Exclusive Article on Call and Put Option Basics
Copyright BusinessEconomics.com
Introduction
Options are a special type of financial asset that give the holder the right but not the obligation to buy or sell an underlying security at a predetermined price.
Options were first traded in Chicago in 1972, and a decade later in 1982 London opened the London International Financial Futures Exchange (LIFFE) and is currently the largest options Exchange in Europe. Options contracts have proved very popular for both commodities and financial securities, and among the most popular contracts traded on LIFFE are interest rate contracts, currency contracts and stock-index contracts.
Like futures, options contracts are derivative instruments; that is, the price of the contract is derived from the price of the underlying asset in the cash or spot market.
The growth of options markets
There has been a massive growth in the use of options markets as illustrated in the Table
Table Turnover of options traded on international exchanges
(Numbers of contracts in millions)
Instruments 1990 1995 2000 2005 2008
Interest rate 52.0 225.5 107.6 430.8 617.7
Currency 18.9 23.3 7.1 19.4 59.8
Equity index 119.1 187.3 481.4 3139.8 4174.1
All Markets 190.0 436.1 596.1 3590.0 4851.6
Source: Bank for International Settlements
As with futures contracts, options are traded on exchanges, and as tailor-made contracts in the over-the-counter instruments offered by leading banks and securities houses to their clients. Also, as with futures contracts, an exchange will protect itself against the risk of default by the writer and will impose capital and stringent margin requirements on option-writers.
Options contracts
An option contract involves two parties:
The writer who sells the option and the holder who purchases it.
The holder of an option contract has the right but not the obligation to either buy or sell the underlying asset at a predetermined price in the future.
The writer of an option sells the right to buy the underlying at a given price (a call option) or sells the right to sell the underlying a predetermined price in the future (a put option).
If the contract gives the holder the right to purchase the underlying asset at a predetermined price from the other party the contact is known as a call option.
If the contract gives the holder the right to sell the underlying asset at a predetermined price from the other party the contact is known as a put option.
An option contract that can be exercised at any time up until its maturity date is known as an American option, whilst one that can only be exercised on the expiration date is known as a European option.
The Table below illustrates a number of options contracts relating to shares of British Petroleum as reported in the Financial Times.
Table Liffe equity options
.....Calls..... .....Puts......
Sep Dec Mar Sep Dec Mar
BP 520 16.0 23.0 28.0 10.0 17.0 27.0
(*525) 540 7.0 13.5 18.0 21.0 27.0 38.0
Source; Financial Times August
Table shows the price of put and call options on British Petroleum shares traded at LIFFE for differing expiry dates. The bracketed price underneath the share (*525 pence) is the current price of the share on the market.
The two strike prices published are at 520 and 540 pence; other strike prices are obtainable but only the ones closest to the current price of the share are published in the financial press. The limited number of strike prices and contract maturity dates, in this case September, December and March, while restricting the potential range of investments for investors are crucial to ensuring there is a sufficient market to guarantee investors the liquidity that they require.
There are two sets of prices quoted, for call options and for put options.
Consider the March call price of 18 pence at a strike price of 540 pence. The price paid for the call option of 18 pence is known as the option premium, and the buyer of such a call option would have the right but not the obligation to buy 1,000 British Petroleum shares at a price of 540 pence in March 2011 for a cost of 18 pence per share (that is, a total cost of £180).
Alternatively, an investor could, for 38 pence per share, have the right but not the obligation to sell 1,000 (that is, a total cost of £380) BP shares at a price of 540 pence in March.
There are basically four types of positions that can be taken on an options contract as follows:
1 Buying a call option – known as being long call.
2 Selling a call option – known as being short call.
3 Buying a put option – known as being long put.
4 Selling a put option – known as being short put.
A call option contract
Consider the underlying asset as 1,000 shares in BP which are currently priced at 525 pence. Mr A buys a call option with a strike price of 540 for March for an option premium of 18 pence a share (a total of £180 ie £0.18 x 1000). Mr A has purchased the right to buy from the writer of the option 1,000 shares in BP at a price of 540 per share. The maximum amount that the option holder can lose is £180, while the maximum profit the option writer can make is £180.
