Page 72 - DCOM510_FINANCIAL_DERIVATIVES

Unit 5: Introduction to Options

Notes

Notes Various other types of options are listed below:
Real options: A real option is a choice that an investor has when investing in the real
economy (i.e. in the production of goods or services, rather than in financial contracts).
This option may be something as simple as the opportunity to expand production, or to
change production inputs. Real options are an increasingly influential tool in corporate
finance. The liquidity of this kind of exchange-traded options is relatively lower.
Traded options - (Exchange-Traded Options): Traded Options are, Exchange-traded derivatives,
as the name implies. As for other classes of exchange traded derivatives, they have:
standardised contracts; quick systematic pricing and are settled through a clearing house
(ensuring fulfilment).

Vanilla and exotic options: Generally speaking, a vanilla option is a ‘simple’ or well understood
option, whereas an exotic option is more complex, or less easily understood (hybrid
options). European options and American options on stock and bonds are usually considered
to be “plain vanilla”. Asian options, look back options, barrier options are often considered
to be exotic, especially if the underlying instrument is more complex than simple equity
or debt.

5.3.1 Call Option

A call option gives the holder a right to buy shares. The option holder will make money if the spot
price is higher than the strike price. The pay off assumes that the option holder will buy at the
strike price and sell immediately at the spot price. But if the spot price is lower than the strike, the
option holder can simply ignore the option. It will be cheaper to buy from the market. The option
holder loss is to the extent of premium he has paid. But if the spot price increases dramatically then
he can make wind fall profits. Thus the profits for an option holder in a call option are unlimited
while losses are capped to the extent of the premium. Conversely, for the writer, the maximum
profit he can make is the premium amount. But the losses he can make are unlimited.

5.3.2 Put Option

The put option gives the right to sell. The option holder will make money if the spot price is
lower than the strike price. The pay off assumes that the option holder will buy at spot price and
sell at the strike price But if the spot price is higher than the strike, the option holder can simply
ignore the option. It will be beneficial to sell to the market.
The option holder loss is to the extent of premium he has paid. But if the spot prices fall
dramatically then he can make wind fall profits. Thus the profits for an option holder in a put
option are unlimited while losses are capped to the extent of the premium. This is a theoretical
fallacy as the maximum fall a stock can have is till zero, and hence the profit of an option holder
in a put option is capped.
Conversely, the maximum profit that an option writer can make in this case is the premium
amount. But in the above pay off, we had ignored certain costs like premium and brokerage.
These are also important, especially the premium. So, in a call option for the option holder to
make money, the spot price has to be more than the strike price plus the premium amount. If the
spot is more than the strike price but less than the sum of strike price and premium, the option
holder can minimise losses but cannot make profits by exercising the option.
Similarly, for a put option, the option holder makes money if spot is less than the strike price less
the premium amount. If the spot is less than the strike price but more than the strike price less
premium, the option holder can minimise losses but cannot make profits by exercising the option.

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