Financial Instruments and Markets: A Casebook

16

Note on Basic Option Properties

Options are contacts that give the right, but not the obligation, to either buy or sell a specific underlying security for a specified price on or before a specific date.

This note takes its cue from this fundamental option definition, to explain the basics of options. It will cover fundamentals such as the payoff schemes of options, parameters that influence their value, the parity between put and call options, and also the upper and lower bounds of options prices. Before we jump into all that, however, let's start with a basic example that shows how options work.

Say that you are interested in owning stock in Acme, Inc. Currently, Acme's shares trade at $100, which you think is low. You believe the stock should be valued more highly and that its price soon will rise. If you bought now and sold it later, you would therefore make money. However, you are not completely sure, so rather than outright buying the stock, you buy an option from someone who does own Acme stock. The option contract gives you the right to buy the stock at $100, no matter what the actual stock price is, before a certain end date that is specified in the contract. Of course, you have to pay an upfront fee to the person that owns the stocks and who might have to part with them. Note that you actually don't own the underlying stock just because you purchased an option. The option derives its value (which is why we call it a derivative instrument) from the stock, but it is not ...