An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

16

Fundamentals of Options

16.1 CHAPTER OVERVIEW

This chapter introduces fundamental option concepts. It takes a ‘building block’ approach and describes the basic option strategies that are applied in different combinations in later chapters. It explains the key ‘jargon’ expressions used in the options market - call and put; strike price; expiry date; premium; intrinsic and time value; in-, at-, and out-of-the-money; break-even point and so on. These concepts are illustrated with practical examples. The chapter shows the payoff profiles for four basic option strategies - long a call; short a call; long a put; short a put. These are compared with the profits and losses achieved by buying or selling underlying shares. To relate option theory to the ‘real world’ of the financial markets the chapter also examines key index option and stock option contracts traded on derivatives exchanges. It explains the specification of the contracts, how the premiums are quoted, and how to calculate potential profits and losses. The Appendix describes some common varieties of exotic options.

16.2 DEFINITIONS

Options contracts on commodities such as grain have been around for many years. Options on financial instruments are relatively recent but volume has expanded rapidly since the introduction of contracts on exchanges such as the Chicago Board Options Exchange (CBOE). The buyer of a financial option contract has the right but not the obligation:

• to buy (call option) or to sell (put option); ...