optionbasics - Option Pricing Basics Aswath Damodaran...

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Option Pricing Basics
Aswath Damodaran

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What is an option?
n
An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or
an exercise price) at or before the expiration date of the option.
n
Since it is a right and not an obligation , the holder can choose not to
exercise the right and allow the option to expire.
n
There are two types of options - call options (right to buy) and put
options (right to sell).

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Call Options
n
A call option gives the buyer of the option the right to buy the
underlying asset at a fixed price (strike price or K) at any time prior to
the expiration date of the option. The buyer pays a price for this right.
n
At expiration,
• If the value of the underlying asset (S) > Strike Price(K)
– Buyer makes the difference: S - K
• If the value of the underlying asset (S) < Strike Price (K)
– Buyer does not exercise
n
More generally,
• the value of a call increases as the value of the underlying asset increases
• the value of a call decreases as the value of the underlying asset decreases

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Payoff Diagram on a Call
Price of underlying asset
Strike
Price
Net Payoff
on Call

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Put Options
n
A put option gives the buyer of the option the right to sell the
underlying asset at a fixed price at any time prior to the expiration date
of the option. The buyer pays a price for this right.
n
At expiration,
• If the value of the underlying asset (S) < Strike Price(K)
– Buyer makes the difference: K-S
• If the value of the underlying asset (S) > Strike Price (K)
– Buyer does not exercise
n
More generally,
• the value of a put decreases as the value of the underlying asset increases
• the value of a put increases as the value of the underlying asset decreases

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Payoff Diagram on Put Option
Price of underlying asset
Strike
Price
Net Payoff
On Put