Introduction to Options No Format

8/12/2019 Introduction to Options No Format

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Jack Farmer

Introduction to Options


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Introduction to Options

Basic Option Positions

Intuitive Option Pricing

Option Premium

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Option Premium

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Basic Option Positions:Long Forward

Obligated to buy

shares at an agreedprice at a futurepoint in time.

No cost upfront.

Makes money whenthe share pricerises.

Loses money when

the share price falls.

3

P&L

Share Price +0

-

+


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Basic Option Positions:Short Forward

Obligated to sell

shares at an agreedprice at a futurepoint in time.

No cost upfront.

Make money whenthe share price falls.

Lose money whenthe share price rises.

4

P&L

Share Price +0

-

+


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Basic Option Positions:Long Call

The right to buy the

share at an agreedprice at a future pointin time.

Pays a percentage ofthe share price up front

(premium). Makes money as the

share price rises abovethe strike price.

Loses premium paidwhen the share price isbelow the strike price.

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P&L

Share Price

+

0

-

+

Strike Price

Breakeven

Loss


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Basic Option Positions:Short Call

Obligated to sell shares

should the long callchoose to exercise.

Receives a percentageof the share price up

front. Loses money when the

share price rises.

P&L equal to premium

when the share pricefalls.

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P&L

Share Price

+0

+

-

Breakeven

Strike Price

Gain


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Basic Option Positions:Long Put

The right to sell the

share at an agreedprice at a future pointin time.

No obligation.

Pay premium up front. Makes money when

the share price falls.

Loses premium when

the share price rises.

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P&L

Share Price

+0

+

-


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Basic Option Positions:Short Put

Obligated to buy

shares should thelong put choose toexercise.

Receives premium up

front. P&L equal to

premium when theshare price rises.

Loses money whenthe share price falls.

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P&L

Share Price +0

+

-


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Option Premium

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Intuitive Option Pricing:Pegboard Game

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0 0 0 0 00 0 100 200 300 40 8050 9060 10070


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Intuitive Option Pricing:Rules

Earn the money shown on the tube into which

the ball drops Drop the ball from anywhere on the board

Pay to drop the ball depending on where you

choose to drop it

How much should each drop cost?

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Which drop should cost more?

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0 0 0 0 00 0 100 200 300 40 8050 9060 10070

Up at the top in

the middle of the

game?

In the middle of the

game both vertically

and horizontally?


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Time to Vote

Up at the top in the middle

In the middle both vertically and horizontally

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Drop in Middle Halfway Down

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0 0 0 0 00 0 100 200 300 40 8050 9060 10070

In the middle of the

game both vertically

and horizontally?

Drop 1,000 balls

2 18

70

164

2 46 246

164

70

18 2


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Weighted Average Payout

Count Payout Cost Wtd Avg

2 0 0 0.00

18 0 0 0.00

70 0 0 0.00

164 0 0 0.00

246 0 0 0.00

246 10 2,460 2.46

164 20 3,280 3.28

70 30 2,100 2.10

18 40 720 0.72

2 50 100 0.10

1,000 8,660 8.66

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Price to Drop in Middle

Average payout using binomial probability is 8.66

To cover expected losses, game owner has tocollect at least that much

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Drop in Middle at Top

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0 0 0 0 00 0 100 200 300 40 8050 9060 10070

Up at the top in

the middle of the

game?

0 0 0 3 7 22

52

96

144 176 176

144

96

52

227 3 0 0 0

Drop 1,000 balls


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3 0 0 0.00

7 0 0 0.00

22 0 0 0.00

52 0 0 0.00

96 0 0 0.00

144 0 0 0.00

176 0 0 0.00

176 10 1,760 1.76

144 20 2,880 2.88

96 30 2,880 2.88

52 40 2,080 2.08

22 50 1,100 1.10

7 60 420 0.42

3 70 210 0.21

1,000 11,330 11.3318


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Price to Drop in Middle at Top

Average payout using binomial probability is

11.33 Why should it cost more than further down?

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Ball Drop Cost Along Middle Line

The cost of dropping a

ball rises as you move upthe middle line

Can you explain why?

