Hedge Fund Market Wizards

Appendix B

Options—Understanding the Basics*

There are two basic types of options: calls and puts. The purchase of a call option provides the buyer with the right—but not the obligation—to purchase the underlying item at a specified price, called the strike or exercise price, at any time up to and including the expiration date. A put option provides the buyer with the right—but not the obligation—to sell the underlying item at the strike price at any time prior to expiration. (Note, therefore, that buying a put is a bearish trade, while selling a put is a bullish trade.) The price of an option is called a premium. As an example of an option, an IBM April 130 call gives the purchaser the right to buy 100 shares of IBM at $130 per share at any time during the life of the option.

The buyer of a call seeks to profit from an anticipated price rise by locking in a specified purchase price. The call buyer’s maximum possible loss will be equal to the dollar amount of the premium paid for the option. This maximum loss would occur on an option held until expiration if the strike price was above the prevailing market price. For example, if IBM was trading at $125 when the 130 option expired, the option would expire worthless. If at expiration, the price of the underlying market was above the strike price, the option would have some value and would hence be exercised. However, if the difference between the market price and the strike price was less than the premium paid for the option, the ...