Page 66 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 6: Introduction to Options

2. While touring the house, you discover that the house is not in proper living conditions. Notes
Though you originally thought you had found the house of your dreams, you now consider
it worthless. On the upside, because you bought an option, you are under no obligation to
go through with the sale. Of course, you still lose the ` 3,000 price of the option, that is
non-refundable.
This example demonstrates two very important points.
First, when you buy an option, you have a right but not an obligation to do something. You can
always let the expiration date go by, at which point the option becomes worthless. If this
happens, you lose 100% of your investment (option premium), which is the money you used to
pay for the option.
Second, an option is merely a contract that deals with an underlying asset. For this reason,
options are called derivatives, which mean an option derives its value from something else. In
our example, the house is the underlying asset.

Notes Options vs Futures
In case of futures, both the buyer and the seller are under obligation to fulfill the contract.
They have unlimited potential to gain if the price of the underlying moves in their favour.
On the contrary, they are subject to unlimited risk of losing if the price of the underlying
moves against their views. In case of options, however, the buyer of the option has the
right and not the obligation. Thus he enjoys an asymmetric risk profile. He has unlimited
potential to profit if the price of the underlying moves in his favour. But a limited potential
to lose, to the extent of the premium paid, in case the price of the underlying moves
against the view taken. Similarly, the seller of the option is under obligation. He has
limited potential to profit, to the extent of the premium received, in case the price of the
underlying moves in his favour, but an unlimited risk of losing in case the price of the
underlying moves against the view taken.
Further with regards to behaviour of prices, trading in futures is one-dimensional as the
price of futures depends upon the price of the underlying only. Trading in options is two-
dimensional as the price of an option depends upon both the price and the volatility of the
underlying.

6.1 Options Terminology

The following are the key terms used in options:
1. Buyer of an option: The option buyer is the person who acquires the rights conveyed by
the option: the right to purchase the underlying futures contract if the option is a call or the
right to sell the underlying futures contract if the option is a put. In other words, the buyer
of an option is the one who by paying the option premium, buys the right but not the
obligation to exercise his option on the seller/writer.

2. Writer of an option: The option seller (also known as the option writer or option grantor)
is the party that conveys the option rights to the option buyer. In other words, the writer
of a call/put option is the one who receives the option premium and is thereby obliged to
sell/buy the asset if the buyer exercises on him.
3. Option Class: All calls and puts on a given underlying security or index represent an
"option class." In other words, all calls and puts on XYZ stock are one class of options,
while all calls and puts on ZYX index are another class.

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