3.3.1 Introduction to Options

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 $\ge$ 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: $\text{Max}(S-X,0)$, Put option: $\text{Max}(X-S,0)$

1.2.2 Time Value (Speculative Value)

The amount by which the option premium(price) exceeds the intrinsic value.

$$\text{Option premium}=\text{Intrinsic value}+\text{Time value}$$

1.2.3 Payoff and Profit Option

Payoff from a long position in a European call option is $\text{Max}(S_T-X,0)$

$\text{profit}=\text{Max}(S_T-X,0)-C_0$, $C_0$: the premium of call option

Payoff from a long position in a European put option is $\text{Max}(X-S_T,0)$

$\text{profit}=\text{Max}(X-S_T,0)-P_0$, $P_0$: 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 $T$	$\text{Max}(S_T-X,0)$	$-\text{Max}(S_T-X,0)$	$\text{Max}(X-S_T,0)$	$-\text{Max}(X-S_T,0)$
Profit at $T$	$\text{Max}(S_T-X,0)-c_0$	$-\text{Max}(S_T-X,0)+c_0$	$\text{Max}(X-S_T,0)-p_0$	$-\text{Max}(X-S_T,0)+p_0$
Max profit	Unlimited	$c_0$	$X-p_0$	$p_0$
Max loss	$c_0$	Unlimited	$p_0$	$X-p_0$
Breakeven	$X+c_0$	$X+c_0$	$X-p_0$	$X-p_0$

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	$S>X$	$S<X$
At the money	$S=X$	$S=X$
Out of the money	$S<X$	$S>X$