options - 1 Options 2 What is an Option? An option is an...

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Unformatted text preview: 1 Options 2 What is an Option? An option is an agreement between two parties that gives the purchaser of the option the right, but not the obligation, to buy or sell a specific quantity of an asset (called the underlying asset) at a specified price during a designated time period. A Call (c) is the right to purchase the underlying asset A Put (p) is the right to sell the underlying asset The Strike Price (K) is the pre-specified price at which the option holder can buy (in the case of a call) or sell (in the case of a put) the asset to the option seller The Expiration date (T) is the date (and time) after which the option expires The Notional Amount is the quantity of the underlying asset that the option buyer has the right to buy or sell under the terms of the option contract The Premium (c or p) is the price of the option contract (the amount paid by the buyer to the seller). The option buyers maximum downside (possible loss) is the amount of the premium. To Exercise means to invoke the right to buy or sell the underlying asset under the terms of the option contract The Seller (or Writer ) of the option receives a payment (the Option Premium ) that then obligates him to sell (in the case of a call) or buy (in the case of a put) the asset. 3 Profit/Loss Diagram for a Long Call Option Option P & L S T = Price of Underlying Asset at expiration K=104 c = 5 General Formula for call P&L Long call p&l = Max ( c, S T K- c) P & L Analysis At expiration, two possible outcomes: (i) S T K Call is in the money Exercise the call and purchase the asset for K. Asset has market value S T Profit = S T K- c Example : S T = 115, K = 104 Buy asset for 104, sell it immediately in the market for 115. Net p&l = 115 104 5 = $6 (ii) S T < K Call is out of the money Option expires worthless. P&L = -c Example : S T = 97. Do not exercise right to buy asset (from the option) at 104. Net p&l = $5 Strike Price K = 104 Market Price of Underlying Asset at expiration = S T Call premium (when purchased) c = 5 109 4 Payoff Diagram for a Long Call Option Option payoff S T = Price of Underlying Asset at expiration K=100 Strike Price K = 100 Market Price of Underlying Asset at expiration = S T Payoff Analysis At expiration, two possible outcomes: (i) S T K Call is in the money Exercise the call: purchase the asset for K. Asset has market value S T Payoff = S T K Example : S T = 105, K = 100. Buy asset for 100. Sell it immediately in the market for 105. Payoff = 105 100 = $5 (ii) S T < K Call is out of the money Option expires worthless. Payoff = 0 Example : S T = 97. Do not exercise right to buy asset (from the option) at100. General Formula for call payoff Long call payoff = Max (0, S T- K) 5 Payoff Diagram for a Long Put Option Option payoff S T K=53 Payoff Analysis At expiration, two possible outcomes: (i) S T K Put is out of the money Put option expires worthless. Payoff = 0 Example : S T = 56, K = 53. Do not exercise right to sell asset at 53.right to sell asset at 53....
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This note was uploaded on 08/03/2011 for the course ECON 172 taught by Professor Emmarasiel during the Spring '11 term at Duke.

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options - 1 Options 2 What is an Option? An option is an...

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