Option Trading: Putting a Price on Choice

An Option is the right, but not the obligation, to buy or sell an underlying asset at a pre-determined price. This distinction from Forward contracts is what makes options unique and powerful.

1. Call Options and Put Options

• Call Option: The right to buy an asset (profits when prices rise).
• Put Option: The right to sell an asset (profits when prices fall).

To acquire these rights, the buyer must pay a fee called the Premium to the seller.

2. Call Option Payoff Structure

A call option buyer profits when the market price is higher than the Strike Price. If the price is below the strike price, the buyer simply chooses not to exercise the option, limiting their loss to the premium paid.

3. The Value of Asymmetry

As seen in the chart above, options have an Asymmetric structure: limited downside risk with potentially unlimited upside potential (for call buyers). Financial engineers leverage this asymmetry to design sophisticated risk-hedging strategies.

💡 Professor’s Tip

Options are very similar to “Insurance.” You pay a premium to protect yourself against an event (price movement). Your car insurance is essentially a Put Option on your vehicle.

🔗 Next Step

• Ch5: The Black-Scholes Model