Financial Analysis, Planning and
Forecasting
Theory and Application
Chapter 9
Option and Option Strategies
By
Alice C. Lee
San Francisco State University
John C. Lee
J.P. Morgan Chase
Cheng F. Lee
Rutgers University
Outline
 9.1
Introduction
 9.2 The Option market and related
definition
 9.3 Index and futures option
 9.4 Put-call parity
 9.5 Risk-return characteristics of options
 9.6 Summary
 Appendix 9A Options and Exchanges
9.2 The Option market and related definition
 What
is an Option?
 Types of Options and Their Characteristics
 Relationship Between the Option Price and
the Underlying Asset Price
 Additional Definitions and Distinguishing
Features
 Types of Underlying Asset
 Institutional Characteristics
9.2 The Option market and related definition
Table 9-1 Options Quotes for Johnson& Johnson at 09/21/2006
Call Options Expiring Fri. Jan.18, 2008
Strike
Symbol
Last
Bid
Ask
Vol
Open Int
40
JNJAH.X
24
25.5
25.6
10
5,427
45
JNJAI.X
20
20.5
20.7
3
2,788
50
JNJAJ.X
15.5
15.7
16
11
8,700
55
JNJAK.X
11.1
10.9
11.1
33
10,327
60
JNJAL.X
6.4
6.4
6.5
275
32,782
65
JNJAM.X
2.65
2.65
2.7
1,544
70,426
70
JNJAN.X
0.55
0.55
0.6
845
48,582
75
JNJAO.X
0.1
0.05
0.1
2
13,629
80
JNJAP.X
0.05
N/A
0.05
10
4,497
85
JNJAQ.X
0.05
N/A
0.05
0
3,275
90
JNJAR.X
0.05
N/A
0.05
0
3,626
9.2 The Option market and related definition
Table 9-1 Options Quotes for Johnson& Johnson at 09/21/2006 (Cont’d)
Put Options Expiring Fri. Jan.18, 2008
Strike
Symbol
Last
Bid
Ask
Vol
Open Int
40
JNJMH.X
0.05
N/A
0.05
0
1,370
45
JNJMI.X
0.1
0.05
0.1
3
5,002
50
JNJMJ.X
0.12
0.1
0.15
1
14,004
55
JNJMK.X
0.25
0.25
0.3
99
31,122
60
JNJML.X
0.7
0.65
0.7
227
69,168
65
JNJMM.X
1.8
1.85
1.95
30
46,774
70
JNJMN.X
5
4.9
5
20
1,582
75
JNJMO.X
13.3
9.7
9.9
0
20
9.2 The Option market and related definition
Intrinsic value =
Underlying asset price－Option exercise price
(9.1)
Time value = Option premium－Intrinsic value
(9.2)
9.2 The Option market and related definition
C  Max ( S  E , 0)
where:
C = the value of the call option;
S = the current stock price; and
E = the exercise price.
9.2 The Option market and related definition
FIGURE 9-1 The Relationship Between an Option’s Exercise Price
and Its Time Value
9.2 The Option market and related definition
FIGURE 9-2 The Relationship Between Time Value and Time to
Maturity for a Near-to-the-Money Option (Assuming a
Constant Price for the Underlying Asset)
9.2 The Option market and related definition
 Sample
Problem 9.1
9.3 Put-call parity
 European
Options
 American
Options
 Futures
Options
 Market Applications
9.3 Put-call parity
C t ,T  Pt ,T  S t  EBt ,T
(9.3)
where:
C t ,T = value of a European call option at time t that matures at time T (T > f);
Pt ,T = value of a European put option at time t, that matures at time T;
S t = value of the underlying stock (asset) to both the call and put options at time t;
E = exercise price for both the call and put options;
Bt ,T = price at time t of a default-free bond that pays $1 with certainty at time T (if it
is assumed that this risk-free rate of interest is the same for all maturities and
equal to r － in essence a flat-term structure － then Bt ,T = e  r T t  , under
continuous compounding), or B = 1 / 1  r T t for discrete compounding.
t ,T
9.3 Put-call parity
CT  Max  0, ST  E 
(9.4)
PT  Max  0, E  ST 
(9.5)
9.3 Put-call parity
TABLE 9-2 Put-Call Parity for a European Option with No Dividends
9.3 Put-call parity
 Sample
Problem 9.2
A call option with one year to maturity and exercise price of
$110 is selling for $5. Assuming discrete compounding, a
risk-free rate of 10 percent, and a current stock price of
$100, what is the value of a European put option with a
strike price of $110 and one-year maturity?