The Table below shows the profit and loss profile per share for the March call option for different possible spot prices of British Petroleum shares in March.
Table Profit and loss profile on a call option
Details:
Option Premium 18
Strike price 540
Expiration March
Contract 1000 shares
Price of BP Holder Writer
shares on Profit/Loss Profit/loss
expiration date on long call on short call
200 -£180 +£180
300 -£180 +£180
400 -£180 +£180
500 -£180 +£180
540 -£180 +£180
550 -£80 +£80
558 £0 +£0
560 +£20 -£20
580 +£220 -£220
600 +£420 -£420
650 +£920 -£920
700 +£1420 -£1420
800 +£2420 -£2420
900 +£3420 -£3420
If the price in March is below 540 pence, the holder will not exercise the option as the shares can be bought more cheaply on the spot market and the option holder will have lost the £180 premium paid, with the writer making £180.
If the price of the shares at the expiration date in March is above 540, then the holder will exercise the option, since it will pay him to buy the shares at 540 pence and sell them spot at a higher price.
If the price rises above 540 pence but to less than 558 pence, it pays the holder to exercise the option; however, since he has paid 18 pence for the option he will make an overall loss. For example, if the price has risen to 550 pence he will exercise the right to buy the shares at 540 pence and sell them spot at 550 pence making 10 pence per share; but taking into account the 18 pence option premium paid he will make a loss of 8 pence per share or £80 in total.
A future spot price of 558 pence will mean the option holder breaks even as the gain from exercising the option of 18 pence per share just matches the option premium paid of 18 pence per share.
If the price rises above 558 pence the holder will exercise his option at a profit. For example, if the price has risen to 580 pence he will exercise the right to buy the shares at 540 pence and sell them spot making 580 pence per share, but taking into account the 18 pence option premium paid he will make a profit of 22 pence per share or £220 in total.
An important point about an option is that the most the option holder can lose is the option premium, that is, 18 pence per share or £180 in total premium, while the maximum that the option writer can make is the option premium received.
However, the option holder has a potentially unlimited upside; for instance, if the share goes up to 800 pence the option holder makes a net profit of 242 pence a share or £2,420 in total and the share could possibly go well-above this level.
Likewise the option writer faces a potentially unlimited downside; for instance, if the share goes up to 800 pence the option writer makes a loss of 242 pence per share or £2,420 in total and, again, the share might probably go well-above this level so increasing his losses.
Hence, the holder of the option has a substantial upside potential profit with limited maximum downside (that is, the option premium), while the writer of the option has a maximum gain (the option premium) and a substantial loss potential.
The asymmetrical profit and loss profile facing the option writer and holder is depicted in the figure below:
Figure The profit and loss profile of a call option
Copyright BusinessEconomics.com
Introduction
Options are a special type of financial asset that give the holder the right but not the obligation to buy or sell an underlying security at a predetermined price.
Options were first traded in Chicago in 1972, and a decade later in 1982 London opened the London International Financial Futures Exchange (LIFFE) and is currently the largest options Exchange in Europe. Options contracts have proved very popular for both commodities and financial securities, and among the most popular contracts traded on LIFFE are interest rate contracts, currency contracts and stock-index contracts.
Like futures, options contracts are derivative instruments; that is, the price of the contract is derived from the price of the underlying asset in the cash or spot market.
The growth of options markets
There has been a massive growth in the use of options markets as illustrated in the Table
Table Turnover of options traded on international exchanges
(Numbers of contracts in millions)
Instruments 1990 1995 2000 2005 2008
Interest rate 52.0 225.5 107.6 430.8 617.7
Currency 18.9 23.3 7.1 19.4 59.8
Equity index 119.1 187.3 481.4 3139.8 4174.1
All Markets 190.0 436.1 596.1 3590.0 4851.6
Source: Bank for International Settlements
As with futures contracts, options are traded on exchanges, and as tailor-made contracts in the over-the-counter instruments offered by leading banks and securities houses to their clients. Also, as with futures contracts, an exchange will protect itself against the risk of default by the writer and will impose capital and stringent margin requirements on option-writers.
