Introduction to Options
To this point, we have presented three classes of risk management instruments: forward contracts, futures contracts, and swaps (which can be viewed as a portfolio of forward contracts). These three classes of risk management instruments share two important features. First, both parties to these contracts, (i.e., the long and the short) are initially bound by the terms of the contract. Second, there is no cash payment required by one party from the other at the initiation of the contract.
In this chapter, we introduce a new class of risk management instruments known as options. There are a number of new terms, concepts, and institutional details associated with options. From a risk management standpoint, a mastery of these fundamental definitions and ideas provides a basis for understanding how options can be used to manage risk.
Perhaps the most fundamental option concept is that option contracts separate rights from obligations. That is, the long has rights, whereas the short has obligations. As a consequence of this separation, the long must pay the short a dollar amount at the initiation of the option contract. This dollar amount, called either the option price, the option premium, or the option value, is the subject of Chapters 17 and 18.
Depending on the nature of the rights and obligations in the option contract, options are classified into two categories known as call options or put options. We begin the study of options by examining the features of call options.
A call option is a contract that gives its owner the right, but not the obligation, to buy something at a specified price on or before a specified date. The “something” that can be bought with the option is called the underlying asset. In this book, the price of the underlying asset will be usually denoted as an S. Much of the description of options in this text will involve options on 100 shares of a specific firm's stock. For example, if you buy one call option on IBM today, you have the right to purchase 100 shares of IBM's common stock at a specified price, any time between today and a prespecified date.
The fact that the call owner does not have the obligation to exercise the option means that he has limited liability. Should the price of the underlying asset fall, he can just walk away from the call contract without ever having had to acquire the underlying asset.
The specified price is called the exercise price, the strike price, or the striking price, and in this text, it will be denoted K (in other books and articles it may be denoted X, or in some cases, E).
The expiration date of an option, or the time to expiration, will be denoted T in this text. The expiration date of U.S. exchange listed options on 100 shares of common stock is the Saturday