Table 2.7 compares call options and forwards/futures based on the following characteristics:
Table 2.7 Comparison of forwards/futures and call option positions Long
forward/futures
Short
forward/futures
Long call option
Short call option Right or
obligation
Obligation Obligation Right Obligation
Buy or sell Buy Sell Buy Sell
Premium None None Paid Received
Name for
purchase price
Forward: Forward price Futures: Futures price
Strike price or exercise price
Payoff at expiration Positive payoff range
None Negative payoff
range
None Zero payoff
point P&L at expiration
Profit range Loss range
Breakeven point ITM range
ATM point Concept of moneyness
not applicable OTM range
Does the position have a right or an obligation?
Will the position be buying or selling?
Does the agreement require the position to pay or receive a premium at initiation?
What is the name of the purchase price at which the transaction will take place in the future?
What is the payoff associated with the position?
When is the payoff positive, negative, and zero?
What is the P&L associated with the position?
When does the position earn a profit, suffer a loss, and break even?
When is the option ITM, ATM, and OTM? Note that the concept of moneyness is not applicable to forwards and futures.
Knowledge check
Q 2.56: In what ways are long and short forwards/futures and calls similar?
Q 2.57: In what ways do long and short forwards/futures and calls differ?
KEY POINTS
A call option is an agreement between two counterparties in which one of the counterparties has the right to purchase an underlying asset from the other
counterparty in the future. The long call has the right to purchase. The short call is obligated to sell the underlying asset to the long call should the long call exercise its right to purchase. The price at which the transaction will take place is agreed-upon at initiation and is known as the strike price or exercise price. The long call pays a
premium at initiation in order to obtain its right.
Call options trade both OTC and through exchanges. Call options are either American- style or European-style. In a European-style call option the right to exercise is only at expiration. In an American-style call option the long call has the right to exercise
earlier as well.
At expiration the long call will exercise its right to purchase when the underlying asset price is greater than the strike price. Its payoff is therefore the larger of either zero or the underlying asset price minus the strike price. The short call's payoff is the smaller of either zero or the strike price minus the underlying asset price.
The long call's P&L at expiration is its payoff minus the call premium paid at initiation. The short call's P&L at expiration is its payoff plus the call premium received at initiation.
Call option payoff and P&L at expiration can be described using equations and P&L diagrams. A P&L diagram illustrates the P&L at expiration as a function of the
underlying asset price at expiration.
Both long and short call options break even when the underlying asset price is equal to the strike price plus the premium.
Call options are zero-sum games, as any profit that one of the counterparties receives is equal to the loss that the other counterparty suffers.
“Moneyness” is whether the long position to an option will exercise or not. The
moneyness of an option is described as being either in-the-money (ITM), out-of-the- money (OTM), or at-the-money (ATM). A call option is ITM when the long call will earn a positive payoff through exercising the option, OTM when the long call will not exercise as it would earn a negative payoff, and ATM when it will earn zero payoff.
An investor should exercise an American-style call option if the advantage of receiving a more valuable asset outweighs the disadvantages of loss of optionality value and paying the strike price earlier.
__________________
1 See www.CBOE.com
2 Another name for optionality value is “time value.”
3 The ex-dividend date is the date used to identify which shareholders receive a dividend.
Dividends are only paid to those holding title before the ex-dividend date.
Chapter 3 Put Options
INTRODUCTION
In this chapter we will explore put options. A put option is an agreement between two counterparties in which one of the counterparties has the right to sell an underlying asset to the other counterparty in the future. A put option is distinct from a call option, as a put option provides the right to sell while a call option provides the right to purchase.
After you read this chapter you will be able to
Describe the key characteristics of a put option.
Explore the decision whether to exercise a put option or not.
Describe a put option's cash flows, payoff, and P&L.
Understand how equations and P&L diagrams can be used to describe put option payoff and P&L.
Understand when put options earn profits, suffer losses, and break even.
Explain why put options are zero-sum games.
Understand when a put option is in-the-money (ITM), at-the-money (ATM), and out- of-the-money (OTM).
Understand when it makes sense to exercise a put option early.
Compare and contrast forwards/futures, call options, and put options.