Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, Second Edition

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Fundamentals of Options

INTRODUCTION

Chapter 1 explained that options on commodities such as rice, oil and grain have been in existence for many years. Options on financial assets are more recent, although they have expanded rapidly since the 1980s.

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.

DEFINITIONS

The buyer of a standard or ‘vanilla’ financial option contract has the right but not the obligation:

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

• an agreed amount of a specified financial asset, called the underlying;

• at a specified price, called the exercise or strike price;

• on or by a specified future date, called the expiry date.

For this right the buyer of an option pays an up-front fee called the premium to the writer of the contract. This is the most money the buyer can ever lose on the deal. On the other hand the writer of an option can ...