Call option

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This article is about financial options. For call options in general, see Option
(law).
A call option, often simply labeled a "call", is a financial contract between tw
o parties, the buyer and the seller of this type of option.[1] The buyer of the
call option has the right, but not the obligation to buy an agreed quantity of a
particular commodity or financial instrument (the underlying) from the seller o
f the option at a certain time (the expiration date) for a certain price (the st
rike price). The seller (or "writer") is obligated to sell the commodity or fina
ncial instrument should the buyer so decide. The buyer pays a fee (called a prem
ium) for this right.
The buyer of a call option wants the price of the underlying instrument to rise
in the future; the seller either expects that it will not, or is willing to give
up some of the upside (profit) from a price rise in return for the premium (pai
d immediately) and retaining the opportunity to make a gain up to the strike pri
ce (see below for examples).
Call options are most profitable for the buyer when the underlying instrument mo
ves up, making the price of the underlying instrument closer to, or above, the s
trike price. The call buyer believes it's likely the price of the underlying ass
et will rise by the exercise date. The risk is limited to the premium. The profi
t for the buyer can be very large, and is limited by how high underlying's spot
rises. When the price of the underlying instrument surpasses the strike price, t
he option is said to be "in the money".
The call writer does not believe the price of the underlying security is likely
to rise. The writer sells the call to collect the premium. The total loss, for t
he call writer, can be very large, and is only limited by how high the underlyin
g's spot price rises.
The initial transaction in this context (buying/selling a call option) is not th
e supplying of a physical or financial asset (the underlying instrument). Rather
it is the granting of the right to buy the underlying asset, in exchange for a
fee - the option price or premium.
Exact specifications may differ depending on option style. A European call optio
n allows the holder to exercise the option (i.e., to buy) only on the option exp
iration date. An American call option allows exercise at any time during the lif
e of the option.
Call options can be purchased on many financial instruments other than stock in
a corporation. Options can be purchased on futures on interest rates, for exampl
e (see interest rate cap), and on commodities like gold or crude oil. A tradeabl
e call option should not be confused with either Incentive stock options or with
a warrant. An incentive stock option, the option to buy stock in a particular c
ompany, is a right granted by a corporation to a particular person (typically ex
ecutives) to purchase treasury stock. When an incentive stock option is exercise
d, new shares are issued. Incentive stock options are not traded on the open mar
ket. In contrast, when a call option is exercised, the underlying asset is trans
ferred from one owner to another.
Contents [hide]
1 Example of a call option on a stock
2 Value of a call
3 Price of options
4 Options
5 See also
6 References

[edit] Example of a call option on a stock

Payoff from buying a call.
Payoff from writing a call.An investor typically 'buys a call' when he or she ex
pects the price of the underlying instrument will go above the call's 'strike pr
ice,' hopefully significantly so, before the call expires. The investor pays a n
on-refundable premium for the legal right to exercise the call at the strike pri
ce, meaning he or she can purchase the underlying instrument at the strike price
. Typically, if the price of the underlying instrument has surpassed the strike
price, the buyer pays the strike price to actually purchase the underlying instr
ument, and then sells the instrument and pockets the profit. Of course, the inve
stor can also hold onto the underlying instrument, if he or she feels it will co
ntinue to climb even higher.
An investor typically 'writes a call' when he or she expects the price of the un
derlying instrument to stay below the call's strike price. The writer (seller) r
eceives the premium upfront as his or her profit. However, if the call buyer dec
ides to exercise his option to buy, then the writer has the obligation to sell t
he underlying instrument at the strike price. Oftentimes the writer of the call
does not actually own the underlying instrument, and must purchase it on the ope
n market in order to be able to sell it to the buyer of the call. The seller of
the call will lose the difference between his or her purchase price of the under
lying instrument and the strike price. This risk can be huge if the underlying i
nstrument skyrockets unexpectedly in price.
The current price of ABC Corp stock is $45 per share, and investor 'Chris' expec
ts it will go up significantly. Chris buys a call contract for 100 shares of ABC
Corp from 'Sumner,' who is the call writer/seller. The strike price for the con
tract is $50 per share, and Chris pays a premium upfront of $5 per share, or $50
0 total. If ABC Corp does not go up, and Chris does not exercise the contract, t
hen Chris has lost $500. However, ABC Corp stock does go up -- to $60 per share
before the contract is expired. Chris exercises the call by buying 100 shares of
ABC from Sumner, for a total of $5,000. Chris sells the stock in the market, at
a total price of $6,000. Chris has paid a $500 contract premium plus a stock co
st of $5000, for a total of $5500. Chris has earned back $6000, for a net profit
of $500. Sumner, however, did not do so well. Sumner did not already own ABC Co
rp stock, so when Chris exercised the contract Sumner had to buy the stock on th
e open market, at $6000. Sumner had already earned the $500 premium for the cont
ract and $5000 from Chris on selling the stock, so the total loss for Sumner was
$500.
What if ABC stock price had dropped to $40 per share? Chris would not have exerc
ised the option. (Why buy a stock at $50 per share from Sumner when Chris could
buy it on the open market at $40 per share?) Chris would have lost his premium,
a total of $500. Sumner, however, would have earned the premium with no other ou
t of pocket expenses, for a profit of $500.
[edit] Value of a call
This examples lead to the following formal reasoning. Fix an underlying financi
al instrument. Let ? be a call option for this instrument, purchased at time 0,
expiring at time , with exercise (strike) price ; and let be the price of the u
nderlying instrument.
Assume the owner of the option ?, wants to make no loss, and does not want to ac
tually possess the underlying instrument, . Then either (i) the person will exer
cise the option and purchase , and then immediately sell it; or (ii) the person
will not exercise the option (which subsequently becomes worthless). In (i), the
pay-off would be - K + ST; in (ii) the pay-off would be 0. So if (i) or (ii) o
ccurs; if ST - K < 0 then (ii) occurs.
Hence the pay-off, i.e. the value of the call option at expiry, is