Options contracts
An option contract involves two parties:
The writer who sells the option and the holder who purchases it.
The holder of an option contract has the right but not the obligation to either buy or sell the underlying asset at a predetermined price in the future.
The writer of an option sells the right to buy the underlying at a given price (a call option) or sells the right to sell the underlying a predetermined price in the future (a put option).
If the contract gives the holder the right to purchase the underlying asset at a predetermined price from the other party the contact is known as a call option.
If the contract gives the holder the right to sell the underlying asset at a predetermined price from the other party the contact is known as a put option.
An option contract that can be exercised at any time up until its maturity date is known as an American option, whilst one that can only be exercised on the expiration date is known as a European option.
The Table below illustrates a number of options contracts relating to shares of British Petroleum as reported in the Financial Times.
Table Liffe equity options
.....Calls..... .....Puts......
Sep Dec Mar Sep Dec Mar
BP 520 16.0 23.0 28.0 10.0 17.0 27.0
(*525) 540 7.0 13.5 18.0 21.0 27.0 38.0
Source; Financial Times August
Table shows the price of put and call options on British Petroleum shares traded at LIFFE for differing expiry dates. The bracketed price underneath the share (*525 pence) is the current price of the share on the market.
The two strike prices published are at 520 and 540 pence; other strike prices are obtainable but only the ones closest to the current price of the share are published in the financial press. The limited number of strike prices and contract maturity dates, in this case September, December and March, while restricting the potential range of investments for investors are crucial to ensuring there is a sufficient market to guarantee investors the liquidity that they require.
There are two sets of prices quoted, for call options and for put options.
Consider the March call price of 18 pence at a strike price of 540 pence. The price paid for the call option of 18 pence is known as the option premium, and the buyer of such a call option would have the right but not the obligation to buy 1,000 British Petroleum shares at a price of 540 pence in March 2011 for a cost of 18 pence per share (that is, a total cost of £180).
Alternatively, an investor could, for 38 pence per share, have the right but not the obligation to sell 1,000 (that is, a total cost of £380) BP shares at a price of 540 pence in March.
There are basically four types of positions that can be taken on an options contract as follows:
1 Buying a call option – known as being long call.
2 Selling a call option – known as being short call.
3 Buying a put option – known as being long put.
4 Selling a put option – known as being short put.
A call option contract
Consider the underlying asset as 1,000 shares in BP which are currently priced at 525 pence. Mr A buys a call option with a strike price of 540 for March for an option premium of 18 pence a share (a total of £180 ie £0.18 x 1000). Mr A has purchased the right to buy from the writer of the option 1,000 shares in BP at a price of 540 per share. The maximum amount that the option holder can lose is £180, while the maximum profit the option writer can make is £180.
The Table below shows the profit and loss profile per share for the March call option for different possible spot prices of British Petroleum shares in March.
Table Profit and loss profile on a call option
Details:
Option Premium 18
Strike price 540
Expiration March
Contract 1000 shares
Price of BP Holder Writer
shares on Profit/Loss Profit/loss
expiration date on long call on short call
200 -£180 +£180
300 -£180 +£180
400 -£180 +£180
500 -£180 +£180
540 -£180 +£180
550 -£80 +£80
558 £0 +£0
560 +£20 -£20
580 +£220 -£220
600 +£420 -£420
650 +£920 -£920
700 +£1420 -£1420
800 +£2420 -£2420
900 +£3420 -£3420
If the price in March is below 540 pence, the holder will not exercise the option as the shares can be bought more cheaply on the spot market and the option holder will have lost the £180 premium paid, with the writer making £180.
If the price of the shares at the expiration date in March is above 540, then the holder will exercise the option, since it will pay him to buy the shares at 540 pence and sell them spot at a higher price.
