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Liuren Wu

Zicklin School of Business, Baruch College

Options Markets

Liuren Wu (Baruch)

Payoffs

Options Markets

1 / 34

An option gives the option holder the right/option, but no obligation, to buy

or sell a security to the option writer/seller

I

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at (or up to) a given time in the future (the expiry date )

Comparison: a forward contract has zero value at inception.

Option types

I

A call option gives the holder the right to buy a security. The payoff is

(ST K )+ when exercised at maturity.

A put option gives the holder the right to sell a security. The payoff is

(K ST )+ when exercised at maturity.

Liuren Wu (Baruch)

Payoffs

Options Markets

2 / 34

More terminologies

Moneyness: the strike relative to the spot/forward level

I

exercised right now:

F

F

F

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value.

F

F

Sometimes it is also defined in terms of the forward price at the same

maturity (in the money forward): Ft > K for call and Ft < K for put

The option has positive intrinsic value when in the money. The

intrinsic value is (St K )+ for call, (K St )+ for put.

We can also define intrinsic value in terms of forward price.

Out-of-the-money forward: Ft < K for call and Ft > K for put.

is equal to the spot (or forward).

Liuren Wu (Baruch)

Payoffs

Options Markets

3 / 34

More terminologies

The value of an option is determined by

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the strike price K ,

the time to maturity = T t,

the option type (Call or put, American or European), and

the dynamics of the underlying security (e.g., how volatile the security

price is).

Out-of-the-money options do not have intrinsic value, but they have time

value.

Time value is determined by time to maturity of the option and the

dynamics of the underlying security.

Generically, we can decompose the value of each option into two

components:

option value = intrinsic value + time value.

Liuren Wu (Baruch)

Payoffs

Options Markets

4 / 34

Stocks (OMON)

Stock indices

Index return variance (new)

Exchange rate (XOPT)

Futures

Liuren Wu (Baruch)

Payoffs

Options Markets

5 / 34

Expiration date (T )

Strike price (K )

European or American

Call or Put (option class)

OTC options (such as OTC options on currencies) are quoted differently.

Liuren Wu (Baruch)

Payoffs

Options Markets

6 / 34

Most exchanges use market makers to facilitate options trading.

A market maker is required to provide bid and ask quotes

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The risk is market movements.

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The bid-ask is wide (stock options). The tick size is 10 cents on

options with prices higher than $3. It is 5 cents otherwise.

Liuren Wu (Baruch)

Payoffs

Options Markets

7 / 34

Since there can be hundreds of options underlying one stock, when the stock

price moves, quotes on the hundreds of options must be updated

simultaneously.

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volume.

The risk exposure is large compared to the benefit.

F

(say, going up), the customer can buy all the call options and sell all

the put options underlying one stock.

The market makers risk exposure is the sum of all the quote sizes he

honors on each contract.

Market makers hedge their risk exposures by buying/selling stocks

according to their option inventories.

quotes, and calculate their optimal hedging ratios.

well-capitalized firms.

Liuren Wu (Baruch)

Payoffs

Options Markets

8 / 34

A rapidly changing landscape

Old exchanges:

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AMEX (American Stock Exchange)

PCX( Pacific Stock Exchange)

PHLX (Philadelphia Stock Exchange)

New developments:

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+ Deuche B

ourse, (2007)

BOX (Boston Options Exchange, February 2004)

NYSE Arca Options: ((Archipelago+PCX)+NYSE)+Euronext (2007)

Liuren Wu (Baruch)

Payoffs

Options Markets

9 / 34

Margins

When a naked option is written the margin is the greater of:

I

share price less the amount (if any) by which the option is out of the

money

A total of 100% of the proceeds of the sale plus 10% of the underlying

share price.

Liuren Wu (Baruch)

Payoffs

Options Markets

10 / 34

For European options, the terminal payoff can be written as (ST K )+ for

calls and (K ST )+ for puts at expiry date T .

Since options have positive value, one needs to pay an upfront price (option

price) to possess an option.

The P&L from the option investment is the difference between the terminal

payoff and the initial price you pay to obtain the option.

Do not confuse the two.

The textbook likes to talk about P&Ls, but I like to talk about payoffs

Different perspectives:

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under different scenarios? Whats my return?

