Options &Different Strategies of OptionsRBAInstructor: M.Jibran Sheikh

Contact : Jibransheikh@comsats.edu.pk

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Determinants of Option ValueThe value of an option is determined by a number of variables relating to the underlying asset and financial markets.Current Value of the Underlying AssetThe buyer of an option acquires the right to buy or sell the underlying asset at a fixed price. The higher the variance in the value of the underlying asset, the greater will the value of the option be1. This is true for both calls and puts. While it may seem counter-intuitive that an increase in a risk measure (variance) should increase value, options are different from other securities since buyers of options can never lose more than the price they pay for them; in fact, they have the potential to earn significant returns from large price movements.Variance in Value of the Underlying AssetOptions are assets that derive value from an underlying asset. Consequently, changes in the value of the underlying asset affect the value of the options on that asset. Since calls provide the right to buy the underlying asset at a fixed price, an increase in the value of the asset will increase the value of the calls.Puts, on the other hand, become less valuable as the value of the asset increase.

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Dividends Paid on the Underlying AssetThe value of the underlying asset can be expected to decrease if dividend payments are made on the asset during the life of the option. Consequently, the value of a call on the asset is a decreasing function of the size of expected dividend payments, and the value of a put is an increasing function of expected dividend payments.Strike Price of OptionIn the case of calls, where the holder acquires the right to buy at a fixed price, the value of the call will decline as the strike price increases. In the case of puts, where the holder has the right to sell at a fixed price, the value will increase as the strike price increases.Time To Expiration On OptionBoth calls and puts become more valuable as the time to expiration increases. This is because the longer time to expiration provides more time for the value of the underlying asset to move, increasing the value of both types of options. Additionally, in the case of a call, where the buyer has to pay a fixed price at expiration, the present value of this fixed price decreases as the life of the option increases, increasing the value of the call.Risk-free Interest Rate Corresponding To Life Of OptionIncreases in the interest rate will increase the value of calls and reduce the value of puts.*

Variables Affecting Call and Put Prices

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Combinations - Straddles

A straddle - an investment in a call and a put at the same exercise price

Essentially a bet on volatility

If the price of the security increases or

decreases sufficiently the strategy will be profitable

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StraddlesThis is a strategy to adopt whenever there is considerable short term uncertainty about the price of a share, and it is anticipated that this uncertainty will be resolved before the expiry of the options. A straddle will lose investor money if there is little change in the share price, but large price changes in either direction will produce gains.

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ExampleConsider the following example:Call price 12p Put price 8p Exercise price 120pTotal Outlay (12p + 8p) = 20pIf the share price at expiry is less than 120p the investor will exercise the put and the call will be valueless, whereas if the share price at expiry exceeds 120p the investor will exercise the call and the put will be valueless. Now main Question is when will investor earn profit??

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Profit on StraddleThe investor can only make a profit if the price of the share at the maturity date must fall below 100p or exceed 140p, ie, the share price at expiry must deviate from the exercise price by an amount at least equal to the initial cost of the options. At a share price of 100p the value of the put will be 20p whereas a share price of 140p will produce the value for the call of 20p. *

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Straddle Profit Graph

Profit\Loss

+

Put

Profitable Unprofitable

Call

Profitable

Cost = C0+P0

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Exercise the putExercise the call

A profitable straddle requires (ST - X) > (C0+P0) or

(X - ST) > (C0+P0)

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Straddle in Efficient marketIf all investors are aware of the impending announcement, and appreciate the possibility of using a straddle to benefit from the likely price movement, the higher demand for calls and puts will push up their prices.These price rises will eliminate the expected profit from the transaction. So this suggests that in an efficient market an investment in a straddle does not have a positive expected value, and an investor without access to inside information can expect to breakeven.

(See page 18 0f your notes for further elaboration of this concept)

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Covered CallsA covered call involves writing a call and investing in the underlying asset.It is a strategy employed by the writers of calls to control their risk exposureThe threat of large losses is eliminated by foregoing the potential for large gains on the share being held.This combination most frequently employed by financial institutions that regularly write calls. It is used above all else as a fee generating strategy by portfolio managers when the outlook for share prices is neutral to mildly bearish.

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The profit (loss) positions from writing a covered call*

ExampleLets assume that a call has been written by Mr. X at an exercise price of 150p (X), the current price of the share is 140p ( S0 = 26p), and the market price of the call is 20p.Than there are following possibilities:if the share price at expiry is zero the investor's maximum loss will be 120p the initial investment in the share (140p) less the proceeds from writing the call (20p). *

for share prices up to 150p, the exercise price of the option, the combination is more profitable than simply holding the share as a result of the contribution of the premium received from the writing of the call;at a share price of 150p the profit will be 30p, the capital gain on holding the share (150p - 140p) plus the proceeds from writing the call (20p);*

If share price is above 150p the call option will be exercised, and the net profit will be restricted to 30p as any gain from increases in the price of the share beyond 150p will be absorbed by the losses associated with the written call.*

Covered Call (5) A Share and Written Call, Net

Profit / Loss

+ C= 20p

Effect

Capital Gain/Loss

Covered Call

Share Price

- 120 -140Written Call

Losses on call offset by the gains on the share.

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StranglesA strangle, like a straddle involves investments in both a call and a put, but for a strangle the exercise prices of the call and put differ. The exercise price of the call is chosen to exceed that of the put i.e., X c > X p. Purchasing a put with a lower exercise price than would be the case in a straddle reduces the probability of the put being exercised. This implies that the market cost of the put used in a strangle will be lower than that in a straddle. Similarly the higher the exercise price for a call the lower the probability that it will be exercised and the lower its market value. But while the overall cost of a strangle may be lower so are the benefits: the movement in share price necessary to recover the cost of a strangle exceeds that necessary to recover the outlay on the straddle.*

A STRANGLE AND STRADDLE COMPARED*

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