Derivatives: Options

• Call Option: The right, but not the obligation, to buy an asset at a specified exercise (or, strike) price on or
before a specified date.

• Put Option: The right, but not the obligation, to sell an asset at a specified exercise (or, strike) price on or
before a specified date.

• Exercise or Strike Price: Price set for calling (buying) or putting (selling) an asset.

• Premium: The purchase price of an option.

• In the money: An option where exercise would be profitable

• Out of the money: An option where exercise would not be profitable

• American Option: The buyer of an option has the right to buy (call) or sell (put) the underlying asset on or
before the expiration date.

• European Option: The buyer of an option has the right to buy (call) or sell (put) the underlying asset only
on the expiration date.

• Expiration Date: Normally the third Friday of the month in the United States.

• Writer of Option: The seller of the option (e.g., write a call means to sell a call option to someone)

• Stock Option Contract: normally (U.S. exchanges) the right to buy or sell 100 shares
Notation

S = the value of the asset at the expiration date

X = the exercise (strike) price

C = the premium (or, price) of the call option

P = the premium (or, price) of the put option

Payoffs and Profit of Call Options:

Payoff = S – X if S > X; otherwise 0

Profit = S – X – C if S > X; otherwise -C

Payoffs and Profit of Put Options:

Payoff = X – S if X > S; otherwise 0

Profit = X – S - P if X > S; otherwise -P

 Simple Numerical Examples of Call and Put Options

(1) Call Option

Current price of stock $50

Exercise (strike) price (X) = $55
Price at expiration (S) = $60
Premium (C) = $2

Payoff = S – X = $60 - $55 = $5

Profit = S – X – C = $60 - $55 - $2 = $3

(2) Put Option

Current price of stock $50

Exercise (strike) price (X) = $45
Price at expiration (S) = $40
Premium (P) = $2

Payoff = X - S = $45 - $40 = $5

Profit = X - S– P = $45 - $40 - $2 = $3

 Graphical Representation of the Profit on the Call Option

Profit/Loss

+3

0 S
50 55 60
-2
 Profit on the Call Option vs. Purchase and Sale of Stock

Profit/Loss
+10

+3

0 S
50 55 60
-2

Why buy the call? Why not just purchase the stock then sell it when the price goes up?
Rate of Return from buying 100 shares of the stock at a price of $50 then selling all at a price of $60

Investment = $50 x 100 = $5,000

Payoff = $60 x 100 = $6,000

Profit = $10 x 100 = $1,000 = $6,000 - $5,000

$1,000
Rate of Return = = .20 = 20%
$5,000

Rate of Return from buying a call option contract (100 shares) with a premium of $2 per share

Investment = $2 x 100 = $200

Payoff = $5 x 100 = $500 = ($60 - $55) x 100

Profit = $3 x 100 = $300 = ($60 - $55 - $2) x 100

$300
Rate of Return = = 1.50 = 150%
$200

Suppose you had used all of your $5,000 to buy call options

Investment = $2 x 2,500 = $5,000

Payoff = $5 x 2,500 = $12,500

Profit = $3 x 2,500 = $7,500

$7,500
Rate of Return = = 1.50 = 150%
$5,000
 Graphical Representation of the Profit on the Put Option
Exercise price (X) = $45; Price at expiration (S) = $40; Premium (P) = $2

Profit/Loss

+3

0 S
40 45
-2

What about the writer (seller) of the call option and put option?
 Profit from a Writing a “Naked” Call Option
Exercise (strike) price (X) = $55; Price at expiration (S) = $60; Premium (C) = $2
Profit/Loss

+2

0 S
55 60

-3
 Profit from a Writing a “Covered” Call Option
Current Price = 50; Exercise (strike) price (X) = $55; Price at expiration (S) = $60; Premium (C) = $2

First, purchase the stock…

Profit/Loss

0 S
50 60
Second, write the call…

Profit/Loss

+2

0 S
55 60

-3
Profit on the ‘covered’ call…

Profit/Loss
Buying the stock

Buying stock and

+7 writing a call option

+2

0 S
48 50 55 60

2-50= -48
 Profit for the Writer of the Put Option
Exercise price (X) = $45; Price at expiration (S) = $40; Premium (C) = $2
Profit/Loss

+2

0 S
40 45
-3
 Option Strategies: Protective Put

Action: Purchase Stock and buy a Put Option

Assumptions:

Purchase price of stock = $30

Exercise Price = $30

Premium on Put Option = $2

Graph the profit potential …

 Option Strategies: Protective Put

Stock Purchase
Profit/Loss
Protective Put

0 S
30
-2

Compare this to the purchase of a stock and writing a call.

Option Strategies: Straddle
Action: Purchase a call and put

Assumptions:

Exercise price (X) for both = $30

Expiration date is the same for both

Call option premium = $3

Put option premium = $2.

Graph the profit potential …

 Option Strategies: Straddle

Profit/Loss

+25

0 S
25 30 35

-5
 Option Strategies: Collar

Action: Owning a share, buying a put, and writing a call

Assumptions:

Current price = $40

Exercise Price of Call = $50

Exercise Price of Put = $30

Premium of Call = Premium on Put (write the call in order to purchase the put)

Graph the potential profit…

 Option Strategies: Collar

Profit/Loss

+10

0 S
30 40 50

-10
 Review Problems

1. Suppose the current price of ABC stock is $30. A call option is selling for $2 with an exercise price of $30 set to expire in 3
months. Illustrate the possible profit/loss from purchasing the stock, then selling it in 3 months. On the same graph, illustrate the
possible profit/loss from purchasing the call option.

2. Suppose the current price of ABC stock is $30. You write a call option for a price of $2 with an exercise price of $30. Assuming
that you do not own the stock illustrate your possible profit/loss from writing the option.

3. Suppose the current price of ABC stock is $30. After purchasing the stock, you write a call option for a price of $2 with an
exercise price of $30. Illustrate your possible profit/loss from writing the option.

4. Suppose the current price of XYZ stock is $70. You do not own the stock, however, you believe that the stock price will be lower
in 3 months time. You purchase a put option at a cost of $5 with an exercise price of $65. Illustrate your possible profit/loss from the
purchase of the put option.

5. The current price of a stock is $80. Explain and graphically illustrate the potential profits and losses for each of the following
investment strategies:
a. An investor purchases a call option for $10 with a strike price of $85.
b. An investor purchases the stock at the current price of $80 and buys a put option for $10 with a strike price of $80.
c. An investor purchases the stock at the current price of $80 and writes (i.e., sells) a call option for $10 with a strike price of
$80.
Under what set of investor beliefs about the movement of the stock price would (c) be a better investment strategy than (b)?

6. An investor purchases a call option and a put option for $3 each. Explain and graphically illustrate the potential profits and losses
for each of the following scenarios:
a. The exercise (strike) price for each option is exactly the same --- e.g., $75.
b. The exercise price for the call option exceeds that of the put option --- e.g., Xcall = $75 Xput = $65