Solution
Pt ,T  C t ,T  EBt ,T  S t
P0,1 yr
 1 
  $100
 $5  $110
1 
 1.1 
P0,1 yr  $5
9.3 Put-call parity
Pt ,T  S  EBt ,T  Ct ,T  Pt ,T  S t  E

(9.6)
Sample problem 9.3
A put option with one year to maturity and an exercise price of $90 is
selling for $15; the stock price is $100. Assuming discrete
compounding and a risk- free rate of 10 percent, what are the
boundaries for the price of an American call option?
Solution
Pt ,T  S  EBt ,T  Ct ,T  Pt ,T  S t  E
 1 
  Ct ,T  $15  $100  $90
$15  $100  $90
1 
 1.1 
$33.18  Ct ,1 yr  $25
9.3 Put-call parity
Ct ,T  Pt ,T  Bt ,T Ft ,T  E 
(9.7)
Pt ,T  C t ,T  Bt ,T Ft ,T  Bt ,T E
(9.8)
TABLE 9-3 Put-Call Parity for a European Futures Option
9.4 Risk-return characteristics of options
Long Call
 Short Call
 Long Put
 Short Put
 Long Straddle
 Short Straddle
 Long Vertical (Bull) Spread
 Short Vertical (Bear) Spread
 Calendar (Time) Spread

9.4 Risk-return characteristics of options
FIGURE 9-3 Profit Profile for a Long Call
9.4 Risk-return characteristics of options
FIGURE 9-4 Profit Profile for a Short Call
9.4 Risk-return characteristics of options
FIGURE 9-5 Profit Profile for a Covered Short Call
9.4 Risk-return characteristics of options
FIGURE 9-6 Profit Profile for a Long Put
9.4 Risk-return characteristics of options
FIGURE 9-7 Profit Profile for an Uncovered Short Call
9.4 Risk-return characteristics of options
FIGURE 9-8 Profit Profile for a Long Straddle
9.4 Risk-return characteristics of options
Sample problem 9.4
Situation:
An investor feels the stock market is going to
break sharply up or down but is not sure which
way. However, the investor is confident that
market volatility will increase in the near future. To
express his position the investor puts on a long
straddle using options on the S&P 500 index,
buying both at-the-money call and put options on
the September contract. The current September
S&P 500 futures contract price is 155.00. Assume
the position is held to expiration.

9.4 Risk-return characteristics of options
Transaction:
1. Buy 1 September 155 call at $2.00.
2. Buy 1 September 155 put at $2.00.
Net initial investment (position value)
($1,000)
($1,000)
($2,000)
Results:
1. If futures price = 150.00:
(a) 1 September call expires at $0.
(b) 1 September put expires at $5.00.
(c) Less initial cost of put
Ending position value (net profit)
($1,000)
$2,500
($1,000)
$ 500
9.4 Risk-return characteristics of options
Results:
2. If futures price = 155.00:
(a) 1 September call expires at $0.
(b) 1 September put expires at $0.
Ending position value (net loss)
($1,000)
($1,000)
$2,000
3. If futures price = 160.00:
(a) 1 September call expires at $5.00
(b) 1 September call expires at $0.
(c) Less initial cost of put
Ending position value (net profit)
$2,500
($1,000)
($1,000)
$ 500
9.4 Risk-return characteristics of options
Summary:
Maximum profit potential: unlimited. If the market had contributed to move
below 150.00 or above 160.00, the position would have continued to
increase in value.
Maximum loss potential: $2,000, the initial investment.