If the price rises above 540 pence but to less than 558 pence, it pays the holder to exercise the option; however, since he has paid 18 pence for the option he will make an overall loss. For example, if the price has risen to 550 pence he will exercise the right to buy the shares at 540 pence and sell them spot at 550 pence making 10 pence per share; but taking into account the 18 pence option premium paid he will make a loss of 8 pence per share or £80 in total.
A future spot price of 558 pence will mean the option holder breaks even as the gain from exercising the option of 18 pence per share just matches the option premium paid of 18 pence per share.
If the price rises above 558 pence the holder will exercise his option at a profit. For example, if the price has risen to 580 pence he will exercise the right to buy the shares at 540 pence and sell them spot making 580 pence per share, but taking into account the 18 pence option premium paid he will make a profit of 22 pence per share or £220 in total.
An important point about an option is that the most the option holder can lose is the option premium, that is, 18 pence per share or £180 in total premium, while the maximum that the option writer can make is the option premium received.
However, the option holder has a potentially unlimited upside; for instance, if the share goes up to 800 pence the option holder makes a net profit of 242 pence a share or £2,420 in total and the share could possibly go well-above this level.
Likewise the option writer faces a potentially unlimited downside; for instance, if the share goes up to 800 pence the option writer makes a loss of 242 pence per share or £2,420 in total and, again, the share might probably go well-above this level so increasing his losses.
Hence, the holder of the option has a substantial upside potential profit with limited maximum downside (that is, the option premium), while the writer of the option has a maximum gain (the option premium) and a substantial loss potential.
The asymmetrical profit and loss profile facing the option writer and holder is depicted in the figure below:
Figure The profit and loss profile of a call option
Share price on expiration
In the figure we can see that the holder of the option has a maximum loss per share of 18 pence and has unlimited upside potential if the future spot price is above 558 pence. Conversely, the writer of the option can only make 18 pence a share at most and has an unlimited downside risk if the future spot price is above 558 pence.
The Difference Between Writing Naked and Writing Covered
Writing options can seem like a very risky business, since the maximum profit obtainable for the writer is the call or put premium received while the losses can be very substantial if there is a large price movement in the underlying share (security or commodity).
For instance, look at the example of British Petroleum call options. The holder has paid a premium of £180 to buy 1000 shares at strike price of 540 pence and the writer has received £180 which is the maximum profit the writer can make.
If, however, the share price rises to 800 pence we have seen the writer will lose £2,420. This is because in the example we have assumed that the writer does not own any shares in British Petroleum. When you write options on a security that you do not own you are said to be “writing naked.” Writing naked is quite risky as the share price can go up and up in value increasing the writer’s loss in the process.
However, writing can be a lot less risky if the writer is “writing covered,” that is the writer actually owns a certain quantity of the shares they are writing the call option on. For example of the writer in our example actually owns 900 shares in British Petroleum at the time of writing the call option then the writer will have a profit from the rise in the price of the shares that will offset his losses from writing the call option.
If the writer owns 900 shares in British Petroleum at the time of writing the option contract then they are worth
900 x £5.25=£4,725
If the share rises in price to 800 pence by the time of expiration in March then the 900 shares will be worth
900 x £8 = £7,200.
The writer thus has an appreciation in value of the shares that he owns of £2,475 which more than covers his loss of £2,420 from having written the call options.
In this case, he is “fully covered” as the appreciation of the shares of £2475 will offset the loss from writing the call option from writing the shares.
If the writer owned only 500 shares then they appreciate in price by £2.75 each giving him a profit from owning the shares of £1,375 which although reducing his loss from writing the options is insufficient to fully cover the loss in this case we say the writer is writing “partially covered.”
From this discussion, we can see that writing naked is quite risky whereas writing covered is far less risky. Writing covered could be a useful strategy for a fund manager owns some shares as part of his portfolio but does not expect them to do too much in the short term. If the fund manager owns 1000 shares in British Petroleum as part of his “core portfolio” and does not expect them to change much between August and March then he could write some call options on the share. If the share remains at £5.25 between August and March then the shares he owns will still be work £5,250 but he will have a useful profit of £180 from having written the call options which expire worthless to the holder. Indeed, if the shares fall in price to £5.10 then his shares will be worth £5,150 which is £100 less but his profit of £180 from writing the call option will mean his net position in British Petroleum is worth £5,150 plus the profit from writing the call of £180 which is £5,330.
