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Calls and Puts

Derivatives
Securities whose price is dependent upon or derived from one or more underlying assets.
The derivative itself is merely a contract between two or more parties. Its value is determined by
fluctuations in the underlying asset.
The most common underlying assets include stock, bonds, commodities, currencies, interest rates
and market index.
Most derivatives are characterized by high leverage.
Futures contracts, forward contracts, options and swaps are the most common types of derivatives

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Options
Options

Call

Put

Long Call

Short Call

Long Put

Short Put

The right to
Buy an option

The obligation to
Sell the underlying

The right to
Sell an option

The obligation to
Buy the underlying

Long options have rights


Short options have obligations

Call

Buy

Put

Sell

Seller of an option is also called as option writer


Option Premium: Price that the owner of an option is required to pay to acquire those rights

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Example: Options And Forward Payoff


If the Spot price of a computer is $1000.

Spot T=0

If the forward
price at Time 1
is
In the
Money

Out of
the
Money
300

Payoff for the


Payoff for Long
forward position Call position

1200

200

200

1100

100

100

1000

900

-100

800

-200

1000

Terminal
stock price ($)

Forward T=1

Payoff
Forward profit and loss

At the
Money
1000

S(T)

Payoff of the Call

200
100
700

800

900

0
-50

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1100

1200

1300

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Long Call
Profit from buying one European call option: option price = $5, strike price = $100, option life = 2
months

30

Profit ($)

20

10

70

80

90

Terminal
stock price ($)

100

-5

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110

120

130

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Short Call
Profit from writing one European call option: option price = $5, strike price = $100

Profit ($)

110

120

130

0
70

80

90

100

Terminal
stock price ($)

-10

-20

-30

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Long Put
Profit from buying an European put option: option price = $7, strike price = $70.

30

Profit ($)

20

10

Terminal
stock price ($)

0
40

50

60

70

80

90

100

-7

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Short Put
Profit from writing an European put option: option price = $7, strike price = $70

Profit ($)

Terminal
stock price ($)

7
40

50

60

0
70

80

90

100

-10

-20

-30

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Payoffs From Options

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Question

Which of the following single option transaction can be most risky?


A.
B.
C.

Writing a put
Buying a put
Writing a call

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Solutions
C.
As the stock price of the underlying increases above the exercise price of a call option, writer of the option
faces unlimited risk whereas buyer of the option face unlimited gain in this situation.

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European & American Options

Options Type

European
Options

Can be exercised
only at the end of
its life

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American
Options

Can be exercised
at any time before
or on expiration

Option Premium
Is Lower

12

Option Premium
is Higher

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