Derivative Securities

FINA 3204
Options Basics

Andrew Chiu, PhD

andrew.chiu@ust.hk

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Course Overview

Forwards &
Futures

Market
Mechanics

Hedging
Strategies

Options

Pricing

Market
Mechanics

Properties

Trading
Strategies

Pricing

Binomial
Tree

Greeks

Black-Scholes

Other Derivatives

Warrants, CBBC

The Hong Kong University of

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Swaps

Convertible
Bonds

Structured
Products

FINA 3204: Derivative Securities

Andrew Chiu

Review of Option Types

A call is an option to buy
A put is an option to sell
A European option can be exercised only at
maturity
An American option can be exercised at any
time

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu

Payoffs from Options

What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff

Payoff

K
K

ST

ST

K
K

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ST

ST

FINA 3204: Derivative Securities

Andrew Chiu

Payoffs in Equation Form

Long Call:
Short Call:

max( 0, ST K )
- max( 0, ST K )

Long Put:
Short Put:

max( 0, K ST )
- max( 0, K ST )

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu

Options Contract Specification

Underlying Asset
Stocks, FX, stock indices, futures
Expiration date (T)
Quarterly, Monthly, Weekly expirations, LEAPS
Strike price (K or X)
European or American
Most options are American style
Call or Put
Settlement (Cash or Physical)
http://www.hkex.com.hk/eng/sorc/frontend/stk_opt_faq_3.htm#04
https://www.interactivebrokers.com/en/index.php?f=deliveryExercis
eActions&p=optionEx
The Hong Kong University of
Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Terminology
Moneyness
At-the-money option (ATM)
In-the-money option (ITM)
Out-of-the-money option (OTM)

Intrinsic Value
The value derived from the options moneyness

Time Value
The part of option value that is in excess of its
intrinsic value
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FINA 3204: Derivative Securities

Andrew Chiu

Margin
Margins are required only when options are
written
Hong Kong Stock Option Margin Requirements:
http://www.hkex.com.hk/eng/sorc/margin_data/margin_data
_search.aspx

Chicago Board of Options Exchange

http://www.cboe.com/micro/margin/introduction.aspx

If you own the stock and you write a call on the

stock, should you be subject to the same margin
requirement?
Portfolio Margin

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu

Options Exchanges
U.S.
CBOE (major options exchange)
CME Group (futures options)

Asia-Pacific
HKEX
http://www.hkex.com.hk/eng/prod/drprod/so/classlist_so.htm

Australian Securities Exchange

Tokyo Stock Exchange
Korea Exchange (index option only)
Singapore Exchange (index option only)

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Notations
c:

European call option

price

C:

American call option

price

p:

European put option

price

P:

American put option

price

S0:

Stock price today

ST:

K:

Strike price

Stock price at option

maturity

T:

Life of option

D:

s:

Volatility of stock
price

PV of dividends paid
during life of option

Risk-free rate for

maturity T with cont.
comp.

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu

Effect of Variables on Option Pricing

Variable

S0

+ (no div)
? (with div)

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu

Bounds for European or American Call

Options (No Dividends)

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu

Bounds for European and American Put

Options (No Dividends)

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Simple Bounds on Option Prices

Upper Bounds

c S0
C S0

p Ke rT
PK

Lower Bounds

c max( S0 Ke -rT , 0 )
p max( Ke -rTS0, 0 )
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Cc
Pp
FINA 3204: Derivative Securities
Andrew Chiu

Calls: An Arbitrage Opportunity?

Suppose that
c=3

S0 = 20

T=1

r = 10%

K = 18

D=0

Is there an arbitrage opportunity?

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FINA 3204: Derivative Securities

Andrew Chiu

Puts: An Arbitrage Opportunity?

Suppose that
p=1
T = 0.5

S0 = 37
r = 5%

K = 40

D =0

Is there an arbitrage opportunity?

