Options
1. Introduction to Options
Option is a derivative contract in which the buyer pays a sum of money to the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
An option is a right, but not an obligation.
Default in options is possible only from the short to the long.
1.1 Options Types
1.1.1 Terminology
Strike Price is exercise price specified in the contract.
Premium, option premium, initial cost, initial investment, or up-front cost is paid by the buyer of option when one buys the option.
Expiration Date/Maturity Date is the date after which an option is void(无效).
1.1.2 Options Types
Based on type of right
A call option gives the holder the right to buy an asset by a certain date for a certain price.
- A long position in a call option: right to buy
- A short position in a call option: obligation to sell
A put option gives the holder the right to sell an asset by a certain date for a certain price.
- A long position in a put option: right to sell
- A short position in a put option: obligation to buy
The seller is sometimes referred to as the writer of the option.
Based on exercise date
European options can be exercised only on the expiration date itself.
American options can be exercised at any time up to the expiration date.
Price of American options ≥ \geq ≥ Price of European options due to more flexibility.
1.2 Payoff and Profit of Option
1.2.1 Intrinsic Value (Exercise Value)
Intrinsic value measures the value of an option if it can only be exercised immediately.
The maximum of zero and the amount that the option is in the money.
Call option: Max ( S − X , 0 ) \text{Max}(S-X,0) Max(S−X,0), Put option: Max ( X − S , 0 ) \text{Max}(X-S,0) Max(X−S,0)
1.2.2 Time Value (Speculative Value)
The amount by which the option premium(price) exceeds the intrinsic value.
Option premium = Intrinsic value + Time value \text{Option premium} = \text{Intrinsic value} + \text{Time value} Option premium=Intrinsic value+Time value
1.2.3 Payoff and Profit Option
Payoff from a long position in a European call option is Max ( S T − X , 0 ) \text{Max}(S_T-X,0) Max(ST−X,0)
profit = Max ( S T − X , 0 ) − C 0 \text{profit}=\text{Max}(S_T-X,0)-C_0 profit=Max(ST−X,0)−C0, C 0 C_0 C0: the premium of call option
Payoff from a long position in a European put option is Max ( X − S T , 0 ) \text{Max}(X-S_T,0) Max(X−ST,0)
profit = Max ( X − S T , 0 ) − P 0 \text{profit}=\text{Max}(X-S_T,0)-P_0 profit=Max(X−ST,0)−P0, P 0 P_0 P0: the premium of put option
1.2.4 Call Option
Profit of long = intrinsic value at expiration - premium
Breakeven underlying price = X - premium
1.2.5 Put Option
Profit of long = intrinsic value at expiration - premium
Breakeven underlying price = X + premium
Long call | Short call | Long put | Short put | |
---|---|---|---|---|
Payoff at T T T | Max ( S T − X , 0 ) \text{Max}(S_T-X,0) Max(ST−X,0) | − Max ( S T − X , 0 ) -\text{Max}(S_T-X,0) −Max(ST−X,0) | Max ( X − S T , 0 ) \text{Max}(X-S_T,0) Max(X−ST,0) | − Max ( X − S T , 0 ) -\text{Max}(X-S_T,0) −Max(X−ST,0) |
Profit at T T T | Max ( S T − X , 0 ) − c 0 \text{Max}(S_T-X,0)-c_0 Max(ST−X,0)−c0 | − Max ( S T − X , 0 ) + c 0 -\text{Max}(S_T-X,0)+c_0 −Max(ST−X,0)+c0 | Max ( X − S T , 0 ) − p 0 \text{Max}(X-S_T,0)-p_0 Max(X−ST,0)−p0 | − Max ( X − S T , 0 ) + p 0 -\text{Max}(X-S_T,0)+p_0 −Max(X−ST,0)+p0 |
Max profit | Unlimited | c 0 c_0 c0 | X − p 0 X-p_0 X−p0 | p 0 p_0 p0 |
Max loss | c 0 c_0 c0 | Unlimited | p 0 p_0 p0 | X − p 0 X-p_0 X−p0 |
Breakeven | X + c 0 X+c_0 X+c0 | X + c 0 X+c_0 X+c0 | X − p 0 X-p_0 X−p0 | X − p 0 X-p_0 X−p0 |
1.2.6 Moneyness
In the money: immediate exercise would generate a positive payoff.
At the money: immediate exercise would generate no payoff.
Out of the money: immediate exercise would result in a loss.
Moneyness | Call Option | Put Option |
---|---|---|
In the money | S > X S>X S>X | S < X S<X S<X |
At the money | S = X S=X S=X | S = X S=X S=X |
Out of the money | S < X S<X S<X | S > X S>X S>X |