Breakeven points: 151.00 and 159.00, for the September S&P 500 futures
contract.2
Effect of time decay: negative, as evidenced by the loss incurred, with no
change in futures price (result 2)
2 Breakeven points for the straddle are calculated as follows:
Upside BEP = Exercise price + Initial net investment (in points)
159.00 = 155.00 + 4.00
Downside BEP = Exercise price - Initial net investment (in points)
159.00 = 155.00 + 4.00
151.00 = 155.00 - 4.00
9.4 Risk-return characteristics of options
FIGURE 9-9 Profit Profile for a Short Straddle
9.4 Risk-return characteristics of options

Sample problem 9.5
Situation:
An investor feels the market is overestimating price volatility
at the moment and that prices are going to remain stable for
some time. To express his opinion, the investor sells a
straddle consisting of at-the-money call and put options on
the September S&P 500 futures contract, for which the
current price is 155.00. Assume the position is held to
expiration.
Transaction:
1. Sell 1 September 155 call at $2.00 (x $500 per point).
$1,000
2. Sell 1 September 155 put at $2.00.
$1,000
Net initial inflow (position value)
$2,000
9.4 Risk-return characteristics of options
Results:
1. If futures price = 150.00:
(a) 1 September 155 call expires at 0.
(b) I September 155 put expires at $5.00.
(c) Plus initial inflow from sale of put
Ending position value (net loss)
$1,000
($2,500)
$1,000
($ 500)
2. If futures price = 155.00:
(a) 1 September 155 call expires at 0.
(b) I September 155 put expires at 0.
Ending position value (net profit)
$1,000
$1,000
$2,000
9.4 Risk-return characteristics of options
Results:
3. If futures price = 160.00:
(a) 1 September 155 call expires at $5.00.
(b) I September put expires at 0.
(c) Plus initial inflow from sale of call
Ending position value (net loss)
($2,500)
$1,000
$1,000
($ 500)
Summary:
Maximum profit potential: $2,000, result 2. where futures price does not move.
Maximum loss potential: unlimited. If futures price had continued up over 160.00 or
down below 145.00, this position would have kept losing money.
Breakeven points: 151.00 and 159.00, an eight-point range for profitability of the
position.3
Effect of time decay: positive, as evidenced by result 2.
3 Breakeven points for the short straddle are calculated in the same manner as for the long straddle:
exercise price plus initial prices of options.
9.4 Risk-return characteristics of options
FIGURE 9-10 Profit Profile for a Long Vertical Spread
9.4 Risk-return characteristics of options
 Sample problem 9.6
Situation:
An investor is moderately bullish on the West German mark. He would
like to be long but wants to reduce the cost and risk of this position in
case he is wrong. To express his opinion, the investor puts on a long
vertical spread by buying a lower-exercise-price call and selling a
higher-exercise- price call with the same month to expiration. Assume
the position is held to expiration.
Transaction:
1. Buy 1 September 0.37 call at 0.0047 (x 125.000 per point). ($ 587.50)
2. Sell 1 September 0.38 call at 0.0013.
$ 1 62.50
Net initial investment (position value)
($ 425.00)
9.4 Risk-return characteristics of options
Results:
1. If futures price = 0.3700:
(a) 1 September 0.37 call expires at 0.
(b) 1 September 0.38 call expires at 0.
Ending position value (net loss)
($ 587.50)
$ 162.50
($ 425.00)
2. If futures price = 0.3800:
(a) 1 September 0.37 call expires at 0.0100.
(b) I September 0.38 call expires at 0.
Less initial cost of 0.37 call
Ending position value (net profit)
$1,250.00
$ 162.50
($ 587.50)
$ 825.00
3. If futures price = 0.3900:
(a) 1 September 0.38 call expires at 0.0200.
(b) 1 September put expires at 0.
Less initial premium of 0.37 call
Plus initial premium of 0.38 call
Ending position value (net profit)
$2,500.00
$2,500.00
($1,250.00)
($ 587.50)
$ 162.50
($ 825.00)
9.4 Risk-return characteristics of options
Summary:
Maximum profit potential: $825.00, result 2.
Maximum loss potential: $425.00, result 1.
