Chapter 24

What are options?

An option is a contract that gives its owner the right (but not the obligation) to buy or sell some asset at a fixed price on or before a given date. An option on a building might give the holder of the option the right to buy the building for $1 million anytime on or before the Saturday prior to the third Wednesday of January 2021. The buyer uses the option only if it is profitable to do so; otherwise, the option can be thrown away.

Out of the money What does it mean? When would it occur for a call vs a put?

Exercising the option would result in a negative payout for the owner (so they walk away) Call: the strike price is greater than the stock price Put: the stock price is greater than strike price

Option vocab: Exercising the option: Strike price, or exercise price: Expiration date: American and European options:

Exercising the option: The act of buying or selling the underlying asset via the option contract is called exercising the option. Strike price, or exercise price: The fixed price specified in the option contract at which the holder can buy or sell the underlying asset is called the strike price or exercise price. The strike price is often called the striking price. Expiration date: An option usually has a limited life. The option is said to expire at the end of its life. The last day on which the option may be exercised is called the expiration date. American and European options: An American option may be exercised anytime up to and INCLUDING the expiration date. A European option may be exercised only on the expiration date.

Hedging

Hedge: To mitigate (reduce) risk by holding contracts or securities whose payoffs are negatively correlated with some risk exposure

In the money What does this mean? When would it occur for a call vs a put?

In the money: Exercising the option would result in a positive payout for the owner Call: the stock price is greater than strike price Put: the strike price is greater than the stock price

Can an option have a negative payoff? What kind of financial instrument does this make options?

No: The holder has the right, but not the obligation, to exercise the option If the option is out of the money, the holder can simply walk away An option is a limited liability instrument: the maximum loss is the purchase price of the instrument

Calls and Puts

Options come in two basic types: Puts and calls. A call option gives the owner the right to buy an asset at a fixed price during a particular time period. It may help you to remember that a call option gives you the right to "call in" an asset. A put option is essentially the opposite of a call option. Instead of giving the holder the right to buy some asset, it gives the holder the right to sell that asset for a fixed exercise price. If you buy a put option, you can force the seller of the option to buy the asset from you for a fixed price and thereby "put it to them."

Speculating

Speculate: To use contracts or securities to place a bet on the direction of the market

At the money What does it mean?

The stock price equals the exercise price; exercising the option would result in zero payout