Damodaran on Valuation

12.6. APPENDIX 12.1: OPTION PRICING MODELS

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. Since it is a right and not an obligation, the holder can choose not to exercise the right and allow the option to expire. There are two types of options: call options and put options.

12.6.1. Call and Put Options: Description and Payoff Diagrams

A call option gives the buyer of the option the right to buy the underlying asset at a fixed price, called the strike or the exercise price, at any time prior to the expiration date of the option. The buyer pays a price (premium) for this right. If at expiration the value of the asset is less than the strike price, the option is not exercised and expires worthless. If, in contrast, the value of the asset is greater than the strike price, the option is exercised—the buyer of the option buys the asset (stock) at the exercise price. And the difference between the asset value and the exercise price comprises the gross profit on the option investment. The net profit on the investment is the difference between the gross profit and the price paid for the call initially.

A payoff diagram illustrates the cash payoff on an option at expiration. For a call, the net payoff is negative (and equal to the price paid for the call) if the value of the underlying asset is less than the strike price. ...