CallandPutOptions

Asyoupossiblyhavelearned,theholderofaforwardcontractisobligedtotradeatmaturity. Unlessthepositionisclosedbeforematuritytheholdermusttakepossessionoftheasset, regardlessofwhethertheunderlyingassethasrisenorfalleninprice.Wouldntitbeniceifwe onlyhadtotakepossessionoftheassetifithadrisen? Toaddressthiswishderivativesknownasoptionsaretraded.Thetwomostfamousonesare calloptionsandputoptions.Inthisarticlewediscussfirstcalloptions,laterputoptions. Definition(CallOption) Acalloptiongivestheinvestortheright(nottheobligation!)tobuyanunderlyingassetatan agreeduponprice(thestrikeprice)atadateinthefuture(theexpirationdate) BeforewediscussaCallOptionindetailwegivesomeOptionTerminology: Premiumtheamountpaidtotheselleratthetimeofagreement.ForaCallOptionthis premiumiscalledCall(K,T),foraPutOption(whichwillbediscussedfurtherbelow)the premiumiscalledPut(K,T). Strikeprice(K)theamountforwhichtheunderlyingassetcanbebought(CallOption)or sold(PutOption) Exercisetheactofpayingthestrikepricetoreceive/selltheasset Timetoexpiration(T)timeunits(atimeunithasthelengtht)untilexpiration EuropeanOptiontheholdercanexercisethisoptiononlyatexpiry AmericanOptiontheholdercanexercisethisoptionatanytimeduringthelifeoftheoption (Therighttoexerciseatanytimeisclearlyvaluable.ThereforethevalueofanAmericanoption cannotbelessthananequivalentEuropeanoption) MarketPrice,orSpotPrice(S)thecurrentpriceyouhavetopayinthemarketforthe Option. Now,ifyouholdacalloption,andatexpirationoftheoptionthepriceoftheunderlyingasset SisbelowtheStrikePriceK,theoptionisclearlyworthlessforyou.Itmakesnosensetobuy theassetforthehigherstrikepriceK,ifyoucanturnaroundandbuyitforthelowermarket priceS. ButiftheunderlyingassethasamarketpricethatisabovetheStrikePrice,thingsare different.HereyougainbythedifferenceofthemarketpriceandtheStrikePrice.Why?You canbuytheunderlyingassetfortheStrikePrice.Youdonthavetopurchasetheassetatthe highermarketprice.Soyoucansavethedifferenceofthemarketpriceandstrikeprice. Wecansummarize,thattheholderofacalloptionwantstheunderlyingassettoriseasmuch aspossiblesothathecanbuytheassetforarelativelysmallamount,thensellitandmake money.

 Letusformalizethingsalittlebit:Byviewingourpurchasedcalloptionthroughpayoffand profitdiagramswegetabetterunderstandingabouttheirworthatexpirationdate. Whileapayoffdiagramsimplygraphsthecashvalueatanypointintimeduringthelifetimeof theoption,aprofitdiagramshowsusexactlywhatwehaveearnedfromthepurchaseofthe option.Wejustshiftthepayoffgraph(orangeline)downwardsbytheaccumulatedpremium (accumulatedbytheriskfreerate)attimeT(thesocalledfuturevalueofthepremiumofthe calloptionattimeT).Bydoingthiswearriveattheprofitgraph(darkblueline)

ExhibitC.1:Thepayoffandprofitdiagramofapurchasedcalloption Thepayoffofapurchasedcalloptionisgivenbytheexpressionmax{SK,0} andbyincludingthefuturevalue(FV)ofthepurchasepricewearriveatthisexpressionforthe profitofapurchasedcall:max{SK,0}FV[Call(K,T)] Thecalloptionwehavediscussedsofarisapurchasedcalloption.Butwecansellacall optionalso.Thenwespeakofawrittencalloption. Thepayoffandtheprofitofawrittencalloptionarejustthemirrorimagesofthe correspondingpurchasedoption.Sothepayoffandprofitgraphsofawrittencalloption lookslike

