Options: Basics and Valuation

Options, like futures and forwards, are derivative instruments that provide the opportunity to buy or sell an underlying asset with a specific expiration date. However, a long option gives the holder the right, not the obligation, to buy (call) or sell (put) an underlying asset. On the other hand, the holder of the short option or the option seller has the obligation to fulfil the option buyer’s right to buy or sell. For the right to purchase or sell an underlying asset, an option premium is paid from the buyer to the seller of the option. By contrast, futures and forwards involve no cash upfront payment. The chapter begins with the basic characteristics and the profit and loss calculation of call and put options. This is followed by an examination of option pricing using the one-stage and two-stage binomial model, the Black–Scholes model, and put–call parity. The leverage is then described, which reflects the return leverage of options against the underlying asset. The chapter ends with the option price sensitivities. They allow to examine how much the option price changes when a risk factor (e.g. price or price volatility of underlying) moves. Options on individual stocks, also called equity options, are among the most popular and are subsequently used to illustrate the profit and loss calculation, the pricing, the leverage effect, and the option price sensitivities.