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FINA 3204: Derivative Securities

Andrew Chiu

Put-Call Parity for European Options

c + Ke -rT = p + S0
If this relationship is violated, then there exists an
arbitrage opportunity because the payoffs are the same on
both sides.
This applies only to European options.
Can you identify the following popular strategies in this
equation?
Protective Put using put option to insure against price
drop
Capital Guaranteed Fund
Covered Write
Synthetic Futures
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FINA 3204: Derivative Securities

Andrew Chiu

Put-Call Parity for European Options

c + Ke -rT = p + S0
70
60

Payoff

50
40
30
20
10
0
0

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10

20
30
40
50
Stock Price at Expiration

60

FINA 3204: Derivative Securities

Andrew Chiu

Put-Call Parity for European Options

c - p = S0 - Ke -rT
c - p = [F0 K]e -rT
40
30

Payoff

20

10
0
-10

-20
-30
-40

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10

20
30
40
50
Stock Price at Expiration

60

FINA 3204: Derivative Securities

Andrew Chiu

Put-Call Parity for European Options

S0 - c = Ke rT - p
35
30

Payoff

25
20
15
10
5
0
0

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10

20
30
40
50
Stock Price at Expiration

60

FINA 3204: Derivative Securities

Andrew Chiu

Using Put-Call Parity for Replication

In the real-world, we can substitute a call with
a put and vice versa.
This is sometimes useful if one option is more
liquid or have tighter bid-ask spread than the
other.
Can you create a straddle using only call
options? Only put options?

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu

Put-Call Parity Arbitrage Example

Suppose that
c= 3

S0= 31

T = 0.25
K =30

r = 10%
D=0

What are the arbitrage possibilities when

p = 2.25 ?
p=1?

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu

Effects of Dividend
Lower Bounds

c max( S0 PV(D) Ke rT, 0 )

p max( Ke -rT S0 + PV(D), 0 )
Put-Call Parity

c + Ke -rT = p + S0 PV(D)
The Hong Kong University of
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FINA 3204: Derivative Securities

Andrew Chiu

Early Exercise of American Options

Should you exercise or sell the option?
An American call on a non-dividend paying stock should
never be exercised early
Call option price is always larger than intrinsic value, so
it is better to sell on the market
In this case, we have C=c
In reality, a large number of calls are exercised
It is optimal to exercise an American put on a nondividend paying stock if it is deep in-the-money
Ex: Imagine a stock falls to $0.01, the put option has almost
reached maximum value and has very little to gain by waiting.
The Hong Kong University of
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FINA 3204: Derivative Securities

Andrew Chiu

Early Exercise of American Options

With dividends, it is more complicated.
Sometimes it is optimal to exercise call options before
an ex-dividend date
In general, it is optimal to exercise if the dividend
amount is larger than the options time value. When
you exercise, you give up the time value in return for
receiving the dividend by holding the stock.

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Early Exercise Example (Call)

Assume rf = 0

One day before

Ex-Dividend Date

Ex-Dividend Date

Stock

S=100

S = 99, Div = 1

European Call (X=90)

c =9.20

American Call (X=90)

Buy call: -9.20

Exercise: -90 (receive stock in 2 days)
Short Stock: +100

Receive Div = 1 to pay borrower

Arbitrage Profit: 0.80
C >= S K

Exercise: pay -90 to buy stock

Cost of call: -10.30

S = 99
Div = 1
Loss = -0.30 (better to exercise)

Dont Exercise
Cost of call: -10.30

C = 9.30
Loss: -1

Exercise: pay -90 to buy stock

Cost of call: -12

S = 99
Div = 1
Loss = -2

Dont Exercise
Cost of call: -12

C = 11
Loss = -1 (better NOT exercise)

Suppose C = 9.20 (too low!)

American Call (X=90)
Short-dated
Suppose C = 10.30

American Call (X=90)

Long-dated
Suppose C = 12

c > S Div K

When exercising is optimal, then the market price will be C = S - K

The Hong Kong University of
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FINA 3204: Derivative Securities

Andrew Chiu

Dividend Capture
Buy stock and Sell in-the-money calls to capture dividend
when the counterparty does not exercise the call.
Assume rf = 0

Before Ex-Dividend Date

S = 100
American Call (X=90)
Suppose C = 10

Counterparty Exercises:

Buy Stock: -100

Sell Call: +10

Ex-Dividend Date

Sell stock for X=90: +90

Profit = 0

Counterparty Doesnt' Exercise:

S=99, Div=1
C=9
Buy back call: -9
Sell stock: +99
Receive Dividend: +1
Profit = +1
Even if S deviates from 99 by small
amounts, the profit is still +1

The Hong Kong University of

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FINA 3204: Derivative Securities

Andrew Chiu