Payoffs: If I desire a certain payoff structure in the future, what types

of options/positions I need to generate it?

Liuren Wu (Baruch)

Payoffs

Options Markets

11 / 34

Consider a European call option on a stock index. The current index level (spot

St ) is 100. The option has a strike (K ) of $90 and a time to maturity (T t) of

1 year. The option has a current value (ct ) of $14.

Is this option in-the-money or out-of-the-money (wrt to spot)?

Whats intrinsic value for this option? Whats its time value?

If you hold this option, whats your terminal payoff?

I

Whats your payoff and P&L if the index level reaches 100, 90, or 80 at

the expiry date T ?

If you write this option and have sold it to the exchange, what does your

terminal payoff look like?

I

Whats your payoff and P&L if the index level reaches 100, 90, or 80 at

the expiry date T ?

Liuren Wu (Baruch)

Payoffs

Options Markets

12 / 34

(St = 100, K = 90, ct = 14)

30

30

20

20

10

10

20

10

20

70

80

90

100

Spot at expiry, ST

110

30

60

120

30

30

20

20

30

60

10

10

10

20

30

60

70

80

90

100

Spot at expiry, ST

110

120

70

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100

Spot at expiry, ST

110

120

10

10

20

70

80

90

100

Spot at expiry, ST

110

120

30

60

Long a call pays off, (ST K ) , bets on index price going up.

Shorting a call bets on index price going down.

Liuren Wu (Baruch)

Payoffs

Options Markets

13 / 34

Consider a European put option on the dollar price of pound (GBPUSD). The

current spot exchange rate (St ) is $1.6285 per pound. The option has a strike

(K ) of $1.61 and a time to maturity (T t) of 1 year. The 1-year forward price

(Ft,T ) is $1.61. The dollar continuously compounding interest rate at 1-year

maturity (rd )is 5%. The option (pt ) is priced at $0.0489.

From the above information, can you infer the continuously compounding

interest rate at 1-year maturity on pound (rf )?

Is this option in-the-money or out-of-the-money wrt to spot? Whats the

moneyness in terms of forward?

In terms of forward, whats intrinsic value for this option? Whats its time

value?

If you hold this option, whats your terminal payoff, if the dollar price of

pound reaches 1.41, 1.61. or 1.81 at the expiry date T ?

Liuren Wu (Baruch)

Payoffs

Options Markets

14 / 34

rf = rd T 1t ln(Ft,T /St ) = .05 ln(1.61/1.6285)/1 = 6.14%.

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( T 1t ln(Ft,T /St )) on exchange rates equals interest rate differential

(rd rf ) between the two currencies.

Long a put option pays off, (K ST )+ , and bets on the underlying currency

(pound) depreciates.

Shorting a put option bets on pound appreciates.

How does it differ from betting using forwards?

Liuren Wu (Baruch)

Payoffs

Options Markets

15 / 34

0.5

0.5

0.4

0.4

0.3

0.3

0.2

0.1

0

0.1

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0

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1

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Spot at expiry, ST

1.8

0.5

0.5

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0.3

0.2

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0

0.1

0.2

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Spot at expiry, ST

1.8

0.1

0

0.1

0.2

0.3

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1.4

1.6

Spot at expiry, ST

0.2

0.3

0.5

1.2

0.5

1.2

Liuren Wu (Baruch)

1.4

1.6

Spot at expiry, ST

1.8

Payoffs

Options Markets

16 / 34

120

15

115

10

10

110

105

100

95

10

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90

15

15

20

80

85

90

95

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105

Spot at expiry, ST

110

115

20

80

120

85

85

90

95

100

105

Spot at expiry, ST

110

115

80

80

120

20

20

80

15

15

85

10

10

90

105

10

110

15

15

85

90

95

100

105

Spot at expiry, ST

Liuren Wu (Baruch)

110

115

120

20

80

90

95

100

105

Spot at expiry, ST

110

115

120

95

100

105

Spot at expiry, ST

110

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95

Payoff

Payoff

Payoff

20

15

Payoff

20

Payoff

Payoff

115

85

90

95

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105

Spot at expiry, ST

Payoffs

110

115

120

120

80

85

90

Options Markets

17 / 34

Put-call conversions

Plot the payoff function of the following combinations of calls/puts and forwards

at the same strike K and maturity T .