Breakeven point: 0.3734.4
Effect of time decay: mixed. positive if price is
at high end of range and negative if at low
end.
4 Breakeven point for the long vertical spread is computed as lower exercise price plus price of
long call minus price of short call (0.3734 = 0.3700 + 0.0047 – 0.0013).
9.4 Risk-return characteristics of options
FIGURE 9-11 Profit Profile for a Short vertical Spread
9.4 Risk-return characteristics of options
FIGURE 9-12 Profit Profile for a Neutral Calendar Spread
9.4 Risk-return characteristics of options
TABLE 9-4 Call and Put Option Quotes for CEG at 07/13/2007
Call Option Expiring close Fri Oct 19, 2007
Strike
Symbol
Bid
Ask
70
CEGJN.X
23.5
25.5
75
CEGJO.X
19
20.9
80
CEGJP.X
14.6
16.4
85
CEGJQ.X
11.4
12.2
90
CEGJR.X
8
8.5
95
CEGJS.X
5
5.4
100
CEGJT.X
2.85
3.2
105
CEGJA.X
1.5
1.75
110
CEGJB.X
0.65
0.9
115
CEGJC.X
0.2
0.45
9.4 Risk-return characteristics of options
TABLE 9-4 Call and Put Option Quotes for CEG at 07/13/2007 (Cont’d)
Put Option Expiring close Fri Oct 19, 2007
Strike
Symbol
Bid
Ask
70
CEGVN.X
0.15
0.35
75
CEGVO.X
0.4
0.65
80
CEGVP.X
0.9
1.15
85
CEGVQ.X
1.6
1.85
90
CEGVR.X
2.95
3.4
95
CEGVS.X
4.9
5.5
100
CEGVT.X
7.7
8.6
9.4 Risk-return characteristics of options
TABLE 9-5 Value of Protective Put position at option expiration
Long a Put at strike price
$95.00
Premium
Buy one share of stock
Stock
One Share of
Stock
Price
Payoff
$5.50
Price
Long Put
(X=$95)
Profit
Payoff
$94.21
Protective Put
Value
Profit
Payoff
Profit
$70.00
$70.00
-$24.21
$25.00
$19.50
$95.00
-$4.71
$75.00
$75.00
-$19.21
$20.00
$14.50
$95.00
-$4.71
$80.00
$80.00
-$14.21
$15.00
$9.50
$95.00
-$4.71
$85.00
$85.00
-$9.21
$10.00
$4.50
$95.00
-$4.71
$90.00
$90.00
-$4.21
$5.00
-$0.50
$95.00
-$4.71
$95.00
$95.00
$0.79
$0.00
-$5.50
$95.00
-$4.71
$100.00
$100.00
$5.79
$0.00
-$5.50
$100.00
$0.29
$105.00
$105.00
$10.79
$0.00
-$5.50
$105.00
$5.29
$110.00
$110.00
$15.79
$0.00
-$5.50
$110.00
$10.29
$115.00
$115.00
$20.79
$0.00
-$5.50
$115.00
$15.29
$120.00
$120.00
$25.79
$0.00
-$5.50
$120.00
$20.29
9.4 Risk-return characteristics of options
Figure 9-12 Profit Profile for Protective Put
P r o te c tive P u t : P r o fit
$30
$20
P rofit
$10
One S ha re
of S toc k
$0
Long Put
(X=$95)
-$10
-$20
Prote c tive
Put Va lue
-$30
$70
$75
$80
$85
$90
$95
$100 $105 $110 $115 $120
S toc k P ric e
9.4 Risk-return characteristics of options
Table 9-6 Value of Covered Call position at option expiration
Write a call at strike price
$100.00
Premium
Buy one share of stock
$2.85
Price
Stock
One Share of Stock
Price
Payoff
Written Call
(X=$100)
Profit
Payoff
$94.21
Covered Call
Profit
Payoff
Profit
$70.00
$70.00
-$24.21
$0.00
$2.85
$70.00
-$21.36
$75.00
$75.00
-$19.21
$0.00
$2.85
$75.00
-$16.36
$80.00
$80.00
-$14.21
$0.00
$2.85
$80.00
-$11.36
$85.00
$85.00
-$9.21
$0.00
$2.85
$85.00
-$6.36
$90.00
$90.00
-$4.21
$0.00
$2.85
$90.00
-$1.36
$95.00
$95.00
$0.79
$0.00
$2.85
$95.00
$3.64
$100.00
$100.00
$5.79
