Page 103 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 7.4 Options Pay-offs

The opportunity characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited, however the profits are
potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to
the options premium; however his losses are potentially unlimited. These non-linear payoffs
are fascinating as they lend themselves to be used to generate various payoffs by using
combinations of options and the underlying.

The following points explains the pay-offs form both the buyer and sellers point of view:

7.4.1 Buyer of Call Option

The buyer of an equity call option has purchased the right, but not the obligation, to buy 100
shares of the underlying stock at the stated exercise price at any time before the option expires.
Once the option is purchased, the buyer is then "long" the call contract, and to purchase 100
underlying shares he notifies his brokerage firm of his intent to exercise the call contract. For
example, the buyer of one XYZ June 60 call option has the right to purchase 100 shares of XYZ
stock at 60 per share up until the June expiration.

Figure 7.25: Pay-off Profile of Buyer of Call Option

Profit + Profit=
Unlimited

o

Increasing Underlying
Loss= Stock Price
Limited
Long call

Loss –
Potential Profit: Unlimited as the underlying stock price increases.
Potential Loss: Limited to premium paid for call option.

7.4.2 Writer (Seller) of Call Option

An investor who sells an option contract that he does not already own is known as the option
"writer," and is then "short" the contract. The writer of an equity call option, commonly referred
to as the "seller," has the obligation to sell 100 shares of the underlying stock at the stated
exercise price if assigned an exercise notice at any time before the option expires.
For example, the writer of an XYZ June 75 call option has the obligation to sell 100 shares of XYZ
stock at 75 per share if assigned at any time until June expiration.
Potential Profit: Limited to premium received from call's initial sale
Potential Loss: Unlimited as the underlying stock price increases.

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