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Liuren Wu (Baruch)

Payoffs

Options Markets

18 / 34

2

15

15

15

10

10

10

Payoff

20

10

10

10

15

15

20

80

85

90

95

100

105

Spot at expiry, ST

110

115

20

80

120

15

85

90

95

100

105

Spot at expiry, ST

110

115

20

80

120

15

15

15

10

10

10

Payoff

20

0

5

10

10

10

15

15

90

95

100

105

Spot at expiry, ST

110

115

120

20

80

95

100

105

Spot at expiry, ST

110

115

120

110

115

120

85

90

20

20

80

85

20

Payoff

Payoff

20

Payoff

Payoff

1

20

15

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90

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100

105

Spot at expiry, ST

110

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120

20

80

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105

Spot at expiry, ST

The dash and dotted lines are payoffs for the two composition instruments.

The solid lines are payoffs of the target.

Liuren Wu (Baruch)

Payoffs

Options Markets

19 / 34

The above conversions reveal the following parity condition in payoffs of put,

call, and forward at the same strike and maturity:

Payoff from a call Payoff from a forward = Payoff from a put

Payoff from a put + Payoff from a forward = Payoff from a call

Payoff from a call Payoff from a put = Payoff from a forward

If the payoff is the same, the present value should be the same put-call

parity:

ct pt = e r (T t) (Ft,T K ).

At a fixed strike (K ) and maturity T , we only need to know the two prices

of the following three: (ct , pt , Ft,T ).

One of the three contracts is redundant.

Liuren Wu (Baruch)

Payoffs

Options Markets

20 / 34

A more formal definition:

ct = e r (T t) (Ft,T K )+ + TVt ,

pt = e r (T t) (K Ft,T )+ + TVt .

Call and put at the same maturity & strike (T , K ) have the same time.

Most option pricing models only deal with the time value, and take the

forward (financing) and hence intrinsic value as given (starting point).

To estimate these option pricing models, one only needs to use the time

value at each (T , K ), which is the out-of-the-money option (call when

Ft < K and put otherwise).

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for the same reason.

Most professional options traders are trading the time value only.

Liuren Wu (Baruch)

Payoffs

Options Markets

21 / 34

Can you use a spot and bond to replicate a forward payoff?

Whats the payoff function of a zero bond?

Liuren Wu (Baruch)

Payoffs

Options Markets

22 / 34

20

15

10

Payoff

5

0

5

10

15

20

80

85

90

95

100

105

Spot at expiry, ST

110

115

120

Can you generate the above payoff structure (solid blue line)

using (in addition to cash/bond):

two calls

two puts

a call, a put, and a stock/forward

Who wants this type of payoff structure?

Liuren Wu (Baruch)

Payoffs

Options Markets

23 / 34

Two calls: Long call at K1 = $90, short call at K2 = $110, short a bond

with $10 par.

Two puts: Long a put at K1 = $90, short put at K2 = $110, long a bond

with $10 par.

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Spot at expiry, ST

Liuren Wu (Baruch)

110

115

120

20

80

10

Payoff

Payoff

Payoff

K2 = $110, long a forward at K = 100 (or long a stock, short a bond at

$100 par).

30

80

0

5

10

15

20

85

90

95

100

105

Spot at expiry, ST

Payoffs

110

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25

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Spot at expiry, ST

110

115

120

Options Markets

24 / 34

Each kinky point corresponds to a strike price of an option contract.

Given put-call party, you can use either a call or a put at each strike point.

Use bonds for parallel shifts.

A general procedure using calls, forwards, and bonds

I Starting from the left side of the payoff graph at S

T = 0 and progress

to each kinky point sequentially to the right.

I If the payoff at S

T = 0 is x dollars, long a zero-coupon bond with an

x-dollar par value. [Short if x is negative].

I If the slope of the payoff at S

T = 0 is s0 , long s0 shares of a

call/forward with a zero strike A call at zero strike is the same as a

forward at zero strike. [Short if s0 is negative.]

I Go to the next kinky point K . If the next slope (to the right of K is

1

1

s1 , long (s1 S0 ) shares of call at strike K1 . Short when the slope

change is negative.

