both options exercised. Investor buys stock from writer of option #1 at K1 and delivers to holder of option #2 at K2. Cash = K2 K1 + c2c1 ($/share)
K2K1+c2c1

Fig. 9 Bull Spread (Calls)

1 total

c2

K1
c2c1 c1

K2 ST 2

c) Example. 1) Data for November 2007: Intel stock price S0 = $27 JAN 08 Intel call options with K1 = $25 trade at c1 = $2.61 JAN 08 Intel calls with K2 = $30 trade at c2 = $0.47 2) Investor buys 20 JAN 08 $25 calls at a cost of 20 100 2.61 = $5,220, and sells 20 JAN 08 $30 calls for 20 100 0.47 = $940, a net cost of 5220 940 = $4,280. 3) If Intel stock price at time T is ST = $32, investor = [(30 25) + (0.47 2.61)] 20 100 = $5,720 ST = $28, investor = [(28 25) + (0.47 2.61)] 20 100 = $1,720

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OPTIONS I

ST = $24, investor = (0.47 2.61) 20 100 = $4,280

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4. Bear Spread with Put Options:

OPTIONS I

a) When used investor believes stock price will fall, wants to protect against downside risk, and will trade some upside potential for a reduced cost of establishing the position. b) Procedure and payoff/profit. [Fig. 10] 1) At time t = 0: Write/sell put option #1 with strike K1 and expiration T, receiving premium p1 Buy put option #2 with same T and with strike K2 > K1, paying premium p2 > p1 Net cost per share of opening position is p2 p1 > 0 2) If, at time T, ST > K2, then both options expire. Cash = p1 p2 < 0 3) If K1 < ST < K2, option #1 expires. Investor exercises #2, buys at ST and sells to writer of option #2 at K2. Cash = K2 ST + p1 p2 4) If ST < K1, then both options are exercised. Investor buys stock from holder of option #1 at K1 and sells to writer of option #2 at K2. Cash = K2 K1 + p1 p2 ($/share)

K2K1+p1p2
p1

Fig. 10 Bear Spread (Puts)

1 K1 K2 total 2 ST

p1p2 p2

c) Example. 1) Data for November 2007: Intel stock price S0 = $27 JAN 08 Intel put options with K1 = $25 trade at p1 = $0.74 JAN 08 Intel puts with K2 = $30 trade at p2 = $3.70 2) Investor sells 10 JAN 08 $25 puts for 10 100 0.74 = $740, and buys 10 JAN 08 $30 calls at cost of 10 100 3.70 = $3,700, a net cost of 3700 740 = $2,960. 3) If Intel stock price at time T is ST = $24, investor = [(30 25) + (0.74 3.70)] 10 100 = $2,040

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OPTIONS I

ST = $28, investor = [(30 28) + (0.74 3.70)] 10 100 = $960 ST = $32, investor = (0.74 3.70) 10 100 = $2,960

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5. Split-Strike Conversion: [omit]

OPTIONS I

a) When used an investor owns stock and has some gains on paper. 1) The split-strike conversion (aka collar or hedge wrapper) protects against down-side loss and establishes sell discipline if larger gains are possible. 2) This strategy was purportedly employed by Bernie Madoff with success for several years. He used European-style options on the S&P 100 stock index and expiration dates of 2-3 months. b) Procedure and payoff/profit (individual stock). [Fig. 11] 1) At time t = 0: Investor owns stock worth S0 per share. Buy an out-of-the-money put on the stock (or related stock index) with strike price Kp < S0 and expiration T; pay p. Write/sell OTM call on the same stock or index with Kc > S0, same T; get c. Net cost to open position is p c, a net gain if c - p > 0 2) If ST < Kp, exercise put to sell stock at Kp to option writer. Let call expire. total = s + p + c = (ST - S0) + (Kp - ST - p) + (c) = Kp - S0 + (c - p) < 0 Note that max loss on stock is S0 Kp; without options, max loss = S0. 3) If Kp < ST < Kc, both options expire, and you keep your stock. total = s + (c - p) = ST - S0 + (c - p), where s is a gain/loss on paper 4) If ST > Kc, let your put expire. You must sell stock (sell discipline) to call holder at Kc. total = s + p + c = (ST - S0) + (-p) + (Kc - ST + c) = Kc - S0 + (c - p) > 0

total c

-p

Kp Kc

S0 ST s

Fig. 11 Collar

c) Example. 1) Data for Feb 20, 2009: Investor owns stock worth S0 = $364 Apr 09 puts with Kp = 350 trade at p = $11.64. Apr 09 calls with Kc = 380 trade at c = $14.30. 2) Investor buys one April put for 11.64 100 = $1,164 and writes/sells one April call for 14.30 100 = $1,430, a net gain of $266. 3) If the stock price at time T is

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OPTIONS I

ST = 300, = (350364) 100 + $266 = $1,134 (worst-case loss limit). ST = 365, = $266 and you still own the stock. ST = 390, = (380364) 100 + $266 = $1,866 (max realized at stock sale).