 ExhibitC.2:Thepayoffandprofitdiagramofawrittencalloption Thepayoffofawrittencalloptionisgivenby:max{SK,0}andtheprofitofawrittencall by:max{SK,0}+FV[Call(K,T)]. Inthederivativemarketwehavethefollowingnamingconvention:Thepurchasedcalloption isnamedlong,thewrittencalloptionisnamedshort.Generallywecansaythatwehavea derivativelong,whentheprofitriseswhenthespotpricerisestoo.Andaccordingly,we speakofashortpositioninaderivative,whentheprofitriseswhilethespotpricedeclines. Nowletuslookatasimplestrategyinvolvingacalloption:Imaginethatyouholdanasset.If younowwriteacalloptiononthatassetyouaredoingwhatisknownascoveredcallwriting. Itiscoveredbecauseyoualreadyowntheasset.Ifthecalloptionisexercisedthenyoujust handovertheasset.Bywritingthisoptionyougainthepremium.Youwillnotlosefromthis position:theworstthatcanhappenisthattheassetpricerisesandyouhavemissedoutthe profitsyouwouldotherwisehavemade.If,ontheotherhand,theassetpricefallsyouhave takeninthepremium. Byanalyzingthispositionyouseethatsellingcoveredcallshastheeffectofgivingawaythe upside.Thatis,theoptionsellercannotbenefitfromincreasesintheassetpricebeyondthe strike. Nowletuscomparetheprofitofapurchasedcalloptionwiththeprofitfromalongforward. Thelongforward(redlineinExhibitC.3)showsthatyoulosesubstantiallywhentheSpotPrice islow.Howcanweavoidthisunfavorablesituation?Wecanpurchaseacalloption.Theprofit ofthepurchasedcalloptionriseswhentheSpotPriceisabovethestrikeprice(attherightof theblackline),likethelongforwardrisesiftheSpotPriceisgreaterthantheagreedupon ForwardPrice.Buttheprofitofthecallisalittlebitlower.

Letuslookattheleftoftheblackline.Herewehavetheunfavorablesituationthatweloseby holdingtheforwardiftheSpotPricedeclines.Herehelpsacalloption:Theloosesituationis leveled,meaning:ourloosesituationdoesntgetworseasthebluelinetotheleftofthe (black)strikepriceKshows.Butforavoidingloosingmoreandmoremoneywehavetopaya price,andthispriceisthefuturevalueofthepremiumofourcalloption.Remember,ourlong forwardhasnoupfrontpaymentunlikethepurchasedcall,thereforethedifferencebetween theredandbluelines.

ExhibitC.3:PurchasedCallOptionisInsurance Thatmeansthatapurchasedcalloptionprotectsagainstafallingassetprice.Soapurchased calloptioncanbeseenasinsurance(wheretheinsurancepremiumisthepremiumofthe purchasedcallaccumulatedtotheexpirationtimeT) NowletustalkaboutPutOptions. Definition(PutOption) APutOptiongivestheholdertheright(butnottheobligation!)tosellanunderlyingassetat anagreeduponprice(thestrikeprice)atadateinthefuture(theexpirationdateT).

 ExhibitC.4:ThepayoffandprofitdiagramofaPurchasedPutOption Ifyoubelievethattheunderlyerisgoingtofall,thenyoureallyshouldbuyaPutOptionb/cin thisscenarioyoucanselltheunderlyerformorethanitisworth. ThepayofffunctionofaPurchasedPutOptionismax{KS,0},andtheprofitfunctionis max{KS,0}FV(Put(K,T)). Nowletusturntowrittenputoptions. Sellingaput(orwritingaput,whatisthesame)isaoptionsstrategywhereaninvestor(the putseller)writesaputcontract,andbysellingthiscontracttotheputbuyer,theputsellerhas soldtherighttoselltheunderlyingassetataspecificprice(thestrikeprice).Thus,theput buyernowhastherighttoselltheassettotheputselleratthestrikepriceK. Butbecauseyou(theputseller)willreceivethepremiuminexchangeforthecommitmentto buytheassetatthestrikeprice,youhavesomechancestogohomewithagain.Butonly whentheputbuyerdoesntexercisetheputoption. Hereisthegraphic:

 ExhibitC.5:ThepayoffandprofitdiagramofaWrittenPutOption InformulaewehaveforthepayofffunctionforaWrittenPutOptionmax{KS,0}andfor theprofitfunctionforaWrittenPutOption:max{KS,0}+FV(Put(K,T)). Beawareoftheminussign:Ifforexamplethestrikepriceis40andthespotpriceis20,then theputsellerhastobuytheunderlyingassetfor40(fromtheputbuyer)butcansellitatthe marketforonly20.Soheloses20.Thereforewehavetoapplytheminussign.