Rows Cost19 11.33

17 10.82

15 10.34

13 9.86

11 9.24

9 8.66

7 7.985 7.18

3 6.25

1 5.00

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21

0 10 20 40 6030 50 10070 11080 12090 130 170140 180150 190160

On the right at the

top?

On the right in the

middle?


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0 10 20 40 6030 50 10070 11080 12090 130 170140 180150 190160

On the right in the

middle?

2 18

70

164

246 246

164

70

18 2

Drop 1,000 balls


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2 50 100 0.10

18 60 1,080 1.08

70 70 4,900 4.90

164 80 13,120 13.12

246 90 22,140 22.14

246 100 24,600 24.60

164 110 18,040 18.04

70 120 8,400 8.4018 130 2,340 2.34

2 140 280 0.28

1,000 95,000 95.00

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Price to Drop on Right in Middle

Average payout using binomial probability is 95

This is the average of the values in the reachablerange

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0 10 20 40 6030 50 10070 11080 12090 130 170140 180150 190160

On the right at the

top?

0 0 0 3 7 22

52

96

144 176 176

144

96

52

227 3 0 0 0

Drop 1,000 balls


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3 30 90 0.09

7 40 280 0.28

22 50 1,100 1.10

52 60 3,120 3.12

96 70 6,720 6.72

144 80 11,520 11.52

176 90 15,840 15.84

176 100 17,600 17.60

144 110 15,840 15.84

96 120 11,520 11.52

52 130 6,760 6.76

22 140 3,080 3.08

7 150 1,050 1.05

3 160 480 0.48

1,000 95,000 95.00

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Price to Drop on Right at Top

Average payout using binomial probability is still

95 What is going on?

Please take a moment and explain this to each

other.

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Ball Drop Cost on the Right

The cost of dropping a

ball does not change asyou move up the rightside.

Can you explain why?

For the price to rise, whatwould have to be thecase?

Rows Cost19 95.00

17 95.00

15 95.00

13 95.00

11 95.00

9 95.00

7 95.005 95.00

3 95.00

1 95.00

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Asymmetrical Payouts

The key lies with the payouts of 0

If no 0s are in reach, the price to drop stays thesame

Each additional tube higher is offset by the

additional tube lower +10 on the right means -10 on the left

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hi h d h ld


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0 0 0 0 00 0 00 00 00 0 00 00 100

On the left at the

top?

On the left in the

middle?

Both drops cost nothing since neither can reach any payouts.

l i O i


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Analogies to Options

Premium

Strike

Time

Volatility

Cost to drop ball. Game

owner is option seller. Boundary between 0 and

positive payouts

Height of drop (number of

rows) Bounciness of game: ball,

pegs, backing

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Option Premium

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O ti P i B & S ll


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Option Premium:Buyers & Sellers

Call buyers Long shares

Own all upside in share

Unlimited gains

Can only lose premiumalready paid

Limited losses

Call sellers Short shares

Must pay all upside in share

Unlimited losses

Can only earn premiumalready paid

Limited gains

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O ti P i G l


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Option Premium:Google

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Source: Bloomberg

StrikesCallPrices

Expiries

Share

Focus on

O ti P i G l J 08 C ll


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Option Premium:Google Jan 08 Calls

On November 2, 2007

Google shares are$706.28

Strike of $700

American style exercise

Last trade at $49.00 percall

Call costs 6.94% of shareprice (leverage).

How much higher wouldGoogles price need to risefor a call buyer to breakeven?

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Source: Bloomberg

L i b t O ti L h Li


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Learning about Options on Lehman Live

LL: Equities

Products and Services Derivatives

Listed Derivatives

Option Class Materials

Class 1 Basics.ppt Definitions

Payoff Diagrams and Examples

Moneyness

Leverage Put-Call Parity

Class 2 Basics.ppt Put-Call Parity Revisited

Introduction to Delta

Introduction to Gamma

Volatility and Vega Effect of Time to Maturity

and Theta

Effect of Interest andDividend

Documents

Introduction to Options No Format