Of course if the share rises to £8 then his shares are worth £8,000 but the loss of £2,420 from writing the call options will mean his net position in British Petroleum is worth only £5,580 an improvement over £5,250 but far less than the £8,000 if he had not written the call option premium.
A put option contract
Let us now consider the profit and loss profiles associated with a put option. As an example we take a put option on the shares of British Petroleum March 2011 at a strike price of 540 pence and a put option premium of 38 pence. The total premium payable is £0.38 x 1000 = £380 for which the holder is acquiring the right to sell 1,000 shares to the writer for £5.40 a share. Let us consider the profit and loss profiles of the buyer and writer of the option. The profit and loss profile of the put option to the holder and writer is shown in the Table below:
Table Profit and loss profiles on a put option Details:
Option Premium 38
Strike price 540
Expiration March
Contract 1000 shares
Price of BP Holder Writer
shares on Profit/Loss Profit/loss
expiration date on long put on short put
100 +£4020 -£4020
200 +£3020 -£3020
300 +£2020 -£2020
350 +£1520 -£1520
400 +£1020 -£1020
450 +£520 -£520
480 +£220 -£220
500 +£20 -£20
502 £0 £0
520 -£180 +£180
540 -£380 +£380
550 -£380 +£380
600 -£380 +£380
650 -£380 +£380
700 -£380 +£380
800 -£380 +£380
The table shows that the holder of the option has a maximum loss of £380 and substantial upside potential once the share is below 502 pence. Conversely, the writer of the option can only make the option premium of £380 at most and has substantial downside risk if the future spot price is below 502 pence.
If in March the price of the shares is 540 pence or more, the holder will not exercise the put option and will make a loss of 38 pence per share or £380 in total and the writer a profit of £380.
If the share is priced at less than 540 pence but greater than 502 pence then the holder will exercise the option but still make a loss. For example, if the stock is priced at 520 pence it will pay the holder to buy the stock at 520 pence and exercise the right to sell it at 540 pence so making 20 pence a share; however, since he paid 38 pence for the put premium he is left with a net loss of 18 pence a share or £180 in total.
If the share price is below 502 pence then the holder of the put option will make a profit from exercising the option. For example, if the price of the share is 450 pence he will exercise the right to sell the shares at 540 pence so making 90 pence less the option premium of 38 pence leaving a net profit of 52 pence a share or £520 in total.
Figure Profit/oss on put options
In the figure we can see that the holder of the option has a maximum loss per share of 18 pence and has unlimited upside potential if the future spot price is above 558 pence. Conversely, the writer of the option can only make 18 pence a share at most and has an unlimited downside risk if the future spot price is above 558 pence.
The Difference Between Writing Naked and Writing Covered
Writing options can seem like a very risky business, since the maximum profit obtainable for the writer is the call or put premium received while the losses can be very substantial if there is a large price movement in the underlying share (security or commodity).
For instance, look at the example of British Petroleum call options. The holder has paid a premium of £180 to buy 1000 shares at strike price of 540 pence and the writer has received £180 which is the maximum profit the writer can make.
If, however, the share price rises to 800 pence we have seen the writer will lose £2,420. This is because in the example we have assumed that the writer does not own any shares in British Petroleum. When you write options on a security that you do not own you are said to be “writing naked.” Writing naked is quite risky as the share price can go up and up in value increasing the writer’s loss in the process.
However, writing can be a lot less risky if the writer is “writing covered,” that is the writer actually owns a certain quantity of the shares they are writing the call option on. For example of the writer in our example actually owns 900 shares in British Petroleum at the time of writing the call option then the writer will have a profit from the rise in the price of the shares that will offset his losses from writing the call option.
If the writer owns 900 shares in British Petroleum at the time of writing the option contract then they are worth
900 x £5.25=£4,725
If the share rises in price to 800 pence by the time of expiration in March then the 900 shares will be worth
900 x £8 = £7,200.
