Understanding Options
Level 1
Course Introduction
How options can How they can be
be used to hedge used for The flexibility of
underlying speculative options
positions purposes
Expiry profiles of Options strategy
options modeler
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What Will Be Learned
This session starts with a The session also explains how
01. comparison of an option versus a 02. option payoff diagrams work
future/forward contract, which is and the intuition behind an
fundamental to understanding option premium (both of which
rights and obligations and other are expanded upon in later
option terminology. sessions).
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Course Objectives
Define the basic terminology Understand option pay off profiles and Interpret time value and intrinsic value
surrounding options such as calls/puts, compare with futures and forwards. and identify the concept of put-call
and obligations/rights. parity.
Explain moneyness of an option and Compare options with simple Describe long call and long put hedges
evaluate how time and price affect the future/forward hedges alongside and summarize the concept of portfolio
premium of an option. examining common option hedges. protection.
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Introduction
What Is a Future/Forward?
Future/Forward
• Obligation to deliver or take delivery of an underlying asset
• Quantity and quality is agreed today at a fixed price for a certain delivery day in the future
• Future and forwards can be cash settled and can also be based upon
derivatives.
• Key thing with forwards and futures, you have this commitment.
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What Is an Option?
Option
Right (not obligation) to buy (call) or sell (put) the underlying asset on or before a certain day in the future.
• Options traded on exchanges can be settled physically or by cash
• Can be traded OTC and are sometimes called exotics
• Warrants are a type of option
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Options – Rights and Obligations
Long call =
Holder/Buyer of Call
Right to buy
Premium
Call
Short call =
Writer/Seller of Call
Obliged to sell
Long put =
Options Holder/Buyer of Put
Put Right to sell
Premium
Short put =
Writer/Seller of Put
Obliged to buy
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Call Option – Refinitiv Example
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Call Option – Refinitiv Example
Strike
Price
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Call Option – Refinitiv Example
Expiry
Date
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Call Option – Refinitiv Example
Option American/
Type European
Option
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Call Option – Refinitiv Example
Contract
Size
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Call Option – Refinitiv Example
Underlying
Asset
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Call Option – Refinitiv Example
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Long Asset and Short Asset (or Future)
Profit Long Asset / Future Short Asset / Future
Profit
S S
Asset Price Asset Price
Loss
Loss
Asset Price (s) = $10 Asset Price (s) = $10
Spot Price Profit/Loss (P/L) Spot Price Profit/Loss (P/L)
8 (2) 8 2
9 (1) 9 1
10 0 10 0
11 1 11 (1)
12 2 12 (2)
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Long Call and Long Put
Long Call Position Long Put Position
P/L P/L
X X
Premium Premium
Exercise price (X) = $10 Exercise price (X) = $10
Premium (P) = $1 Premium (P) = $1
ST Profit/Loss (P/L) Exercise Option ST Profit/Loss (P/L) Exercise Option
Out-of-the-money In-the-money
8 (1) No 8 1 Yes
(OTM by $2) (ITM by $2)
9 (1) No 9 0 Yes
10 (1) ? 10 (1) ?
11 0 Yes Out-of-the- 11 (1) No
In-the-money money (OTM)
12 1 Yes 12 (1) No
(ITM by $2)
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Short Call and Short Put
Short Call Short Put
P/L P/L
Premium Premium
X X
Exercise price (X) = $10 Exercise price (X) = $10
Premium (P) = $1 Premium (P) = $1
ST Profit/Loss (P/L) Exercise Option ST Profit/Loss (P/L) Exercise Option
8 1 No 6 (3) Yes
9 1 No 8 (1) Yes
10 1 ? 9 0 Yes
11 0 Yes 10 1 ?
12 (1) Yes 11 1 No
15 (4) Yes 12 1 No
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Risk Offset
Bullish Positions Bearish Positions
Long Call Short Call
Long Asset Short Asset
Long Future Short Future
Short Put Long Put
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Terminology and Applications
Intrinsic Value and Time Value
Underlying Price = $100
Calls 80 90 100 110 120
Intrinsic Value 20 10 0 0 0
Time Value 2 5 9 4 1
Premium 22 15 9 4 1
American
Option can be exercised at any time prior to maturity.
Style
European
Option can be exercised only on maturity day.
Style
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Long Asset and Long Put vs. Short Future
Concerned that prices may
fall between now and then.
Sell a future or forward
How can you hedge
An individual is long an yourself?
2
asset and is committed
to selling that asset in
two months’ time.
Buy a put
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Long Asset and Short Future Hedge
Long Asset
Profit
Hedge Position
Price of Underlying 70 80 90 100 110 120 130
Short Future
Loss
The futures hedge locks in a maximum/minimum
selling price of 100.
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Long Asset and Long Put Hedge
Long Asset
Profit
Hedge Position
Price of Underlying 70 80 90 100 110 120 130
10
Long Put
(100 Strike, 10 Premium)
Loss
The long put hedge locks in a minimum selling price of 90
with an unlimited upside potential.
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Put-Call Parity
Long Asset + Long Put Long Call + Hold Cash
Long Asset Long Call
Profit
Profit
Hedge Position
Price of Underlying 70 80 90 100 110 120 130 Price of Underlying 70 80 90 100 110 120 130
10 10
Long Put
(100 Strike, 10 Premium)
Loss
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Generic Futures Contract Description
Unit of Trading One futures contract (e.g., 1000 shares, barrels oil, tons sugar).
Expiry Months March, June, September, December.
Quotation Dollar ($) and cents per 1 ton.
$0.01 per ton and a value of $10.
Tick Size & Value
Tick size ($0.01) x 1000 = $10
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Price Screen Example
Current Future Price = 180
A = Ask Price At-the-money
B = Bid Price In-the-money (ITM) (ATM) Out-of-the-money (OTM)
Calls 160 170 180 190 200
Offer 23A 16A 10A 5A 2A
Bid 21B 14B 8B 3B 1B
Trade 22 15 9 4 1
At-the-money
Out-of-the-money (OTM) (ATM) In-the-money (ITM)
Calls 160 170 180 190 200
Offer 2A 4A 9A 15A 21A
Bid 1B 3B 8B 14B 19B
Trade 1 3 8 14 20
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Hedging and Calculations
Option Pricing Model
Exercise Price If an option is more in the money, the higher the premium will be relatively.
Futures/Asset Price May be a physical product or based on a future.
Options are similar to insurance policies.
Maturity Date
• The longer the period, the higher the premium.
May have to factor in the dividend for equities, or
Interest Rate
the coupon for a bond.
Assets vary in volatility, and the returns may not be easily predictable.
Volatility
• Higher volatility results in a higher premium.
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Option Pricing Model
Exercise Price Objective
Known
Futures/Asset Price Objective
Known
Maturity Date Objective
Known
Interest Rate Objective
Known
Volatility Subjective
Forecast
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Option Pricing Model
Exercise Price
Known
Futures/Asset Price
Known
Maturity Date Option Premium
Known
Interest Rate
Known
Volatility
Blank
Update implied volatility
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