Chapter 1: Options (C5721886)

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Introduction

Options are contracts which give the buyer the right (but not the obligation) to buy or sell an underlying asset at a specific price, known as the strike price or exercise price. So it includes:

  • Call option, which gives the right to buy at the strike price. Evidently, the buyer won't exercise the right to buy an asset at the strike price, if it is greater than the market price. (They could get the asset for cheaper by buying at the market price, rather than the strike!) Thus, it is only valuable if the market price EXCEEDS the strike price
  • Put option, which gives the right to sell at the strike price. Evidently, the buyer won't exercise the right to sell an asset at the strike price, if it is lower than the market price. (They could sell the asset for more by selling it at the market price, rather than the strike!) Thus, it is only valuable if the market price is BELOW the strike price

Frequently asked questions
What is an option?
The buyer has the right, but not obligation to buy or sell something at a set price.

When is it buy, and when is it sell?
Call option gives the right to buy, and put option gives the right to sell.

What is the strike price? How is it different from exercise price?
It's not, it's the same thing. It's the set price at which the buyer has the right to buy or sell something at.

Correspondingly, the seller has the obligation to fulfill the transaction if the buyer chooses to "exercise" their option. The buyer pays a premium to the seller for this right.

The expiry date of the option is either, in an:

  • American option, can be exercised on or before the expiry date
  • European option, can be exercised only on (but NOT before) the expiry date
Option valuation

The value of an option is composed of two portions:

  • Intrinsic value, which is the difference between the market price, and the strike price
  • Time value

The modern options valuation method is to use the Black-Scholes model.




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Derivatives - Financial markets - MR. SHUM'S CLASSROOM