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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.