Volatility

CHAPTER 2Understanding Options Without a Model

The previous chapter provided a short tour of the main ideas in options theory. This chapter proceeds with less pace and more detail. The main objectives are to understand option pricing functions, the concepts of delta and delta hedging, and how these ideas relate to each other. Most textbooks on options introduce these ideas in the context of the BSM model. However, one of the objectives in this book is to show that the most important concepts in options theory and practical options trading can be understood without a full stochastic financial model.

2.1 VANILLA OPTIONS

A European vanilla call option is a contract that gives its holder the right to buy the underlying asset at the expiry time, , for a prespecified price, , also called the strike price. A European put option is the same except that it gives its holder the right to sell, rather than buy, the underlying asset.

In the context of FX, it is important to note that every option is both a call and a put. For example, suppose that our currency pair of interest is EUR‐USD and we buy a call option on EUR with strike and notional of 100 million EUR. Then, one month from today, ...