which is also written or (ST - K) + .

[edit] Price of options
Option values vary with the value of the underlying instrument over time. The pr
ice of the call contract must reflect the "likelihood" or chance of the call fin
ishing "in-the-money." The call contract price generally will be higher when the
contract has more time to expire (except in cases when a significant dividend i
s present) and when the underlying financial instrument shows more volatile. Det
ermining this value is one of the central functions of financial mathematics. Th
e most common method used is the Black-Scholes formula. Whatever the formula use
d, the buyer and seller must agree on the initial value (the premium or price of
the call contract), otherwise the exchange (buy/sell) of the call will not take
place.
[edit] Options
Binary option
Bond option
Credit default option
Exotic interest rate option
Foreign exchange option
Interest rate cap and floor
Options on futures
Stock option
Swaption
Warrant (finance)

Put option
From Wikipedia, the free encyclopedia
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It has been suggested that Naked put be merged into this article or section. (D
iscuss)
A put option (usually just called a "put") is a financial contract between two p
arties, the writer (seller) and the buyer of the option. The buyer acquires a lo
ng position by purchasing the right to sell the underlying instrument to the sel
ler of the option for a specified price (the strike price) during a specified pe
riod of time. If the option buyer exercises their right, the seller is obligated
to buy the underlying instrument from them at the agreed upon strike price, reg
ardless of the current market price. In exchange for having this option, the buy
er pays the seller or option writer a fee (the option premium).
By providing a guaranteed buyer and price for an underlying instrument (for a sp
ecified span of time), put options offer insurance against excessive loss. Simil
arly, the seller of put options profits by selling options that are not exercise
d. Such is the case when the ongoing market value of the underlying instrument m
akes the option unnecessary; i.e. the market value of the instrument remains abo
ve the strike price during the option contract period.
Purchasers of put options may also profit from the ability to sell the underlyin
g instrument at an inflated price (relative to the current market value) and rep
urchase their position at the much reduced current market price.
Contents [hide]
1 Instrument models
2 Example of a put option on a stock
3 Value of a put
4 See also
4.1 Options
5 External links

