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Chapter 8
Options

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Learning Objectives
• Examine the nature of options contracts and
markets
• Describe the types of options contracts available
• Explain the profit and loss payoff profiles of options
contracts
• Explain the factors affecting the price of options

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Chapter Organisation
8.1 The Nature of Options
8.2 Option Profit and Loss Payoff Profiles
8.3 Organisation of the Market
8.4 Pricing an Option
8.5 Summary

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8.1 The Nature of Options (cont.)

• An option gives the buyer the right, but not the
obligation, to buy or sell a specified commodity or
financial instrument at a predetermined price
(exercise or strike price), on or before a specified
date (expiration date)
• An option will only be exercised if it is in the
buyer’s best interest
• Options involve the payment of a premium by the
buyer to the seller (writer)

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8.1 The Nature of Options (cont.)

• Types of options
– Call options
▪ Give the option buyer the right to buy the commodity or
instrument at the exercise price
– Put options
▪ Give the buyer the right to sell the commodity or instrument
at the exercise price
• Options can be exercised either
– Only on expiration date (European)
– Any time up to expiration date (American)

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8.1 The Nature of Options (cont.)

• Premium
– The price paid by an option buyer to the writer (seller) of
the option

• Exercise price or strike price

– The price specified in an options contract at which the
option buyer can buy or sell

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Chapter Organisation
8.1 The Nature of Options
8.2 Option Profit and Loss Payoff Profiles
8.3 Organisation of the Market
8.4 Pricing an Option
8.5 Summary

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8.2 Option Profit and Loss Payoff

Profiles
• Call option profit and loss payoff profiles
– Example: a call option for shares in a listed company at a
strike or exercise price (X) of $12, and a premium (P) of
$1.50
▪ Figure 8.1 indicates the profit and loss profiles of a call
option for (a) the buyer or holder (long call) and (b) the
writer or seller (short call)
▪ The critical break points of the market price of the share (S)
at expiration date are <$12, $12 to $13.50 and >$13.50
▪ If S (market price of asset) > X (i.e. > $12) , option is ‘in-the-
money’

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8.2 Option Profit and Loss Payoff

Profiles (cont.)

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8.2 Option Profit and Loss Payoff

Profiles (cont.)

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8.2 Option Profit and Loss Payoff

Profiles (cont.)
• Call option profit and loss payoff profiles (cont.)
– The value of the option to the buyer or holder (long call
party) is

V = max(S - X, 0) - P (8.1)

– The value of the option to the writer (short call party) is

V = P - max(S - X, 0) (8.2)

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8.2 Option Profit and Loss Payoff

Profiles (cont.)
• Put option profit and loss payoff profiles
– Example: a put option for shares in a listed company at a
strike or exercise price (X) of $12, and premium (P) of
$1.50
▪ Figure 8.2 indicates the profit and loss profiles of a put
option for (a) the buyer or holder (long put) and (b) the
writer or seller (short put)
▪ The critical break points of the market price of the share (S)
at expiration date are <$10.50, $10.50 to $12 and >$12
▪ Buyer exercises option if S < X (i.e. < $12)

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8.2 Option Profit and Loss Payoff Profiles

(cont.)

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8.2 Option Profit and Loss Payoff Profiles

(cont.)

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8.2 Option Profit and Loss Payoff Profiles

(cont.)
• Put option profit and loss payoff profiles (cont.)
– The value of the option to the buyer or holder (long put
party) is

V = max(X - S, 0) - P (8.3)

– The value of the option to the writer (or short put party) is

V = P - max(X - S, 0) (8.4)

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8.2 Option Profit and Loss Payoff Profiles

(cont.)
• Covered and uncovered options
– Unlike futures, the risk of loss for a buyer of an option
contract is limited to the premium
– However, sellers (writers) of options have potentially
unlimited risk and may be subject to margin requirements
unless they write a covered option
▪ i.e. the writer of an option holds the underlying asset or
provides a financial guarantee

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8.2 Option Profit and Loss Payoff Profiles

(cont.)
• Covered and uncovered options (cont.)
– The writer of a call option has written a covered option if
either
▪ The writer owns sufficient of the underlying asset to satisfy
the option contract if exercised, or
▪ The writer is also the holder of a call option on the same
asset, but with a lower exercise price
– The writer of a put option has written a covered option if
the writer is also the holder of a put option on the same
asset, but with a higher exercise price

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Chapter Organisation
8.1 The Nature of Options
8.2 Option Profit and Loss Payoff Profiles
8.3 Organisation of the Market
8.4 Pricing an Option
8.5 Summary

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8.4 Pricing an Option

• Option price (or premium) is influenced by four key
factors
– Intrinsic value
– Time value
– Price volatility
– Interest rates

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8.4 Pricing an Option (cont.)

• Intrinsic value
– The market price of the underlying asset relative to the
exercise price
– The greater the intrinsic value, the greater the premium,
i.e. positive relationship

• Time value
– The longer the time to expiry, the greater the possibility
that the option will be able to be exercised for a profit (‘in-
the-money’), i.e. positive relationship
– If the spot price moves adversely, the loss is limited to the
premium

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8.4 Pricing an Option (cont.)

• Price volatility
– The greater the volatility of the spot price, the greater the
chance of exercising the option for a profit, or a loss
– The option will only be exercised if the price moves
favourably
– The greater the spot price volatility, the greater the option
premium, i.e. positive relationship

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8.4 Pricing an Option (cont.)

• Interest rates
– Interest rates have opposite impacts on put and call
options
▪ Positive relationship between interest rates and the price of
a call
• Benefit of present value of deferred payment if exercised >
lower present value of profit if exercised
▪ Negative relationship between interest rates and the price of
a put
• Opportunity cost of holding asset
• Lower present value of the profit if exercised

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8.5 Summary
• The holder of an option (long party) has the right to
buy (call) or sell (put) the commodity at a specified
exercise price
• The writer (seller) is the short party
• The premium paid to buy an option is affected by
its intrinsic value, time value, price volatility, and
interest rates

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