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1. Lecture
FIN550

2. Learning Outcomes
 Appraise with the option terminology to manage an
organization’s risk and reduce it through hedging .
 Differentiate between the different Future and Option in
derivative segment.
 Magnify the impact of option value on investment and
hedging strategies

3. Options
 Options allow you to make money whether the stock
market is going up, down or sideways because, just as the
name suggests,
 Options give you the option to buy or sell a security (stocks,
exchange-traded funds, indices, commodities, etc.) at some
point in the future.

4. Option Terminology
Put Option
Right to sell an asset at a specified exercise price
on or before the exercise date
Call Option
Right to buy an asset at a specified exercise
price on or before the exercise date

5. It is vital to know who has the Right to
transact vs. who may be Obliged to
transact in order to determine the
direction of cash flows at expiry
CALL
PUT
BUYER SELLER
Has the Right to Buy
the Asset
Has the Potential Obligation to
Sell the Asset if Exercised
Has the Right to Sell
the Asset
Has the Potential Obligation to
Buy the Asset if Exercised

6. Options Terminology
Terminology
 Derivatives - Any financial instrument that is derived from
another. (e.g.. options, warrants, futures, swaps, etc.)
 Option - Gives the holder the right to buy or sell a security at a
specified price during a specified period of time.
 Call Option - The right to buy a security at a specified price within a
specified time.

7. Terminology
 Put Option - The right to sell a security at a specified price within a
specified time.
 Option Premium - The price paid for the option, above the price of
the underlying security.
 Intrinsic Value - Diff between the strike price and the stock price
 Time Premium - Value of option above the intrinsic value
Options Terminology

8. Terminology
 Exercise Price - (Striking Price) The price at which you buy or
sell the security.
 Expiration Date - The last date on which the option can be
exercised.
 American Option - Can be exercised at any time prior to and
including the expiration date.
 European Option - Can be exercised only on the expiration date.
Options Terminology

9. Call Option
 A call option gives you the right to buy a stock from the investor who
sold you the call option at a specific price on or before a specified date
 For instance,
 If you bought a 35 next month call option on General Electric , the option
would come with terms telling you that you could buy the stock for 35 (the
strike price) any time before the the expiration date.
 What this means is, if GE rises anywhere above 35 before the expiration
date, you can buy the stock for less than its market value.
 Or if you don't want to buy the stock yourself or exercise the option, you can
sell your option to someone else for a profit.

10. Put Option
 A put option gives you the right to sell a stock to the investor who sold
you the put option at a specific price, on or before a specified date.
 For instance,
 If you bought a 25 next month put option on Pfizer , the option would come
with terms telling you that you could sell the stock for 25 (the strike price)
any time before the expiration date.
 What this means is, if Pfizer falls anywhere below 25 before the expiration
date, you can sell the stock for more than its market value.
 And if you don't want to sell the stock yourself, you can sell your option to
someone else for a profit.

11. Example (Call Option)/ Bullish
 Profit from stock price gains with limited risk and lower cost than buying the
stock outright
 Example:
 You buy one Reliance Communication (RCOM) 25 call with the stock at 25, and
you pay Rs.1 as premium
 Rcom moves up to 28 and so your option is Rs. 3 in value
 Returns?

12. Example (Put Option)/ Bearish
 Strategy:
 Profit from stock price drops with limited risk and lower cost than shorting the
stock
 Example:
 You buy one Reliance Communication (RCOM) 20 put with the stock at 21, and
you pay Rs.0.8 as premium
 Rcom drops to 18 and so your option is Rs. 2 in value
 Returns?

13. Money Ness of options

14. Money Ness of options

15. Option Value Payoffs
 Call buyer profit – assume strike of $530 and option
price of $36.00
Share price
Position
value
Long call
530 566.00
-36.00
Break even

16.  Put seller profit – assume strike of $530 and option
price of $34.55
Share price
Position
value
Short put
495.45 530
+34.55
Break even
Option Value Payoffs

17. Chapter 29
Options
17

18. Chapter 29
Options
18

19. Put option Pay off
 https://financetrain.com/put-option-payoff

20. Graphical View
Call Holder & Writer
Options
Graphical View; Pay off of Call Option for Buyer and Seller
Pay off Pay off
HOLDER/BUYER WRITER/SELLER
(S-X-c)
X c
- c Price, S X Price, S
- (S-X-c)

21. Graphical View
Put Holder & Writer
Options
Graphical View; Pay off of Put Option for Buyer and Seller
Pay off Pay off
HOLDER/BUYER WRITER/SELLER
-(X-S-p)
X p
X
Price, S Price, S
(X-S-p) - p

22. Chapter 29
Options
22

24.  Delta
 Gamma
 Vega
 Theta
 Rho
THE “GREEKS”

25. OPTION GREEKS (SUMUP)

26. VALUING OPTIONS
 Simple Option Valuation Model
26

27. OPTION VALUATION
METHODS
 Google call options have an exercise price of
$530
Case 1 (20% Fall)
Stock price falls to
$424
Option value = $0
Case 2 (25% Rise)
Stock price rises to
$662.50
Option value = $132.50

28. OPTION VALUATION
METHODS
Since the Google call option is equal to a leveraged
position in .556 shares, the option delta can be
computed as follows:
555556
.
424
50
.
662
0
50
.
132
prices
share
possible
of
spread
prices
option
possible
of
spread
delta
Option






29. OPTION VALUATION
METHODS
Assume you buy .556 of a Google share and borrow $235.56
from the bank (@1.0%)
Value of call = .556 × 530 – 235.56/1.01
= $61.22

30. OPTION VALUATION
METHODS
The Google PUT option can then be valued based on
the following method:
Case 1(20% Fall)
Stock price falls to $424
Option value = $106.00
Case 2(25% Rise)
Stock price rises to $662.50
Option value = $0

31. OPTION VALUATION
METHODS
Since the Google PUT option is equal to a leveraged
position in .4444 shares, the option delta can be
computed as follows:
4444
.
424
50
.
662
00
.
106
0
prices
share
possible
of
spread
prices
option
possible
of
spread
delta
Option







32. OPTION VALUATION
METHODS
Assume you SELL .4444 of a Google share and lend
$294.44 (@1.0%)
Value of put = -(.4444) × 530 + 294.44/1.01
= $55.97

33. OPTION VALUE
Components of the Option Price
1 - Underlying stock price
2 - Striking or exercise price
3 - Volatility of the stock returns (standard deviation
of annual returns)
4 - Time to option expiration
5 - Time value of money (discount rate)

34. OPTION VALUE
   
)
(
PV
)
(
)
( 2
1 EX
d
N
P
d
N
OC 



Black-Scholes Option Pricing Model

35. OC - call option price
P - stock price
N(d1) - cumulative normal probability density function of (d1)
PV(EX) - present value of strike or exercise price
N(d2) - cumulative normal probability density function of (d2)
r - discount rate (90 day comm paper rate or risk free rate)
t - time to maturity of option (as % of year)
v - volatility - annualized standard deviation of daily returns
BLACK-SCHOLES OPTION
PRICING MODEL
   
)
(
PV
)
(
)
( 2
1 EX
d
N
P
d
N
OC 


