Principles of Financial Engineering, 2nd Edition

CHAPTER 8

Mechanics of Options

1. Introduction

This chapter is an introduction to methods used in dealing with optionality in financial instruments. Compared to most existing textbooks, the present text adopts a different way of looking at options. We discuss options from the point of view of an options market maker. In our setting, options are not presented as instruments to bet on or hedge against the direction of an underlying risk. Instead, options are motivated as instruments of volatility.

In the traditional textbook approach, options are introduced as directional instruments. This is not how market professionals think of options. In most textbooks, a call option becomes in-the-money and hence profitable if the underlying price increases, ...