$0.00
$2.85
$100.00
$8.64
$105.00
$105.00
$10.79
-$5.00
-$2.15
$100.00
$8.64
$110.00
$110.00
$15.79
-$10.00
-$7.15
$100.00
$8.64
$115.00
$115.00
$20.79
-$15.00
-$12.15
$100.00
$8.64
$120.00
$120.00
$25.79
-$20.00
-$17.15
$100.00
$8.64
9.4 Risk-return characteristics of options
Figure 9-13 Profit Profile for Covered Call
C o ve r e d C a ll : P r o fit
$30
$20
One S ha re
of S toc k
P rofit
$10
Writte n Ca ll
(X=$100)
$0
-$10
Cove re d Ca ll
-$20
-$30
$70
$75
$80
$85
$90
$95
$100 $105 $110 $115 $120
S toc k P ric e
9.4 Risk-return characteristics of options
Table 9-7 Value of Collar position at option expiration
Long a Put at strike price
$85.00
Premium
$1.85
Write a Call at strike price
$105.00
Premium
$1.50
Buy one share of stock
Price
One Share of Stock
Stock
Price
Payoff
Long put (X=$85)
Profit
Payoff
Profit
$94.21
Write Call (X=$105)
Collar Value
Payoff
Payoff
Profit
Profit
$70.00
$70.00
-$24.21
$15.00
$13.15
$0.00
$1.50
$85.00
-$9.56
$75.00
$75.00
-$19.21
$10.00
$8.15
$0.00
$1.50
$85.00
-$9.56
$80.00
$80.00
-$14.21
$5.00
$3.15
$0.00
$1.50
$85.00
-$9.56
$85.00
$85.00
-$9.21
$0.00
-$1.85
$0.00
$1.50
$85.00
-$9.56
$90.00
$90.00
-$4.21
$0.00
-$1.85
$0.00
$1.50
$90.00
-$4.56
$95.00
$95.00
$0.79
$0.00
-$1.85
$0.00
$1.50
$95.00
$0.44
$100.00
$100.00
$5.79
$0.00
-$1.85
$0.00
$1.50
$100.00
$5.44
$105.00
$105.00
$10.79
$0.00
-$1.85
$0.00
$1.50
$105.00
$10.44
$110.00
$110.00
$15.79
$0.00
-$1.85
-$5.00
-$3.50
$105.00
$10.44
$115.00
$115.00
$20.79
$0.00
-$1.85
-$10.00
-$8.50
$105.00
$10.44
$120.00
$120.00
$25.79
$0.00
-$1.85
-$15.00
-$13.50
$105.00
$10.44
9.4 Risk-return characteristics of options
Figure 9-14 Profit Profile for Collar
Co lla r : P ro fit
P rofit
$30
$20
One S ha re of
S toc k
$10
Long put
(X=$85)
$0
Write Ca ll
(X=$105)
Colla r Va lue
-$10
-$20
-$30
$70
$75
$80
$85
$90
$95
$100
S toc k P ric e
$105
$110
$115
$120
9.6 Summary
This chapter has introduced some of the essential differences between
the two most basic kinds of option, calls and puts. A delineation was
made of the relationship between the option’s price or premium and that
of the underlying asset. The option’s value was shown to be composed
of intrinsic value, or the underlying asset price less the exercise price,
and time value. Moreover, it was demonstrated that the time value
decays over time, particularly in the last month to maturity for an option.
Index and futures options were studied to introduce these important
financial instruments. Put-call parity theorems were developed for
European, American, and futures options in order to show the basic
valuation relationship between the underlying asset and its call and put
options. Finally, investment application of options and related
combinations were discussed, along with relevant risk-return
characteristics. A thorough understanding of this chapter is essential as
a basic tool to successful study of option-valuation models in the next
chapter.