I Go to the next kinky point K with a new slope s , and long (s s )

2

2

2

1

shares of calls at strike K2 . Short when the slope change is negative.

I Keep going until there are no more slope changes.

Liuren Wu (Baruch)

Payoffs

Options Markets

25 / 34

A general procedure using puts, forwards, and bonds

I

Starting from the right side of the payoff graph at the highest strike

under which there is a slope change. Let this strike be K1 .

x-dollar par value. [Short if x is negative].

K1 . Short the forward if s0 is negative.

Long if (s1 s0 ) is negative.

(s2 s1 ) put with strike K2 .

Liuren Wu (Baruch)

Payoffs

Options Markets

26 / 34

20

15

10

Payoff

5

0

5

10

15

20

80

85

90

95

100

105

Spot at expiry, ST

110

115

120

How many (at minimum) options do you need to replicate the bear spread?

Do the exercise, get familiar with the replication.

Who wants a bear spread?

Liuren Wu (Baruch)

Payoffs

Options Markets

27 / 34

Example: Straddle

30

25

20

Payoff

15

10

5

0

5

10

80

85

90

95

100

105

Spot at expiry, ST

110

115

120

How many (at minimum) options do you need to replicate the straddle?

Do the exercise, get familiar with the replication.

Who wants long/short a straddle?

Liuren Wu (Baruch)

Payoffs

Options Markets

28 / 34

Example: Strangle

40

35

Payoff

30

25

20

15

10

80

85

90

95

100

105

Spot at expiry, ST

110

115

120

How many (at minimum) options do you need to replicate the strangle?

Do the exercise, get familiar with the replication.

Who wants long/short a strangle?

Liuren Wu (Baruch)

Payoffs

Options Markets

29 / 34

30

25

20

15

Payoff

10

5

0

5

10

15

20

80

85

90

95

100

105

Spot at expiry, ST

110

115

120

How many (at minimum) options do you need to replicate the butterfly

spread?

Do the exercise, get familiar with the replication.

Who wants long/short a butterfly spread?

Liuren Wu (Baruch)

Payoffs

Options Markets

30 / 34

10

10

Payoff

Payoff

8

10

80

8

85

90

95

100

105

Spot at expiry, ST

110

115

120

10

80

85

90

95

100

105

Spot at expiry, ST

110

115

120

How many (at minimum) options do you need to replicate the risk reversal?

Do the exercise, get familiar with the replication.

Who wants long/short a risk reversal?

Liuren Wu (Baruch)

Payoffs

Options Markets

31 / 34

400

350

300

Payoff

250

200

150

100

50

0

80

85

90

95

100

105

Spot at expiry, ST

110

115

120

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The weight on each strike K is 2dK .

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Variance swap contracts on major stock indexes are actively traded.

Liuren Wu (Baruch)

Payoffs

Options Markets

32 / 34

f (ST )

f (Ft )

bonds

+f(0 (Ft )(ST Ft )

forwards

)

R Ft 00

+

(K

)(K

S

)

dK

f

T

+ R0 00

OTM options

f (K )(ST K )+ dK

Ft

I With bonds, forwards, and European options, we can replicate any

terminal payoff structures.

I More exotic options deal with path dependence, correlations, etc.

You do not need to memorize the formula.

Proof: Optimal positioning in derivative securitiesby Carr and Madan,

Quantitative Finance, 2001.

Can you reconcile this formula with my tips on using calls alone, or puts

alone to replicate any payoffs?

Can you provide some tips (suggested steps) to replicate any payoffs using

out-of-the-money options only (plus cash & forwards)?

Code them up and see if they work.

Liuren Wu (Baruch)

Payoffs

Options Markets

33 / 34

Replication applications

Replicate the return variance swap using options and futures.

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in the options market.

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I

Information

Information

Information

Information

about

about

about

about

return variance.

large movements of a certain direction.

large movements of either direction.

Examples:

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I

portfolio approach, Review of Derivatives Research, 2006, 9, 3765.

Jianfeng Hu.

Put-call parity violations and stock returns

may not be reliable.

Example: ATM volatility versus synthetic variance swap.

Liuren Wu (Baruch)

Payoffs

Options Markets

34 / 34

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