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The document discusses option moneyness and how an option's strike price determines if it is in-the-money, at-the-money, or out-of-the-money. It also discusses how options provide leverage but also come with risk, such as losing the entire premium if the option expires worthless. Additionally, it explains that an option premium has intrinsic value and time value components, and how factors like time decay, volatility, and dividends affect the premium. Finally, it provides examples of the payoffs for long and short positions in call and put options.
The document discusses option moneyness and how an option's strike price determines if it is in-the-money, at-the-money, or out-of-the-money. It also discusses how options provide leverage but also come with risk, such as losing the entire premium if the option expires worthless. Additionally, it explains that an option premium has intrinsic value and time value components, and how factors like time decay, volatility, and dividends affect the premium. Finally, it provides examples of the payoffs for long and short positions in call and put options.
The document discusses option moneyness and how an option's strike price determines if it is in-the-money, at-the-money, or out-of-the-money. It also discusses how options provide leverage but also come with risk, such as losing the entire premium if the option expires worthless. Additionally, it explains that an option premium has intrinsic value and time value components, and how factors like time decay, volatility, and dividends affect the premium. Finally, it provides examples of the payoffs for long and short positions in call and put options.
• This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock). • An investor can see large percentage gains from comparatively small, favourable percentage moves in the underlying product. Leverage and Risk • Leverage also has downside implications. • If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage could magnify the investment's percentage loss. • Options offer their owners a predetermined, set risk. • However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. • An uncovered option writer may face unlimited risk. In-the-money, At-the-money, Out- of-the-money
An option’s strike price, or exercise price, determines
whether a contract is in-the-money, at-the-money, or out- of-the-money.
If the strike price of a call option is less than the current
market price of the underlying security, the call is said to be in-the-money. (Market Price > Strike Price)
This is because the holder of this call has the right to
buy the stock at a price less than the price he would pay to buy the stock in the stock market. In-the-money, At-the-money, Out- of-the-money Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is said to be in-the-money,
because the holder of this put has the
right to sell the stock at a price greater than the price he would receive selling the stock in the stock market. Out of the Money • The inverse of in-the-money is out-of-the-money. • If the strike price of a call (right to buy) option is more than the current market price of the underlying security, the call is said to be out-the-money • This is because the holder of this call allows the option to expire worthless.
• Likewise, if a put (right to sell) option has a strike price
that is less than the current market price of the underlying security, it is said to be out-the-money. • This is because the holder of this put allows the option to expire worthless. At the money • If the strike price equals the current market price, the option is said to be at-the-money. Equity Call Option • In-the-money = strike price less than stock price • At-the-money = strike price same as stock price • Out-of-the-money = strike price greater than stock price Equity Put Option • In-the-money = strike price greater than stock price • At-the-money = strike price same as stock price • Out-of-the-money = strike price less than stock price Option Premium • Intrinsic Value + Time Value Factors having a significant effect on options premium include: • Underlying price • Strike • Time until expiration • Implied volatility • Dividends • Interest rate Main Components of an Option's Premium • An option’s premium has two main components: intrinsic value and time value. Intrinsic Value (Calls) • A call option is in-the-money when the underlying security's price is higher than the strike price. Intrinsic Value (Puts)
• A put option is in-the-money if the
underlying security's price is less than the strike price. • Only in-the-money options have intrinsic value. • It represents the difference between the current price of the underlying security and the option's exercise price, or strike price. Intrinsic Value • The amount that an option, call or put is in- the-money at any time is called intrinsic value. • By definition, an at-the-money or out-of- the-money option has no intrinsic value. • This does not mean investors can obtain these options at no cost. Intrinsic Value • Fluctuations in volatility, • interest rates, • dividend amounts and • the passage of time • all affect the time value portion of an option’s premium. • These factors give options value and therefore affect the premium at which they are traded. Time Value
• Time value is any premium in excess of
intrinsic value before expiration. • Time value is often explained as the amount an investor is willing to pay for an option above its intrinsic value. • This amount reflects hope that the option’s value increases before expiration due to a favourable change in the underlying security’s price. • The longer the amount of time available for market conditions to work to an investor's benefit, the greater the time value. Time Decay
• The longer the time remaining until an
option's expiration, the higher its premium will be. • This is because the longer an option's lifetime, the greater the possibility that the underlying share price might move the option in-the-money. Time Decay
• Even if all other factors affecting an
option's price remain the same, • the time value portion of an option's premium will decrease (or decay) with the passage of time. • The intrinsic value of an option is defined as the maximum of zero and the value the option would have if it were exercised immediately. • For a call option, the intrinsic value is therefore max(S – K, 0). For a put option, it is max (K - S, 0). An in-the-money American option must be worth at least as much as its intrinsic value because the holder can realize the intrinsic value by exercising immediately. Often it is optimal for • the holder of an in-the-money American option to wait rather than exercise immediately. Payoffs from Long and Short Call Positions • Consider an example. • Suppose you have a call option to buy the stock of XY Z corporation at a strike price of K = 100. • What will you do on date T ? • If the price ST of XY Z is less than 100, it is obviously best to let the option lapse: • There is no point paying K = 100 for a stock that is worth less than that amount. • The call is said to be out-of-the-money in this case. • If ST = 100(stock price), then you are indifferent between exercising the option and not exercising the option (although transactions costs, which we ignore, may push you towards not exercising). • The call is said to be at-the-money in this case. • Finally, if ST > 100, it is very much in your interest to exercise the call: the call allows you to buy for 100 an asset that is worth ST > 100. • The call is said to be in-the-money in this case. The profit from exercising the call is ST −100; the higher is ST , the greater the profits. • What about the short position who sold you the option? • The short position has only a contingent obligation in the contract; the decision on exercise is made by buyer with the long position. • So to identify the payoffs to the short, we must see when the option will be exercised by the long position and calculate the consequences to the short. Long Call Pay offs / Short Call Pay offs Payoffs from Long and Short Put Positions • Consider the payoffs to a long position in a put on XY Z stock with a strike of K = 100. • If the price ST < 100, it is in the long position’s interest to exercise the put; • The put enables the long to sell for K = 100 an asset that is worth ST < 100. • The put is in-the money in this case. • The payoff from exercise is 100 − ST . The lower is ST , the greater the profit from exercising the put. Long Put • If ST = 100, the long is indifferent between exercising and not exercising the put; • Either action leads to a payoff of zero. • The put is said to be at-the-money in this case. • If ST > 100, it is obviously best to let the option lapse: there is no point in selling for K = 100 a stock that is worth more than 100. • The put is said to be out-of-the-money in this case. Short Put Pay offs • The payoffs to the short position are the reverse of the payoffs to the long; • IfST < 100, the short position buys for K = 100 an asset that is worth ST < 100. • The short loses 100− ST . For example, if ST = 90, the short is buying for 100 a stock worth only 90, so loses 10. At ST = 80, the loss climbs to 20. And so on. • If ST = 100, the payoff to the short is zero. • If ST > 100, the put lapses unexercised, and the payoff to the short is once again zero. Pay offs Long Put / Short Put