[edit] Instrument models

The terms for exercising the option's right to sell it differ depending on optio
n style. A European put option allows the holder to exercise the put option for
a short period of time right before expiration, while an American put option all
ows exercise at any time before expiration.
The most widely-traded put options are on equities, but they are traded on many
other instruments such as interest rates (see interest rate floor) or commoditie
s.
The put buyer either believes that the underlying asset's price will fall by the
exercise date or hopes to protect a long position in it. The advantage of buyin
g a put over short selling the asset is that the option owner's risk of loss is
limited to the premium paid for it, whereas the asset short seller's risk of los
s is unlimited (its price can rise greatly, in fact, in theory it can rise infin
itely, and such a rise is the short seller's loss.) The put buyer's prospect (ri
sk) of gain is limited to the option's strike price less the underlying's spot p
rice and the premium/fee paid for it.
The put writer believes that the underlying security's price will rise, not fall
. The writer sells the put to collect the premium. The put writer's total potent
ial loss is limited to the put's strike price less the spot and premium already
received. Puts can be used also to limit the writer's portfolio risk and may be
part of an option spread.
A naked put, also called an uncovered put, is a put option whose writer (the sel
ler) does not have a position in the underlying stock or other instrument. This
strategy is best used by investors who want to accumulate a position in the unde
rlying stock, but only if the price is low enough. If the buyer fails to exercis
e the options, then the writer keeps the option premium as a 'gift' for playing
the game.
If the underlying stock's market price is below the option's strike price when e
xpiration arrives, the option owner (buyer) can exercise the put option, forcing
the writer to buy the underlying stock at the strike price. That allows the exe
rciser (buyer) to profit from the difference between the stock's market price an
d the option's strike price. But if the stock's market price is above the option
's strike price at the end of expiration day, the option expires worthless, and
the owner's loss is limited to the premium (fee) paid for it (the writer's profi
t).
The seller's potential loss on a naked put can be substantial. If the stock fall
s all the way to zero (bankruptcy), his loss is equal to the strike price (at wh
ich he must buy the stock to cover the option) minus the premium received. The p
otential upside is the premium received when selling the option: if the stock pr
ice is above the strike price at expiration, the option seller keeps the premium
, and the option expires worthless. During the option's lifetime, if the stock m
oves lower, the option's premium may increase (depending on how far the stock fa
lls and how much time passes). If it does, it becomes more costly to close the p
osition (repurchase the put, sold earlier), resulting in a loss. If the stock pr
ice completely collapses before the put position is closed, the put writer poten
tially can face catastrophic loss.
[edit] Example of a put option on a stock
Payoff from buying a put.
Payoff from writing a put.Buying a put:
A Buyer thinks price of a stock will decrease.
Pay a premium which buyer will never get back,
unless it is sold before expiration.
The buyer has the right to sell the stock
at strike price.
Writing a put:
Writer receives a premium.
If buyer exercises the option,
writer will buy the stock at strike price.
If buyer does not exercise the option,
writer's profit is premium.
'Trader A' (Put Buyer) purchases a put contract to sell 100 shares of XYZ Corp.
to 'Trader B' (Put Writer) for $50/share. The current price is $55/share, and 'T
rader A' pays a premium of $5/share. If the price of XYZ stock falls to $40/shar
e right before expiration, then 'Trader A' can exercise the put by buying 100 sh
ares for $4,000 from the stock market, then selling them to 'Trader B' for $5,00
0.
Trader A's total earnings (S) can be calculated at $500.
Sale of the 100 shares of stock at strike price of $50
to 'Trader B' = $5,000 (P)
Purchase of 100 shares of stock at $40 = $4,000 (Q)
Put Option premium paid to Trader B for buying the contract of
100 shares @ $5/share, excluding commissions = $500 (R)
S=P-(Q+R)=$5,000-($4,000+$500)=$500
If, however, the share price never drops below the strike price (in this case, $
50), then 'Trader A' would not exercise the option. (Why sell a stock to 'Trader
B' at $50, if it would cost 'Trader A' more than that to buy it?). Trader A's o
ption would be worthless and he would have lost the whole investment, the fee (p
remium) for the option contract, $500 (5/share, 100 shares per contract). Trader
A's total loss are limited to the cost of the put premium plus the sales commis
sion to buy it.
A put option is said to have intrinsic value when the underlying instrument has
a spot price (S) below the option's strike price (K). Upon exercise, a put optio
n is valued at K-S if it is "in-the-money", otherwise its value is zero. Prior t
o exercise, an option has time value apart from its intrinsic value. The followi
ng factors reduce the time value of a put option: shortening of the time to expi
re, decrease in the volatility of the underlying, and increase of interest rates
. Option pricing is a central problem of financial mathematics.
[edit] Value of a put
This examples lead to the following formal reasoning. Fix an underlying financi
al instrument. Let ? be a put option for this instrument, purchased at time 0, e
xpiring at time , with exercise (strike) price ; and let be the price of the un
derlying instrument.
Assume the owner of the option ?, wants to make no loss, and does not want to ac
tually possess the underlying instrument, . Then either (i) the person will purc
hase at expiry, and then immediately exercise the selling option; or (ii) the p
erson will not exercise the option (which subsequently becomes worthless). In (i
), the pay-off would be - ST + K; in (ii) the pay-off would be 0. So if (i) or
(ii) occurs; if K - ST < 0 then (ii) occurs.
Hence the pay-off, i.e. the value of the put option at expiry, is

which is alternatively written or (K - ST) + .