Ec 174 p. 22 of 25

OPTIONS I

6. Long Calendar (aka Time or Horizontal) Spread: [Read only] a) When used. 1) Investors expect very little price movement in St; they are betting against volatility (as with the butterfly spread). 2) A short calendar spread is a bet on high volatility (as with the long straddle). 3) To analyze this spread, recall the following about option prices and values: Premium = intrinsic value + time value. At a give St and K, premiums rise with increasing T because of rising time value b) Procedure and payoff/profit. 1) At time t = 0: write/sell call #1 with strike price K and expiration T1, receiving premium c1 buy call #2 with the same K and expiration T2 > T1, paying premium c2 > c1 Net cost to open position is c2 c1 > 0. This is net long because you pay more for the long position (buy) than you get from the short position (write/sell). 2) At time t = T1 (when call #1 reaches maturity and when stock price St = S1): Both calls have intrinsic value S1 K > 0 or o, but you own one and owe the other, so they net out to $0 for you. Call #1 has $0 time value, but call #2 has time value > 0, which you recover by offset order to exit the position. You make a profit if the time value of call #2 > original cost c2 c1. c) Example. 1) It is 14 Jan 2010 and you believe Intel stock will remain close to S0 = 21.24. You write an April K = 21 call and sell it for $1.28, and buy a July K = 21 call for $1.68. You have paid (1.68-1.28)100 = $40 to open this long calendar spread. 2) Call #1 reaches expiration on 16 Apr and you will pay the holder S1 K if S1 > $21, or $0. Your Call #2 is worth S1 K > 0 or 0, plus its time value. You recoup this value by an off-setting order where you sell this same call #2 and exit your position. 3) Using the Black-Scholes-Merton model, we can figure out what the Call #2 premium will be on 16 Apr for various values of S1. The table and Figure 12 show the results.

Ec 174 p. 23 of 25 $
73

OPTIONS I
Exam ple S1 $10 $19 $20 $21 $22 $23 $24 $25 Pay on #1 $ 0 0 0 0 100 200 300 400 Get on #2 $0 40 70 113 170 239 317 403 Tot al $40 0 30 73 30 1 23 37

Fig. 12

-40

17

19

21

23

25 S1

Ec 174 p. 24 of 25

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PRACTICE PROBLEMS
Problem 1 A stock is currently trading at S0 = $26.80. An American-style call on this stock with strike price K = $25 and 12 days to expiration is trading at C = $1.80. Is this option in, at, or out of the money? What are the intrinsic and the time value of the option Problem 2 A stock price S0 = $40, and a 1-year European put on the stock with Kp = $30 is at p = $7, and a 1-year call with Kc = $50 is at c = $5. Suppose you own 100 shares, write one call option, and buy one put. Draw a diagram showing how your profit or loss varies with stock price over the next year. Problem 3 It is DEC 07 now. Use JUL 08 Amgen stock options to construct a butterfly spread, noting that S0 $55. A) Why might you favor this option position? B) What do you do today to open this position? C) Amgen is selling at ST = $48 at option maturity. What do you do, and what is your final profit? D) Graph profit ($/share) on this position as a function of ending stock price ST.

Amgen Inc.
Expirati on T Stri ke K $50 $55 $60

S0 = $54.89 Call c $8.9 0 5.50 3.65 Put p

$2. 61 4.5 JUL 08 0 7.9 Problem 4 0 Suppose that c1, c2, and c3 are the prices of European options with strike prices K1, K2, and K3. All have the same maturity date T. Let K2 = (K1 + K3)/2. A) Show that c2 (c1 + c3)/2. [Hint: consider portfolio that holds 1 K1 and 1 K3 call, and writes 2 K2 calls] B) Find the equivalent result for European put options.

ANSWERS
Problem 1 In the money; intrinsic = $1.80; time = $0

Collar

total

Problem 2 See Collar at right: total = s + p + c + c - p 8 ST < 30, call expires; = (ST - 40) + (30 - ST) - 2 = -12 30 < ST < 50, both expire; = (ST - 40) - 2 ST > 50, put expires; = (ST - 40) - (ST - 50) - 2 = 8

30 ST

40

50

-12 Problem 3 A) Favor if you think Amgen stock will stay close to $55/share. B) Buy the $50 and $60 calls, and write two $55 calls, all with July 2008 expiration. C) All options expire. = 2(5.50) (8.90 + 3.65) = $1.55/share D) See similar graph in notes. Problem 4 A) This is a butterfly spread. The payoff at T is always 0, so the PV is also 0. Therefore, the portfolio must have a value 0 today. But value today = cost to open c1 + c3 2c2 0, or c2 (c1 + c3)/2.

Ec 174 p. 25 of 25
B) p2 (p1 + p3)/2

OPTIONS I