Options are the right but not the obligation to buy (call) or sell (put) the underlying asset. The buyer of an option pays a premium for these rights to the seller of the contract. The seller of the contract is obligated to perform if the buyer exercises.
For purposes of this module, terms and conditions will relate to equity options.
The buyer of a call has the right, but not the obligation to buy the underlying asset at the strike price prior to or on the expiration date (depending on the expiration type). The buyer of the call pays a premium for the right.
The seller of a call receives the premium in exchange for taking on the obligation of selling the underlying asset (at the strike price) if the buyer of the call exercises. The call buyer is likely to exercise their right if the asset is ABOVE the strike price.
The buyer of a put has the right, but not the obligation to sell the underlying asset at the strike price prior to or on the expiration date (depending on the expiration terms of the option). The buyer of the put pays a premium for the right.
The seller of the put receives the premium in exchange for taking on the obligation of buying the underlying asset (at the strike price) if the buyer of the put exercises. The put buyer is likely to exercise their right if the asset is BELOW the strike price.
To price a call or put on the common stock of a public company, the following variables are known:
Asset price – the current price of the common stock (currency units per share)
Strike price – the price at which the option holder can buy (sell) the underlying asset upon exercising the call (put)
Expiration date – calculate the fraction of a year to expiration. i.e., 60 days to expiration = 60/365 = .16438
Expiration type – There are different types of exercise features:
Dividends – Any dividends which will be paid during the life of the option
Interest rate – The interest rate charged to borrow money from today to expiration day.
Implied Volatility – The market’s expectation of the magnitude of price change (up or down) at expiration.
The price of an option is broken down into two components: the intrinsic value and the time value.
Intrinsic Value is the amount the option is In-The-Money
Time Value is the amount above the Intrinsic Value
The diagram below shows the Theoretical Value & the Greeks for the option described.
The table below
Three questions to ask for any option strategy
The diagrams below show the payoff profiles (a.k.a. Hockeysticks) at expiration. The graphs show:
Viewing each of the four illustrations above, on the left is an intrinsic value table. Intrinsic tables show the intrinsic value of the option on the expiration day.
Intrinsic Tables make it easier to draw the “hockeysticks” or payoff profile graphs. Especially with spreads, straddles, etc.
Put-Call Parity defines the “arbitrage-free” price of the options.
The asset is purchased for $65.00.
To create a SYNTHETIC LONG position in the underlying asset: BUY CALL & SELL PUT (same strike & expiration date).
Notice the Synthetic Long Stock and Actual Long Stock provide the same result. This tells us the options are correctly priced with “no-arbitrage”.
Call Price (C) + Present value of Strike Price (Ke-rt) = Spot price of Asset (S) + put price (p)
MEMORY TIP: ClicK = SoaP
Just as we can create synthetic stock using options, we can create synthetic options using a combination of options and the underlying asset. The table below illustrates each possible single option position.
|USING OPTIONS TO CREATE SYNTHETIC POSITIONS IN UNDERLYING ASSET|
|SYNTHETIC LONG STOCK||=||LONG CALL + SHORT PUT|
|SAME STRIKE & EXPIRATION|
|SYNTHETIC SHORT STOCK||=||SHORT CALL + LONG PUT|
|SAME STRIKE & EXPIRATION|
|USING OPTIONS & ASSETS TO CREATE SYNTHETIC POSITION IN OPTIONS|
|SYNTHETIC LONG CALL||=||LONG STOCK + LONG PUT (1:1)|
|* long put against long stock|
|SYNTHETIC SHORT CALL||=||SHORT STOCK + SHORT PUT (1:1)|
|SYNTHETIC LONG PUT||=||SHORT STOCK + LONG CALL (1:1)|
|SYNTHETIC SHORT PUT||=||LONG STOCK + SHORT CALL (1:1)|