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Unformatted text preview: t;X for a put
At the money when S = X
Out of the money when S<X for a call, and S>X for a put As long as an option has not expired, there is a chance that a stock out of the money can finish in the money,
and a stock in the money can finish further in the money, on or before the expiration date because the
underlying stock price may change over time.
Time value is related to the time to expiration and stock volatility. The longer time to expiration and the
higher the stock volatility, the higher the probability that the stock will eventually finish in the money or
further in the money. I.e. S*>X for a call and S*<X for a put, where S* stand for the stock price on the
Due to the time value component, the fact that an American option is in the money does not imply that it is
worthwhile to exercise early. Similar, it is not true that prior to the expiration date, options that are out of
money are worthless. P AYOFF AND PROFIT/LOSS OF A POSITION
A position is used to describe a trading strategy. There are six basic positions for options:
6. Long a stock – buy a share
Short a stock – short sell a share
Long a call – buy a call option
Short a call – sell or write a call option
Long a put – buy a put option
Short a put – sell or write a put option There are more sophisticated positions that can be achieved by combining these 6 basic positions: Protective Put – to combine a long stock and a long put, so the put can protect the downside risk of
the underlying stock
Covered Call – to combine a long stock and a short call, where in the event of a call being exercised,
the position has a share to deliver.
Butterfly Spread – 2 long calls (different exercise prices), 2 short calls with an exercise price in the
Inverted Butterfly Spread – 2 short class (different exercise prices), 2 long calls with exercise price in
the middle L ONG A STOCK
Payoff – the value of a position at any point in time.
Initial Payoff – value of 1 share at time of purchase = S0.
Final Payoff – value of one share at the time of sale = S*.
Profit and Loss = S* - S0 11 Cheryl Mew FINS2624 –...
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