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Understanding Options

If you have managed to reach this point, you are probably in need of a rest and a stiff gin and tonic. So we will summarize what we have learned so far and take up the subject of options again in the next chapter when you are rested (or drunk).

There are two types of option. An American call is an option to buy an asset at a specified exercise price on or before a specified maturity date. Similarly, an American put is an option to sell the asset at a specified price on or before a specified date. European calls and puts are exactly the same except that they cannot be exercised before the specified maturity date. Calls and puts are the basic building blocks that can be combined to give any pattern of payoffs.

What determines the value of a call option? Common sense tells us that it ought to depend on three things:

  1. To exercise an option you have to pay the exercise price. Other things being equal, the less you are obliged to pay, the better. Therefore, the value of a call option increases with the ratio of the asset price to the exercise price.
  2. You do not have to pay the exercise price until you decide to exercise the option. Therefore, a call option gives you a free loan. The higher the rate of interest and the longer the time to maturity, the more this free loan is worth. So the value of a call option increases with the interest rate and time to maturity.
  3. If the price of the asset falls short of the exercise price, you won't exercise the call option. You will, therefore, lose 100% of your investment in the option no matter how far the asset depreciates below the exercise price. On the other hand, the more the price rises above the exercise price, the more profit you will make. Therefore the option holder does not lose from increased volatility if things go wrong, but gains if they go right. The value of an option increases with the variance per period of the stock return multiplied by the number of periods to maturity.

Always remember that an option written on a risky (high-variance) asset is worth more than an option on a safe asset. It's easy to forget, because in most other financial contexts increases in risk reduce present value.

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