Options are interesting for several reasons. Puts and calls on underlying securities are widely traded and allow investors to transfer risk. Many types of bonds have options embedded in the underlying security, including callable bonds and putable bonds, discussed in a separate chapter. In addition, many corporations give their employees options on the company's stock as a part of their compensation.
There are two types of options: European and American. European options can be exercised only at expiration. American options can be exercised at any time. Most options traded in the United States are American options.
A call option is the right to purchase the underlying asset for a specified exercise price until the expiration date. After the expiration date, the option is worthless. The following notation is used:
C = market value of the call option
P = market value of underlying asset
E = exercise price (strike price)
If the price of the underlying asset (P) is less than the exercise price (E), the call is described as being out-of-the-money. If P equals E, the call option is described as being at-the-money. If the price of the underlying asset exceeds the exercise price (P > E), the call option is described as being in-the-money.
To understand how options are priced, the potential option worth at the expiration date needs to be considered. At expiration, the value of the call must be 0 if the market value of the ...