The writer thus has an appreciation in value of the shares that he owns of £2,475 which more than covers his loss of £2,420 from having written the call options.
In this case, he is “fully covered” as the appreciation of the shares of £2475 will offset the loss from writing the call option from writing the shares.
If the writer owned only 500 shares then they appreciate in price by £2.75 each giving him a profit from owning the shares of £1,375 which although reducing his loss from writing the options is insufficient to fully cover the loss in this case we say the writer is writing “partially covered.”
From this discussion, we can see that writing naked is quite risky whereas writing covered is far less risky. Writing covered could be a useful strategy for a fund manager owns some shares as part of his portfolio but does not expect them to do too much in the short term. If the fund manager owns 1000 shares in British Petroleum as part of his “core portfolio” and does not expect them to change much between August and March then he could write some call options on the share. If the share remains at £5.25 between August and March then the shares he owns will still be work £5,250 but he will have a useful profit of £180 from having written the call options which expire worthless to the holder. Indeed, if the shares fall in price to £5.10 then his shares will be worth £5,150 which is £100 less but his profit of £180 from writing the call option will mean his net position in British Petroleum is worth £5,150 plus the profit from writing the call of £180 which is £5,330.
Of course if the share rises to £8 then his shares are worth £8,000 but the loss of £2,420 from writing the call options will mean his net position in British Petroleum is worth only £5,580 an improvement over £5,250 but far less than the £8,000 if he had not written the call option premium.
A put option contract
Let us now consider the profit and loss profiles associated with a put option. As an example we take a put option on the shares of British Petroleum March 2011 at a strike price of 540 pence and a put option premium of 38 pence. The total premium payable is £0.38 x 1000 = £380 for which the holder is acquiring the right to sell 1,000 shares to the writer for £5.40 a share. Let us consider the profit and loss profiles of the buyer and writer of the option. The profit and loss profile of the put option to the holder and writer is shown in the Table below:
Table Profit and loss profiles on a put option Details:
Option Premium 38
Strike price 540
Expiration March
Contract 1000 shares
Price of BP Holder Writer
shares on Profit/Loss Profit/loss
expiration date on long put on short put
100 +£4020 -£4020
200 +£3020 -£3020
300 +£2020 -£2020
350 +£1520 -£1520
400 +£1020 -£1020
450 +£520 -£520
480 +£220 -£220
500 +£20 -£20
502 £0 £0
520 -£180 +£180
540 -£380 +£380
550 -£380 +£380
600 -£380 +£380
650 -£380 +£380
700 -£380 +£380
800 -£380 +£380
The table shows that the holder of the option has a maximum loss of £380 and substantial upside potential once the share is below 502 pence. Conversely, the writer of the option can only make the option premium of £380 at most and has substantial downside risk if the future spot price is below 502 pence.
If in March the price of the shares is 540 pence or more, the holder will not exercise the put option and will make a loss of 38 pence per share or £380 in total and the writer a profit of £380.
If the share is priced at less than 540 pence but greater than 502 pence then the holder will exercise the option but still make a loss. For example, if the stock is priced at 520 pence it will pay the holder to buy the stock at 520 pence and exercise the right to sell it at 540 pence so making 20 pence a share; however, since he paid 38 pence for the put premium he is left with a net loss of 18 pence a share or £180 in total.
If the share price is below 502 pence then the holder of the put option will make a profit from exercising the option. For example, if the price of the share is 450 pence he will exercise the right to sell the shares at 540 pence so making 90 pence less the option premium of 38 pence leaving a net profit of 52 pence a share or £520 in total.
Figure Profit/oss on put options
Share price on expiration
We have now covered the basic profit and loss profiles on call and put option contracts. There is one slight complication that so far we have ignored, which is that when buying an option the holder pays the writer of the option a fee at the time of the sale. This means that the holder is foregoing interest and the writer has funds that can earn interest. The effect of the interest rate factor is to lower the profit profile for the buyer of the option and raise the profit profile for the writer of the option, but the interest factor is usually relatively unimportant.
Copyright BusinessEconomics.com
