8: OptionsCall options grant investors the right to purchase a share for a fairly short time period, usually just
a few months.^1 The point at which this right expires is called the option’s expiration date. An American call
option gives holders the right to purchase shares at a fixed price, on or before its expiration date, whereas
a European call option grants that right only on the expiration date. If we compare the prices of two options
that are identical in every respect, except that one is American and one is European, the price of the
American option should be at least as high as the European option because of the American option’s
greater flexibility.
A put option grants the right to sell a share at a fixed price on or before a certain date. The right to
sell shares at a fixed price becomes more and more valuable as the price of the underlying share price
decreases. Thus, we have the most basic distinction between put and call options: put options rise in
value as the underlying price goes down, whereas call options increase in value as the underlying share
price goes up. Just like call options, put options specify both an exercise price at which investors can sell
the underlying shares and an expiration date at which the right to sell vanishes. Also, put options come
in American and in European varieties, as do call options.
The most distinctive feature of options, both puts and calls, can be deduced from the term option.
Investors who own calls and puts have the right to buy or sell shares, but they are not obligated to do so.
This feature creates an asymmetry in option payoffs, and that asymmetry is central to understanding how
to use options effectively and how to price them, as we will soon see.8 -1a OPTION TradING
An important feature distinguishing calls and puts from other securities we’ve studied, such as shares
and bonds, is that options are not necessarily issued by companies.^2 Rather, an option is a contract
between two parties, neither of whom need have any connection to the company whose shares serve
as the underlying asset for the contract. For example, suppose Tony and Oscar, neither of whom works
for BHP Billiton, decide to enter into an option contract. Tony agrees to pay Oscar $3 for the right to
purchase one ordinary share in BHP Billiton for $20 at any time during the next month. As the option
buyer, Tony has a long position in a call option. He can decide at any point whether or not he wants to
exercise the option. If he chooses to exercise his option, he will pay Oscar $20, and Oscar will deliver one
share in BHP Billiton to Tony. Naturally, Tony will choose to exercise the option only if BHP Billiton
shares are worth more than $20 each. If BHP Billiton shares are worth less than $20, Tony will let the
option expire worthless and will lose his $3 investment.
On the other side of this transaction, Oscar, as the seller of the option, has a short position in
a call option.^3 If Tony decides to exercise his option, Oscar’s obligation is to follow through on his
promise to deliver one share of BHP Billiton for $20. If Oscar does not already own a share of BHP
Billiton, he can buy one in the market. Why would Oscar agree to this arrangement? Because he
receives the option premium, the $3 payment that Tony made at the beginning of their agreement. If
BHP Billiton’s share price rises above $20, Oscar will lose part or all of the option premium because1 Employee share options, which typically give workers the right to buy shares at a fixed price for up to 10 years, are an important exception to
this rule. Some publicly traded options have long expiration dates, too, such as the long-term equity anticipation securities (LEAPS) introduced
by the American Stock Exchange in 1990.
2 This is not to say that companies cannot issue options if they want to. Companies do issue options to employees and may also sell options,
as part of their risk management activities, or bundle options with other securities, such as bonds and preferred shares, that they sell to raise
capital. Options issued by companies on their own shares are called warrants, and these are discussed later in this chapter.
3 We may also say that Oscar writes an option when he sells the option to Tony.LO8.1 expiration date
The date on which the right to
buy or to sell the underlying
asset expires
American call option
An option that grants the right
to buy an underlying asset, on
or before the expiration date
European call option
An option that grants the right
to buy the underlying asset
only on the expiration date
put option
An option that grants the right
to sell an underlying asset at a
fixed price
long position
To own an option or another
security
exercise the option
Pay (receive) the strike price
and buy (sell) the underlying
asset
short position
To sell an option or another
security
option premium
The market price of the option
Myron Scholes, Stanford
University and Chairman of
Oak Hill Platinum Partners
‘Options markets have
grown dramatically over
the last thirty years.’
See the entire interview on
the CourseMate website.COurSeMaTe
SMarT VIdeO